Chapter 4, Problem 25SP

a.

Summary Introduction

To determine: The liquidity position of C Corporation, comparison of liquidity position with peers and the changes in liquidity position over the time.

Ratio Analysis: Ratio is used to compare two arithmetical figures. In case of the ratio analysis of the company, the financial ratios are calculated. The financial ratios examines the performance of the company and are used in comparing with other same business. It indicates relationship of two or more parts of financial statements.

Liquidity Position: The liquidity position of the company is indicated by liquidity ratios, which gives the idea of whether the company has the ability to pay back its liabilities, which has less than one year maturity.

Explanation of Solution

Solution:

Current ratio

2013

Given,

Current asset is $1,206,000.

Current liabilities is $571,500.

The formula to calculate current ratio is,

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

Substitute $1,206,000 for current assets and $571,500 for current liabilities.

$\begin{array}{c}\text{Current Ratio}=\frac{\$1,206,000}{\$571,500}\\ =2.11\text{ times}\end{array}$

Thus, current ratio is 2.11 times.

2014

Given,

Current asset is $1,405,000.

Current liabilities is $602,000.

The formula to calculate current ratio is,

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

Substitute $1,405,000 for current assets and $602,000 for current liabilities in above formula.

$\begin{array}{c}\text{Current Ratio}=\frac{\$1,405,000}{\$602,000}\\ =2.33\text{times}\end{array}$

Thus, current ratio is 2.33times.

Comparison:

Ratios	Year 2013	Year 2014	Industry
Current ratio	2.11 times	2.33 times	2.7 times

Table (1)

The current ratio of the company in year 2014 has been increased so it can be said that the liquidity position of the company is improved.

Conclusion

Therefore, the liquidity position is improved in year 2014 as comparison to year 2013 but it is lower than industry average.

b.

Summary Introduction

To determine: The Assets management position of C Corporation, comparison of assets management position with peers and the changes in assets management position over the time.

Assets Management Position: The assets management position of the company is indicated by assets management ratios which give idea how well the company is using its assets.

Explanation of Solution

Solution:

Inventory turnover ratio:

2013

Given,

Total sale is $3,635,000.

Total inventory is $813,000.

The formula of inventory turnover ratio is,

$\text{ Inventory Turnover Ratio}=\frac{\text{Total Sales}}{\text{Total Inventory }}$

Substitute $3,635,000 for total sales and $813,000 for total inventory.

$\begin{array}{c}\text{ Inventory Turnover Ratio}=\frac{\$3,635,000}{\$813,000}\\ =4.47\text{ times}\end{array}$

Thus, inventory turnover ratio is 4.47 times.

2014

Given,

Total sale is $4,240,000

Total inventory is $894,000.

The formula of inventory turnover ratio is:

$\text{ Inventory Turnover Ratio}=\frac{\text{Total Sales}}{\text{Total Inventory }}$

Substitute $4,240,000 for total sales and $894,000 for total inventory.

$\begin{array}{c}\text{ Inventory Turnover Ratio}=\frac{\$4,240,000}{\$894,000}\\ =4.74\text{times}\end{array}$

Thus, inventory turnover ratio is 4.74 times.

Days sales outstanding

2013

Given,

Receivables are $328,000.

Annual sale is $3,635,000.

The formula to calculate days sales outstanding is,

$\begin{array}{c}\text{Days Sales Outstanding}=\frac{\text{Account Receivable}}{\frac{\text{Annual Sales}}{\text{365}}}\\ =\frac{\text{Account Receivables}}{\text{Annual Sales}}\times 365\end{array}$

Substitute $328,000 for account receivables and $3,635,000 for annual sales.

$\begin{array}{c}\text{Days Sales Outstanding}=\frac{328,000}{\$3,635,000}\times 365\\ =32.94\text{days}\end{array}$

Thus, days sales outstanding is 32.94 days.

2014.

Given,

Receivables are $439,000.

Annual sale is $4,240,000.

