Chapter 13, Problem 13.4AP

(a)

To determine

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

To compute: Liquidity ratios and Profitability ratios for Corporation P for the year 2017 and 2016.

Explanation of Solution

Given info: Balance sheet and income statement

Liquidity ratios:

Liquidity explains the extent of cash’s nearness to assets and liabilities. It explains how easily assets can be converted into cash. Following are the types of ratios that help to find liquidity position of a company:

1.

Current ratio for 2017

$\begin{array}{c}\text{Current ratio = }\frac{\text{Current assets}}{\text{Current liabilities}}\\ =\frac{\$484,000}{\$275,000}\\ =1.76:1\end{array}$

Current ratio for 2016

$\begin{array}{c}\text{Current ratio = }\frac{\text{Current assets}}{\text{Current liabilities}}\\ =\frac{\$383,000}{\$212,000}\\ =1.81:1\end{array}$

Explanation:

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

Formula:

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

Total current assets and total current liabilities are determined as follows:

Total current assets and current liabilities for 2017 and 2016
Details	2017	2016
Current Assets	Amount($)	Amount($)
Cash	70,000	65,000
Short-term investments	55,000	40,000
Accounts receivables	1,04,000	90,000
Inventory	2,30,000	1,65,000
Prepaid expenses	25,000	23,000
Total current assets	4,84,000	3,83,000
Current Liabilities	Amount($)	Amount($)
Note payable	1,70,000	1,20,000
Accounts Payable	65,000	52,000
Accrued liabilities	40,000	40,000
Total Current liabilities	2,75,000	2,12,000

Hence, current ratio is 1.76:1 and 1.81:1 for 2017 and 2016 respectively.

2.

Accounts receivable turnover ratio for 2017

$\begin{array}{c}\begin{array}{l}\text{Accounts receivable }\\ \text{turnover ratio}\end{array}\}\text{ = }\frac{\text{Net credit sales}}{\text{Average accounts receivables}}\\ =\frac{\$882,000}{\$97,000}\\ =9.1\text{times}\end{array}$

Accounts receivable turnover ratio for 2016

$\begin{array}{c}\begin{array}{l}\text{Accounts receivable }\\ \text{turnover ratio}\end{array}\}\text{ = }\frac{\text{Net credit sales}}{\text{Average accounts receivables}}\\ =\frac{\$790,000}{\$88,000}\\ =9.0\text{times}\end{array}$

Explanation:

This 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. Main purpose of accounts receivable turnover ratio is to manage the working capital of the company.

Formula:

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

Average accounts receivable for 2017 and 2016 is calculated as follows:

Average accounts receivable for 2017

$\begin{array}{c}\text{Average accounts receivable = }\frac{\left(\begin{array}{l}\text{Opening accounts receivable+}\\ \text{Closing accounts receivable}\end{array}\right)}{2}\\ =\frac{\$90,000+\$104,000}{2}\\ =\$97,000\end{array}$

Average accounts receivable for 2016

$\begin{array}{c}\text{Average accounts receivable = }\frac{\left(\begin{array}{l}\text{Opening accounts receivable+}\\ \text{Closing accounts receivable}\end{array}\right)}{2}\\ =\frac{\$86,000+\$90,000}{2}\\ =\$88,000\end{array}$

Hence, accounts receivable turnover ratio is 9.1 times and 9.0 times for 2017 and 2016 respectively.

3.

Inventory turnover ratio for 2017

$\begin{array}{c}\text{Inventory turnover = }\frac{\text{Cost of goods sold}}{\text{Average inventory}}\\ =\frac{\$640,000}{\$197,000}\\ =3.2\text{ times}\end{array}$

Inventory turnover ratio for 2016

$\begin{array}{c}\text{Inventory turnover = }\frac{\text{Cost of goods sold}}{\text{Average inventory}}\\ =\frac{\$575,000}{\$140,000}\\ =4.1\text{ times}\end{array}$

Explanation:

Inventory turnover ratio is used to determine the number of times inventory used or sold during the particular accounting period.

