Chapter 13, Problem 13.13E

(a)

To determine

Financial Ratios: Financial ratios are the metrics used to evaluate the liquidity, capabilities, profitability, and overall performance of a company.

To compute: Current ratio for 2017 and 2016

Explanation of Solution

Given info: Balance sheet and Income statement

Current ratio for 2017

$\begin{array}{c}\text{Current}\text{ratio}=\frac{\text{Current}\text{assets}}{\text{Current}\text{liabilities}}\\ =\frac{\text{\$1,390}}{\text{\$820}}\\ =\text{1}\text{.70:1}\end{array}$

Current ratio for 2016

$\begin{array}{c}\text{Current}\text{ratio}=\frac{\text{Current}\text{assets}}{\text{Current}\text{liabilities}}\\ =\frac{\text{\$1,310}}{\text{\$790}}\\ =\text{1}\text{.66:1}\end{array}$

Current Ratio: Current ratio is used to determine the relationship between current assets and current liabilities. The ideal current ratio is 2:1.

Formula:

$\text{Current ratio}=\frac{\text{Current assets}}{\text{Current}\text{liabilities}}$

Corporation N’s current ratio is 1.70:1 in the year 2017 and1.66:1 in the year 2016. Thus, the current ratio of Corporation N has increased in the year2017.

(b)

To determine

To compute: Inventory turnover ratio for 2017 and 2016

Explanation of Solution

Given info: Balance sheet and Income statement

Inventory Turnover Ratio for 2017

$\begin{array}{c}\text{Inventory}\text{turnover}\text{ratio}=\frac{\text{Cost}\text{of}\text{goods}\text{sold}}{\text{Average}\text{inventory}}\\ =\frac{\text{\$970}}{\text{\$425 }}\\ =\text{2}\text{.28 times}\end{array}$

Inventory Turnover Ratio for 2016

$\begin{array}{c}\text{Inventory}\text{turnover}\text{ratio}=\frac{\text{Cost}\text{of}\text{goods}\text{sold}}{\text{Average}\text{inventory}\left(\text{Refer 1}\right)}\\ =\frac{\text{\$890}}{\text{\$365}}\\ =\text{2}\text{.44 times}\end{array}$

Inventory turnover ratio is used to determine the number of times inventory used or sold during the particular accounting period.

Formula:

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

Average inventory for 2017 and 2016 is determined as follows:

Average inventory for 2017

$\begin{array}{c}\text{Average inventory}=\frac{\text{Opening}\text{inventory}+\text{Closing}\text{inventory}}{\text{2}}\\ =\frac{\$390+\$460}{2}\\ =\$425\end{array}$

Average inventory for 2016

$\begin{array}{c}\text{Average inventory}=\frac{\text{Opening}\text{inventory}+\text{Closing}\text{inventory}}{\text{2}}\\ =\frac{\text{\$340}+\text{\$390}}{\text{2}}\\ =\text{\$365}\end{array}$

Note: Inventory on 12/31/15 was $340 (Opening inventory)

Corporation N’s inventory turnover ratio for 2017 is 2.28 times and for 2016 is 2.44 times. The ratio has decreased when compared to 2016.

(c)

To determine

To compute: Profit margin ratio for 2017 and 2016

Explanation of Solution

Given info: Balance sheet and Income statement

Profit margin ratio for 2017

$\begin{array}{c}\text{Profit margin ratio}=\frac{\text{Net}\text{income}}{\text{Net}\text{sales}}\\ =\frac{\text{\$252}}{\text{\$3,800}}\\ =6.63\text{\%}\end{array}$

Profit margin ratio for 2016

$\begin{array}{c}\text{Profit margin ratio}=\frac{\text{Net}\text{income}}{\text{Net}\text{sales}}\\ =\frac{\text{\$132}}{\text{\$3,460}}\\ =3.82\text{\%}\end{array}$

Profit margin ratio is used to determine the percentage of net income that is being generated per dollar of revenue or sales.

Formula: $\text{Profit Margin}=\frac{\text{Net}\text{income}}{\text{Net}\text{revenue}}$

Hence, profit margin ratio for 2016 and 2017 is 3.82% and 6.63% respectively. This ratio has increased because net income is increased.

