Chapter 12, Problem 4AP

1.

To determine

Calculate the following risk ratios for both the companies for the year ended February 3, 2018.

1. a. Receivable turnover ratio.
2. b. Average collection period.
3. c. Inventory turnover ratio.
4. d. Average days in inventory.
5. e. Current ratio.
6. f. Acid-test ratio.
7. g. Debt to equity ratio.

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:

Receivables turnover ratio: 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. This ratio is determined by dividing credit sales and sales return. It is calculated by using the following formula:

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

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.

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

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.

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.

Debt to Asset Ratio: Debt to asset ratio is the ration between total asset and total liability of the company. Debt ratio reflects the finance strategy of the company. It is used to evaluate company’s ability to pay its debts. Higher debt ratio implies the higher financial risk.

The risk ratios for both the companies for the year ended February 3, 2018 is as follows:

Ratio Analysis
1. Risk Ratios	Company B	Company AE
a. Receivable turnover ratio
Net Sales (A)	$913,380	$3,795,549
Beginning Receivables (B)	8,588	78,304
Ending Receivables (C)	8,210	86,634
Average Receivables (D) $\left[\left(\text{B + C}\right)\text{ ÷ 2}\right]$	8,399	82,304
Receivable Turnover $\left(\text{A ÷ B}\right)$	108.74 Times	46 Times
b. Average collection period
Days' Sales Receivables:
Days in a Year (A)	365	365
Receivable Turnover (B)	108.74	46
Days' Sales Outstanding $\left(\text{A ÷ B}\right)$	3.4	7.9
	Days	Days
c. Inventory Turnover Ratio
Cost of Goods Sold (A)	$533,357	$2,425,044
Beginning Inventories (B)	$118,007	$398,213
Ending Inventories (C)	125,694	358,446
Average Inventories $\left(\text{D}\right)\text{ = }\left[\left(\text{B + C}\right)\text{ ÷ 2}\right]$	121,851	378,330
Inventory Turnover $\left(\text{A ÷ B}\right)$	4.4 Times	6.40 Times
d. Average days in inventory
Days in a Year (A)	365	365
Receivable Turnover (B)	4.4	6.40
Days' Inventory Outstanding $\left(\text{A ÷ B}\right)$	83	57
	Days	Days
e. Current ratio
Total current assets (A)	$360,584	$968,530
Total current liabilities (B)	97,906	485,221
Current ratio $\left(\text{A ÷ B}\right)$	3.7	2.0
f. Acid-test ratio
Cash	$165,086	$413,613
Short-term investments	50,833	0
Accounts receivable	8,588	78,304
Quick assets  (A)	224,507	491,917
Total current liabilities (B)	97,906	485,221
Acid-test ratio $\left(\text{A ÷ B}\right)$	2.3	1.01
h. Debt to Equity ratio
Total liabilities (A)	$146,868	$569,522
Total stockholders' equity (B)	391,248	1,246,791
Debt to equity ratio$\left(\text{A ÷ B}\right)$	37.5%	45.67%

Table (1)

2.

To determine

Calculate the Profitability ratios for both companies for the year ended February 3, 2018.

1. a. Gross profit ratio.
2. b. Return on assets ratio.
3. c. Profit Margin Ratio.
4. d. Asset turnover ratio.
5. e. Return on equity ratio.

Explanation of Solution

Profitability ratios:

In general, financial ratios are used to evaluate capabilities, profitability, and overall performance of a company.

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.

Gross profit ratio:

Gross profit ratio 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 total revenue and the cost of goods sold. It can be calculated by using the following formula:

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

The Profitability ratios for both companies for the year ended February 3, 2018 is as follows:

Ratio Analysis
1. Profitability Ratios	B Company	AE Company
a. Gross profit ratio
Net sales (A)	$380,023	$1,370,505
Gross profit (B)	913,380	3,795,549
Gross profit ratio $\left(\text{A ÷ B}\right)$	41.6%	36.1%
b. Rate of return on assets
Net income (A)	$89,707	$204,163
Total assets (2017) ( B )	538,116	1,816,313
Total assets (2018) (C)	579,847	1,782,660
Average total assets $\left(\text{D}\right)\text{ = }\left(\text{B+C}\right)\text{÷2}$	558,982	1,799,487
Rate of return on assets $\left(\text{A ÷ E}\right)$	16.04%	11.3%
c.  Profit Margin ratio
Net income (A)	$89,707	$204,163
Net revenue (B)	913,380	3,795,549
Profit margin ratio$\left(\text{A ÷ B}\right)$	9.8%	5.4%
d. Asset turnover ratio
Net revenue (A)	$913,380	$3,795,549
Average total assets (B)	558,982	1,799,487
Asset turnover $\left(\text{A ÷ B}\right)$	1.6 Times	2.1 Times
e. Return on equity ratio
Net income (A)	$89,707	$204,163
Stockholders' Equity (2017) (B)	391,248	1,246,791
Stockholders' Equity (2018) (C )	430,539	1,204,569
Average common stock $\left(\text{D = B+C÷2}\right)$	410,894	1,225,680
Return on equity ratio $\left(\text{E = A÷D}\right)$	21.83%	16.65%

Table (2)