Chapter 13, Problem 4BP

To determine

Compute the following ratios for Corporation O: (1) current ratio, (2) acid-test ratio, (3) days’ sales uncollected, (4) inventory turnover,(5) days’ sales in inventory, (6) debt-to-equity ratio, (7) times interest earned, (8) profit margin ratio, (9) total asset turnover, (10) return on total assets, and (11) return on common stockholders’ equity.

Explanation of Solution

1. 1) Current ratio: Current ratio is one of the liquidity ratios, which measures the capacity of the company to meet its short-term obligations using its current assets. Current ratio is calculated by using the formula:

$\text{Current ratio}=\frac{\text{Current Assets}}{\text{Current Liabilities}}$

Determine the current ratio.

Ratio	Result
Cash	$6,100
Short term investments	$6,900
Accounts receivables, net	$12,100
Current notes receivable (trade)	$3,000
Merchandise inventory	$13,500
Prepaid expenses	$2,000
Current assets (A)	$43,600
Accounts payable	$11,500
Accrued wages payable	$3,300
Income taxes payable	$2,600
Current liabilities (B)	$17,400
Current ratio  $\left(\text{A}\right)÷\left(\text{B}\right)$	2.5:1

Table (1)

Hence, the current ratio is 2.5:1.

1. 2) 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.

$\text{Acid-test ratio}=\frac{\text{Quick Assets}}{\text{Current Liabilities}}$

Determine the acid-test ratio.

Ratio	Result
Cash	$6,100
Short term investments	$6,900
Accounts receivables, net	$12,100
Current notes receivable (trade)	$3,000
Quick assets (A)	$28,100
Accounts payable	$11,500
Accrued wages payable	$3,300
Income taxes payable	$2,600
Current liabilities (B)	$17,400
Acid-test ratio  $\left(\text{A}\right)÷\left(\text{B}\right)$	1.6:1

Table (2)

Hence, the acid-test ratio is 1.6:1.

1. 3) Days’ sales uncollected: This ratio is used to determine the number of days a particular company takes to collect accounts receivables.

$\text{Days’ sales uncollected}\text{=}\frac{\text{Ending accounts receivable}}{\text{ Sales}}\times 365\text{days}$

Determine the days’ sales uncollected.

Ratio	Result
Accounts receivables, net	$12,100
Current notes receivable (trade)	$3,000
Ending  net accounts (including notes) receivables (A)	$15,100
Net credit sales (B)	$315,500
Days’ sales uncollected  $\left[\left(\text{A}\right)÷\left(\text{B}\right)\right]\times 365$	17.5 days

Table (3)

Hence, the days’ sales uncollected are 17.5 days.

1. 4) Inventory Turnover Ratio: This ratio is a financial metric used by a company to quantify the number of times inventory is used or sold during the accounting period. It is calculated by using the formula:

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

Determine the inventory turnover ratio.

Ratio	Result
Ending inventory (A)	$13,500
Beginning inventory (B)	$17,400
Average inventory (C) $\left[\left(\text{A}\right)+\left(\text{B}\right)\right]÷2$	$15,450
Cost of goods sold (D)	$236,100
Inventory turnover ratio $\left(\text{D}\right)÷\left(\text{C}\right)$	15.3 times

Table (4)

Hence, the inventory turnover ratio is 15.3 times.

1. 5) Days’ sales in inventory: Days’ in inventory is determined as the number of days a particular company takes to make sales of the inventory available with them.

$\text{Days’ in inventory}\text{=}\frac{\text{Ending}\text{Inventory}}{\text{Cost of goods sold}}\times 365\text{days}$

Determine the days’ sales in inventory.

Ratio	Result
Ending inventory (A)	$13,500
Cost of goods sold (B)	$236,100
Days’ sales in inventory$\left[\left(\text{A}\right)÷\left(\text{B}\right)\right]\times 365$	20.9 days

Table (5)

Hence, the days’ sales in inventory are 20.9 days.

1. 6) Debt–to-equity ratio or Debt equity ratio: The debt-to-equity ratio indicates that the company’s debt as a proportion of its stockholders’ equity. The debt-to-equity ratio is calculated using the formula:
   
   

$\text{Debt-to-equity ratio}=\frac{\text{Total liabilities}}{\text{Total stockholders' equity}}$

Determine debt-to-equity ratio.