Formula:

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

Average inventory is calculated as follows:

Average inventory for 2017

$\begin{array}{c}\text{Average inventory = }\frac{\left(\begin{array}{l}\text{Opening inventory+}\\ \text{Closing inventory}\end{array}\right)}{2}\\ =\frac{\$165,000+\$230,000}{2}\\ =\$197,500\end{array}$

Average inventory for 2016

$\begin{array}{c}\text{Average inventory = }\frac{\left(\begin{array}{l}\text{Opening inventory+}\\ \text{Closing inventory}\end{array}\right)}{2}\\ =\frac{\$115,000+\$165,000}{2}\\ =\$140,000\end{array}$

Hence, inventory turnover ratio is 3.2 times and 4.1 times for 2017 and 2016 respectively.

Changes in the ratios

Ratios	2017	2016	(Increase /Decrease)
			Amount	Percentage
Current ratio	1.76	1.81	(0.05)	(3%)
Accounts receivable turnover ratio	9.1	9.0	0.10	1.1%
Inventory turnover ratio	3.2	4.1	(0.9)	(22%)

Explanation:

Horizontal analysis is prepared to make comparison between the financial statements to determine the changes in the financial statements for the previous year to the current year. The changes of the company are measured in dollars as well as in percentage.

Formula:

$\text{Percentage change = 100}\times \frac{\text{Later period amount }-\text{Base period amount}}{\text{Base period amount}}$

When current ratio and inventory turnover ratios are considered, there is a decrease in percentage. When accounts receivable turnover ratios are considered, there is an increase of 1%.

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.

Profit margin ratio for 2017

$\begin{array}{c}\text{Profit margin = }\frac{\text{Net income}}{\text{Net revenue}}\\ =\frac{\$52,000}{\$882,000}\\ =5.9\%\end{array}$

Profit margin ratio for 2017

$\begin{array}{c}\text{Profit margin = }\frac{\text{Net income}}{\text{Net revenue}}\\ =\frac{\$48,000}{\$790,000}\\ =6.1\%\end{array}$

Explanation:

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

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

Hence, profit margin ratio for 2017 and 2016 is 5.9% and 6.1% respectively.

2.

Asset turnover ratio for 2017

$\begin{array}{c}\text{Asset turnover = }\frac{\text{Net revenue}}{\text{Average total assets}}\\ =\frac{\$882,000}{\$786,000}\\ =1.12\text{ times}\end{array}$

Asset turnover ratio for 2016

$\begin{array}{c}\text{Asset turnover = }\frac{\text{Net revenue}}{\text{Average total assets}}\\ =\frac{\$790,000}{\$767,000}\\ =1.16\text{ times}\end{array}$

Explanation:

Asset turnover ratio is used to determine the asset’s efficiency towards sales.

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

Average total assets are determined as follows:

Average total assets for 2017

$\begin{array}{c}\text{Average total assets = }\frac{\left(\begin{array}{l}\text{Opening total assets+}\\ \text{Closing total assets}\end{array}\right)}{2}\\ =\frac{\$874,000+\$698,000}{2}\\ =\$786,000\end{array}$

Average total assets for 2016

$\begin{array}{c}\text{Average total assets = }\frac{\left(\begin{array}{l}\text{Opening total assets+}\\ \text{Closing total assets}\end{array}\right)}{2}\\ =\frac{\$660,000+\$874,000}{2}\\ =\$767,000\end{array}$

Hence, asset turnover ratio for 2017 and 2016 is 1.12 times and 1.16 times respectively.

3.

Return on assets for 2017

$\begin{array}{c}\text{Rate of return on assets = }\frac{\text{Net income}}{\text{Average total assets}}\\ =\frac{\$52,000}{\$786,000}\\ =6.6\%\end{array}$

Return on assets for 2016

$\begin{array}{c}\text{Rate of return on assets = }\frac{\text{Net income}}{\text{Average total assets}}\\ =\frac{\$48,000}{\$679,000}\\ =7.1\%\end{array}$

Explanation

Return on assets determines the particular company’s overall earning power.

Formula:

$\text{Rate of return on assets = }\frac{\text{Net income}}{\text{Average total assets}}$

Average total assets are calculated above.

