Chapter 13, Problem 9BP

a.

To determine

Calculate the ratios of Incorporation AI for 2016 and compare the ratios with the industry averages and comment on the performance.

Answer to Problem 9BP

Computation of ratios for year 2016 and comparison of ratios with industry average:

Ratios and Formula	2016	Industry averages
1. Quick ratio: $\frac{\text{Quick Assets}}{\text{Current Liabilities}}$ Quick assets: $\text{Cash}+\text{Accounts receivable}$	$\begin{array}{c}=\frac{\$64,500,000}{\$45,200,000}\\ =1.42:1\end{array}$ $\begin{array}{l}\text{=\$18,500,000}+\text{\$46,000,000}\\ \text{=\$64,500,000}\end{array}$	1.3
2. Current ratio: $\frac{\text{Current Assets}}{\text{Current Liabilities}}$	$\begin{array}{c}=\frac{\$104,000,000}{\$45,200,000}\\ =2.30:1\end{array}$	2.4
3. Receivables turnover: $\frac{\text{}\text{Net credit sales}}{\left(\begin{array}{l}\text{Average accounts }\\ \text{receivables}\end{array}\right)}$ Average accounts receivable: $\frac{\left(\begin{array}{l}\text{Beginning Net }\\ \text{Receivables}\end{array}\right)+\left(\begin{array}{l}\text{Ending Net }\\ \text{Receivables}\end{array}\right)}{2}$	$\begin{array}{c}=\frac{\$220,000,000}{\$44,500,000}\\ =4.94\text{ times}\end{array}$ $\begin{array}{c}=\frac{\$43,000,000+\$46,000,000}{2}\\ =\frac{\$89,000,000}{2}\\ =\$44,500,000\end{array}$	5.9 times
4. Inventory turnover: $\frac{\text{Cost of goods sold}}{\text{Average inventory}}$ Average inventory: $\frac{\left(\begin{array}{l}\text{Beginning}\\ \text{ Inventory}\end{array}\right)+\left(\begin{array}{l}\text{Ending }\\ \text{Inventory}\end{array}\right)}{2}$	$\begin{array}{c}=\frac{\text{\$125,000,000}}{\text{\$41,600,000}}\\ =\text{3}\text{.00 times}\end{array}$ $\begin{array}{c}=\frac{\text{\$43,700,000}+\text{\$39,500,000}}{2}\\ =\frac{\$83,200,000}{2}\\ =\$41,600,000\end{array}$	3.5 times
5. Debt to equity ratio: $\frac{\text{Total liabilities }}{\left(\begin{array}{l}\text{Total stockholders' }\\ \text{equity}\end{array}\right)}$	$\begin{array}{c}=\frac{\text{Total liabilities}}{\text{Total equity}}\\ =\frac{\$85,200,000}{\$87,000,000}\\ =\text{0}\text{.98 times}\end{array}$	0.73
6. Gross profit percentage: $\frac{\text{Gross profit}}{\text{Net sales}}\times 100$ Gross Profit: $\text{Sales}-\text{Cost of goods sold}$	$\begin{array}{c}=\frac{\$95,000,000}{\$220,000,000}\times 100\\ =\text{43}\text{.18}\%\end{array}$ $\begin{array}{l}=\$220,000,000-\$125,000,000\\ =\$95,000,000\end{array}$	44.3%
7. Return on sales: $\frac{\text{Net income}}{\text{Net sales}}$	$\begin{array}{c}=\frac{\$8,000,000}{\$220,000,000}\times 100\\ =\text{ 3}\text{.64\%}\end{array}$	4.5%
8. Return on assets: $\frac{\text{Net income }}{\text{Average total assets}}$ Average total assets: $\frac{\left(\begin{array}{l}\text{Beginning }\\ \text{total assets}\end{array}\right)+\left(\begin{array}{l}\text{Ending }\\ \text{total assets}\end{array}\right)}{2}$	$\begin{array}{c}=\frac{\$8,000,000}{\$171,100,000}\times 100\\ =\text{ 4}\text{.67\%}\end{array}$ $\begin{array}{c}=\frac{170,000,000+\$172,200,000}{2}\\ =\frac{342,200,000}{2}\\ =\$171,100,000\end{array}$	7.6%

Table (1)

Explanation of Solution

1. 1. 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.

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

1. 2. 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:

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

1. 3. 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.

$\text{Receivables turnover}=\frac{\text{}\text{Net credit sales}}{\text{Average accounts receivables}}$

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:

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

1. 5. 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:
   
   

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

2. 6. Gross profit percentage: The percentage of gross profit generated by every dollar of net sales is referred to as gross profit percentage. This ratio measures the profitability of a company by quantifying the amount of income earned from sales revenue generated after cost of goods sold are paid. The higher the ratio, the more ability to cover operating expenses. It is computed by the formula:
   
   

$\text{Gross profit percentage}=\frac{\text{Gross profit on sales}}{\text{Net sales}}$

1. 7. Return on sales: It is one of the profitability ratios. Return on sales ratio is used to measure the percentage of net income that is being generated per dollar of revenue or sales.

