Chapter 5, Problem 21E

To determine

Ascertain the following ratios of Company M:

1. 1. Gross profit margin.
2. 2. Operating profit margin.
3. 3. Net profit margin.
4. 4. Total assets turnover ratio.
5. 5. Return on assets ratio.
6. 6. Return on common equity.
7. 7. Current ratio.
8. 8. Inventory turnover ratio.
9. 9. Payable ratio.

Explanation of Solution

Gross margin (gross profit): Gross margin is the amount of revenue earned from goods sold over the costs incurred for the goods sold.

Net margin: This ratio gauges the operating profitability by quantifying the amount of income earned from business operations from the sales generated.

Asset turnover ratio:

The Asset turnover is a contrast to the profit margin ratio and it is calculated to determine the net sales and average total assets. Use the following formula to calculate the asset turnover ratio:

$\text{Asset turnover =}\frac{\text{Net}\text{sales}}{\text{Average total assets}}$

Return on assets:

Return on assets is the ratio of the net income, and interest expense to the average total assets. The rate of return on total assets measures the efficiency of the business. It measures how efficiently the business is using its total assets in generating the income.

$\left\{\begin{array}{l}\text{Return }\\ \text{on assets}\end{array}\right\}=\frac{\text{Net income}}{\text{Total assets}}$

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 operating cycle is referred to as current ratio. This ratio assesses the liquidity of a company.

Inventory turnover: This is the ratio which analyzes the number of times inventory is sold during the period. This ratio gauges the efficacy of inventory management. Larger the ratio, more efficient the inventory management.

Compute the ratio as follows:

1. 1.      Calculate the gross profit margin of Company M:

$\begin{array}{c}\text{Gross profit margin}=\frac{\text{Gross profit}}{\text{Net sales}}\\ =\frac{\text{\$120,800}}{\text{\$304,400}}\times 100\\ =39.68\%\end{array}$

1. 2.      Calculate the operating profit margin of Company M:

$\begin{array}{c}\text{operating profit margin}=\frac{\text{Operating income}}{\text{Net sales}}\\ =\frac{\text{\$38,800}}{\text{\$304,400}}\times 100\\ =12.75\%\end{array}$

1. 3.      Calculate the net profit margin of Company M:

$\begin{array}{c}\text{Net profit margin}=\frac{\text{Net income}}{\text{Net sales}}\\ =\frac{\text{\$21,800}}{\text{\$304,400}}\times 100\\ =7.16\%\end{array}$

1. 4.      Calculate the total asset turnover ratio of Company M:

$\begin{array}{c}\text{Total Assets turnover ratio}=\frac{\text{Net sales}}{\text{Average total assets}}\\ =\frac{\text{\$304,400}}{\text{\$231,000 (1)}}\\ =1.32\end{array}$

Working note (1):

Calculate the value of average total assets.

$\begin{array}{c}\text{Average total assets}=\frac{\left[\begin{array}{l}\text{Total assets in balance sheet}\\ +\text{Total assets in adjustments}\end{array}\right]}{2}\\ =\frac{\text{\$224,000}+\$238,000}{2}\\ =\frac{\text{\$462,000}}{2}\\ =\$231,000\end{array}$

1. 5.      Calculate the return on total assets of Company M:

$\begin{array}{c}\text{Return on total assets}=\frac{\text{Net income}+\text{Interest expense}}{\text{Average total assets}}\\ =\frac{\text{\$21,800}+\text{\$4,830 (2)}}{\text{\$231,000 (1)}}\\ =11.53\%\end{array}$

Working note (2):

Calculate the value of interest expense.

$\begin{array}{c}\text{Interest expense}=\text{Interest }\exp \text{ense}\times \left(\text{1}-\text{Effective tax rate}\right)\\ =\$7,000\times \left(\text{1}-\frac{\text{\$10,000 (Income taxes)}}{\text{\$31,800}}\right)\\ =\$7,000\times \left(\text{1}-0.31\right)\\ =\$4,830\end{array}$

1. 6.      Calculate the return on common equity of Company M:

$\begin{array}{c}\text{Return on commmon equity}=\frac{\text{Net income}}{\text{Average sahreholder's equity}}\\ =\frac{\text{\$21,800}}{\text{\$137,000 (3)}}\\ =15.91\%\end{array}$

Working note (3):

Calculate the average shareholder’s equity.

$\begin{array}{c}\text{Average shareholder's equity}=\frac{\left[\begin{array}{l}\text{Common stock}+\text{Paid in }\\ \text{capital}+\text{Retained earnings}\end{array}\right]+\text{Shareholder's equity}}{2}\\ =\frac{\left(\text{\$80,500}+\text{\$24,000}+\text{\$38,700}\right)+\text{\$130,800}}{2}\\ =\frac{\$274,000}{2}\\ =\$137,000\end{array}$

1. 7.      Calculate the current ratio of Company M:

$\begin{array}{c}\text{Current ratio}=\frac{\text{Current assets}}{\text{Current liabilities}}\\ =\frac{\text{\$42,200 (4)}}{\text{\$24,800 (5)}}\\ =1.70\text{times}\end{array}$

Working note (4):

Compute the current assets:

$\begin{array}{c}\text{Current assets}=\text{Cash}+\text{Receivables}+\text{Inventory}\\ =\text{\$8,200}+\text{\$14,700}+\$19,300\\ =\$42,200\end{array}$

Working note (5):

Compute the current liabilities:

$\begin{array}{c}\text{Current liabilities}=\text{Accounts payable}+\text{Other current liabilities}\\ =18,000+\$6,800\\ =\$24,800\end{array}$

1. 8.      Calculate the inventory turnover of Company M:

$\begin{array}{c}\text{Inventory turnover}=\frac{\text{Cost of goods sold}}{\text{Average inventory (6)}}\\ =\frac{\text{\$183,600}}{\text{\$20,400}}\\ =9\text{ times or 40}\text{.56 days}\left(\frac{\text{365}}{9\text{ times}}\right)\end{array}$

Working note (6):

Compute the average inventory:

$\begin{array}{c}\text{Average inventory}=\frac{\text{Opening balance}+\text{closing balance}}{2}\\ =\frac{\$21,500+\$19,300}{2}\\ =\frac{\$40,800}{2}\\ =\$20,400\end{array}$

1. 9.      Calculate the payable turnover of Company M:

$\begin{array}{c}\text{Payable turnover}=\frac{\text{Cost of goods sold}}{\text{Average accounts payable (7)}}\\ =\frac{\text{\$183,600}}{\text{\$18,400}}\\ =9.98\text{ times or 36}\text{.57 days}\left(\frac{\text{365}}{9.98\text{ times}}\right)\end{array}$

Working note (7):

Compute the average accounts payable:

$\begin{array}{c}\text{Average accounts payable}=\frac{\text{Opening balance}+\text{closing balance}}{2}\\ =\frac{\$18,800+\$18,000}{2}\\ =\frac{\$36,800}{2}\\ =\$18,400\end{array}$