Hence, return on assets for 2017 and 2016 is 6.6% and 7.1% respectively.

Earnings per share for 2017

$\begin{array}{c}\text{Earning per share = }\frac{\text{Net income}}{\text{Weighted average number of common shares outstanding}}\\ =\frac{\$52,000}{20,000}\\ =\$2.60\end{array}$

Earnings per share for 2016

$\begin{array}{c}\text{Earning per share = }\frac{\text{Net income}}{\text{Weighted average number of common shares outstanding}}\\ =\frac{\$48,000}{20,000}\\ =\$2.40\end{array}$

Explanation

Earnings per share help to measure the profitability of a company. Earnings per share are the amount of profit that is allocated to each share of outstanding stock.

Formula:

$\text{Earning per share = }\frac{\text{Net income }-\text{Preferred dividends}}{\text{Weighted average number of common share outstanding}}$

Weighted average common shares outstanding for 2017 and 2016 is calculated as

$\begin{array}{c}\begin{array}{l}\text{Weighted average number of common share }\\ \text{outstanding for the year 2017 and 2016}\end{array}\}\text{ = }\frac{\text{Total value of common shares}}{\text{Par value of each stocks}}\\ =\frac{\$200,000}{\$10}\\ =\$20,000\end{array}$

Hence, earnings per share for 2017 and 2016 are $2.60 per share and $2.40 per share respectively.

Changes in the ratios

Ratios	2017	2016	(Increase /Decrease)
			Amount	Percentage
Profit margin ratio	5.9%	6.1%	(0.2)	(3%)
Asset turnover ratio	1.12 times	1.16 times	(0.04)	(3%)
Return on assets ratio	6.6%	7.1%	(0.5)	(7%)
Earnings per share	$2.60	$2.40	0.2	8%

Explanation:

Horizontal analysis is prepared to make comparison between the financial statements to determine the changes in the financial statements for the previous year to the current year. The changes of the company are measured in dollars as well as in percentage.

Formula:

$\text{Percentage change = 100}\times \frac{\text{Later period amount }-\text{Base period amount}}{\text{Base period amount}}$

Thus, profit margin ratio, asset turnover ratio, and return on assets ratio has decreased and earnings per shares are increased in the year 2017 when compared to 2016.

(b)

To determine

To compute: Compute affected ratios.

Explanation of Solution

Explanation

Given info: Three independent situations

Situation 1

Return on stockholders’ equity for 2017

$\begin{array}{c}\text{Return on stockholders' equity = }\frac{\text{Net income}}{\text{Average common stockholders' equity}}\\ =\frac{\$52,000}{\$332,000}\times 100\\ =15.6\%\end{array}$

Return on stockholders’ equity for 2018

$\begin{array}{c}\text{Return on stockholders' equity = }\frac{\text{Net income}}{\text{Average common stockholders' equity}}\\ =\frac{\$54,000}{\$466,000}\times 100\\ =11.6\%\end{array}$

Explanation

Rate of return on stockholders’ equity is used to determine the relationship between the net income and the average common equity that are invested in the company.

Formula: $\text{Rate of return = }\frac{\text{Net isncome }-\text{Preferred dividends}}{\text{Average common stockholder's equity}}$   

Average common stockholders’ equity for 2017 is calculated as follows:

$\begin{array}{c}\begin{array}{l}\text{Average common}\\ \text{ stockholder's equity}\end{array}\}\text{ = }\frac{\left[\begin{array}{l}\text{Common stock (2017) + }\\ \text{Retained earnings (2017)}\end{array}\right]+\left[\begin{array}{l}\text{Common stock (2016)+}\\ \text{Retained earnings (2016)}\end{array}\right]}{2}\\ =\frac{\$200,000+\$149,000+\$200,000+\$116,000}{2}\\ =\$332,500\end{array}$

Total value of common shares outstanding in the year 2018 is determined as follows:

Number of common shares outstanding in 2018= 18,000

Value of common shares outstanding in 2018= $10 × 18,000

= $180,000

$\begin{array}{c}\begin{array}{l}\text{Total value of common}\\ \text{ share outstanding in 2018}\end{array}\}=\left(\begin{array}{l}\text{Value of common shares outstanding in 2017+}\\ \text{Value of common share issued in 2018}\end{array}\right)\\ =\$200,000+\$180,00\\ =\$380,000\end{array}$

