Chapter 13, Problem 13.5AP

(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: Financial ratios for T and W company.

Explanation of Solution

Given info: Income statement and Balance sheet

1.

Current ratio for T Company and W Company

T Company

$\begin{array}{c}\text{Current ratio = }\frac{\text{Current assets}}{\text{Current liabilities}}\\ =\frac{\$18,424}{\$11,327}\\ =1.63:1\end{array}$

W Company

$\begin{array}{c}\text{Current ratio = }\frac{\text{Current assets}}{\text{Current liabilities}}\\ =\frac{\$48,331}{\$55,561}\\ =0.87:1\end{array}$

Explanation:

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

Formula:

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

Hence, current ratio for T Company and W Company are 1.63:1 and 0.87:1 respectively.

2.

Accounts receivable turnover ratio for T Company and W company

T Company

$\begin{array}{c}\begin{array}{l}\text{Accounts receivable }\\ \text{turnover ratio}\end{array}\}\text{ = }\frac{\text{Net credit sales}}{\text{Average accounts receivables}}\\ =\frac{\$65,357}{\$7,525}\\ =8.7\text{times}\end{array}$

W Company

$\begin{array}{c}\begin{array}{l}\text{Accounts receivable }\\ \text{turnover ratio}\end{array}\}\text{ = }\frac{\text{Net credit sales}}{\text{Average accounts receivables}}\\ =\frac{\$408,214}{\$4,025}\\ =101.4\text{times}\end{array}$

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. All sales are assumed as credit sales.

Formula:

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

Hence, accounts receivables turnover ratio for T Company and W Company are 8.7 times and 101.4 times respectively.

3.

Average collection period for T Company and W Company

T Company

$\begin{array}{c}\text{Days' sales in receivables = }\frac{\text{Days in accounting period}}{\text{Accounts receivable turnover}}\\ =\frac{365\text{ days}}{8.7\text{ times}}\\ =42.0\text{ days}\end{array}$

W company

$\begin{array}{c}\text{Average collection period = }\frac{\text{Days in accounting period}}{\text{Accounts receivable turnover}}\\ =\frac{365\text{ days}}{\text{101}\text{.4 times}}\\ =3.6\text{ days}\end{array}$

Explanation:

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

Formula:

$\text{Average collection period = }\frac{\text{Days in accounting period}}{\text{Accounts receivable turnover}}$

Hence, average collection period for T Company and W Company are 42.0 days and 3.6 days respectively.

4.

Inventory turnover ratio for T Company and W Company

T Company

$\begin{array}{c}\text{Inventory turnover = }\frac{\text{Cost of goods sold}}{\text{Average inventory}}\\ =\frac{\$45,583}{\$6,942}\\ =6.6\text{ times}\end{array}$

W Company

$\begin{array}{c}\text{Inventory turnover = }\frac{\text{Cost of goods sold}}{\text{Average inventory}}\\ =\frac{\$304,583}{\$33,836}\\ =9\text{ times}\end{array}$

Explanation:

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

Formula:

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

Hence, inventory turnover ratio for T Company and W Company are 6.6 times and 9 times respectively.

5.

Days in inventory ratio for T Company and W Company

T Company

$\begin{array}{c}\text{Days in inventory = }\frac{\text{Days in accounting period}}{\text{Inventory turnover}}\\ =\frac{365\text{ days}}{6.6\text{ times}}\\ =55\text{ days}\end{array}$

W Company

$\begin{array}{c}\text{Days in inventory = }\frac{\text{Days in accounting period}}{\text{Inventory turnover}}\\ =\frac{365\text{ days}}{\text{9 times}}\\ =40.55\text{ days}\end{array}$

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:

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

Hence, days’ sales in inventory for T Company and W Company are 55.55 days and 40.55 days respectively.

6.

Profit margin ratio for T Company and W Company

T Company

$\begin{array}{c}\text{Profit margin = }\frac{\text{Net income}}{\text{Net revenue}}\\ =\frac{\$2,488}{\$65,357}\\ =3.8\%\end{array}$

W Company

$\begin{array}{c}\text{Profit margin = }\frac{\text{Net income}}{\text{Net revenue}}\\ =\frac{\$14,335}{\$408,214}\\ =3.5\%\end{array}$

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 T Company and W Company is 3.8% and 3.5% respectively.

7.

