Chapter 12, Problem 12.1APCP

1.

To determine

To compute: The risk ratios of Company GA for the year 2020.

Explanation of Solution

Financial Ratios: Financial ratios are the metrics used to evaluate the liquidity, capabilities, profitability, and overall performance of a company. The risk ratios are as follows:

1. a. 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.

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

Determine receivables turnover ratio.

$\begin{array}{c}\text{Receivables turnover ratio}=\frac{\text{Net credit sales}}{\text{Average accounts receivables}}\\ =\frac{\$661,000}{\text{\$40,000 }\left(1\right)}\\ =16.525\text{ times}\end{array}$

Working Notes:

Determine the amount of average accounts receivables.

$\begin{array}{c}\begin{array}{l}\text{Average accounts}\\ \text{receivables}\end{array}\}=\frac{\left(\begin{array}{l}\text{Opening acounts }\\ \text{receivables}\end{array}\right)+\left(\begin{array}{l}\text{Closing acounts }\\ \text{receivables}\end{array}\right)}{\text{2}}\\ =\frac{\text{\$35,000}+\text{\$45,000}}{2}\\ =\frac{\text{\$80,000}}{2}\\ =\text{\$40,000}\end{array}$ (1)

1. b. Average collection period: This ratio is used to determine the number of days a particular company takes to collect accounts receivables.

$\text{Average collection period}=\frac{365\text{ days}}{\text{Receivables turnover ratio}}$

Determine average collection period.

$\begin{array}{c}\text{Average collection period}=\frac{365\text{ days}}{\text{Receivables turnover ratio}}\\ =\frac{365\text{ days}}{\text{16}\text{.52 times}}\\ =22.01\text{ days}\end{array}$

1. c. 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.  

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

Determine receivables turnover ratio.

$\begin{array}{c}\text{Inventory turnover ratio}=\frac{\text{Cost of goods sold}}{\text{Average inventory}}\\ =\frac{\$70,000}{\text{\$15,500 }\left(2\right)}\\ =4.51\text{ times}\end{array}$

Working Notes:

Determine the amount of average accounts receivables.

$\begin{array}{c}\text{Average inventory}=\frac{\text{Opening inventory}+\text{Closing inventory}}{\text{2}}\\ =\frac{\text{\$14,000}+\text{\$17,000}}{2}\\ =\frac{\text{\$31,000}}{2}\\ =\text{\$15,500}\end{array}$ (2)

1. d. Average days in inventory: Average days’ in inventory is determined as the number of days a particular company takes to make sales of the inventory available with them.

$\text{Average days in inventory}=\frac{365\text{ days}}{\text{ Inventory turnover ratio}}$

Determine average days in inventory.

$\begin{array}{c}\text{Average days in inventory}=\frac{365\text{ days}}{\text{ Inventory turnover ratio}}\\ =\frac{365\text{ days}}{\text{4}\text{.51 times}}\\ =80.93\text{ days}\end{array}$

1. e. Current Ratio: Current ratio is used to determine the relationship between current assets and current liabilities. Current ratio is determined by dividing current assets and current liabilities. The ideal current ratio is 2:1

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

Determine current ratio.

$\begin{array}{l}\text{Current ratio}=\frac{\text{Current assets}}{\text{Current liabilities}}\\ =\frac{\$397,362\left(3\right)}{\$69,750\left(4\right)}\\ =5.69:1\end{array}$

Current assets and current liabilities are determined as follows:

$\begin{array}{c}\text{Current assets}=\text{Cash}+\text{Accounts receivable}+\text{Inventory}+\text{Other current assets}\\ =\$322,362+\$45,000+\$17,000+\$13,000\\ =\$397,362\end{array}$ (3)

$\begin{array}{c}\text{Current liabilities}=\text{Accounts payable}+\text{Interest payable}+\text{Income tax payable}\\ =\$12,000+\$750+\$57,000\\ =\$69,750\end{array}$ (4)

1. f. Acid-Test Ratio: This ratio denotes that this ratio is a more rigorous test of solvency than the current ratio. It is determined by dividing quick assets and current liabilities. The acceptable acid-test ratio is 0.90 to 1.00. Use the following formula to determine the acid-test ratio:

$\text{Acid Ratio}=\frac{\text{Quick assets}}{\text{Current}\text{liabilities}}$

Determine acid-test ratio.