The formula to calculate days sales outstanding is,

$\begin{array}{c}\text{Days Sales Outstanding}=\frac{\text{Account Receivable}}{\frac{\text{Annual Sales}}{\text{365}}}\\ =\frac{\text{Account Receivables}}{\text{Annual Sales}}\times 365\end{array}$

Substitute $439,000 for account receivables and $4,240,000 for annual sales.

$\begin{array}{c}\text{Days Sales Outstanding}=\frac{\$439,000}{\$4,240,000}\times 365\\ =37.79\text{days}\end{array}$

Thus, days sales outstanding is 37.79 days.

Fixed assets turnover

2013

Given,

Sales are $3,635,000.

Total fixed assets are $461,000.

The formula to calculate fixed assets turnover is,

$\text{Fixed Assets Turnover}=\frac{\text{Total Sales}}{\text{ Net Fixed Assets}}$

Substitute $3,635,000 for total sales and $461,000 for fixed assets.

$\begin{array}{c}\text{Fixed Assets Turnover}=\frac{\$3,635,000}{\$461,000}\\ =7.89\text{ times}\end{array}$

Thus, fixed assets turnover is 7.89times.

Working notes:

Compute total fixed assets.

Given,

Land and building is$271,000.

Machinery is $133,000.

Other fixed assets are $57,000.

Calculation of total fixed assets,

$\begin{array}{c}\text{Total Fixed Assets}=\text{Land and Building}+\text{Machinery}+\text{Other Fixed Assets}\\ =\$271,000+\$133,000+\$57,000\\ =\$461,000\end{array}$

Thus, total amount of fixed assets is $461,000.

2014

Given,

Sales are $4,240,000.

Total fixed assets are $431,000.

The formula to calculate fixed assets turnover is,

$\text{Fixed Assets Turnover}=\frac{\text{Total Sales}}{\text{ Net Fixed Assets}}$

Substitute $4,240,000 for total sales and $431,000 for fixed assets.

$\begin{array}{c}\text{Fixed Assets Turnover}=\frac{\$4,240,000}{\$431,000}\\ =9.84\text{times}\end{array}$

Thus, fixed assets turnover is 9.84times.

Working notes:

Compute total fixed assets.

Given,

Land and building is $238,000.

Machinery is $132,000.

Other fixed assets are $61,000.

The total amount of the fixed assets is:

$\begin{array}{c}\text{Total Fixed Assets}=\text{Land and Building}+\text{Machinery}+\text{Other Fixed Assets}\\ =\$238,000+\$132,000+\$61,000\\ =\$431,000\end{array}$

Thus, total amount of fixed assets is $431,000.

Total assets turnover

2013

Given,

Total sales are $3,635,000.

Total assets are $1,667,000.

The formula of total assets turnover is,

$\text{Total Assets Turnover}=\frac{\text{Total Sales}}{\text{Total Assets}}$

Substitute $3,635,000 for total sales and $1,667,000 for total assets.

$\begin{array}{c}\text{Total Assets Turnover}=\frac{\$3,635,000}{\$1,667,000}\\ =2.18\text{ times}\end{array}$

Thus, total assets turnover is 2.18 times.

2014

Given,

Total sales are $4,240,000.

Total assets are $1,836,000.

The formula of total assets turnover is,

$\text{Total Assets Turnover}=\frac{\text{Total Sales}}{\text{Total Assets}}$

Substitute $4,240,000 for total sales and $1,836,000 for total assets.

$\begin{array}{c}\text{Total Assets Turnover}=\frac{\$4,240,000}{\$1,836,000}\\ =2.31\text{ times}\end{array}$

Thus, total assets turnover is 2.31 times.

Comparison

Ratios	Year 2013	Year 2014	Industry
Inventory turnover ratio	4.47 times	4.74 times	7 times
Days sales outstanding	32.94 days	37.79 days	32 days
Fixed assets turnover	7.89 times	9.84 times	13 times
Total assets turnover	2.18 times	2.31 times	2.60times

Table (2)

• The inventory turnover ratio has been improved in year 2014 comparing to 2013. However it is lower than industry average.
• Days sales outstanding is higher in 2014, the company should look over the receivables to be collected if the credit policy is same. It is somehow close to the industry average.
• Fixed assets turnover has been increased in 2014 comparing to 2013. But it is still below the industry average.
• Total assets turnover is increased in 2014 comparing it to 2013. The industry average seems higher than company however.

