Chapter 12, Problem 12.2APFA

1.

To determine

To Calculate: The given risk ratios for Company AE for 2015.

Answer to Problem 12.2APFA

The given risks ratios for Company AE for 2015 are:

1. a. Receivables turnover ratio – 46.3 times
2. b. Average Collection period – 7.9 days
3. c. Inventory turnover ratio – 7.5 times
4. d. Average days in inventory – 48.7 days
5. e. Current ratio – 1.9:1
6. f. Acid-test ratio – 1.04:1
7. g. Debt to equity ratio – 48.9%

Explanation of Solution

Risk Ratios: Risk ratios are the metrics used to evaluate the liquidity, capabilities, profitability, and overall performance of a company. The following are the ratios that evaluate the risk of a company:

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. It is calculated by using the following formula:

   $\text{Receivables turnover ratio = }\frac{\text{Net Credit sales}}{\text{Average Accounts Receivables}}\times 100$

   Calculate the receivables turnover ratio for Company AE for 2015:

   $\begin{array}{c}\text{Receivables turnover ratio = }\frac{\text{Net Credit sales}}{\text{Average Accounts Receivables}}\\ =\frac{\$3,282,867}{\left(\$73,882+\$67,894\right)/2}\\ =\frac{\$3,282,867}{\$141,776/2}\\ =\frac{\$3,282,867}{\$70,888}\\ =46.3\text{ times}\end{array}$

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

Formula:

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

Calculate the average collection period for Company AE for 2015:

$\begin{array}{c}\text{Average collection period}=\frac{\text{365 Days}}{\text{Receivables turnover ratio}}\\ =\frac{\text{365 Days}}{46.3\text{ times}}\\ =7.9\text{ days}\end{array}$

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.

   Formula: $\text{Inventory turnover ratio}=\frac{\text{Cost of Goods Sold}}{\text{Average Inventory}}$

   Calculate the inventory turnover ratio for Company AE for 2015:

   $\begin{array}{c}\text{Inventory turnover ratio}=\frac{\text{Cost of Goods Sold}}{\text{Average Inventory}}\\ =\frac{\$2,128,193}{\left(\$291,541+\$278,972\right)/2}\\ =\frac{\$2,128,193}{\$570,513/2}\\ =\frac{\$2,128,193}{\$285,257}\\ =7.5\text{ times}\end{array}$

2. 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.

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

   Calculate the average days in inventory for Company AE for 2015:

   $\begin{array}{c}\text{Average days in inventory = }\frac{\text{365 days}}{\text{Inventory turnover ratio}}\\ =\frac{\text{365 days}}{\text{7}\text{.5}}\\ =48.7\text{ days}\end{array}$

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

   Formula:

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

   Calculate the current ratio for Company AE for 2015:

   $\begin{array}{c}\text{Current ratio = }\frac{\text{Current Assets}}{\text{Current Liabilities}}\\ =\frac{\$890,513}{\$459,093}\\ =1.9:1\end{array}$

4. f. Acid-test Ratio: It is a ratio used to determine a company’s ability to pay back its current liabilities by liquid assets that are current assets except inventory and prepaid expenses.

Formula:

$\text{Acid test}\text{Ratio}=\frac{\text{Cash + Current Investments + Accounts Receivables}}{\text{Current Liabilities}}$

Calculate the acid test ratio for Company AE for 2015:

$\begin{array}{c}\text{Acid test}\text{Ratio}=\frac{\text{Cash + Current Investments + Accounts Receivables}}{\text{Current Liabilities}}\\ =\frac{\$410,697+\$0+\$67,894}{\$459,093}\\ =\frac{\$478,591}{\$459,093}\\ =1.04:1\end{array}$

1. g. Debt to equity Ratio: Debt to equity ratio is used by the company to determine how well the company is able to survive the losses without damaging the creditors’ interest. It is determined by dividing total debt and total equity. 

Formula:

$\text{Debt to Equity Ratio}=\frac{\text{Total Liabilities }}{\text{Stockholder's Equity}}$

Calculate the debt to equity ratio for Company AE for 2015:

$\begin{array}{c}\text{Debt to Equity Ratio}=\frac{\text{Total Liabilities }}{\text{Stockholder's Equity}}\\ =\frac{\$557,162}{\$1,139,746}\\ =48.9\%\end{array}$

2.

