Chapter 10, Problem 10.4EYCT

(a)

To determine

Liquidity ratio

Liquidity ratio measures the short-term capacity of a company to pay its maturing obligations and to meet unanticipated requirements for cash. Liquidity ratios are current ratio, working capital ratio, acid test ratio and more.

Solvency ratio

Solvency ratio measures the capacity of a company to sustain over a long period of time. Solvency ratios are debt to assets ratio, time interest earned ratio, debt to equity ratio, and more.

To Calculate: The working capital and current ratio of Company H and Company HD.

Answer to Problem 10.4EYCT

Calculate working capital of Company H as shown below:

  $\begin{array}{c}\text{Working capital}\text{=}\text{Current assets }-\text{Current liabilites}\\ \text{=}\text{\$1,153}\text{Million}-\$938\text{Million}\\ \text{=}\text{\$215}\text{Million}\end{array}$

Hence, working capital of Company H is $215 million.

Calculate working capital of Company HD as shown below:

  $\begin{array}{c}\text{Working capital}\text{=}\text{Current assets }-\text{Current liabilites}\\ \text{=}\text{\$4,933}\text{Million}-\$2,857\text{Million}\\ \text{=}\text{\$2,076}\text{Million}\end{array}$

Hence, working capital of HD is $2,076 million.

Calculate Current ratio of Company H as shown below:

  $\begin{array}{c}\text{Current ratio =}\frac{\text{Current assets}}{\text{Current liabilites}}\\ =\frac{\$1,153\text{Million}}{\$938\text{Million}}\\ =1.23:1\end{array}$

Hence, current ratio of Company H is 1.23:1.

Calculate Current ratio of Company HD as shown below:

  $\begin{array}{c}\text{Current ratio =}\frac{\text{Current assets}}{\text{Current liabilites}}\\ =\frac{\$4,933\text{Million}}{\$2,857\text{Million}}\\ =1.73:1\end{array}$

Hence, current ratio of Company HD is 1.73:1.

Explanation of Solution

Working capital is calculated by deducting current liabilities from current assets. Hence, working capital of Company H is $215 million, and working capital of HD is $2,076 million. Current ratio is calculated by dividing current assets with current liabilities. Hence, current ratio of Company H is 1.23:1 and current ratio of Company HD is 1.73:1.

To determine

To Discuss: The relative liquidity of company H and HD.

Explanation of Solution

Computation of current ratio of the Company H is 1.23: 1 which is lesser than the Company HD is 1.73: 1. Hence, Company HD current ratio is 50% greater than the Company H current ratio.

(b)

To determine

To Compute: The debt to asset ratio and Times interest earned ratio for Company H and Company HD.

Answer to Problem 10.4EYCT

Calculate debt to asset ratio for Company H as shown below:

  $\begin{array}{c}\text{Debt to assets ratio = }\frac{\text{Total liabilites}}{\text{Total assets}}\times 100\\ =\frac{\$1,339\text{Million}}{\$1,577\text{Million}}\times 100\\ =85\%\end{array}$

Therefore, Company H, debt to assets ratio is 85%.

Calculate debt to asset ratio for Company HD as shown below:

  $\begin{array}{c}\text{Debt to assets ratio = }\frac{\text{Total liabilites}}{\text{Total assets}}\times 100\\ =\frac{\$4,716\text{Million}}{\$13,465\text{Million}}\times 100\\ =35\%\end{array}$

Therefore, Company HD, debt to assets ratio is 35%.

Calculate the times interest earned ratio for the Company H as shown below:

$\begin{array}{c}\text{Times interest earned ratio}\text{=}\frac{\text{Income before interest expense and income taxes}}{\text{Interest expense}}\\ =\frac{(\$93\text{Million)}\text{+\$67 Million}+\$3\text{Million}}{\$67\text{Million}}\\ =-3.4\text{Times}\end{array}$

Therefore, Company H, times interest earned ratio is –3.4 times.

Calculate the times interest earned ratio for the Company HD as shown below:

$\begin{array}{c}\text{Times interest earned ratio}\text{=}\frac{\text{Income before interest expense and income taxes}}{\text{Interest expense}}\\ =\frac{\$1,614\text{Million}\text{+\$37 Million}+\$1,040\text{Million}}{\$37\text{Million}}\\ =72.7\text{Times}\end{array}$

Therefore, Company HD, times interest earned ratio is 72.7 times.

Explanation of Solution

Debt to assets ratio is calculated by dividing total liabilities with total assets and multiplying it with 100. Total liabilities are calculated by deducting total shareholders’ equity from total assets. Therefore, Company H, debt to assets ratio is 85% and Company HD, debt to assets ratio is 35%. Times interest earned ratio is calculated by dividing Income before interest expense and income taxes with interest expense. Income before interest expense and income taxes is calculated by adding net income, interest expense and income taxes. Therefore, Company H, times interest earned ratio is –3.4 times and Company HD, times interest earned ratio is 72.7 times.

