Chapter 13, Problem 13.4EYCT

(a)

To determine

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

Liquidity ratios: Liquidity ratios are used to measure the ability of the company towards fulfilling the obligations and requirements of the cash at the short-term.  Some of the ratios are current ratio, acid-test ratio, inventory turnover ratio, and accounts receivable ratio.

Solvency ratio: Next, solvency ratios are those ratios used to measure the ability of the company towards survival for a longer period.

Profitability ratio: Profitability ratios are those ratios used to measure the extent of income for particular time period.

To compute: Liquidity ratios for C Company and P Company

Explanation of Solution

Given info: Data from consolidated financial statements.

(1)

Current ratio of C Company and P Company

C Company

$\begin{array}{c}\text{Current}\text{ratio}=\frac{\text{Current}\text{assets}}{\text{Current}\text{liabilities}}\\ =\frac{\$17,551}{\$13,721}\\ =1.28:1\end{array}$

P Company

$\begin{array}{c}\text{Current}\text{ratio}=\frac{\text{Current}\text{assets}}{\text{Current}\text{liabilities}}\\ =\frac{\$12,571}{\$8,756}\\ =1.44:1\end{array}$

Explanation:

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

Formula:

$\text{Current ratio}=\frac{\text{Current assets}}{\text{Current}\text{liabilities}}$

Thus, current ratio for C Company and P Company is 1.28:1 and 1.44:1 respectively.

(2)

Accounts Receivable Turnover Ratio of C Company and P Company

C Company

$\begin{array}{c}\text{Receivables turnover}=\frac{\text{Net credit sales}}{\text{Average net receivables}}\\ =\frac{\text{\$30,990}}{\$3,424}\\ =9.1\text{ times}\end{array}$

P Company

$\begin{array}{c}\text{Receivables turnover}=\frac{\text{Net credit sales}}{\text{Average net receivables}}\\ =\frac{\text{\$43,232}}{\$4,654}\\ =9.3\text{ times}\end{array}$

Explanation:

Accounts receivable 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. Main purpose of accounts receivable turnover ratio is to manage the working capital of the company. Assume all sales are credit sales.

Formula:

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

Thus, accounts receivable turnover ratio for C Company and P Company is 9.1 times and 9.3 times respectively.

(3)

Average collection period of C Company and P Company

C Company

$\begin{array}{c}\text{Average}\text{collection}\text{period}=\frac{\text{Days in accounting period }\left(365\text{days}\right)}{\text{Accounts receivables turnover}}\\ =\frac{365\text{days}}{9.05\text{times }\left(\text{From a}\left(\text{2}\right)\right)}\\ =40.1days\end{array}$

P Company

$\begin{array}{c}\text{Average}\text{collection}\text{period}=\frac{\text{Days in accounting period }\left(365\text{days}\right)}{\text{Accounts receivables turnover}}\\ =\frac{365\text{days}}{9.29\text{times }\left(\text{From a}\left(\text{2}\right)\right)}\\ =39.2days\end{array}$

Explanation:

Average collection period is used to determine the number of days a particular company takes to collect accounts receivables.

Formula:

$\text{Days' sales in receivables}=\frac{\text{Days in accounting period}}{\text{Accounts receivables turnover}}$

Thus, average collection period for C Company and P Company is 40.1 days and 39.2 days respectively.

(4)

Inventory Turnover Ratio of C Company and P Company

C Company

$\begin{array}{c}\text{Inventory turnover}=\frac{\text{Cost of goods sold}}{\text{Average inventory}}\\ =\frac{\text{\$11,088}}{\$2,271}\\ =\text{4}\text{.9 times}\end{array}$

P Company

$\begin{array}{c}\text{Inventory turnover}=\frac{\text{Cost of goods sold}}{\text{Average inventory}}\\ =\frac{\text{\$20,099}}{\$2,570}\\ =\text{7}\text{.8 times}\end{array}$

Explanation:

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

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

Thus, inventory turnover ratio for C Company and P Company is 4.9 times and 7.8 times respectively.