Next, calculate the amount of retained earnings for the year 2018 as below:

Balance in retained earnings account on 31^st December, 2017= $149,000

Add: Net income of 2018=   $54,000

Total amount of retained earnings for the year 2018= $203,000

Thus, average common stockholders’ equity for 2018 is calculated as follows:

$\begin{array}{c}\begin{array}{l}\text{Average common}\\ \text{ stockholder's equity}\end{array}\}\text{ = }\frac{\left[\begin{array}{l}\text{Common stock (2017) + }\\ \text{Retained earnings (2017)}\end{array}\right]+\left[\begin{array}{l}\text{Common stock (2016)+}\\ \text{Retained earnings (2016)}\end{array}\right]}{2}\\ =\frac{\$380,000+\$203,000+\$200,000+\$149,000}{2}\\ =\$466,000\end{array}$

Hence, return on stockholders’ equity for 2017 and 2018 is 15.6% and 11.6% respectively.

Situation 2

Determine the debt to assets ratio for 2017.

$\begin{array}{c}\text{Debt ratio = }\frac{\text{Total liabilities}}{\text{Total assets}}\\ =\frac{\$355,000}{\$900,000}\\ =39\%\end{array}$

Determine the debt to assets ratio for 2018.

$\begin{array}{c}\text{Debt ratio = }\frac{\text{Total liabilities}}{\text{Total assets}}\\ =\frac{\$525,000}{\$874,000}\\ =60\%\end{array}$

Explanation:

Debt to asset ratio is used to determine the relationship between total liabilities and total assets. This ratio help the company in determining the debt used for asset financing. When the determined ratio is more than 50%, company faces higher risk.

Formula: $\text{Debt ratio = }\frac{\text{Total liabilities}}{\text{Total assets}}$

Total assets for the year 2018 and 2017 are $900,000 and $874,000. Total debts for 2018 and 2017 are calculated as follows:

Details	2018	2017
Total liabilities	Amount($)	Amount($)
Accounts payable	65,000	65,000
Notes payable	----	1,70,000
Accrued liability	40,000	40,000
Bonds payable, due	2,50,000	2,50,000
Total liabilities	3,55,000	5,25,000

Hence, debt to assets ratio for 2017 and 2018 is 39% and 60% respectively.

Situation 3

Price earnings ratio for 2017

$\begin{array}{c}\text{Price/earnings ratio = }\frac{\text{Market price per share of common stokc}}{\text{Earning per share}}\\ =\frac{\$9.00}{\$2.60}\\ =3.5\text{ times}\end{array}$

Price earnings ratio for 2018

$\begin{array}{c}\text{Price/earnings ratio = }\frac{\text{Market price per share of common stokc}}{\text{Earning per share}}\\ =\frac{\$12}{\$2.70}\\ =4.4\text{ times}\end{array}$

Explanation:

Price/earnings ratio is used to determine the profitability of a company. This ratio is abbreviated as P/E.

Formula:

$\text{Price/earnings ratio = }\frac{\text{Market price per share of common stokc}}{\text{Earning per share}}$

Calculate earnings per share for the year 2018 as below:

$\begin{array}{c}\begin{array}{l}\text{Weighted average common}\\ \text{ shares outstanding in 2018 }\end{array}\}\text{= }\frac{\left(\begin{array}{l}\text{Number of common shares outstanding in 2017+}\\ \text{Number of common share outstanding in 2018}\end{array}\right)}{2}\\ =\frac{20,0000+20,000}{2}\\ =20,000\end{array}$

Earnings per share for the year 2018 are determined as below:

$\begin{array}{c}\text{Earning per share = }\frac{\text{Net income}}{\text{Weighted average number of common shares outstanding}}\\ =\frac{\$54,000}{20,000}\\ =\$2.70\end{array}$

Hence, price earnings ratio for 2017 and 2018 is 3.5 times and 4.4 times.