Chapter 12, Problem 12.6AP

1.

To determine

To Calculate: The given risk ratios for Company VGS for 2015 & 2016.

Answer to Problem 12.6AP

The given risk ratios for Company VGS for 2015:

1. a. Receivables turnover ratio – 38.33 times
2. b. Inventory turnover ratio – 15.07 times
3. c. Current ratio – 3.99:1
4. d. Debt to equity ratio – 72.94%

The given risk ratios for Company VGS for 2016:

1. a. Receivables turnover ratio – 39.33 times
2. b. Inventory turnover ratio – 19.52 times
3. c. Current ratio – 2.47:1
4. d. Debt to equity ratio – 145.87%

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 VGS for 2015:

$\begin{array}{c}\text{Receivables turnover ratio = }\frac{\text{Net Credit sales}}{\text{Average Accounts Receivables}}\\ =\frac{\$3,086,000}{\$80,500\left(1\right)}\\ =38.33\text{ times}\end{array}$

Determine the amount of average account receivables.

$\begin{array}{c}\text{Average account receivables }=\frac{\left(\begin{array}{l}\text{Opening account }\\ \text{receivables}\end{array}\right)+\left(\begin{array}{l}\text{Closing account }\\ \text{receivables}\end{array}\right)}{2}\\ \text{=}\frac{\$70,000+\$91,000}{2}\\ =\frac{\$1,740,200}{2}\\ =\$80,500\end{array}$ (1)

Calculate the receivables turnover ratio for Company VGS for 2016:

$\begin{array}{c}\text{Receivables turnover ratio = }\frac{\text{Net Credit sales}}{\text{Average Accounts Receivables}}\\ =\frac{\$3,560,000}{\$90,500\left(2\right)}\\ =39.33\text{ times}\end{array}$

Determine the amount of average account receivables.

$\begin{array}{c}\text{Average account receivables }=\frac{\left(\begin{array}{l}\text{Opening account }\\ \text{receivables}\end{array}\right)+\left(\begin{array}{l}\text{Closing account }\\ \text{receivables}\end{array}\right)}{2}\\ \text{=}\frac{\$91,000+\$90,000}{2}\\ =\frac{\$181,000}{2}\\ =\$90,500\end{array}$ (2)

1. b. 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 VGS for 2015:

$\begin{array}{c}\text{Inventory turnover ratio}=\frac{\text{Cost of Goods Sold}}{\text{Average Inventory}}\\ =\frac{\$1,960,000}{\$130,000\left(3\right)}\\ =15.07\text{ times}\end{array}$

Determine the amount of average inventory.

$\begin{array}{c}\text{Average inventory }=\frac{\text{Opening inventory}+\text{Closing inventory}}{2}\\ \text{=}\frac{\$145,000+\$115,000}{2}\\ =\frac{\$260,000}{2}\\ =\$130,000\end{array}$ (3)

Calculate the inventory turnover ratio for Company VGS for 2016:

$\begin{array}{c}\text{Inventory turnover ratio}=\frac{\text{Cost of Goods Sold}}{\text{Average Inventory}}\\ =\frac{\$2,490,000}{\$127,500\left(4\right)}\\ =19.52\text{ times}\end{array}$

Determine the amount of average inventory.

$\begin{array}{c}\text{Average inventory }=\frac{\text{Opening inventory}+\text{Closing inventory}}{2}\\ \text{=}\frac{\$115,000+\$140,000}{2}\\ =\frac{\$255,000}{2}\\ =\$127,500\end{array}$ (4)

1. c. 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 VGS for 2015:

$\begin{array}{c}\text{Current ratio = }\frac{\text{Current Assets}}{\text{Current Liabilities}}\\ =\frac{\$415,000}{\$104,000}\\ =3.99:1\end{array}$

Calculate the current ratio for Company VGS for 2016:

$\begin{array}{c}\text{Current ratio = }\frac{\text{Current Assets}}{\text{Current Liabilities}}\\ =\frac{\$461,000}{\$186,000}\\ =2.47:1\end{array}$

1. d. 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 VGS for 2015:

$\begin{array}{c}\text{Debt to Equity Ratio}=\frac{\text{Total Liabilities }}{\text{Stockholder's Equity}}\\ =\frac{\$399,000}{\$547,000}\\ =72.94\%\end{array}$

Calculate the debt to equity ratio for Company VGS for 2016:

$\begin{array}{c}\text{Debt to Equity Ratio}=\frac{\text{Total Liabilities }}{\text{Stockholder's Equity}}\\ =\frac{\$636,000}{\$436,000}\\ =145.87\%\end{array}$

2.