(5)

Days in inventory of C Company and P Company

C Company

$\begin{array}{c}\text{Days in inventory}=\frac{\text{Days in accounting period}\left(365\text{days}\right)}{\text{Inventory turnover}}\\ =\frac{365\text{days}}{\text{4}\text{.88 times}}\\ =74.5\text{days}\end{array}$

P  Company

$\begin{array}{c}\text{Days in inventory}=\frac{\text{Days in accounting period}\left(365\text{days}\right)}{\text{Inventory turnover}}\\ =\frac{365\text{days}}{\text{7}\text{.82 times}}\\ =46.8\text{days}\end{array}$

Conclusion:

Explanation:

Days’ sales in inventory are used to determine number of days a particular company takes to make sales of the inventory available with them.

Formula:

$\text{Days' sales in inventory}=\frac{\text{Days in accounting period}}{\text{Inventory turnover}}$

Thus, inventory turnover ratio for C Company and P Company is 74.5 days and 46.8 days.

Comment on the liquidity ratios:

P Company has better current ratio than the CC Company. P Company’s accounts receivable turnover ratio and average collection period are better than the CC Company. P’s inventory turnover ratio and days in inventory ratio are better than the CC Company. Therefore, on the whole, P Company is better in liquidity.

(b)

To determine

To compute: Solvency ratios for C Company and P Company

Explanation of Solution

Given info: Data from consolidated financial statements.

(1)

Debt to assets ratio of C Company and P Company

C Company

$\begin{array}{c}\text{Debt}\text{to}\text{total}\text{assets}\text{ratio}=\frac{\text{Total}\text{debt}}{\text{Total assets}}\\ =\frac{\$23,872}{\text{\$48,671}}\\ =49\%\end{array}$

P Company

$\begin{array}{c}\text{Debt}\text{to}\text{total}\text{assets}\text{ratio}=\frac{\text{Total}\text{debt}}{\text{Total assets}}\\ =\frac{\$23,044}{\text{\$39,848}}\\ =57\%\end{array}$

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:

$\text{Debt ratio}=\frac{\text{Total liabilties}}{\text{Total assets}}$

Hence, debt to assets ratio for CC Company and P Company are 49% and 58% respectively.

(2)

Times interest earned ratio of C Company and P Company

C Company

$\begin{array}{c}\text{Times interest earned ratio}=\frac{\left(\begin{array}{l}\text{Netincome}+\text{Interest expense}\\ +\text{Income tax expense}\end{array}\right)}{\text{Interest}\text{expense}}\\ =\frac{\$6,824+\$355+\$2,040}{\$355}\\ =26\text{times}\end{array}$

P Company

$\begin{array}{c}\text{Times interest earned ratio}=\frac{\left(\begin{array}{l}\text{Netincome}+\text{Interest expense}\\ +\text{Income tax expense}\end{array}\right)}{\text{Interest}\text{expense}}\\ =\frac{\$5,946+\$397+\$2,100}{\$397}\\ =21.3\text{times}\end{array}$

Explanation:

Times interest earned ratio quantifies the number of times the earnings before interest and taxes can pay the interest expense.  Use the following formula to calculate times-interest-earned ratio:

$\begin{array}{l}\text{Times-interest-earned}\\ \text{ratio }\end{array}\}=\frac{\text{Net income}+\text{Income tax expense}+\text{Interest expense}}{\text{Interest expense}}$

Hence, times interest earned ratio for C Company and P Company are 26.0 times and 21.3 times.

3.

Free Cash Flow of C Company and P Company

C Company

$\begin{array}{c}\text{Free cash flow = }\left(\begin{array}{l}\text{Net cash provided by operating activities }\\ \text{– Capital expenditures – Cash dividends}\end{array}\right)\\ =\$8,186-\$1,993-\$3,800\\ =\$2,393\end{array}$

P Company

$\begin{array}{c}\text{Free cash flow = }\left(\begin{array}{l}\text{Net cash provided by operating activities }\\ \text{– Capital expenditures – Cash dividends}\end{array}\right)\\ =\$6,796-\$2,128-\$2,732\\ =\$1,936\end{array}$

Explanation:

Free cash flow determines to know the extent of how company survives in a longer time period. Free cash flow is determined by deducting net cash provided by operating activities and capital expenditures and cash dividends.