(d)

To determine

To compute: Return on assets ratio for 2017 and 2016

Explanation of Solution

Given info: Balance sheet and Income statement

Return on assets ratio for 2017

$\begin{array}{c}\text{Return}\text{on}\text{assets}=\frac{\text{Net}\text{income}}{\text{Average}\text{assets}}\\ =\frac{\text{\$252}}{\text{\$2,275}}\\ =11.\text{08\%}\end{array}$

Return on assets ratio for 2016

$\begin{array}{c}\text{Return}\text{on}\text{assets}=\frac{\text{Net}\text{income}}{\text{Average}\text{assets}}\\ =\frac{\text{\$132}}{\text{\$2,055 }}\\ =6.42\text{\%}\end{array}$

Return on assets determines the particular company’s overall earning power.

Formula:

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

Average total assets are determined by dividing opening and closing total assets by 2. It is calculated as follows:

Average assets for 2017

$\begin{array}{c}\text{Average assets}=\frac{\text{Opening}\text{balance}\text{of}\text{assets}+\text{Closing}\text{balance}\text{of}\text{assets}}{\text{2}}\\ =\frac{\text{\$2,210}+\text{\$2,340}}{\text{2}}\\ =\text{\$2,275}\end{array}$

Average assets for 2016

$\begin{array}{c}\text{Average assets}=\frac{\text{Opening}\text{balance}\text{of}\text{assets}+\text{Closing}\text{balance}\text{of}\text{assets}}{\text{2}}\\ =\frac{\text{\$1,900}+\text{\$2,210}}{\text{2}}\\ =\text{\$2,055}\end{array}$

Note: Assets 12/31/15 was $1,900 (Opening balance)

Hence, rate of return on assets for 2017 and 2016 is 11.08% and 6.42% respectively. This ratio has increased because net income is increased.

(e)

To determine

To compute: Return on common stockholders’ equity for 2017 and 2016

Explanation of Solution

Given info: Balance sheet and Income statement

Return on common stockholders’ equity for 2017

$\begin{array}{c}\text{Return}\text{on}\text{common}\text{stockholders'}\text{equity}=\frac{\text{Net}\text{income}}{\text{Average}\text{stockholders' equity}}\\ =\frac{\text{\$252}}{\text{\$1,040}}\\ =\text{24}\text{.23\%}\end{array}$

Return on common stockholders’ equity for 2016

$\begin{array}{c}\begin{array}{l}\text{Return}\text{on}\text{common}\\ \text{stockholders'}\text{equity}\end{array}\}=\frac{\text{Net}\text{income}}{\text{Average}\text{stockholders'}\text{equity}}\\ =\frac{\text{\$132}}{\text{\$970}}\\ =13.61\text{\%}\end{array}$

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

Formula: $\text{Rate of return }=\frac{\text{Net income }-\text{Preferred dividends}}{\text{Average common stockholder’s equity}}$

Average common stockholders’ equity is determined by dividing opening and closing total common stockholders’ equity by 2. It is calculated as follows:

Average common stockholder’s equity for 2017

$\begin{array}{c}\begin{array}{l}\text{Average common}\\ \text{stockholders equity}\end{array}\}=\frac{\left(\begin{array}{l}\text{Opening}\text{balance}\text{of common stockholders' equity }\\ +\text{Closing balance of common stockholders' equity}\end{array}\right)}{\text{2}}\\ =\frac{\text{\$1,040}\text{+}\text{\$1,040}}{\text{2}}\\ =\text{\$1,040}\end{array}$

Average common stockholder’s equity for 2016

$\begin{array}{c}\begin{array}{l}\text{Average common}\\ \text{stockholders equity}\end{array}\}=\frac{\left(\begin{array}{l}\text{Opening}\text{balance}\text{of common stockholders' equity }\\ +\text{Closing balance of common stockholders' equity}\end{array}\right)}{\text{2}}\\ =\frac{\text{\$900}+\text{\$1,040}}{\text{2}}\\ =\text{\$970}\end{array}$

Note: Equity on 12/31/15 was $900 (Opening balance)

Hence, rate of return on stockholders’ equity for 2017 and 2016 is 24.23% and 13.61% respectively.

