Chapter 13, Problem 11EYK

To determine

Compute the ratios of Company LV for 2014 and 2013 and comment on the results.

Answer to Problem 11EYK

Computation of ratios of Company LV for 2014 and 2013:

Ratios and Formula	2014 (in million £)	2013 (in million £)
a. Current ratio: $\frac{\text{Current Assets}}{\text{Current Liabilities}}$	$\begin{array}{c}=\frac{\pounds 18,110}{\pounds 12,175}\\ =\text{1}\text{.48:1}\end{array}$	$\begin{array}{c}=\frac{\pounds 15,971}{\pounds 11,639}\\ =\text{1}\text{.37:1}\end{array}$
b. Quick ratio: $\frac{\left[\begin{array}{l}\text{Cash and cash equivalents}\\ +\text{Trade receivables}\end{array}\right]}{\text{Current Liabilities}}$	$\begin{array}{c}=\frac{\left[\pounds 4,091+\pounds 2,274\right]}{\pounds 12,175}\\ =\text{0}\text{.52:1}\end{array}$	$\begin{array}{c}=\frac{\left[\pounds 3,226+\pounds 2,174\right]}{\pounds 11,639}\\ =\text{0}\text{.46:1}\end{array}$
c. Receivables turnover: $\frac{\text{}\text{Net credit sales}}{\left(\begin{array}{l}\text{Average accounts }\\ \text{receivables}\end{array}\right)}$ Average accounts receivable: $\frac{\left(\begin{array}{l}\text{Beginning Net }\\ \text{Receivables}\end{array}\right)+\left(\begin{array}{l}\text{Ending Net }\\ \text{Receivables}\end{array}\right)}{2}$	$\begin{array}{c}=\frac{\pounds 30,638}{\pounds 2,224}\\ =13.77\text{ times}\end{array}$ $\begin{array}{c}=\frac{\pounds 2,174+\pounds 2,274}{2}\\ =\pounds 2,224\end{array}$	$\begin{array}{c}=\frac{\pounds 29,016}{\pounds 2,073}\\ =14\text{ times}\end{array}$ $\begin{array}{c}=\frac{\pounds 1,972+\pounds 2,174}{2}\\ =\pounds 2,073\end{array}$
d. Inventory turnover: $\frac{\text{Cost of goods sold}}{\text{Average inventory}}$ Average inventory: $\frac{\left(\begin{array}{l}\text{Beginning}\\ \text{ Inventory}\end{array}\right)+\left(\begin{array}{l}\text{Ending }\\ \text{Inventory}\end{array}\right)}{2}$	$\begin{array}{c}=\frac{\pounds 10,801}{\pounds 8,984}\\ =1.20\text{ times}\end{array}$ $\begin{array}{c}=\frac{\pounds 8,492+\pounds 9,475}{2}\\ =\pounds 8,984\end{array}$	$\begin{array}{c}=\frac{\pounds 9,997}{\pounds 8,243}\\ =1.21\text{ times}\end{array}$ $\begin{array}{c}=\frac{\pounds 7,994+\pounds 8,492}{2}\\ =\pounds 8,243\end{array}$
e. Debt to equity ratio: $\frac{\text{Total liabilities }}{\left(\begin{array}{l}\text{Total stockholders' }\\ \text{equity}\end{array}\right)}$	$\begin{array}{c}=\frac{\text{£18,184}+\text{£12,175 }}{\text{£23,003 }}\\ =\frac{\text{£}30,359}{\text{£23,003 }}\\ =1.32\end{array}$	$\begin{array}{c}=\frac{\text{£16,630}+\text{£11,639 }}{\text{£23,003 }}\\ =\frac{\text{£}28,269}{\text{£27,907 }}\\ =1.01\end{array}$
f. Number of times interest was earned: $\frac{\left[\begin{array}{l}\text{Earnings before interest}\\ \text{ and tax expense}\end{array}\right]}{\text{Interest expense}}$	$\begin{array}{c}=\frac{\text{£}5,801\left(1\right)}{\text{£101 }}\\ =57.43\end{array}$	$\begin{array}{c}=\frac{\text{£}8,493\left(2\right)}{\text{£115 }}\\ =73.85\end{array}$
g. Return on sales: $\frac{\text{Net income}}{\text{Net sales}}$	$\begin{array}{c}=\frac{\pounds 6,105}{\pounds 30,638}\\ =20.00\%\end{array}$	$\begin{array}{c}=\frac{\pounds 3,947}{\pounds 29,016}\\ =13.60\%\end{array}$
h. Return on assets: $\frac{\text{Net income }}{\text{Average total assets}}$ Average total assets: $\frac{\left(\begin{array}{l}\text{Beginning }\\ \text{total assets}\end{array}\right)+\left(\begin{array}{l}\text{Ending }\\ \text{total assets}\end{array}\right)}{2}$	$\begin{array}{c}=\frac{\pounds 6,105}{\pounds 54,769}\\ =11.15\%\end{array}$ $\begin{array}{c}=\frac{\pounds 56,176+\pounds 53,362}{2}\\ =\pounds 54,769\end{array}$	$\begin{array}{c}=\frac{\pounds 3,947}{\pounds 53,013}\\ =7.44\%\end{array}$ $\begin{array}{c}=\frac{\pounds 49,850+\pounds 56,176}{2}\\ =\pounds 53,013\end{array}$
i. Return on common stockholders’ equity: $\frac{\text{Net income }-\text{Preferred dividends}}{\left[\begin{array}{l}\text{Average common }\\ \text{stockholders' equity}\end{array}\right]}$	$\begin{array}{c}=\frac{\pounds 6,105-\pounds 0}{\pounds 25,455\left(3\right)}\\ =24\%\end{array}$	$\begin{array}{c}=\frac{\pounds 3,947-\pounds 0}{\pounds 26,708\left(4\right)}\\ =14.78\%\end{array}$

Table (1)

Note: Quick assets include cash and accounts receivable (net).