Conclusion

Therefore, the assets management ratios are improved in 2014 comparing 2013 but ratios are still below the industry’s average.

c.

Summary Introduction

To determine: The debt management position of C Corporation, comparison of debt management position with peers and the changes in debt management position over the time.

Debt Management Position: Debt management position is indicated by the debt management ratios which give an idea how the company finances its assets as well as the capability to pay back its long-term debt.

Explanation of Solution

Solution:

Debt-to capital ratio

2013

Given,

Total debt is $716,810.

Equity is $836,602.

The formula of debt-to-capital ratio is,

$\text{Debt-to-Capital Ratio}=\frac{\text{Total Debt}}{\text{Debt}+\text{Equity}}\times 100$

Substitute $716,810 for total debt and $836,602 for equity in above formula.

$\begin{array}{c}\text{Debt-to-Capital Ratio}=\frac{\$716,810}{\$716,810+\$836,602}\times 100\\ =\frac{\$716,810}{\$1,553,412}\times 100\\ =46.41\%\end{array}$

Thus, debt-to-capital ratio is 46.41%.

Working notes:

Compute total debt.

Given,

Long term debt is $258,898.

Notes payable is $457,912.

Calculation of total debt,

$\begin{array}{c}\text{Total Debt}=\text{Long-term Debt}+\text{Notes Payable}\\ =\$258,898+\$457,912\\ =\$716,810\end{array}$

Thus, total debt is $716,810.

Compute the total value of equity.

Common stock is $575,000.

Retained earnings are $261,602.

Calculation of total equity value,

$\begin{array}{c}\text{Total Equity Value}=\text{Common Stock}+\text{Retained Earnings}\\ =\$575,000+\$261,602\\ =\$836,602\end{array}$

Thus, total equity value is $836,602.

2014

Given,

Total debt is $881,280.

Equity is $829,710.

The formula of debt-to-capital ratio is,

$\text{Debt-to-Capital Ratio}=\frac{\text{Total Debt}}{\text{Debt}+\text{Equity}}\times 100$

Substitute $881,280 for total debt and $829,710 for equity.

$\begin{array}{c}\text{Debt-to-Capital Ratio}=\frac{\$881,280}{\$881,280+\$829,710}\times 100\\ =\frac{\$881,280}{\$1,710,990}\times 100\\ =51.50\%\end{array}$

Thus, debt-to-capital ratio is 51.50%.

Working notes:

Compute total debt.

Long term debt is $404,290.

Notes payable is 476,990.

Calculation of total debt,

$\begin{array}{c}\text{Total Debt}=\text{Long-term Debt}+\text{Notes Payable}\\ =\$404,290+\$476,990\\ =\$881,280\end{array}$

Thus, the total debt is $881,280.

Compute the total value of equity.

Common stock is $575,000.

Retained earnings are $254,710.

Calculation of total equity value

$\begin{array}{c}\text{Total Equity Value}=\text{Common Stock}+\text{Retained Earnings}\\ =\$575,000+\$254,710\\ =\$829,710\end{array}$

Thus, total equity value is $829,710.

Compute total debt.

Long term debt is $404,290.

Notes payable is 476,990.

Calculation of total debt,

$\begin{array}{c}\text{Total Debt}=\text{Long-term Debt}+\text{Notes Payable}\\ =\$404,290+\$476,990\\ =\$881,280\end{array}$

Thus, the total debt is $881,280.

Comparison:

Ratios	Year 2013	Year 2014	Industry
Debt-to-capital ratio	46.41%	51.50%	50%

Table (3)

The debt ratio of the company has been increased in year 2014 which is not good. In 2013 it was lower than industry average but in 2014 it is higher than industry average.

Conclusion

Therefore, the debt management position of the company is not good in year 2014 the company should improve its position by paying the liabilities.

d.

Summary Introduction

To determine: The profitability ratio of C Corporation, compare it with peers and the change in the profitability of the company over the time.