To determine

To Calculate: The given profitability ratios for Company VGS for 2015 & 2016.

Answer to Problem 12.6AP

The given profitability ratios for Company VGS for 2015 are:

1. a. Gross Profit ratio – 36.48%
2. b. Return on Assets ratio – 15.97%
3. c. Profit margin – 4.5%
4. d. Assets turnover ratio – 3.54 times

The given profitability ratios for Company VGS for 2016 are:

1. a. Gross Profit ratio – 30.05%
2. b. Return on Assets ratio – 3.27%
3. c. Profit margin – 0.9%
4. d. Assets turnover ratio – 3.52 times

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 VGS for 2015:

   $\begin{array}{c}\text{Gross Profit ratio = }\frac{\text{Gross Profit}}{\text{Net Sales}}\times 100\\ =\frac{\$1,126,000}{\$3,086,000}\times 100\\ =36.48\%\end{array}$

Calculate the gross profit ratio for Company VGS for 2016:

$\begin{array}{c}\text{Gross Profit ratio = }\frac{\text{Gross Profit}}{\text{Net Sales}}\times 100\\ =\frac{\$1,070,000}{\$3,560,000}\times 100\\ =30.05\%\end{array}$

1. 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 VGS for 2015:

$\begin{array}{c}\text{Return on assets ratio}=\frac{\text{Net Income}}{\text{Average total assets}}\times 100\\ =\frac{\$139,000}{\$870,100\left(5\right)}\times 100\\ =15.97\%\end{array}$

Determine the amount of average total assets.

$\begin{array}{c}\text{Average total assets }=\frac{\left(\text{Opening total assets}\right)+\left(\text{Closing total assets}\right)}{2}\\ \text{=}\frac{\$794,200+\$946,000}{2}\\ =\frac{\$1,740,200}{2}\\ =\$870,100\end{array}$ (5)

Calculate the return on asset ratio for Company VGS for 2016:

$\begin{array}{c}\text{Return on assets ratio}=\frac{\text{Net Income}}{\text{Average total assets}}\times 100\\ =\frac{\$33,000}{\$1,009,000\left(6\right)}\times 100\\ =3.27\%\end{array}$

Determine the amount of average total assets.

$\begin{array}{c}\text{Average total assets }=\frac{\left(\text{Opening total assets}\right)+\left(\text{Closing total assets}\right)}{2}\\ \text{=}\frac{\$946,000+\$1,072,000}{2}\\ =\frac{\$1,740,200}{2}\\ =\$1,009,000\end{array}$ (6)

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 VGS for 2015:

   $\begin{array}{c}\text{Profit Margin ratio}=\frac{\text{Net income}}{\text{Net revenue}}\\ =\frac{\$139,000}{\$3,086,000}\\ =4.5\%\end{array}$

   Calculate the profit margin ratio for Company VGS for 2016:

   $\begin{array}{c}\text{Profit Margin ratio}=\frac{\text{Net income}}{\text{Net revenue}}\\ =\frac{\$33,000}{\$3,560,000}\\ =0.9\%\end{array}$

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 VGS for 2015:

   $\begin{array}{c}\text{Asset turnover }=\frac{\text{Net revenue}}{\text{Average total assets}}\\ =\frac{\$3,086,000}{\$870,100\left(5\right)}\\ =3.54\text{ times}\end{array}$

   Calculate the assets turnover ratio for Company VGS for 2016:

   $\begin{array}{c}\text{Asset turnover }=\frac{\text{Net revenue}}{\text{Average total assets}}\\ =\frac{\$3,560,000}{\$1,009,000\left(6\right)}\\ =3.52\text{ times}\end{array}$

3.

To determine

whether overall risk and profitability ratios are improved from 2015 to 2016.

Explanation of Solution

The risk ratios are mixed where it has been increased and decreased from 2015 to 2016. The receivables and inventory turnover ratios are improved in 2016, while current ratio and debt to equity ratio indicate greater risk in 2016.

Profitability decreased as indicated by the lower gross profit ratio and return on assets in 2016. It appears that the lower return on assets in 2016 is due to lower profit margins rather than to a decrease in asset turnover.