Chapter 2, Problem 2.2DIE

(a)

To determine

Earnings per share (EPS): The amount of net income available to each shareholder per common share outstanding is referred to as earnings per share (EPS).

Use the following formula to compute EPS:

$\text{EPS = }\frac{\text{Net income – Preferred dividends}}{\text{Weighted average common shares outstanding}}$

To determine: (a) EPS of Corporation N for 2016 and 2017 and comment on the changes in comparison to its competitor, Corporation M.

Explanation of Solution

Compute EPS of Corporation N for 2017, if net income is $80,000, preferred dividends are $6,000, and weighted common shares outstanding at the beginning of 2017 40,000 and end of 2017 are 75,000.

$\begin{array}{c}\text{EPS = }\frac{\text{Net income – Preferred dividends}}{\text{Weighted average common shares outstanding}}\\ \text{=}\frac{\text{\$80,000–\$6,000}}{\left(\text{40,000 +75,000}\right)\text{ shares}}\\ =\frac{\text{74,000}}{\text{57,500 shares}}\\ \text{= \$1}\text{.29 per share}\end{array}$

Compute EPS of Corporation N for 2016, if net income is $40,000, preferred dividends are $6,000, and weighted common shares outstanding at the beginning of 2016 are 30,000 and end of 2016 are 40,000.

$\begin{array}{c}\text{EPS = }\frac{\text{Net income – Preferred dividends}}{\text{Weighted average common shares outstanding}}\\ \text{=}\frac{\text{\$40,000–\$6,000}}{\left(\text{30,000 +40,000}\right)\text{ shares}}\\ =\frac{\text{34,000}}{\text{35,000 shares}}\\ \text{= \$0}\text{.97 per share}\end{array}$

Comments: EPS of Corporation N has increased from 2016 to 2017. This infers that the profitability of the company has increased. The size of the company with respect to number of shares differs for each company. Hence, EPS of Corporation N cannot be compared to Corporation M.

(b)

To determine

Current ratio: The financial ratio which evaluates the ability of a company to pay off the debt obligations which mature within one year, or within completion of the operating cycle, is referred to as current ratio. This ratio assesses the liquidity of a company.

Formula of current ratio:

$\text{Current ratio = }\frac{\text{Current assets}}{\text{Current liabilities}}$

Debt to assets ratio: This financial ratio evaluates the ability of a company to pay off long-term debt obligations owed to creditors. This ratio assesses the solvency of a company.

Formula of debt to assets ratio:

$\text{Debt to assets ratio = }\frac{\text{Total liabilities}}{\text{Total assets}}$

To determine: (b) Current ratio and debt to assets ratio for 2016 and 2017.

Explanation of Solution

Compute current ratio for Corporation N for 2017, if current assets are $54,000 and current liabilities are $22,000.

$\begin{array}{c}\text{Current ratio = }\frac{\text{Current assets}}{\text{Current liabilities}}\\ =\frac{\$54,000}{\$22,000}\\ =2.45:1\end{array}$

Compute current ratio for Corporation N for 2016, if current assets are $36,000 and current liabilities are $30,000.

$\begin{array}{c}\text{Current ratio = }\frac{\text{Current assets}}{\text{Current liabilities}}\\ =\frac{\$36,000}{\$30,000}\\ =1.20:1\end{array}$

Compute debt to assets ratio for Corporation N for the year 2017, if total assets are $240,000 and total liabilities are $72,000.

$\begin{array}{c}\text{Debt to assets ratio = }\frac{\text{Total liabilities}}{\text{Total assets}}\\ \text{=}\frac{\text{\$72,000}}{\text{\$240,000}}\\ \text{= 0}\text{.3 or 30\%}\end{array}$

Compute debt to assets ratio for Corporation N for the year 2016, if total assets are $205,000 and total liabilities are $100,000.

$\begin{array}{c}\text{Debt to assets ratio = }\frac{\text{Total liabilities}}{\text{Total assets}}\\ \text{=}\frac{\text{\$100,000}}{\text{\$205,000}}\\ \text{= 0}\text{.49 or 49\%}\end{array}$

Comments: Current ratio evaluates liquidity whereas debt to assets ratio evaluates solvency. By observing the current ratio for 2016 and 2017, it can be inferred that the liquidity of Corporation N has increased from 1.20 to 2.45. The decrease in debt to assets ratio infers that solvency of Corporation N has improved from 49% in 2016 to 30% in 2017.

(c)

To determine

Free cash flow: This measure evaluates the cash-generating capacity of a company from its operating activities, after paying capital expenditures and dividends.

Formula of free cash flow:

$\text{Free cash flow = }\left\{\begin{array}{l}\text{Net cash provided by operating activities–}\\ \text{Capital expenditures–}\\ \text{Dividends}\end{array}\right\}$

To determine: (c) Free cash flow of Corporation N for 2016 and 2017 and comment on the changes.

Explanation of Solution

Compute free cash flow for Corporation N for 2017, if net cash provided by operating activities is $90,000, capital expenditures are $27,000, preferred dividends paid are $6,000, and common dividends paid are $3,000.

$\begin{array}{c}\text{Free cash flow = }\left\{\begin{array}{l}\text{Net cash provided by operating activities–}\\ \text{Capital expenditures–}\\ \text{Preferred and common dividends paid}\end{array}\right\}\\ =\$90,000–\$27,000–\$6,000–\$3,000\\ =\$54,000\end{array}$

Compute free cash flow for Corporation N for 2016, if net cash provided by operating activities is $56,000, capital expenditures are $12,000, preferred dividends paid are $6,000, and common dividends paid are $1,500.

$\begin{array}{c}\text{Free cash flow = }\left\{\begin{array}{l}\text{Net cash provided by operating activities–}\\ \text{Capital expenditures–}\\ \text{Preferred and common dividends paid}\end{array}\right\}\\ =\$56,000–\$12,000–\$6,000–\$1,500\\ =\$36,500\end{array}$

Comments: The cash-generating capacity of Corporation N has increased from $36,500 in 2016 to $54,000 in 2017.