Chapter 17, Problem 4BPSB

To determine

Concept Introduction:

Financial Statement analysis is done using the components of financial statement. These components are Balance sheet, Income statement, Statement of Cash flows etc. Annual report of a company contains financial statement of that year and previous year for comparison. If the company has subsidiaries or segments, the financial statement shall be consolidated for whole business of the company.

Current Ratio: Current Ratio is measure of the company’s ability to pay off its current liabilities using its current assets. It is calculated by dividing the total current assets by total current liabilities. The formula of the current ratio is as follows:

  $CurrentRatio=\frac{Currentassets}{Currentliabilities}$

Acid test ratio: Acid test ration is also called Quick ratio. This ratio is calculated by dividing the quick assets (Cash, Cash equivalents, Short term investments and current receivables) by total current liabilities for the year. The formula for Acid test ratio is as follows:

  $Acidtestratio=\frac{\left(Cash+Cashequivalents+Shortterminvestments+Accountsreceivables\right)}{CurrentLiabilities}$

Accounts receivable turnover ratio: This is an efficiency ratio that indicates the conversion of accounts receivable into cash. This ratio is calculated by dividing the Net credit Sales by the Average accounts receivable. The formula to calculate this ratio is as follows:

  $Accountsreceivableturnoverratio= \frac{NetcreditSales}{Averageaccountsreceivable}$

Days Sales in receivable ratio: This is an efficiency ratio that indicates the period for which credit sales remain as receivable. The ratio is calculated by dividing 365 days by the Accounts receivable turnover ratio. The formula to calculate this ratio is as follows:

  $DaysSalesinreceivableratio=\frac{365}{Accountsreceivableturnoverratio}$

Inventory Turnover Ratio: Inventory Turnover Ratio measures the efficiency of the company in converting its inventory into sales. It is calculated by dividing the Cost of goods sold by Average inventory. The formula of the Inventory Turnover Ratio is as follows:

  $InventoryTurnoverRatio=\frac{Costofgoodssold}{Averageinventory}$

Note: Average inventory is calculated with the help of following formula:

  $Averageinventory=\frac{(Beginninginventory+Endinginventory)}{2}$

Day’s sales in inventory: Days sales in inventory represent the number of days the inventory waits for the sale. It is calculated by dividing the 365 days by Inventory Turnover Ratio. The formula of the Days sales in inventory is as follows:

  $Dayssalesininventory=\frac{365}{InventoryTurnoverRatio}$

Debt to Equity Ratio:

Debt to equity ratio is calculated to determine the leverage position of the company. It compares the total liabilities of the company with it total shareholders’ equity. The debt to equity ratio is calculated by dividing the Total Liabilities by Total Stockholder’s Equity. The formula to calculate Debt to equity ratio is as follows:

  $\text{Debt to equity ratio = }\frac{\text{Total liabilities}}{\text{Total Stockholder’s Equity}}$

Times interest earned Ratio:

A company pays its interest expenses from the Net operating Income available. To find the company’s ability to pay the interest expenses, the ratio of Net operating income to Interest expense should be calculated. Times Interest earned ratio shows the number of times interest expenses are covered by the net operating income. It is calculated by dividing the Net operating Income by Interest Expense. The formula is as under:

Times interest earned Ratio = Net Operating Income / Interest Expense

(Note: The numerator of the formula “Net operating income” is equal to the Income before deduction of Interest and taxes)

Profit Margin Ratio:

Profit Margin Ratio is a profitability ratio that represents the percentage income earned on the sales. It is calculated by dividing the Net Income by the Sales. The formulas to calculate the Profit margin is as follows:

  $ProfitMargin =\frac{NetIncome}{Sales}$

Total Asset Turnover Ratio:

Asset Turnover Ratio is an efficiency ratio that represents the sales earned on the average assets invested in the business. It is calculated by dividing the Sales by Average total assets. The formulas to calculate the Asset Turnover Ratio is as follows:

  $AssetTurnoverRatio =\frac{Sales}{Averagetotalassets}$

Return on total Assets: The Return on total assets is profitability ratio that measures the percentage of profit earned on average assets invested in the business. Return on asset is calculated by dividing the net income by average total assets. The formula to calculate Return on assets is as follows:

  $Returnonassets=\frac{Netincome}{AverageTotalAssets}$

Note: Average total assets are calculated as an average of beginning and ending total assets. The formula to calculate the average total assets is as follows:

  $AveragetotalAssets=\frac{\left(Beginningtotalassets+Endingtotalassets\right)}{2}$

Return on Common Stockholder’s Equity:

