Chapter 12, Problem 3AP

1.

To determine

Calculate the given risk ratios of Company B for the year 2018.

Explanation of Solution

Accounts receivable turnover: This is the ratio which analyzes the number of times accounts receivables is collected and converted into cash during the period. This ratio gauges the efficacy of collecting receivables. Larger the ratio, more efficient in collecting receivables.

Average days to collect accounts receivable (average collection period): This ratio measures the number of times receivables are collected in the period. This ratio analyzes the period receivables are outstanding. So, this ratio also gauges the efficacy of collecting receivables. Lower the ratio, more efficient the collection of receivables.

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.

Average days to sell inventory (average days in inventory): This ratio analyzes the period from the time inventory is acquired, to the period it is sold, in the period. This ratio measures the period inventory is held with the company. So, this ratio also gauges the efficacy of inventory management. Lower the ratio, more efficient the inventory management.

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.

Acid-test ratio: The financial ratio which evaluates the ability of a company to pay off the instant debt obligations is referred to as quick ratio. Quick assets are cash, marketable securities, and accounts receivables. This ratio assesses the short-term liquidity of a company.

Times interest earned ratio: This financial metric gauges the company’s capability to pay the interest expense during a year. This ratio is also called as coverage ratio because this ratio analyzes the risk of the company to pay interest expense, at times of low earnings.

Calculate the given risk ratios of Company B for the year 2018 as follows:

a. Receivables turnover ratio:

$\begin{array}{c}\text{Receivables turnover ratio}=\frac{\text{Net credit sales}}{\text{Average accounts receivables}}\\ =\frac{\$913,380}{\text{\$8,399 }\left(1\right)}\\ =108.7\text{times}\end{array}$

Working Notes:

Calculate the amount of average accounts receivables.

$\begin{array}{c}\begin{array}{l}\text{Average accounts}\\ \text{receivables}\end{array}\}=\frac{\left(\begin{array}{l}\text{Opening acounts }\\ \text{receivables}\end{array}\right)+\left(\begin{array}{l}\text{Closing acounts }\\ \text{receivables}\end{array}\right)}{\text{2}}\\ =\frac{\text{\$8,588}+\text{\$8,210}}{2}\\ =\text{\$8,399}\end{array}$ (1)

b. Average collection period:

$\begin{array}{c}\text{Average collection period}=\frac{365\text{ days}}{\text{Receivables turnover ratio}}\\ =\frac{365\text{ days}}{\text{108}\text{.7 times}}\\ =3.4\text{ days}\end{array}$

c. Inventory Turnover Ratio:

$\begin{array}{c}\text{Inventory turnover ratio}=\frac{\text{Cost of goods sold}}{\text{Average inventory}}\\ =\frac{\$533,357}{\text{\$121}\text{.850}\text{.5 }\left(2\right)}\\ =4.4\text{ times}\end{array}$

Working Notes:

Calculate the amount of average accounts receivables.

$\begin{array}{c}\text{Average inventory}=\frac{\text{Opening inventory}+\text{Closing inventory}}{\text{2}}\\ =\frac{\text{\$118,007}+\text{\$125,694}}{2}\\ =\text{\$121,850}\text{.5}\end{array}$ (2)

d. Average days in inventory:

$\begin{array}{c}\text{Average days in inventory}=\frac{365\text{ days}}{\text{ Inventory turnover ratio}}\\ =\frac{365\text{ days}}{\text{4}\text{.4 times}}\\ =83.0\text{ days}\end{array}$

e. Current Ratio:

$\begin{array}{c}\text{Current ratio}=\frac{\text{Current assets}}{\text{Current liabilities}}\\ =\frac{\$360,584}{\$97,906}\\ =3.7:1\end{array}$

f. Acid-Test Ratio:

$\begin{array}{c}\text{Acid Ratio}=\frac{\text{Quick assets}}{\text{Current liabilities}}\\ =\frac{\text{\$254,507}\left(3\right)}{\$97,906}\\ =2.3:1\end{array}$

Working note:

Calculate the quick assets:

$\begin{array}{c}\text{Quick assets = Cash +Accounts receivable+Investment}\\ =\$165,086+\$8,588+\$80,833\\ =\$254,507\end{array}$

(3)

g. Debt to equity Ratio

$\begin{array}{c}\text{Debt equity Ratio}=\frac{\text{Total liabilities}}{\text{Stockholders' equity}}\\ =\frac{\text{\$146,868}}{\text{\$391,248}}\\ =0.375:1\text{ or 37}\text{.5}\%\end{array}$

2.

To determine

Compute the given profitability ratios of Company B for the year 2018.

Explanation of Solution

Return on Assets (ROA): This financial ratio evaluates a company’s efficiency in operating the assets to generate net income. So, ROA is a tool used to measure the performance of a company.

Profit margin: The percentage of net income generated by every dollar of net sales is referred to as profit margin. This ratio measures the profitability of a company by quantifying the amount of income earned from sales revenue generated after the expenses are paid. The higher the ratio, the more ability to cover operating expenses.

Asset turnover: This ratio analyzes number of times sales or revenue generated from the available assets.

Return on equity (ROE): This financial ratio evaluates a company’s efficiency in using stockholders’ equity to generate net income. So, ROE is a tool used to measure the performance of a company.

Compute the given profitability ratios of Company B for the year 2018 as follows:

a. Gross profit ratio:

$\begin{array}{c}\text{Gross profit ratio}=\frac{\text{Gross profit }}{\text{Net sales}}\times 100\\ =\frac{\text{\$380,023 }}{\text{\$913,380 }}\times 100\\ =41.6\%\end{array}$

b. Return on assets:

$\begin{array}{c}\text{Return on assets}=\frac{\text{Net income }}{\text{Average total assets}}\times 100\\ =\frac{\$89,707}{\$558,981.5\text{(4)}}\\ =16.0\%\end{array}$

Working Note:

Determine the amount of average total assets.

$\begin{array}{c}\text{Average total assets}=\frac{\text{Opening total assets }+\text{Closing total assets }}{\text{2}}\\ =\frac{\$538,116+\$579,847}{2}\\ =\$558,981.5\end{array}$ (4)

c. Profit margin:

$\begin{array}{c}\text{Profit margin}=\frac{\text{Net income }}{\text{Net sales}}\times 100\\ =\frac{\$89,707}{\$913,380}\times 100\\ =9.8\%\end{array}$

d. Asset Turnover

$\begin{array}{c}\text{Asset turnover}=\frac{\text{Net sales }}{\text{Average total assets}}\times 100\\ =\frac{\$913,380}{\$558,981.5\text{ (4)}}\\ =1.6\text{ times}\end{array}$

e. Return on equity:

$\begin{array}{c}\text{Return on equity}=\frac{\text{Net income }}{\text{Average stockholders' equity}}\times 100\\ =\frac{\$89,707}{\$410,893.5\text{ (5)}}\times 100\\ =21.8\%\end{array}$

Working Note:

Determine the amount of average stockholders’ equity.

$\begin{array}{c}\text{Average stockholder’s equity}=\frac{\left(\begin{array}{l}\text{Opening }\\ \text{stockholder’s }\\ \text{equity}\end{array}\right)+\left(\begin{array}{l}\text{Closing }\\ \text{stockholder’s}\\ \text{ equity}\end{array}\right)}{\text{2}}\\ =\frac{\$391,248+\$430,539}{\text{2}}\\ =\$410,893.5\end{array}$ (5)