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

1. 8. 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:

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

Analysis of ratios:

The computed ratios are compared in the following ways:

1. 1. Quick ratio: The quick ratio of Incorporation AI is 1.42 which is higher than the industry average of 0.3. This reveals that the liquidity position of Incorporation AI is higher than the industry average.
2. 2. Current ratio: The computed ratio is 2.30:1 which is much more than the industry average of 1.9 times. This shows that the short-term liquidity position of Incorporation AI is much better than its industry.
3. 3. Accounts receivable ratio: The accounts receivable turnover of Incorporation AI 4.94 times which is much less than the industry average of 5.9 times. This shows that Incorporation AI has managed its receivables inefficiently.
4. 4. Inventory turnover ratio: The inventory turnover of Incorporation AI is 3.00 times which is very lower than the industry average of 3.5 times. This shows that inventory is piled up for Incorporation AI and has made lower volume of sales.
5. 5. Debt-to-equity ratio: The debt equity ratio of Incorporation AI is 0.98 which is much more than the industry average of 0.73. This shows that Incorporation AI is has higher amount of debts in its financial structure and it bears higher risk.
6. 6. Gross profit percentage: The computed ratio is 43.18 percent that is lower than the industry average of 44.3 percent. This shows that the cost of production of Incorporation P is higher.
7. 7. Return on sales ratio: The return on sales ratio is 3.64 percent which is much less than the industry average of 4.5 percent. This shows that Incorporation AI’s net income earned per every dollar of sales revenue is very less.
8. 8. Return on assets ratio: The return on assets ratio is 4.67 percent which is lower than the industry average of 7.6 percent. This shows that Incorporation AI is managing its assets inefficiently to generate sufficient net income.

b.

To determine

Compute dividends paid per share of common stock and compute dividend payout ratio.

Explanation of Solution

Dividends per share: The amount of dividends paid to each common stockholder is referred to as dividends per share. This ratio is calculated by using the given formula:

$\text{Dividends per share }=\frac{\text{Dividends}}{\text{ Number of common stock outstanding}}$

Dividends payout ratio: The financial metric which measures the dividends declared per common share in relation to the earnings per share of a company is referred to as dividend payout ratio. This ratio is calculated by using the given formula:

$\text{Dividend payout ratio }=\frac{\text{Annual dividend per share}}{\text{Earnings per share}}$

Compute dividends per share for Incorporation AI for the year 2016.

$\begin{array}{c}\text{Dividends per share }=\frac{\text{Dividends}}{\text{ Number of common stock outstanding}}\\ =\frac{\$2,600,000}{2,000,00\text{0 shares}}\\ =\text{\$1}\text{.3 per share}\end{array}$ (1)

Compute dividend payout ratio.

Given: Earnings per share = $4.25

$\begin{array}{c}\text{Dividend payout ratio }=\frac{\text{Annual dividend per share }\left(1\right)}{\text{Earnings per share}}\\ =\frac{\$1.3}{\$4.25}\times 100\\ =30.58\%\end{array}$

Hence, the dividends per share of Incorporation AI are $1.3 per share and dividend payout ratio is 30.58%.

c.

To determine

Compute price earnings ratio and dividend yield ratio when the price per share of common stock is $63.

Explanation of Solution

Price/Earnings Ratio: The price/earnings ratio shows the market value of the amount invested to earn $1 by a company. It is major tool used by investors for making decisions related to the investment in a company.

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

Compute price earnings ratio of Incorporation AI for 2016.

$\begin{array}{c}\text{Price/Earnings }=\frac{\text{Market price per share}}{\text{Earnings per share}}\\ =\frac{\$63}{\$4.25}\\ =14.82\text{ times}\end{array}$

Dividend yield: Dividend yield ratio indicates how much percentage of share prices a company pays out in the form of dividends price. The formula to calculate the dividend yield percentage is as follows:

$\text{Dividend yield}=\frac{\text{Dividends per share}}{\text{Stock price}}\times 100$

Compute dividends yield ratio for Incorporation AI for the year 2016.

Given: Market price per share: $62.25

$\begin{array}{c}\text{Dividend yield}=\frac{\text{Dividends per share}}{\text{Market price per share}}\\ =\frac{\$1.3\left(1\right)}{\$63}\times 100\\ =2.06\%\end{array}$

Hence, the price earnings ratio of Incorporation AI is 14.82 times and dividend yield ratio is 2.06%.