$\begin{array}{c}\text{Acid Ratio}=\frac{\text{Quick assets}}{\text{Current liabilities}}\\ =\frac{\text{\$367,362}\left(5\right)}{\$69,750\left(4\right)}\\ =5.26:1\end{array}$

Quick assets are determined as follows:

$\begin{array}{c}\text{Quick assets = Cash +Accounts receivable}\\ =\$322,362+\$45,000\\ =\$367,362\end{array}$ (5)

1. g. Debt-equity Ratio: The debt equity ratio measures the relationship between the capital contributed by creditors and the capital contributed by the stockholders or owners. It indicates the long term solvency position of the company.

$\text{Debt equity Ratio}=\frac{\text{Total liabilities}}{\text{Stockholders' equity}}$

Determine debt equity ratio.

$\begin{array}{c}\text{Debt equity Ratio}=\frac{\text{Total liabilities}}{\text{Stockholders' equity}}\\ =\frac{\text{\$562,112}\left(6\right)}{\text{\$1,325,000}\left(7\right)}\\ =0.424:1\text{ or }42.4\%\end{array}$

Total liabilities and stockholders’ equity are determined as follows:

$\begin{array}{c}\text{Total liabilities}=\left(\begin{array}{l}\text{Accounts payable}+\text{Interest}\\ \text{ payable}+\text{Income tax payable}\end{array}\right)+\left(\text{Notes Payable}\left(\begin{array}{l}\text{Long term }\\ \text{liabilities}\end{array}\right)\right)\\ =\left(\$12,000+\$750+\$57,000\right)+\$492,362\\ =\$562,112\end{array}$ (6)

$\begin{array}{c}\text{Stockholders' equity}=\left(\begin{array}{l}\text{Common stock}+\text{Paid-in Capital}\\ +\text{Retained earnings}\end{array}\right)-\text{Treasury stock}\\ =\left(\$120,000+\$1,105,000+\$175,000\right)-\$75,000\\ =\$1,400,000-\$75,000\\ =\$1,325,000\end{array}$ (7)

1. h. Times interest earned ratio: Times interest earned ratio quantifies the number of times the earnings before interest and taxes can pay the interest expense. First, determine the sum of income before income tax and interest expense. Then, divide the sum by interest expense.

$\begin{array}{l}\text{Times Interest }\\ \text{Earned Ratio}\end{array}\}=\frac{\text{Net income}+\text{Interest expense}+\text{Tax expense}}{\text{Interest expense}}$

Determine times interest earned ratio

$\begin{array}{c}\begin{array}{l}\text{Times Interest }\\ \text{Earned Ratio}\end{array}\}=\frac{\text{Net income}+\text{Interest expense}+\text{Income tax expense}}{\text{Interest expense}}\\ =\frac{\text{\$150,000}+\text{\$29,724}+\text{\$57,000}}{\text{\$29,724}}\\ =7.96\text{ times}\end{array}$

2.

To determine

To compute: The profitability ratios of Company GA for the year 2020.

Explanation of Solution

Financial Ratios: Financial ratios are the metrics used to evaluate the liquidity, capabilities, profitability, and overall performance of a company. The profitability ratios are as follows:

1. a. Gross profit ratio: Gross profit is the financial ratio that shows the relationship between the gross profit and net sales. It represents gross profit as a percentage of net sales. Gross Profit is the difference between the net sales revenue, and the cost of goods sold. It can be calculated by dividing gross profit and net sales.

 Formula:

$\text{Gross profit ratio}=\frac{\text{Gross profit }}{\text{Net sales}}\times 100$

Determine gross profit ratio.

$\begin{array}{c}\text{Gross profit ratio}=\frac{\text{Gross profit }}{\text{Net sales}}\times 100\\ =\frac{\text{\$48,000}\left(8\right)}{\text{\$118,000 }}\times 100\\ =40.67\%\end{array}$

Working Note:

Determine the amount of gross profit.

