Chapter 12, Problem 12.4APCA

1.

To determine

To calculate: The following ratios for both the companies for the year ended January 31, 2013.

1. a. Receivable turnover ratio.
2. b. Average collection period.
3. c. Inventory turnover ratio.
4. d. Average days in inventory.
5. e. Current ratio.
6. f. Acid-test ratio.
7. g. Debt to equity ratio.

Explanation of Solution

Current Ratio: A part of liquidity ratios, current ratio reflects the ability to oblige the short term debts of a company. It is calculated based on the current assets and current liabilities; a company has in an accounting period.

Acid-test Ratio: It is a ratio used to determine a company’s ability to pay back its current liabilities by liquid assets that are current assets except inventory and prepaid expenses.

Accounts Receivable Turnover:

The accounts receivable turnover ratio determines the efficiency of a company to use its assets and issue the credit to the customers and collects the funds from them. The accounts receivable turnover is determined by dividing the credit sales by the average accounts receivable of that accounting period.

Average Collection Period:

The average collection period refers to the average number of days which a company takes to collect the accounts receivable. The average collection period is determined by dividing the number of days in a year by the accounts receivable turnover.

Debt to Asset Ratio: Debt to asset ratio is the ration between total asset and total liability of the company. Debt ratio reflects the finance strategy of the company. It is used to evaluate company’s ability to pay its debts. Higher debt ratio implies the higher financial risk.

Inventory turnover ratio: Inventory turnover ratio is a financial measure that is used to evaluate as to how many times a company sells or uses its inventory during an accounting period. It can be calculated by using the following formula:

$\text{Inventory turnover}=\frac{\text{Cost of goods sold}}{\text{Average inventory}}$

Days’ sales in inventory: Days’ sales in inventory are used to determine number of days a particular company takes to make sales of the inventory available with them. The formula to calculate the days’ sales in inventory ratio is as follows:

$\text{Days' sales in inventory}=\frac{\text{Days in accounting period}}{\text{Inventory turnover}}$

The ratios for both the companies for the year ended January 31, 2013 is prepared as follows:

Ratio Analysis
1. Risk Ratios	Company B	Company AE
a. Receivable turnover ratio
Net Sales (A)	$1,124,007	$3,475,802
Beginning Receivables (B)	$4,584	$40,310
Ending Receivables (C)	$3,470	$46,321
Average Receivables (D) [(B + C) ÷ 2]	$4,027	43,315.5
Receivable Turnover (A ÷ D)	279.11	80.24
b. Average collection period
Days' Sales Receivables:
Days in a Year (A)	365	365
Receivable Turnover (B)	279.11	80.24
Days' Sales Outstanding (A ÷ B)	1.30	4.54
	Days	Days
c. Inventory Turnover Ratio
Cost of Goods Sold (A)	$624,692	2,085,480
Beginning Inventories (B)	$104,209	$367,514
Ending Inventories (C)	$103,853	$332,452
Average Inventories (D) [(B + C) ÷ 2]	$104,031	$349,983
Inventory Turnover (A ÷ D)	5.99	5.95
d. Average days in inventory
Days in a Year (A)	365	365
Receivable Turnover (B)	5.99	5.95
Days' Inventory Outstanding (A ÷ B)	60.93	61.34
	Days	Days
e. Current ratio
Total current assets (A)	$276,873	$1,141,800
Total current liabilities (B)	$128,596	$435,902
Current ratio (A÷B)	2.15	2.61
f. Acid-test ratio
Cash	$117,608	$509,119
Short-term investments	$26,414	$121,873
Accounts receivable	$3,470	$46,321
Quick assets  (A)	$147,492	$677,313
Total current liabilities (B)	$128,596	$435,902
Acid-test ratio (A÷B)	1.14	1.55
h. Debt to Equity ratio
Total liabilities (A)	$188,325	$534,866
Total stockholders' equity (B)	$289,649	$1,221,187
Debt to equity ratio (A÷B)	65.01%	43.79%

Table (1)

2.

To determine

To calculate: The Profitability ratios for both companies for the year January 31, 2013.

1. a. Gross profit ratio.
2. b. Return on assets ratio.
3. c. Profit Margin Ratio.
4. d. Asset turnover ratio.
5. e. Return on equity ratio.

Explanation of Solution

Profitability ratios:

In general, financial ratios are used to evaluate capabilities, profitability, and overall performance of a company.

Gross profit ratio:

Gross profit ratio is the financial ratio that shows the relationship between the gross profit and net sales. It represents gross profit as a percentage of net sales. Gross Profit is the difference between the total revenue and the cost of goods sold. It can be calculated by using the following formula:

$\text{Gross}\text{profit ratio}=\frac{\text{Gross}\text{profit}}{\text{Net}\text{sales}}\text{×100}$

Rate of return on total assets:

Rate of return on the total assets is the ratio of the net income, and interest expense to the average total assets. The rate of return on total assets measures the efficiency of the business. It measures how efficiently the business is using its total assets in generating the income.

The rate of return on the total assets is calculated as follows:

$\text{Rate of return on assets=}\frac{\text{Net}\text{income +Interest expense}}{\text{Average total assets}}$

Profit Margin Ratio:

Profit margin provides an indication of the earnings per dollar of sales, and it is determining the net profit as a percentage of the revenues. Use the following formula to calculate the profit margin ratio.

$\text{Profit margin ratio}=\frac{\text{Net}\text{income}}{\text{Net}\text{sales}}\times 100$

Asset turnover ratio:

The Asset turnover is a contrast to the profit margin ratio and it is calculated to determine the net sales and average total assets. Use the following formula to calculate the asset turnover ratio:

$\text{Asset turnover =}\frac{\text{Net}\text{sales}}{\text{Average total assets}}$

Return on equity ratio:

Rate of return on equity ratio is used to determine the relationship between the net income available for the common stockholders’ and the average common equity that is invested in the company.

The Return on equity ratio is calculated as follows:

$\begin{array}{l}\text{Rate of return on common}\\ \text{stockholders' equity}\end{array}\}\text{=}\frac{\text{Net income}}{\text{Average common stockholders' equity}}$

The Profitability ratios for both companies for the year January 31, 2013 is prepared as follows:

Ratio Analysis
1. Profitability Ratios	B Company	AE Company
a. Gross profit ratio
Net sales (A)	$1,124,007	$3,475,802
Gross profit (B)	$499,315	$1,390,322
Gross profit ratio (B÷A)	44.42%	40.00%
b. Rate of return on assets
Net income (A)	$164,305	$232,108
Total assets (2012) ( B )	$531,539	$1,950,802
Total assets (2013) (C)	$477,974	$1,756,053
Average total assets (D) = (B+C)÷2	$504,756.5	$1,853,427.5
Rate of return on assets (A÷E)	32.55%	12.52%
c.  Profit Margin ratio
Net income (A)	$164,305	$232,108
Net sales (B)	$1,124,007	$3,475,802
Profit margin ratio(A)÷(B)	14.61%	6.67%
d. Asset turnover ratio
Net sales (A)	$1,124,007	$3,475,802
Average total assets (B)	$504,756.5	$1,853,427.5
Asset turnover (A÷B)	2.22	1.87
e. Return on equity ratio
Net income (A)	$164,305	$232,108
Stockholders' Equity (2012) (B)	$363,147	$1,416,851
Stockholders' Equity (2013) (C )	$289,649	$1,221,187
Average common stock (D = B+C÷2)	$326,398	$1,319,019
Return on equity ratio (E = A÷D)	50.33%	17.59%

Table (2)