Formula:

$\text{Free cash flow = }\left(\begin{array}{l}\text{Net cash provided by operating activities }\\ \text{– Capital expenditures – Cash dividends}\end{array}\right)$

Hence, free cash flow for T Company and W Company are $2,393 and $1,936 respectively.

Comment on the solvency ratios:

C Company has better debt to assets ratio than the P Company. C Company has better times interest earned ratio than the P Company. C Company has better free cash flow than the P Company. Therefore, on the whole, C Company is better in solvency.

(c)

To determine

To compute: Profitability ratios for C Company and P Company

Explanation of Solution

Given info: Data from consolidated financial statements.

(1)

C Company

$\begin{array}{c}\text{Profit margin=}\left(\frac{\text{Net income}}{\text{Net sales}}\right)\times 100\\ =\left(\frac{\$6,824}{\$30,990}\right)\times 100\\ =22.0\%\end{array}$

P Company

$\begin{array}{c}\text{Profit margin=}\left(\frac{\text{Net income}}{\text{Net sales}}\right)\times 100\\ =\left(\frac{\$5,946}{\$43,232}\right)\times 100\\ =13.8\%\end{array}$

Explanation:

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

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

Hence, profit margin ratio for C Company and P Company is 22.0% and 13.8% respectively.

(2)

Asset turnover ratio for C Company and P Company

C Company

$\begin{array}{c}\text{Asset turnover}\text{=}\frac{\text{Net sales}}{\text{Average}\text{assets}}\\ \text{=}\frac{\$30,990}{\$44,595}\\ =0.69\text{times}\end{array}$

P Company

$\begin{array}{c}\text{Asset turnover}\text{=}\frac{\text{Net sales}}{\text{Average}\text{assets}}\\ \text{=}\frac{\$43,232}{\$37,921}\\ =1.14\text{times}\end{array}$

Explanation:

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

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

Hence, asset turnover ratio for C Company and P Company is 0.69 times and 1.14 times respectively.

(3)

Return on assets for C Company and P Company

C Company

$\begin{array}{c}\text{Return on assets}\text{=}\frac{\text{Net income}}{\text{Average}\text{assets}}\\ \text{=}\frac{\text{\$6,824}}{\$44,595}\\ \text{=}15.3\%\end{array}$

P Company

$\begin{array}{c}\text{Return on assets}\text{=}\frac{\text{Net income}}{\text{Average}\text{assets}}\\ \text{=}\frac{\text{\$5,946}}{\$37,921}\\ \text{=}15.7\%\end{array}$

Explanation

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

Formula:

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

Thus, the return on assets ratio for C Company and P Company is 15.3% and 15.7% respectively.

d)

To determine

Return on common stockholders’ equity ratio for C Company and P Company

Explanation of Solution

C Company

$\begin{array}{c}\begin{array}{l}\text{Return on common}\\ \text{stockholders’ equity}\end{array}\}\text{=}\frac{\text{Net income –Preferred dividends}}{\text{Average common stockholder’s equity}}\\ \text{=}\frac{\text{\$6,824}}{\$\text{}22,636}\\ \text{=30}\text{.1\%}\end{array}$

P Company

$\begin{array}{c}\begin{array}{l}\text{Return on common}\\ \text{stockholders’ equity}\end{array}\}\text{=}\frac{\text{Net income –Preferred dividends}}{\text{Average common stockholder’s equity}}\\ \text{=}\frac{\text{\$5,946}}{\$14,556}\\ \text{=40}\text{.8\%}\end{array}$

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

Hence, return on stockholders’ equity for C Company and P Company are 30.1% and 40.8% respectively.

Comment on the profitability ratios

C Company has better profit margin ratio when compared to P Company. P Company has better asset turnover ratio than the C Company. P Company has better return on asset ratio than the C Company. P Company has better return on stockholders’ equity ratio than the CC Company. Therefore, P Company is better than CC Company in terms  of profitability.