Chapter 13, Problem 6AP

a.

To determine

Compute the ratios for Company W for the years 2016 and 2015

Answer to Problem 6AP

Company W
Computation of Ratio
Particulars	Amount $ (in 000’s)	Amount $ (in 000’s)
	2016	2015
Current Ratio:
Cash and cash equivalents	19,000	12,000
Accounts receivable	55,000	43,000
Inventory	120,000	105,000
Prepaid expenses	20,000	14,000
Total Current Assets (A)	214,000	174,000
Total Current Liabilities (B)	91,000	82,000
Current Ratio $\left(\text{A ÷ B}\right)$	2.35	2.12
Quick Ratio:
Cash and Cash Equivalents	$19,000	$12,000
Trade Receivables	55,000	43,000
Total Quick Assets (A)	74,000	55,000
Total Current Liabilities (B)	91,000	82,000
Quick ratio $\left(\text{A ÷ B}\right)$	0.81	0.67
Operating-cash-flows-to-current-liabilities:
Beginning Current liabilities (A)	82,000	77,000
Ending Current Liabilities (B)	91,000	82,000
Average Current Liabilities (C) $\left[\left(\text{A}+\text{B}\right)\text{ ÷ 2}\right]$	86,500	79,500
Cash flows from operating activities (D)	65,200	60,500
Operating-cash-flows-to-current-liabilities $\left(\text{D ÷ C}\right)$	0.75	0.76
Inventory Turnover Ratio:
Cost of Goods Sold (A)	545,000	433,920
Beginning Inventory (B)	105,000	87,000
Ending Inventory (C)	120,000	105,000
Average Inventory (D) $\left[\left(\text{B}+\text{C}\right)\text{ ÷2}\right]$	112,500	96,000
Inventory Turnover Ratio $\left(\text{A ÷ D}\right)$	4.84 Times	4.52 Times
Debt-to-Equity:
Total Current Liabilities	91,000	82,000
Bonds payable	225,000	160,000
Total Liabilities (A)	316,000	242,000
Preferred stock	75,000	75,000
Common stock	200,000	200,000
Retained earnings	94,000	68,000
Total Stockholders’ Equity (B)	369,000	343,000
Debt-to-Equity $\left(\text{A ÷ B}\right)$	0.85	0.70
Times-Interest-Earned:
Income before interest and income tax expense (A)	100,000	94,880
Interest Expense (B)	22,500	16,000
Times-Interest-Earned $\left(\text{A}+\text{B}\right)$	4.44 Times	5.93 Times
Return on Assets:
Beginning Total Assets (A)	585,000	490,000
Ending Total Assets (B)	685,000	585,000
Average Total Assets (C) $\left[\left(\text{A}+\text{B}\right)\text{ ÷ 2}\right]$	635,000	537,500
Net Income (D)	54,600	57,580
Return on Assets $\left(\text{D}\right)÷\left(\text{C}\right)$	8.60%	10.71%
Return on Common Stockholders’ Equity:
Net Income	54,600	57,580
Less: Preferred Dividends	(6,750)	(6,750)
Net Income Available for Common Stockholders (A)	47,850	50,830
Common stock	200,000	200,000
Retained earnings	94,000	68,000
Ending Stockholders’ Equity (B)	294,000	268,000
Beginning Common Stockholders’ Equity (C)	268,000	235,000
Average Common Stockholders’ Equity (D) $\left[\left(\text{B}+\text{C}\right)\text{ ÷ 2}\right]$	281,000	251,500
Return on Common Stockholders’ Equity $\left(\text{A ÷ D}\right)$	17.02%	20.03%

Table (1)

Explanation of Solution

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:

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

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.

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

Operating-cash-flow-to-current-liabilities ratio: The operating-cash-flow-to-current-liabilities ratio measures the firm’s ability to pay the current liabilities from the cash flows from operating activities. It can be calculated by using the given formula:

$\begin{array}{l}\text{Operating-cash-flows-}\\ \text{current-liabilities Ratio}\end{array}]=\frac{\text{Cash flows from operating activities}}{\text{Average Current liabilities}}$

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:

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

Debt–to-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:

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

Number of times interest was earned: Number of times interest is earned 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.

$\begin{array}{l}\text{Number of times }\\ \text{interest is earned}\end{array}\}=\frac{\text{Earnings before interest and taxes expense}}{\text{Interest expense}}$

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. Return on investment is calculated as follows:

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

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:

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

b.

To determine

Calculate common size percentage for each year’s income statement.

Explanation of Solution

Common size financial statements: These are the financial statements in which all the items are expressed as percentages, assuming a base value, to help the intra-comparison of financial data for different years, and inter-comparison of data with other companies.

Formula:

$\text{Vertical analysis percentage}=\frac{\text{Financial statement item}}{\text{Base amount}}\times 100$

Prepare a common size income statement of Company W for the years ended 2015 and 2016.

W Company
Common-Size Income Statement
For the years 2015 and 2016
Particulars	2016		2015
	Amount $	Percentage of Sales	Amount $	Percentage of Sales
Sales	820,000	100.00%	678,000	100.00%
Less: Cost of Goods Sold	545,000	66.46%	433,920	64.00%
Gross Profit	275,000	33.54%	244,080	36.00%
Less: Selling and Administrative Expenses	175,000	21.34%	149,200	22.01%
Income before Interest Expense and Income Taxes	100,000	12.20%	94,880	13.99%
Less: Interest Expenses	22,500	2.74%	16,000	2.36%
Income before Income Taxes	77,500	9.45%	78,880	11.63%
Less: Income Tax Expense	22,900	2.79%	21,300	3.14%
Net Income	54,600	6.66%	57,580	8.49%

Table (2)

c.

To determine

Comment on the results of the analysis.

Explanation of Solution

Analysis of the ratios:

Company W
Ratio Analysis
Ratios	2015	2016	Change
Current Ratio	2.12	2.35	Increased
Quick Ratio	0.67	0.81	Increased
Operating-cash-flows-to-current-liabilities	0.76	0.75	Decreased
Inventory Turnover Ratio	4.52 Times	4.84 Times	Increased
Debt-to-Equity	0.70	0.85	Decreased
Times-Interest-Earned	5.93 Times	4.44 Times	Decreased
Return on Assets	10.71	8.60%	Decreased
Return on Common Stockholders’ Equity	20.03%	17.02%	Decreased

Table (3)