Profitability Ratios: These ratios give an idea whether the company is able to operate profitably and is efficient in using its assets.

Explanation of Solution

Solution:

Return on assets

2013

Given,

Net income is $95,970.

Total asset is $1,667,000.

The formula of return on asset is,

$\text{Return on Assets}=\frac{\text{Net Income}}{\text{Total Value of Asset}}\times 100$

Substitute $95,970 for net income and $1,667,000 for total value of assets.

$\begin{array}{c}\text{Return on Assets}=\frac{\$95,970}{\$1,667,000}\times 100\\ =5.76\%\end{array}$

Thus, return on assets is 5.76%.

2014

Given,

Net income is $18,408.

Total asset is $1,836,000.

The formula of return on asset is,

$\text{Return on Assets}=\frac{\text{Net Income}}{\text{Total Value of Asset}}\times 100$

Substitute $18,408 for net income and $1,836,000 for total value of assets.

$\begin{array}{c}\text{Return on Assets}=\frac{\$18,408}{\$1,836,000}\times 100\\ =1\%\end{array}$

Thus, return on assets is 1%.

Return on equity

2013

Given,

Net income is $95,970.

Equity is $836,602.

The formula of return on equity is,

$\text{Return on Equity}=\frac{\text{Net Income}}{\text{ Equity}}\times 100$

Substitute $95,970 for net income and $836,602 for equity.

$\begin{array}{c}\text{Return on Equity}=\frac{\$95,970}{\$836,602}\times 100\\ =11.47\%\end{array}$

Thus, return on equity is 11.47%.

Working notes:

Compute the total value of equity.

Common stock is $575,000.

Retained earnings are $261,602.

Calculation of total equity value,

$\begin{array}{c}\text{Total Equity Value}=\text{Common Stock}+\text{Retained Earnings}\\ =\$575,000+\$261,602\\ =\$836,602\end{array}$

Thus, total equity value is $836,602.

2014

Given,

Net income is $18,408.

Equity is $829,710.

The formula of return on equity is,

$\text{Return on Equity}=\frac{\text{Net Income}}{\text{Equity}}$

Substitute $18,408 for net income and $829,710 for equity.

$\begin{array}{c}\text{Return on Equity}=\frac{\$18,408}{\$829,710}\\ =2.21\%\end{array}$

Thus, return on equity is 2.21%.

Working note:

Compute the total value of equity.

Common stock is $575,000.

Retained earnings are $254,710.

Calculation of total equity value,

$\begin{array}{c}\text{Total Equity Value}=\text{Common Stock}+\text{Retained Earnings}\\ =\$575,000+\$254,710\\ =\$829,710\end{array}$

Thus, total equity value is $829,710.

Return on invested capital

2013

Given,

Earnings before interest and tax (EBIT) is $202,950.

Tax rate is 40%.

Total debt is $ 716,810.

Total equity is $836,602.

The formula of return on invested capital is,

$\text{Return on Invested Capital}=\frac{\text{EBIT}\left(1-\text{T}\right)}{\text{Debt}+\text{Equity}}\times 100$

Substitute $202,950 for EBIT, $716,810 for debt and $836,602 for equity.

$\begin{array}{c}\text{Return on Invested Capital}=\frac{\$202,950\left(1-40\%\right)}{\$716,810+\$836,602}\times 100\\ =\frac{\$121,770}{\$1,553,412}\times 100\\ =7.83\%\end{array}$

Thus, return on invested capital is 7.83%.

Working note:

Compute total debt.

Long term debt is $258,898.

Notes payable is 457,912.

Calculation of total debt,

$\begin{array}{c}\text{Total Debt}=\text{Long-term Debt}+\text{Notes Payable}\\ =\$258,898+\$457,912\\ =\$716,810\end{array}$

Thus, the total debt is $716,810.

2014

Given,

Earnings before interest and tax (EBIT) are $97,680.

Tax rate is 40%.

Total debt is $881,280.

Total equity is $829,710.

The formula of return on invested capital is,

$\text{Return on Invested Capital}=\frac{\text{EBIT}\left(1-\text{T}\right)}{\text{Debt}+\text{Equity}}\times 100$

Substitute $97,680 for EBIT, $881,280 for debt and $829,710 for equity.