To determine

To Calculate: The given profitability ratios for Company AE for 2015.

Answer to Problem 12.2APFA

The given profitability ratios for Company AE for 2015 are:

1. a. Gross Profit ratio – 35.2%
2. b. Return on Assets ratio – 4.7%
3. c. Profit margin – 2.4%
4. d. Assets turnover ratio – 1.9 times
5. e. Return on Equity ratio –7%

Explanation of Solution

Profitability ratios: In general, financial ratios are used to evaluate capabilities, profitability, and overall performance of a company. The following are the ratios that evaluate the profitability of a company:

1. a. Gross Profit ratio: Gross profit ratio is the financial ratio that shows the relationship between the gross profit and net sales. Gross profit is the difference between the total revenues and cost of goods sold. It is calculated by using the following formula:

   $\text{Gross Profit ratio = }\frac{\text{Gross Profit}}{\text{Net Sales}}\times 100$

   Calculate the gross profit ratio for Company AE for 2015:

   $\begin{array}{c}\text{Gross Profit ratio = }\frac{\text{Gross Profit}}{\text{Net Sales}}\times 100\\ =\frac{\$1,154,674}{\$3,282,867}\times 100\\ =35.2\%\end{array}$

2. b. Return on asset ratio: Rate of return on total assets measures the profit generated from the use of total assets.

Formula:

$\text{Return on assets ratio}=\frac{\text{Net Income}}{\text{Average total assets}}$

Calculate the return on asset ratio for Company AE for 2015:

$\begin{array}{c}\text{Return on assets ratio}=\frac{\text{Net Income}}{\text{Average total assets}}\times 100\\ =\frac{\$80,322}{\left(\$1,694,164+\$1,696,908\right)/2}\times 100\\ =\frac{\$80,322}{\$3,391,072/2}\times 100\\ =\frac{\$80,322}{\$1,695,536}\times 100\\ =4.7\%\end{array}$

1. c. Profit margin: Profit margin ratio is used to determine the percentage of net income that is being generated per dollar of revenue or sales.

   Formula: $\text{Profit Margin}=\frac{\text{Net income}}{\text{Net revenue}}$

   Calculate the profit margin ratio for Company AE for 2015:

   $\begin{array}{c}\text{Profit Margin ratio}=\frac{\text{Net income}}{\text{Net revenue}}\\ =\frac{\$80,322}{\$3,282,867}\\ =2.4\%\end{array}$

2. d. Assets turnover ratio: Asset turnover ratio is used to determine the asset’s efficiency towards sales.

   Formula: $\text{Asset turnover }=\frac{\text{Net}\text{revenue}}{\text{Average total assets}}$

   Calculate the assets turnover ratio for Company AE for 2015:

   $\begin{array}{c}\text{Asset turnover }=\frac{\text{Net}\text{revenue}}{\text{Average total assets}}\\ =\frac{\$3,282,867}{\left(\$1,694,164+\$1,696,908\right)/2}\\ =\frac{\$3,282,867}{\$3,391,072/2}\\ =\frac{\$3,282,867}{\$1,695,536}\\ =1.9\text{ times}\end{array}$

3. e. Return on Equity ratio: Rate of return on equity ratio is used to determine the relationship between the net income available for the common stockholders’ and the average common equity that is invested in the company.

   Formula:

   $\text{Return on equity ratio}=\frac{\text{Net Income}}{\text{Average total assets}-\text{Average total liabilities}}$

   Calculate the return on equity ratio for Company AE for 2015:

   $\begin{array}{c}\text{Return on equity ratio}=\frac{\text{Net Income}}{\text{Average stockholder's equity}}\times 100\\ =\frac{\$80,322}{\left(\$1,166,178+\$1,139,746\right)/2}\times 100\\ =\frac{\$80,322}{\$2,305,924/2}\times 100\\ =\frac{\$80,322}{\$1,152,962}\times 100\\ =7\%\end{array}$