To determine

To Discuss: The relative solvency of Company H and Company HD.

Explanation of Solution

From the calculation of debt to assets ratio, it is noted that for Company H, it is 85% greater than the Company HD, which is 35%. The higher percentage of debt to assets ratio shows that the Incorporation is at more risk to meet its maturing debts. Hence, Company HD significantly better to meet its obligations comparing to Company H.

The times interest earned ratio identifies a company’s ability to meet interest payments. From the computation of times interest earned ratio, it is found that, Company H’s times interest earned ratio is –3.4 times, which is lesser than Company H, which is 72.7 times. It indicates that Corporation HD has more ability to meet its interest payments than Company H.

(c)

To determine

To Compute: The return on assets and profit margin of Company H and Company HD.

Answer to Problem 10.4EYCT

Calculate return on assets ratio of Company H as shown below:

  $\begin{array}{c}\text{Return on assets = }\frac{\text{Net income}}{\frac{\left(\text{Openning total assets + Ending total assets }\right)}{2}}\\ =\frac{(\$93\text{Million)}}{\frac{(\$1,577\text{Million}\text{+}\text{\$1,668}\text{Million}}{2}}\\ =-5.7\%\end{array}$

Hence, return on assets of Company H is –5.7%.

Calculate return on assets ratio of Company HD as shown below:

  $\begin{array}{c}\text{Return on assets = }\frac{\text{Net income}}{\frac{\left(\text{Openning total assets + Ending total assets }\right)}{2}}\\ =\frac{\$1,614\text{Million}}{\frac{(\$13,465\text{Million}\text{+}\text{\$11,229}\text{Million}}{2}}\\ =13.1\%\end{array}$

Hence, return on assets of Company H is 13.1%.

Calculate profit margin of Company H as shown below:

  $\begin{array}{c}\text{Profit margin =}\frac{\text{Net income }}{\text{Net sales}}\times 100\\ =\frac{(\$93\text{Million)}}{\$3,444\text{Million}}\\ =-2.7\%\end{array}$

Hence, profit margin of Company H is –2.7%.

Calculate profit margin of Company HD as shown below:

  $\begin{array}{c}\text{Profit margin =}\frac{\text{Net income }}{\text{Net sales}}\times 100\\ =\frac{\$1,614\text{Million}}{\$30,219\text{Million}}\\ =5.3\%\end{array}$

Hence, profit margin of Company H is 5.3%.

Explanation of Solution

Return on assets is calculated by dividing net income by average total assets. Average total assets is calculated by adding opening total assets and ending total assets and then divided by 2. Hence, return on assets of Company H is –5.7% and return on assets of Company H is 13.1%. Profit margin is calculated by dividing net income by net sales and then multiplying with 100. Hence, profit margin of Company H is –2.7% and profit margin of Company H is 5.3%.

To determine

To Discuss: The relativity profitability of Company H and Company HD.

Explanation of Solution

Company H’s return on assets is –5.7%, which is lesser than the company HD, which is 13.11%, and Company H’s profit margin is –2.7%, which is lesser than the Company HD, which is 5.3%. The higher percentage of profit margin would get more net income. Therefore, Company HD gets more net income comparing with Company H.

(d)

To determine

To Discuss: The debt to assets ratio before and after lease obligations of Company HD.

Answer to Problem 10.4EYCT

Calculate debt to asset ratio for Company HD before lease obligations, as shown below:

  $\begin{array}{c}\text{Debt to assets ratio = }\frac{\text{Total liabilites}}{\text{Total assets}}\times 100\\ =\frac{\$4,716\text{Million}}{\$13,465\text{Million}}\times 100\\ =35\%\end{array}$

Therefore, Company HD, debt to assets ratio before lease obligations is 35%.

Calculate debt to asset ratio for Company HD after lease obligations as shown below:

  $\begin{array}{c}\text{Debt to assets ratio = }\frac{\text{Total liabilites}}{\text{Total assets}}\times 100\\ =\frac{\$4,716\text{Million}\text{+}\text{\$2,347}\text{Million}}{\$13,465\text{Million}\text{+}\text{\$2,347}\text{Million}}\times 100\\ =45\%\end{array}$

Therefore, Company HD, debt to assets ratio after lease obligations is 45%.

Explanation of Solution

Debt to assets ratio is calculated by dividing total liabilities with total assets, and then multiplying with 100. Total liabilities are calculated by deducting total shareholders’ equity from total assets. Therefore, Company H’s debt to assets ratio is 85%, and Company HD’s debt to assets ratio after lease obligations is 45%.

To determine

To Discuss: The implications of operating lease obligations.

Explanation of Solution

Company HD’s debt to asset ratio is 10% (45% – 35%) increased after operating lease obligations. Though it recommends that support on debt is actually higher than by the  balance sheet. Its support on debt is still quite reasonable.