$\begin{array}{c}\text{Return on Invested Capital}=\frac{\$97,680\left(1-40\%\right)}{\$881,280+\$829,710}\times 100\\ =\frac{\$58,608}{\$1,710,990}\times 100\\ =3.42\%\end{array}$

Thus, return on invested capital is 3.42%.

Working note:

Compute total debt.

Long term debt is $404,290.

Notes payable is 476,990.

The total debt of the company is,

$\begin{array}{c}\text{Total Debt}=\text{Long-term Debt}+\text{Notes Payable}\\ =\$404,290+\$476,990\\ =\$881,280\end{array}$

Thus, the total debt is $881,280.

Compute the total value of equity.

Common stock is $575,000.

Retained earnings are $254,710.

Calculation of total equity value,

$\begin{array}{c}\text{Total Equity Value}=\text{Common Stock}+\text{Retained Earnings}\\ =\$575,000+\$254,710\\ =\$829,710\end{array}$

Thus, total equity value is $829,710.

Profit margin

2013

Given,

Net income is $95,970.

Sales are $3,635,000.

The formula to calculate profit ratio is,

$\text{Profit Ratio}=\frac{\text{Net Income}}{\text{Sales}}\times 100$

Substitute $95,970 for net income and $3,635,000 for sales.

$\begin{array}{c}\text{Profit Ratio}=\frac{\$95,970}{\$3,635,000}\times 100\\ =2.64\%\end{array}$

Thus, profit ratio is 2.64%.

2014

Given,

Net income is $18,408.

Sales are $4,240,000.

The formula to calculate profit ratio is,

$\text{Profit Ratio}=\frac{\text{Net Income}}{\text{Sales}}\times 100$

Substitute $18,408 for net income and $4,240,000 for sales.

$\begin{array}{c}\text{Profit Ratio}=\frac{\$18,408}{\$4,240,000}\times 100\\ =0.43\%\end{array}$

Thus, profit ratio is 0.43%.

Comparison

Ratios	Year 2013	Year 2014	Industry
Return on assets	5.76%	1%	9.1%
Return on equity	11.47%	2.21%	18.2%
Return on invested capital	7.83%	3.42%	14.5%
Profit margin	2.64%	0.43%	3.5%

Table (4)

• Return on assets has been declined in year 2014 comparing to 2013   and it I lower than industry average.
• Return on equity has been declined in year 2014 comparing to 2013 and it is lower than industry average
• Return on invested capital is declined in year 2014 comparing to 2013 and it is lower than industry average.
• The profit margin has fallen in 2014 comparing to 2013 and it is loer than industry average.

Conclusion

Therefore, the profitability ratios have been declined in year 2014 comparing to 2013 and are lower than the industry’s average.

e.

Summary Introduction

To determine: The market value ratios, comparison of ratios with peers and changes in market values over the time.

Market Value Ratios: The market value ratios give idea about the view of investors towards the company and company’s future scenario.

Explanation of Solution

Solution:

Comparison

Ratios	Year 2013	Year 2014	Industry
P/E ratio	5.65	15.42	6

Table (5)

P/E ratio of 2013 is 5.65 times and P/E ratio in 2014 is 15.42. The P/E ratio has been increased in the year 2014 comparing to 2013. It is higher than industry average.

Conclusion

Therefore, the market value ratios have been improved in year 2014 and higher than industry average.

f.

Summary Introduction

To calculate: The ROE of the C company as well industry average ROE using DuPont equation and way of comparing of Company’s financial position with industry’s average numbers.

Return on Equity (ROE): Return on equity is the return from the equity. It is the ratio of net income and shareholders’ equity. This ratio measures the performance of the company and tells how well the company is performing. This ratio is used to compare own firm with competitors.