Ratio	Result
Accounts payable	$11,500
Accrued wages payable	$3,300
Income taxes payable	$2,600
Long term note payable	$30,000
Total liabilities (A)	$47,400
Common stock	$35,000
Retained earnings	$35,100
Total stockholders’ equity (B)	$70,100
Debt-to-Equity ratio  $\left(\text{A}\right)÷\left(\text{B}\right)$	0.68:1

Table (6)

Hence, the debt to equity ratio is 0.68:1.

1. 7) Times interest earned ratio: The times interest earned ratio quantifies the number of times the earnings before interest and taxes can pay the interest expense. First, determine the sum of income before income tax and interest expense. Then, divide the sum by interest expense.

$\begin{array}{l}\text{Times interest}\\ \text{earned ratio}\end{array}\}=\frac{\text{Earnings before interest and taxes expense}}{\text{Interest expense}}$

Determine times interest earned ratio.

Ratio	Result
Net income	$23,800
Interest expense	$2,200
Income taxes	$4,200
Income before interest expense and income taxes (A)	$30,200
Interest expense (B)	$2,200
Times interest earned ratio $\left(\text{A}\right)÷\left(\text{B}\right)$	13.7 times

Table (7)

Hence, the times interest earned ratio is 13.7 times.

1. 8) Profit margin: It is one of the profitability ratios. Profit margin ratio is used to measure the percentage of net income that is being generated per dollar of revenue or sales.

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

Determine profit margin ratio.

Ratio	Result
Net income (A)	$23,800
Net sales (B)	$315,500
Profit margin ratio $\left(\text{A}\right)÷\left(\text{B}\right)$	7.5%

Table (8)

Hence, the profit margin ratio is 7.5%.

1. 9) Total asset turnover: Total asset turnover is a ratio that measures the productive capacity of the total assets to generate the sales revenue for the company. Thus, it shows the relationship between the net sales and the average total assets. Turnover of assets is calculated as follows:

$\text{Turnover of assets}=\frac{\text{Net sales }}{\text{Average total assets}}$

Determine total asset turnover ratio.

Ratio	Result
Ending total assets (A)	$117,500
Beginning total assets  (B)	$94,900
Average total assets (C) $\left[\left(\text{A}\right)+\left(\text{B}\right)\right]÷2$	$106,200
Net sales (D)	$315,500
Total asset turnover ratio $\left(\text{D}\right)÷\left(\text{C}\right)$	3.0 times

Table (9)

Hence, the total asset turnover ratio is 3.0 times.

1. 10)  Return on total assets: Return on total assets is the financial ratio that determines the amount of net income earned by the business with the use of total assets owned by it. It indicates the magnitude of the company’s earnings with relative to its total assets. Return on investment is calculated as follows:

$\text{Return on total assets}=\frac{\text{Net income }}{\text{Average total assets}}$

Determine return on asset ratio.

Ratio	Result
Ending total assets (A)	$117,500
Beginning total assets  (B)	$94,900
Average total assets (C) $\left[\left(\text{A}\right)+\left(\text{B}\right)\right]÷2$	$106,200
Net income (D)	$23,800
Return on asset ratio $\left(\text{D}\right)÷\left(\text{C}\right)$	22.4%

Table (10)

Hence, the return on asset ratio is 22.4%.

Return on common stockholders’ equity ratio: It is a profitability ratio that measures the profit generating ability of the company from the invested money of the shareholders. The formula to calculate the return on equity is as follows:

$\text{Return on equity}=\frac{\text{Net income}}{\text{Average stockholders' equity}}\times 100$

Determine return on common stockholders’ equity ratio.

Ratio	Result
Common stock	$35,000
Retained earnings	$35,100
Ending total stockholders’ equity (A)	$70,100
Common stock	$35,500
Retained earnings	$18,800
Beginning total stockholders’ equity (B)	$54,300
Average common stockholders’ equity (C) $\left[\left(\text{A}\right)+\left(\text{B}\right)\right]÷2$	$62,200
Net income (D)	$23,800
Return on common stockholders’ equity ratio $\left(\text{D}\right)÷\left(\text{C}\right)$	38.3%

Table (11)

Hence, the return on common stockholders’ equity ratio is 38.3%.