$\begin{array}{c}\text{Gross profit}=\text{Net sales}-\text{Cost of goods sold}\\ =\text{\$118,000}-\text{\$70,000}\\ =\$48,000\end{array}$ (8)

1. b. Return on assets: Return on assets determines the particular company’s overall earning power. It is determined by dividing sum of net income and average total assets.

Formula:

$\text{Return on assets}=\frac{\text{Net}\text{income }}{\text{Average total assets}}\times 100$

Determine return on assets ratio.

$\begin{array}{c}\text{Return on assets}=\frac{\text{Net income }}{\text{Average total assets}}\times 100\\ =\frac{\$150,000}{\$1,062,431\text{ (9)}}\\ =14.11\%\end{array}$

Working Note:

Determine the amount of average total assets.

$\begin{array}{c}\text{Average total assets}=\frac{\text{Opening total assets }+\text{Closing total assets }}{\text{2}}\\ =\frac{\$237,750+\$1,887,112}{2}\\ =\frac{\$2,124,862}{\text{2}}\\ =\$1,062,431\end{array}$ (9)

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

Formula:

$\begin{array}{l}\text{Profit margin}=\frac{\text{Net}\text{income }}{\text{Net sales}}\times 100\\ \end{array}$

Determine profit margin ratio.

$\begin{array}{c}\text{Profit margin}=\frac{\text{Net income }}{\text{Net sales}}\times 100\\ =\frac{\$150,000}{\$661,000}\times 100\\ =22.69\%\end{array}$

1. d. Asset Turnover: Asset turnover refers to the ratio calculated which determines the amount of sales revenue generated by the business with the use of the total assets owned by it.

Formula:

$\begin{array}{l}\text{Asset turnover}=\frac{\text{Net}\text{sales }}{\text{Average total assets}}\times 100\\ \end{array}$

Determine asset turnover ratio.

$\begin{array}{c}\text{Asset turnover}=\frac{\text{Net sales }}{\text{Average total assets}}\times 100\\ =\frac{\$661,000}{\$1,062,431\text{ (9)}}\\ =0.62\text{ times}\end{array}$

1. e. Return on equity: Return on equity is used to determine the relationship between the net income and the average common equity that are invested in the company.

Formula:

$\text{Return on stockholders' equity }=\frac{\text{Net income}}{\text{Average stockholder’s equity}}$

Determine return on stockholders’ equity ratio.

$\begin{array}{c}\text{Return on equity}=\frac{\text{Net income }}{\text{Average stockholders' equity}}\times 100\\ =\frac{\$150,000}{\$742,500\text{ (10)}}\\ =20.2\%\end{array}$

Working Note:

Determine the amount of average stockholders’ equity.

$\begin{array}{c}\text{Average stockholder’s equity}=\frac{\left(\begin{array}{l}\text{Opening }\\ \text{stockholder’s }\\ \text{equity}\end{array}\right)+\left(\begin{array}{l}\text{Closing }\\ \text{stockholder’s}\\ \text{ equity}\end{array}\right)}{\text{2}}\\ =\frac{\$160,000\left(11\right)+\$1,325,000\left(12\right)}{\text{2}}\\ =\frac{\$1,485,000}{\text{2}}\\ =\$742,500\end{array}$ (10)

Compute the amount of opening and closing stockholders’ equity.

$\begin{array}{c}\begin{array}{l}\text{Opening Stockholders'}\\ \text{ equity}\end{array}\}=\left(\begin{array}{l}\text{Common stock}+\text{Paid-in Capital}\\ +\text{Retained earnings}\end{array}\right)-\text{Treasury stock}\\ =\left(\$20,000+\$0+\$140,000\right)-\$0\\ =\$160,000-\$0\\ =\$160,000\end{array}$ (11)

$\begin{array}{c}\begin{array}{l}\text{Closing Stockholders'}\\ \text{ equity}\end{array}\}=\left(\begin{array}{l}\text{Common stock}+\text{Paid-in Capital}\\ +\text{Retained earnings}\end{array}\right)-\text{Treasury stock}\\ =\left(\$120,000+\$1,105,000+\$175,000\right)-\$75,000\\ =\$1,400,000-\$75,000\\ =\$1,325,000\end{array}$ (12)