Analysis of trends:

1. a. The current ratio of Company LV has increased in the year 2014.
2. b. The quick ratio of Company LV has moderately increased in the year 2014.
3. c. The receivables turnover ratio of Company LV has decreased from 14 times in 2013 to 13.77 times in 2014.
4. d. The inventory turnover ratio of Company LV has decreased from 1.21 times in 2013 to 1.20 times in 2014.
5. e. The Debt equity ratio of Company LV has increased in 2014(1.32) as compared in 2013 (1.01).
6. f. The number of times interest earned ratio has decreased drastically in 2014 (57.43) as compared in 2013 (73.85).
7. g. The return on sales of Company LV has slightly increased from 13.60% in 2013 to 20.00% in 2014.
8. h. The return on assets of Company LV has increased from 7.44% in 2013 to 11.15% in 2014.
9. i. The return on common stockholders’ equity of Company LV has increased from 17.78% in 2013 to 24% in 2014.

Explanation of Solution

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

1. a. Current ratio: Current ratio is one of the liquidity ratios, which measures the capacity of the company to meet its short-term obligations using its current assets. Current ratio is calculated by using the formula:

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

1. b. Quick 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.

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

1. c. 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.

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

1. d. 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. It is calculated by using the formula:

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

1. e. Debt–to-equity ratio: The debt-to-equity ratio indicates that the company’s debt as a proportion of its stockholders’ equity. The debt-to-equity ratio is calculated using the formula:
   
   

$\text{Debt-to-equity ratio}=\frac{\text{Total liabilities}}{\text{Total stockholders' equity}}$

1. f. Number of times interest was earned: Number of times interest is earned 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.

$\begin{array}{l}\text{Number of times }\\ \text{interest is earned}\end{array}\}=\frac{\text{Earnings before interest and taxes expense}}{\text{Interest expense}}$

1. g. Return on sales: It is one of the profitability ratios. Profit margin ratio is used to measure the percentage of net income that is being generated per dollar of revenue or sales.

$\text{Net margin}=\frac{\text{Net income}}{\text{Net sales}}$

1. h. Return on assets: Return on assets is the financial ratio which determines the amount of net income earned by the business with the use of total assets owned by it. It indicates the magnitude of the company’s earnings with relative to its total assets. Return on investment is calculated as follows:

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

1. i. Return on common stockholders’ equity ratio: It is a profitability ratio that measures the profit generating ability of the company from the invested money of the shareholders. The formula to calculate the return on equity is as follows:

$\text{Return on equity}=\frac{\text{Net income}}{\text{Average stockholders' equity}}\times 100$

Working Note:

Determine the amount of earnings before interest and expenses for 2013.

$\begin{array}{c}\begin{array}{l}\text{Earnings before income }\\ \text{tax and interest}\end{array}\}=\left(\begin{array}{l}\text{Profits }\\ \text{after tax}\end{array}\right)+\left(\begin{array}{l}\text{Cost of net }\\ \text{financial debts}\end{array}\right)+\left(\begin{array}{l}\text{Tax}\\ \text{ expense}\end{array}\right)\\ =\text{£3,947 million}+\text{ £101 million}+\text{£1,753 million}\\ =\text{£5,801 million}\end{array}$ (1)

Determine the amount of earnings before interest and expenses for Year 2014.

$\begin{array}{c}\begin{array}{l}\text{Earnings before income }\\ \text{tax and interest}\end{array}\}=\left(\begin{array}{l}\text{Profits }\\ \text{after tax}\end{array}\right)+\left(\begin{array}{l}\text{Cost of net }\\ \text{financial debts}\end{array}\right)+\left(\begin{array}{l}\text{Tax}\\ \text{ expense}\end{array}\right)\\ =\text{£6,105 million}+\text{ £115 million}+\text{£2,273 million}\\ =\text{£8,493 million}\end{array}$ (2)

Determine the average common stockholders’ equity for Year 2013.

$\begin{array}{c}\begin{array}{l}\text{Average Common }\\ \text{Stockholders' Equity }\end{array}]=\frac{\left(\begin{array}{l}\text{Beginning Common Stockholders' Equity }\\ +\text{Ending Common Stockholders' Equity}\end{array}\right)}{2}\\ =\frac{\text{£25,508}+\text{£27,907}}{2}\\ =\text{£}26,708\end{array}$ (3)

Determine the average common stockholders’ equity for Year 2014.

$\begin{array}{c}\begin{array}{l}\text{Average Common }\\ \text{Stockholders' Equity }\end{array}]=\frac{\left(\begin{array}{l}\text{Beginning Common Stockholders' Equity }\\ +\text{Ending Common Stockholders' Equity}\end{array}\right)}{2}\\ =\frac{\pounds 27,907+\pounds 23,003}{2}\\ =\pounds 25,455\end{array}$ (4)