Du Pont Equation: Among all ratios, return on equity is very common. It shows the value of the firm. Improvement in the ROE is considered as valued addition to the firm. ROE can be linked with other ratios. Analysis of such ratios will indicate proper reason for change in ROE. The combination is known as Du Pont equation which is shown below:

$\begin{array}{c}\text{ROE }=\frac{\text{Net Income}}{\text{Common Equity}}\\ =\frac{\text{Net Income}}{\text{Total Assets}}\times \frac{\text{Total Assets}}{\mathrm{Common}\text{Assets}}\\ =\frac{\text{Net Income}}{\text{Sales}}\times \frac{\text{Sales}}{\text{Total Assets}}\times \frac{\text{Total Assets}}{\text{Total Common Equity}}\\ =\text{Profit Margin}\times \text{ Total Assets Turnover Ratio}\times \text{Equity Multiplier}\end{array}$

Explanation of Solution

Solution:

The formula of ROE is,

$\text{ROE}=\text{Profit Margin}\times \text{ Total Assets Turnover Ratio}\times \text{Equity Multiplier}$

Year 2013

Given,

Net income of the company is $95,970.

Sales of the company are $3,635,000.

Total asset is $1,667,000

Total common equity is $836,602.

The Du point relation of the company’s ratios is shown below,

$\begin{array}{c}\text{ROE}=\text{Profit Margin}\times \text{ Total Assets Turnover Ratio}\times \text{Equity Multiplier}\\ =\frac{\text{Net Income}}{\text{Sales}}\times \frac{\text{Sales}}{\text{Total Assets}}\times \frac{\text{Total Assets}}{\text{Total Common Equity}}\\ =\frac{\$95,970}{\$3,635,000}\times \frac{\$3,635,000}{\$1,667,000}\times \frac{\$1,667,000}{\$836,602}\end{array}$

Simplify the above equation to get $\text{ROE}$,

$\begin{array}{c}\text{ROE}=2.64\%\times 2.18\text{times}\times \text{2 times}\\ =11.47\%\end{array}$

2014

Given,

Net income of the company is $18,408.

Sales of the company are $4,240,000.

Total asset is $1,836,000.

Total common equity is $879,710.

The Du point relation of the company’s ratios is shown below,

$\begin{array}{c}\text{ROE}=\text{Profit Margin}\times \text{ Total Assets Turnover Ratio}\times \text{Equity Multiplier}\\ =\frac{\text{Net Income}}{\text{Sales}}\times \frac{\text{Sales}}{\text{Total Assets}}\times \frac{\text{Total Assets}}{\text{Total Common Equity}}\\ =\frac{\$18,408}{\$4,240,000}\times \frac{\$4,240,000}{\$1,836,000}\times \frac{\$1,836,000}{\$829,710}\end{array}$

Simplify the above equation to get $\text{ROE}$,

$\begin{array}{c}\text{ROE}=0.43\%\times 2.30\text{times}\times \text{2}\text{.21 times}\\ =2.21\%\end{array}$

Industry average

The industry has return on equity 18.2%.

• The ROE calculated on the basis of Du Pont Equation shows the profit margin lower in comparison to 2013 in year 2014 and also lower than industry average.
• The firms total assets turnover has been improved comparing to 2013 in year 2014.
• The equity multiplier has been increased in 2014 comparing to the 2013.

Conclusion

Therefore, return on equity on year 2013,2014 and of industry are 11.47% 2.21%and 18.2% and the return on equity has been decreased in year 2014 comparing to 2013 and is lower than industry average.

g.

Summary Introduction

To identify: The changes in the ratios, if the company initiated cost-cutting measures that allowed it to hold lower level of the inventory and substantially deceased the cost of goods sold.

Answer to Problem 25SP

Solution:

The profitability ratios and market value ratios will be improved. Similarly, there will be decrease in level of the inventory, which would improve the current ratio liability as well

There would be improvement in inventory turnover and total asset turnover ratios. The reduction in cost will also improve debt ratio.

If the C Corporation initiated the cost-cutting measures this would increase its net income.

Explanation of Solution

If the C Corporation initiated the cost-cutting measures this would increase its net income because the cost will get decreased. And also the liabilities will get decreased.

Conclusion

Therefore, if the company initiated the cost cutting measures that allowed holding lower level of inventory and substantially decreased cost of goods sold, the ratios of the company will be improved and net income will increase.