Return on Equity is the rate of return earned by the Stockholders on their investment in the company. It is calculated with the help of following formula:

  $\mathrm{Re}turnonEquity=\frac{NetIncome}{AverageStockholder’sEquity}$

The Average stock holder’s equity calculated with the help of following formula:

  $Averagestockholder’sequity=\frac{( Beginningstockholder’sequity+Endingstockholder’sequity)}{2}$

To calculate: The ratio analysis for the given case

Answer to Problem 4BPSB

Solution: The ratio analysis for the given case is as follows:

1	Current Ratio	2.5
2	Acid Test Ratio	1.6
3	Days Sales Uncollected	13.8
4	Inventory Turnover	15.3
5	Days Sales in inventory	23.6
6	Debt to Equity Ratio	0.68
7	Times Interest Earned	13.7
8	Profit Margin Ratio	7.5%
9	Total Assets Turnover	3.0
10	Return on Total Assets	22.4%
11	Return on Common stock holder's Equity	38.3%

Explanation of Solution

The ratio analysis for the given case is as calculated as follows:

1	Current Ratio:
	Cash	$ 6,100
	Short term Investments	$ 6,900
	Accounts Receivable, net	$ 12,100
	Notes Receivable (trade)	$ 3,000
	Merchandise Inventory	$ 13,500
	Prepaid Expenses	$ 2,000
	Total Current Assets (A)	$ 43,600
	Accounts Payable	$ 11,500
	Accrued wages payable	$ 3,300
	Income Tax Payable	$ 2,600
	Total Current Liabilities (B)	$ 17,400
	Current Ratio (A/B)	2.5
2	Acid Test Ratio:
	Cash	$ 6,100
	Short term Investments	$ 6,900
	Accounts Receivable, net	$ 12,100
	Notes Receivable (trade)	$ 3,000
	Total Liquid Assets (A)	$ 28,100
	Accounts Payable	$ 11,500
	Accrued wages payable	$ 3,300
	Income Tax Payable	$ 2,600
	Total Current Liabilities (B)	$ 17,400
	Acid Test Ratio (A/B)	1.6
3	Days Sales Uncollected:
	Accounts Receivable (A)	$ 12,100
	Credit Sales (B)	$ 315,500
	Days Sales Uncollected = (A*360/B)	13.8
4	Inventory Turnover:
	Cost of Goods sold (A)	$ 236,100
	Beginning Inventory (B)	$ 17,400
	Ending Inventory (C)	$ 13,500
	Average inventory (D) = (B+C)/2	$ 15,450
	Inventory Turnover = (A/D)	15.3
5	Days Sales in inventory:
	Inventory Turnover (A)	15.3
	Days Sales in inventory = (360/A)	23.6
6	Debt to Equity Ratio:
	Accounts Payable	$ 11,500
	Accrued wages payable	$ 3,300
	Income Tax Payable	$ 2,600
	Long term notes payable	$ 30,000
	Total Debts (A)	$ 47,400
	Common Stock	$ 35,000
	Retained earnings	$ 35,100
	Total Equity (B)	$ 70,100
	Debt to Equity Ratio =(A/D)	0.68
7	Times Interest Earned:
	Income before taxes (A)	$ 28,000
	Add: Interest Expense (B)	$ 2,200
	Income before interest and taxes (C) =A+B	$ 30,200
	Times Interest Earned =(C/B)	13.7
8	Profit Margin Ratio:
	Net Income (A)	$ 23,800
	Sales (B)	$ 315,500
	Profit Margin Ratio =(A/B)	7.5%
9	Total Assets Turnover:
	Sales (A)	$ 315,500
	Beginning Total Assets (B)	$ 94,900
	Ending Total Assets (C)	$ 117,500
	Average Total Assets (D) = (B+C)/2	$ 106,200
	Inventory Turnover = (A/D)	3.0
10	Return on Total Assets:
	Net Income (A)	$ 23,800
	Beginning Total Assets (B)	$ 94,900
	Ending Total Assets (C)	$ 117,500
	Average Total Assets (D) = (B+C)/2	$ 106,200
	Return on Total Assets = (A/D)	22.4%
11	Return on Common stock holder's Equity:
	Net Income (A)	$ 23,800
	Beginning Common Stockholder's Equity (B)	$ 54,300
	Ending Common Stockholder's Equity (C)	$ 70,100
	Average Common Stockholder's Equity (D) = (B+C)/2	$ 62,200
	Return on Common stock holder's Equity = (A/D)	38.3%

Conclusion

Financial Statement analysis is done using the components of financial statement. These components are Balance sheet, Income statement, Statement of Cash flows etc.