(a)
Financial Ratios: Financial ratios are the metrics used to evaluate the liquidity, capabilities, profitability, and overall performance of a company.
To compute:
(a)
Explanation of Solution
Given info: Balance sheet and income statement
Liquidity ratios:
Liquidity explains the extent of cash’s nearness to assets and liabilities. It explains how easily assets can be converted into cash. Following are the types of ratios that help to find liquidity position of a company:
1.
Current ratio for 2016
Explanation:
Current ratio is used to determine the relationship between current assets and current liabilities. The ideal current ratio is 2:1.
Formula:
Total current assets and total current liabilities are determined as follows:
Total current assets and current liabilities for 2017 and 2016 | ||
Details | 2017 | 2016 |
Current Assets | Amount($) | Amount($) |
Cash | 70,000 | 65,000 |
Short-term investments | 55,000 | 40,000 |
Accounts receivables | 1,04,000 | 90,000 |
Inventory | 2,30,000 | 1,65,000 |
Prepaid expenses | 25,000 | 23,000 |
Total current assets | 4,84,000 | 3,83,000 |
Current Liabilities | Amount($) | Amount($) |
Note payable | 1,70,000 | 1,20,000 |
Accounts Payable | 65,000 | 52,000 |
Accrued liabilities | 40,000 | 40,000 |
Total Current liabilities | 2,75,000 | 2,12,000 |
Hence, current ratio is 1.76:1 and 1.81:1 for 2017 and 2016 respectively.
2.
Accounts receivable turnover ratio for 2016
Explanation:
This ratio is mainly used to evaluate the collection process efficiency. It helps the company to know the number of times the accounts receivable is collected in a particular time period. Main purpose of accounts receivable turnover ratio is to manage the
Formula:
Average accounts receivable for 2017 and 2016 is calculated as follows:
Average accounts receivable for 2017
Average accounts receivable for 2016
Hence, accounts receivable turnover ratio is 9.1 times and 9.0 times for 2017 and 2016 respectively.
3.
Inventory turnover ratio for 2017
Inventory turnover ratio for 2016
Explanation:
Inventory turnover ratio is used to determine the number of times inventory used or sold during the particular accounting period.
Formula:
Average inventory is calculated as follows:
Average inventory for 2017
Average inventory for 2016
Hence, inventory turnover ratio is 3.2 times and 4.1 times for 2017 and 2016 respectively.
Changes in the ratios
Ratios | 2017 | 2016 | (Increase /Decrease) | |
Amount | Percentage | |||
Current ratio | 1.76 | 1.81 | (0.05) | (3%) |
Accounts receivable turnover ratio | 9.1 | 9.0 | 0.10 | 1.1% |
Inventory turnover ratio | 3.2 | 4.1 | (0.9) | (22%) |
Explanation:
Horizontal analysis is prepared to make comparison between the financial statements to determine the changes in the financial statements for the previous year to the current year. The changes of the company are measured in dollars as well as in percentage.
Formula:
When current ratio and inventory turnover ratios are considered, there is a decrease in percentage. When accounts receivable turnover ratios are considered, there is an increase of 1%.
Profitability ratios:
In general, financial ratios are used to evaluate capabilities, profitability, and overall performance of a company. The following are the ratios that evaluate the profitability of a company:
1.
Profit margin ratio for 2017
Profit margin ratio for 2017
Explanation:
Profit margin ratio is used to determine the percentage of net income that is being generated per dollar of revenue or sales.
Formula:
Hence, profit margin ratio for 2017 and 2016 is 5.9% and 6.1% respectively.
2.
Asset turnover ratio for 2017
Asset turnover ratio for 2016
Explanation:
Asset turnover ratio is used to determine the asset’s efficiency towards sales.
Formula:
Average total assets are determined as follows:
Average total assets for 2017
Average total assets for 2016
Hence, asset turnover ratio for 2017 and 2016 is 1.12 times and 1.16 times respectively.
3.
Return on assets for 2017
Return on assets for 2016
Explanation
Return on assets determines the particular company’s overall earning power.
Formula:
Average total assets are calculated above.
Hence, return on assets for 2017 and 2016 is 6.6% and 7.1% respectively.
Earnings per share for 2017
Earnings per share for 2016
Explanation
Earnings per share help to measure the profitability of a company. Earnings per share are the amount of profit that is allocated to each share of outstanding stock.
Formula:
Weighted average common shares outstanding for 2017 and 2016 is calculated as
Hence, earnings per share for 2017 and 2016 are $2.60 per share and $2.40 per share respectively.
Changes in the ratios
Ratios | 2017 | 2016 | (Increase /Decrease) | |
Amount | Percentage | |||
Profit margin ratio | 5.9% | 6.1% | (0.2) | (3%) |
Asset turnover ratio | 1.12 times | 1.16 times | (0.04) | (3%) |
Return on assets ratio | 6.6% | 7.1% | (0.5) | (7%) |
Earnings per share | $2.60 | $2.40 | 0.2 | 8% |
Explanation:
Horizontal analysis is prepared to make comparison between the financial statements to determine the changes in the financial statements for the previous year to the current year. The changes of the company are measured in dollars as well as in percentage.
Formula:
Thus, profit margin ratio, asset turnover ratio, and return on assets ratio has decreased and earnings per shares are increased in the year 2017 when compared to 2016.
(b)
To compute: Compute affected ratios.
(b)
Explanation of Solution
Explanation
Given info: Three independent situations
Situation 1
Return on
Return on stockholders’ equity for 2018
Explanation
Formula:
Average common stockholders’ equity for 2017 is calculated as follows:
Total value of common shares outstanding in the year 2018 is determined as follows:
Number of common shares outstanding in 2018= 18,000
Value of common shares outstanding in 2018= $10 × 18,000
= $180,000
Next, calculate the amount of
Balance in retained earnings account on 31st December, 2017= $149,000
Add: Net income of 2018= $54,000
Total amount of retained earnings for the year 2018= $203,000
Thus, average common stockholders’ equity for 2018 is calculated as follows:
Hence, return on stockholders’ equity for 2017 and 2018 is 15.6% and 11.6% respectively.
Situation 2
Determine the debt to assets ratio for 2017.
Determine the debt to assets ratio for 2018.
Explanation:
Debt to asset ratio is used to determine the relationship between total liabilities and total assets. This ratio help the company in determining the debt used for asset financing. When the determined ratio is more than 50%, company faces higher risk.
Formula:
Total assets for the year 2018 and 2017 are $900,000 and $874,000. Total debts for 2018 and 2017 are calculated as follows:
Details | 2018 | 2017 |
Total liabilities | Amount($) | Amount($) |
Accounts payable | 65,000 | 65,000 |
Notes payable | ---- | 1,70,000 |
Accrued liability | 40,000 | 40,000 |
Bonds payable, due | 2,50,000 | 2,50,000 |
Total liabilities | 3,55,000 | 5,25,000 |
Hence, debt to assets ratio for 2017 and 2018 is 39% and 60% respectively.
Situation 3
Price earnings ratio for 2017
Price earnings ratio for 2018
Explanation:
Price/earnings ratio is used to determine the profitability of a company. This ratio is abbreviated as P/E.
Formula:
Calculate earnings per share for the year 2018 as below:
Earnings per share for the year 2018 are determined as below:
Hence, price earnings ratio for 2017 and 2018 is 3.5 times and 4.4 times.
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Chapter 13 Solutions
FINANCIAL ACCT.:TOOLS...(LL)-W/ACCESS
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