Astro Languet established Languet Products Co. as a soleproprietorship on January 5, 2020. At the company’s year end ofDecember 31, 2020, the accounts had the following balances (inthousands):
| Current assets, excluding inventory | | $10 |
| Other assets | | 107 |
| Current liabilities | | 30 |
| Long-term bank loan | | 50 |
| Owner’s investment (excluding income) | | 40 |
| Purchases during year | | |
| Jan. 2: 5,000 @ $11 | | 55 |
| June 30: 8,000 @ $12 | | 96 |
| Dec. 10: 6,000 @ $16 | | 96 |
| | 247 |
| Sales | | 284 |
| Other expenses | | 40 |
A count of ending inventory on December 31, 2020, showed there were4,000 units on hand.
Astro is now preparing financial statements for the year. He isaware that inventory may be costed using the FIFO or weightedaverage cost formula. He is unsure of which one to use and asks foryour assistance. In discussions with Astro, you learn thefollowing.
| 1. | | Suppliers to Languet Products provide goods at regular pricesas long as Languet Products’ current ratio is at least 2 to 1. Ifthis ratio is lower, the suppliers increase their price by 10% inorder to compensate for what they consider to be a substantialcredit risk. |
| 2. | | The terms of the long-term bank loan include the bank’s abilityto demand immediate repayment of the loan if the debt to totalassets ratio is greater than 45%. |
| 3. | | Astro thinks that, for the company to be a success, the rate ofreturn on total assets should be at least 30%. |
| 4. | | Astro has an agreement with the company’s only employee that,for each full percentage point above a 25% rate of return on totalassets, she will be given an additional one day off with pay in thefollowing year. |
a) Discuss the impact of using the FIFO cost formula versus theweighted average cost formula on the key ratios.
| Current ratio: |
| FIFO: | | 2.47 |
| W.A.: | | 2.07 |
| | |
| Debt to total assets ratio: |
| FIFO: | | 44.2% |
| W.A: | | 47.3% |
| | |
| Rate of return on totalassets: |
| FIFO: | | 33.7% |
| W.A.: | | 29.0% |
b) Which method do you recommend? Explain briefly.
c) Considering the choice of inventory cost formulas that areavailable, do the ratios noted above adequately measure thefinancial performance of Languet Products from the perspective ofthe users?