(f)

To determine

To compute: Debt to total assets ratio for 2017 and 2016

Explanation of Solution

Given info: Balance sheet and Income statement

Debt to total asset ratio for 2017

$\begin{array}{c}\text{Debt}\text{to}\text{total}\text{assets}\text{ratio}=\frac{\text{Total}\text{debt}}{\text{Total assets}}\\ =\frac{\text{\$1,240}}{\text{\$2,340}}\\ =52.99\%\end{array}$

Debt to total asset ratio for 2017

$\begin{array}{c}\text{Debt}\text{to}\text{total}\text{assets}\text{ratio}=\frac{\text{Total}\text{debts}}{\text{Total assets}}\\ =\frac{\text{\$1,170}}{\text{\$2,210}}\\ =52.94\%\end{array}$

Debt to asset ratio is used by the company to determine how well the company is able to survive the losses without damaging the creditors’ interest. It is determined by dividing total debt and total assets.

Formula:

$\begin{array}{l}\text{Debt to assets}\\ \text{ratio}\end{array}\}\text{=}\frac{\text{Total debt}}{\text{Total assets}}$

Total debt is determined by adding total current liabilities and total long-term liabilities.

Total debt for 2017

$\begin{array}{c}\text{Total debt}=\left(\text{Total current liabilities}+\text{Total long}-\text{term liabilities}\right)\\ =\$820+\$\text{42}0\\ =\$\text{1,240}\end{array}$

Total debt for 2016

$\begin{array}{c}\text{Total debt}=\left(\text{Total current liabilities}+\text{Total long}-\text{term liabilities}\right)\\ =\$\text{79}0+\$\text{38}0\\ =\$\text{1},\text{17}0\end{array}$

Hence, debt to total assets for 2017 and 2016 is 52.99% and 52.94% respectively. This ratio indicates that the amount of total percentage of assets of Corporation M was provided by creditors.

(g)

To determine

To compute: Times interest earned ratio for 2017 and 2016

Explanation of Solution

Given info: Balance sheet and income statement

Times interest earned ratio for 2017

$\begin{array}{c}\text{Times interest earned ratio}=\frac{\left(\begin{array}{l}\text{Netincome}+\text{Interest expense}\\ +\text{Income tax expense}\end{array}\right)}{\text{Interest}\text{expense}}\\ =\frac{\$430}{\$10}\\ =43\text{times}\end{array}$

Times interest earned ratio for 2016

$\begin{array}{c}\text{Times interest earned ratio}=\frac{\left(\begin{array}{l}\text{Netincome}+\text{Interest expense}\\ +\text{Income tax expense}\end{array}\right)}{\text{Interest}\text{expense}}\\ =\frac{\$240}{\$20}\\ =12\text{times}\end{array}$

Times - interest earned ratio quantifies the number of times the earnings before interest and taxes can pay the interest expense.

Formula:

$\begin{array}{l}\text{Times-interest-earned}\\ \text{ratio }\end{array}\}=\frac{\text{Net income}+\text{Income tax expense}+\text{Interest expense}}{\text{Interest expense}}$

Income before income tax and interest expense is the sum of net income, interest expense, and income tax expense. For 2017 and 2016, income before income tax and interest expense is calculated as below:

Income before income tax and interest expense for 2017

$\begin{array}{c}\begin{array}{l}\text{Income before income}\\ \text{tax and interest expense}\end{array}\}=\left(\begin{array}{l}\text{Net}\text{income}\\ \text{+Interest expense }\\ \text{+ Income tax expense}\end{array}\right)\\ =\$252+\$10+\$168\\ =\$430\end{array}$

Income before income tax and interest expense for 2016

$\begin{array}{c}\begin{array}{l}\text{Income before income}\\ \text{tax and interest expense}\end{array}\}=\left(\begin{array}{l}\text{Net}\text{income}\\ \text{+Interest expense }\\ \text{+ Income tax expense}\end{array}\right)\\ =\$132+\$20+\$88\\ =\$240\end{array}$

Hence, times interest earned ratio for 2017 and 2016 is 43 times and 12 times respectively. Company’s ability towards payment of interest has increased in the year 2017.