Chapter 13, Problem 5AP

1.

To determine

Compute the tests of (a) profitability, (b) liquidity, (c) solvency, and (d) market.

Answer to Problem 5AP

Compute the tests of (a) profitability, (b) liquidity, (c) solvency, and (d) market.

	Ratio	Formula	Calculation	Result
	Profitability ratios
1	Return on Equity (ROE)	$\frac{\text{Net}\text{Income}}{\text{Average}\text{Total}\text{Stockholder'}\text{Equity}}$	$\left(\frac{\$12,600}{\$120,500}\right)$	10.5%
2	Return on Assets (ROA)	$\frac{\text{Net}\text{Income}}{\text{Average}\text{Total}\text{Assets}}$	$\frac{\$12,600}{\left(\$4,000\times 70\%\right)}$	7.7%
3	Financial leverage percentage	$\text{ROE}-\text{ROA}$	$10.5–7.7$	2.8%
4	Net profit margin	$\frac{\text{Net}\text{Income}}{\text{Net Sales Revenue}}$	$\frac{\$12,600}{\$110,000}$	11.5%
5	Earnings per share (EPS)	$\frac{\text{Net}\text{Income}}{\left(\begin{array}{l}\text{Weighted Average Number of }\\ \text{common Shares Outstanding}\end{array}\right)}$	$\frac{\$12,600}{18,000\text{shares}}$	$0.7
	Turnover ratios
6	Fixed asset turnover	$\frac{\text{Net}\text{Sales}\text{Revenue}}{\text{Average}\text{Net}\text{Fixed}\text{Assets}}$	$\frac{\$110,000}{\$100,000}$	1.1 times
7	Receivables turnover	$\frac{\text{Net Credit}\text{Sales}}{\text{Average}\text{Net Receivables}}$	$\frac{\$55,000}{\left(\$32,000+\$37,000\right)÷2}$	1.6  times
7.a	Average collection period	$\frac{365\text{days}}{\text{Receivables turnover ratio}}$	$\frac{365\text{days}}{1.6}$	228 days
8	Inventory turnover	$\frac{\text{Cost of Goods Sold}}{\text{Average Inventory}}$	$\frac{\$52,000}{\left(\$38,000+\$25,000\right)÷2}$	1.7  times
8.a	Average day’s supply in inventory	$\frac{365\text{days}}{\text{Inventory turnover ratio}}$	$\frac{365\text{days}}{1.7}$	215 days
	Liquidity ratios
9	Current ratio	$\frac{\text{Current}\text{Assets}}{\text{Current}\text{Liabilities}}$	$\frac{\$111,500}{\$43,000}$	2.6  times
10	Quick ratio	$\frac{\text{Quick}\text{Assets}}{\text{Current}\text{Liabilities}}$	$\frac{\$86,500}{\$43,000}$	2.0  times
11	Cash ratio	$\frac{\text{Cash \& Cash Equivalents}}{\text{Current}\text{Liabilities}}$	$\frac{\$49,500}{\$43,000}$	1.2  times
	Solvency ratio
12	Debt-to-equity ratio	$\frac{\text{Total}\text{Liabilities}}{\text{Total}\text{Stockholder's}\text{Equity}}$	$\frac{\$83,000}{\$123,500}$	0.67  times
13	Time interest earned ratio	$\frac{\text{Net Income}\text{+}\text{Interest +}\text{Income Tax Expense}}{\text{Interest Expense}}$	$\frac{\left(\$12,600+\$\$4,000+\$5,400\right)}{\$4,000}$	5.5  times
	Market ratios
14	Price/Earnings (P/E) ratio	$\frac{\text{Market Price per Share}}{\text{Earnings}\text{per Share}}$	$\frac{\$23}{\$0.70}$	32.9  times
15	Dividend yield ratio	$\frac{\text{Dividend per Share}}{\text{ Market Price per Share}}$	$\frac{\$0.375}{\$23}$	1.63%

Table (1)

Explanation of Solution

1. 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.

$\text{Return on Equity}\text{=}\frac{\text{Net}\text{Income}}{\text{Average}\text{Total}\text{Stockholder'}\text{Equity}}$

Return on equity ratio of Company T is 10.5%.

2. Return on assets:

Return on assets is the financial ratio which 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.

$\text{Return on Assets }\left(\text{ROA}\right)=\frac{\text{Net}\text{Income}}{\text{Average}\text{Total}\text{Assets}}$

Return on assets ratio of the Company T is 7.7%.

3. Financial Leverage Percentage:

Financial Leverage Percentage is one of the profitability ratios. It measures that the assets held by a Company proportionate to its common stock (Equity). It measures the advantages or disadvantages that occur due to variance between the return on equity and return on assets.

$\text{Financial Leverage Precentage}=\text{Rate}\text{of}\text{Return}\text{on}\text{Equity}-\text{Rate}\text{of}\text{Return}\text{on}\text{Assets}$

Financial leverage percentage of the Company T is 2.8%.

4. Profit margin:

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

$\text{Net profit margin}\text{=}\frac{\text{Net}\text{Income}}{\text{Net Sales Revenue}}$

Profit margin of the Company T is 11.5%.

5. Earnings per share:

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.

$\text{EPS}\text{=}\frac{\text{Net}\text{Income}}{\left(\text{Weighted Average Number of common Shares Outstanding}\right)}$

Earnings per share of the Company T are $0.7.

6. Fixed Asset turnover:

Fixed asset turnover is a ratio that measures the productive capacity of the fixed assets to generate the sales revenue for the company. Thus, it shows the relationship between the net sales and the average total fixed assets.

