Chapter 13, Problem 8BP

a)

To determine

Calculate the following ratios:

1. 1) Return on sales ratio
2. 2) Return on assets
3. 3) Return on common stockholders’ equity
4. 4) Quick ratio
5. 5) Current ratio
6. 6) Debt to equity ratio

Explanation of Solution

1) Return on sales ratio: The ratio which evaluates the amount of net income earned for every dollar of net sales is referred to as return on sales ratio. Higher ratio indicates highly profitable company.

$\text{Return on sales ratio = }\frac{\text{Net income}}{\text{Net sales}}$

Compute the return on sales ratio for Company L for the year 2016.

Net income= $680,000

Net sales = $8,800,000

$\begin{array}{c}\text{Return on sales ratio }=\frac{\text{Net income}}{\text{Net sales}}\\ =\frac{\$675,000}{\$8,600,000}\\ =7.85\%\end{array}$

Hence, return on sales ratio for 2016 is 7.85%.

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.

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

Compute return on assets ratio for 2016:

Net income = $680,000

Average total assets = $4,905,000 (1)

$\begin{array}{c}\text{Return on asset ratio }= \frac{\text{Net income}}{\text{Average total assets}}\\ =\frac{\$675,000}{\$4,905,000}\\ =13.76\%\end{array}$

Therefore, the company’s accounts return on assets ratio for 2016 is 13.76%.

Working note:

Compute average of total assets:

Beginning total assets - $4,870,000

Ending total assets - $5,500,000

$\begin{array}{c}\text{Average total assets }=\frac{\text{Beginning balance }\left(2012\right)+\text{ Closing balance }\left(\text{2013}\right)}{2}\\ =\frac{\$4,870,000+\$5,500,000}{2}\\ =\frac{\$10,370,000}{2}\\ =\$5,185,000\end{array}$ (1)

3) Return on common stockholders’ 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.

$\text{Return on Common}\text{Stockholders'}\text{ Equity}\text{=}\frac{\text{Net}\text{Income - preference dividend}}{\text{Average Common}\text{Stockholders'}\text{Equity}}$

Compute the return on common stockholders’ equity for the Company L for the year 2016.

Net income = $680,000

Average common stockholders’ equity = $2,435,000 (2)

Preference dividends = $65,000

$\begin{array}{c}\text{Return on common stockholders' equity}=\frac{\text{Net income}\text{–Preference dividends}}{\text{Average common stockholders' equity}}\times 100\\ =\frac{\$680,000–\$65,000}{\$2,435,000}\times 100\\ =\frac{\$612,000}{\$2,435,000}\\ =25.25\%\end{array}$

Hence, return on common stockholders’ equity for 2016 is 25.25%.

Working notes:

Compute average stockholders’ equity for 2016:

Beginning balance of common stockholder’s equity = $2,170,000 $\left(\$1,800,000+\$370,000\right)$

Ending balance of common stockholder’s equity = $2,700,000 $\left(\$1,900,000+\$800,000\right)$

$\begin{array}{c}\text{Average common stockholders’ equity}=\left(\frac{\begin{array}{l}\text{Beginning balance of stockholders’ equity }\\ +\text{Ending balance of stockholders’ equity }\end{array}}{2}\right)\\ =\frac{\$2,170,000+\$2,700,000}{2}\\ =\frac{\$4,870,000}{2}\\ =\$2,435,000\end{array}$ (2)

Note: common stockholders’ equity includes the common stock and retained earnings.

4) 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.

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

Compute Quick ratio for 2016:

$\begin{array}{c}\text{Quick ratio}=\frac{\text{Quick assets}}{\text{Current}\text{liabilities}}\\ =\frac{\$385,000}{\$600,000}\\ =0.64:1\end{array}$

Therefore, quick ratio for 2016 is 0.64 times.

5) 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.

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

Quick assets	$385,000
Inventory and prepaid expenses	$950,000
Total current assets	$1,335,000
Current liabilities	$600,000

Table (1)

Compute current ratio for 2016.

$\begin{array}{c}\text{ Current ratio }=\frac{\text{Current asset}}{\text{ Current liabilities}}\\ =\frac{\$1,335,000}{\$600,000}\\ =2.225\end{array}$

Therefore, current ratio for 2016 is 2.225 times.

Note: “Other assets” are considered as non-current assets. Hence, it is not included in the total current assets.

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

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

Compute debt to equity ratio for Company L for the year 2016.

Total stockholders’ equity = $1,900,000 (3)

Total liabilities = $3,600,000 (4)

$\begin{array}{c}\text{Debt-to-equity }=\frac{\text{Total liabilties }}{\text{Total stockholders' equity}}\\ =\frac{\$1,900,000}{\$3,600,000}\\ =0.52:1\end{array}$

Therefore, debt to equity ratio for 2016 is 0.52:1.

Working notes:

Compute the total liabilities:

$\begin{array}{c}\text{Total liabilities }=\text{ Current Liabilities }+\text{ 10\% bonds payable}\\ =\$600,000+\$1,300,000\\ =\$1,900,000\end{array}$ (3)

Compute the total stockholders’ equity:

$\begin{array}{c}\text{Total stockholders' equity }=\left(\text{7\% preferred stock}+\text{}\text{Common stock}+\text{Retained earnings}\right)\\ =\left(\$900,000+\$1,900,000+\$800,000\right)\\ =\$3,600,000\end{array}$ (4)

b)

To determine

Compare Company L’s performance with industry performance

Explanation of Solution

Compare the Company L Performance with the industry performance.

• The return on sales ratio (7.85%) of the company is better than the average industry performance.
• The return on assets ratio (13.76%) of the company is better than the average industry performance.
• The return on common stockholders’ equity (25.25%) is better than the average industry performance.
• The quick ratio (0.64:1) is below the average industry performance.
• The current ratio (2.22:1) is similar to the average industry performance.
• The debt-to-equity ratio (0.52:1) is better than the average industry performance.