$\text{Fixed Assets turnover}\text{ratio}\text{=}\frac{\text{Net}\text{Sales}\text{Revenue}}{\text{Average}\text{Net}\text{Fixed}\text{Assets}}$

Fixed assets turnover of the Company T is 1.1 times.

7. Receivables turnover ratio:

Receivables turnover 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. This ratio is determined by dividing credit sales and sales return.

$\text{Receivables Turnover Ratio}\text{=}\frac{\text{Net Sales}}{\text{Average}\text{Accounts}\text{Receivables}}$

Receivables turnover of the Company T is 1.6 times.

7(a) Average collection period:

This ratio is used to determine the number of days a particular company takes to collect accounts receivables.

$\text{Average days’ in collection period}\text{=}\frac{365\text{days}}{\text{Inventory turnover}}$

The average collection period of the Company T is 228 days.

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

$\text{Inventory Turnover Ratio =}\frac{\text{Cost of Goods Sold }}{\text{Average Inventory}}$

Inventory turnover of the Company T is 1.7 times.

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

$\text{Average days’ in inventory}\text{=}\frac{365\text{days}}{\text{Inventory turnover}}$

Average days’ in inventory of the Company T is 215 days.

9. 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. The ideal current ratio is 2:1. The following formula is used to calculate current ratio.

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

Current ratio of the Company T is 2.6 times.

10. Quick 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.

$\text{Quick Ratio}\text{=}\frac{\text{Quick}\text{Assets}}{\text{Current}\text{Liabilities}}$

Quick ratio of the Company T is 2.0 times.

11. Cash ratio:

This ratio is used to measure the adequacy of the cash in the business.

$\frac{\text{Cash \& Cash Equivalents}}{\text{Current}\text{Liabilities}}$

Cash ratio of the Company T is 1.2 times.

12. Debt-equity ratio:

The debt-to-equity ratio indicates that the company’s debt as a proportion of its stockholders’ equity.

$\text{Debt-equity ratio}\text{=}\frac{\text{Total}\text{Liabilities}}{\text{Total}\text{Stockholder's}\text{Equity}}$

Debt-to-equity ratio of the Company T is 0.67 times.

13. Times Interest Earned Ratio:

It is one of the solvency ratios. It is a measure to evaluate the net income for interest payment on debt of a company. It is calculated as follows:

$\text{Times Interest earned ratio}\text{=}\frac{\text{Net Income}\text{+ Interest Expense}\text{+}\text{Income Tax Expense}}{\text{Interest Expense}}$

Times interest earned ratio of the Company T is 5.5 times

14. Price/Earnings Ratio:

It depicts the relation of market price of a share to earnings per share of that company. The price/earnings ratio presents the market value of the amount invested to earn $1 by a company. It is major tool to be used by investors before the decisions related to investments in a company.

$\text{Price/Earnings Ratio}\text{=}\frac{\text{Market Price per Share }}{\text{Earnings per Share}}$

Price/earnings ratio of the Company T is 32.9 times

15. Dividend yield:

This is the ratio which measures the amount of dividends paid relative to the market price.

$\text{Dividend Yield Ratio}\text{=}\frac{\text{Dividends per Share}}{\text{ Market Price per Share}}$

Dividend yield ratio of the Company T is 1.63.

2.

To determine

(a) Compute the percentage changes in sales, net income, cash, inventory, and debt and (b) compute the amount that appears to be the pre-tax interest rate on the note payable.

Explanation of Solution

(a) Compute the percentage changes in sales, net income, cash, inventory, and debt.

Comparing across time analysis of financial statements:

In Comparing across time analysis of financial statements, the amount of each item of the current year financial statement is compared with the previous year financial statement. The amount of each item increased or decreased in the current financial statements, and its respective percentage can be computed by taking the earlier statement as the base.

Company T
Comparing across time analysis
Particulars	2015 Amount ($)(A)	2014 Amount   ($)(B)	Increase (decrease) From 2014 to 2015
			Amount $\left(\text{C=A-B}\right)$ $	Percent $\left(\text{D=C÷B}\right)$$
Sales revenue	110,000	99,000	11,000	11.1%
Net income	12,600	9,800	2,800	28.6%
Cash	49,500	18,000	31,500	175%
Inventory	25,000	38,000	13,000	(34.2%)
Debt	83,000	75,500	7,500	9.9%

Table (2)

(b) Compute the pre-tax interest rate on the note payable.

The note payable, long-term is $40,000 and the interest is $4,000. Then the interest rate is calculated as follows:

$\begin{array}{c}\text{Interest amount}\text{=}\text{Principle amount}\times \text{Interest rate}\times \text{Time }\\ \text{\$4000}\text{=}\text{\$40,000}\times \text{Interest rate}\times 1\text{year}\\ \text{Interest rate}=\frac{\$4,000}{\$40,000}\\ \text{Interest rate}=10\%\end{array}$

Hence, the pre-tax interest rate on the note payable is 10%.

3.

To determine

Identify at least two problems facing the company that are based on the requirements (1) and (2).

Explanation of Solution

• The receivable turnover ratio of the Company T is very low, that is 1.6 and the average collection period of the Company T is 228 days. This indicates that the Company is failing to collect the receivables in time.
• The inventory turnover ratio of the company T is 1.7 which is very low. This indicates that the inventory management of the Company T is very poor.
• Cash balance is increased significantly from 2014 to 2015. Need to investigate the reasons for such increase in the cash balance.
• Accounts payable is increased by 20% from 2014 to 2015. This is material in amount that should be investigated.