Asset turnover ratio for T Company and W company

T Company

$\begin{array}{c}\text{Assets turnover = }\frac{\text{Net sales}}{\text{Average assets}}\\ =\frac{\$65,357}{\$44,319.5}\\ =1.5\text{ times}\end{array}$

W Company

$\begin{array}{c}\text{Assets turnover = }\frac{\text{Net sales}}{\text{Average assets}}\\ =\frac{\$408,214}{\$167,067.5}\\ =2.4\text{ times}\end{array}$

Explanation:

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

Formula:

$\text{Assets turnover = }\frac{\text{Net sales}}{\text{Average assets}}$

Average total assets are determined as follows:

Average total assets for T Company

$\begin{array}{c}\text{Average total assets = }\frac{\left(\begin{array}{l}\text{Opening total assets+}\\ \text{Closing total assets}\end{array}\right)}{2}\\ =\frac{\$44,106+\$44,533}{2}\\ =\$44,319.5\end{array}$

Average total assets for W Company

$\begin{array}{c}\text{Average total assets = }\frac{\left(\begin{array}{l}\text{Opening total assets+}\\ \text{Closing total assets}\end{array}\right)}{2}\\ =\frac{\$163,429+\$170,706}{2}\\ =\$167,067.5\end{array}$

Hence, asset turnover ratio for T Company and W Company is 1.5 times and 2.4 times respectively.

8.

Return on assets ratio for T Company and W Company

T Company

$\begin{array}{c}\text{Rate of return on assets = }\frac{\text{Net income}}{\text{Average total assets}}\\ =\frac{\$2,488}{\$44,319.50}\\ =5.6\%\end{array}$

W Company

$\begin{array}{c}\text{Rate of return on assets = }\frac{\text{Net income}}{\text{Average total assets}}\\ =\frac{\$14,335}{\$167,067.50}\\ =8.6\%\end{array}$

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 T Company and W Company are 5.6% and 8.6% respectively.

9.

Return on stockholders’ equity for T Company and W Company

T Company

$\begin{array}{c}\text{Return on stockholders' equity = }\frac{\text{Net income}}{\text{Average common stockholders' equity}}\\ =\frac{\$2,488}{\frac{\$13,712+\$15,347}{2}}\times 100\\ =17.1\%\end{array}$

W Company

$\begin{array}{c}\text{Return on stockholders' equity = }\frac{\text{Net income}}{\text{Average common stockholders' equity}}\\ =\frac{\$2,488}{\frac{\$71,056+\$65,682}{2}}\times 100\\ =21.0\%\end{array}$

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

Hence, return on stockholders’ equity for T Company and W Company are 17.1% and 21.0% respectively.

10.

Debt to assets ratio for T company and W Company

T Company

$\begin{array}{c}\text{Debt to total assets ratio =}\frac{\text{Current liabilities +Long-term liabilities}}{\text{Total assets}}\\ =\frac{\$11,327+\$17,859}{\$44,533}\\ =66\%\end{array}$

W Company

$\begin{array}{c}\text{Debt to total assets ratio =}\frac{\text{Current liabilities +Long-term liabilities}}{\text{Total assets}}\\ =\frac{\$55,561+\$44,089}{\$170,706}\\ =58\%\end{array}$

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:

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

Hence, debt to assets ratio for T Company and W Company are 66% and 58% respectively.

11.

Times interest earned ratio for T Company and W Company

T Company

$\begin{array}{c}\text{Times interest earned ratio = }\frac{\left(\begin{array}{l}\text{Net inocme +Interest expense}\\ \text{+Income tax expense}\end{array}\right)}{\text{Interest expense}}\\ =\frac{\$2,488+\$707+\$1,384}{\$707}\\ =6.5\text{ times}\end{array}$

W Company

$\begin{array}{c}\text{Times interest earned ratio = }\frac{\left(\begin{array}{l}\text{Net inocme +Interest expense}\\ \text{+Income tax expense}\end{array}\right)}{\text{Interest expense}}\\ =\frac{\$14,335+\$2,063+\$7,139}{\$2,063}\\ =11.4\text{ times}\end{array}$

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:

$\text{Times interest earned ratio = }\frac{\left(\begin{array}{l}\text{Net inocme +Interest expense}\\ \text{+Income tax expense}\end{array}\right)}{\text{Interest expense}}$

Hence, times interest earned ratio for T Company and W Company are 6.5 times and 11.4 times respectively.

12.

Free cash flow for T Company and W Company

T Company

$\begin{array}{c}\text{Free cash flow = }\left(\begin{array}{l}\text{Net cash provided by operating acitivites}-\\ \text{Capital expenditure}-\text{Cash dividends}\end{array}\right)\\ =\$5,881-\$1,729-\$496\\ =\$3,656\end{array}$

W Company

$\begin{array}{c}\text{Free cash flow = }\left(\begin{array}{l}\text{Net cash provided by operating acitivites}-\\ \text{Capital expenditure}-\text{Cash dividends}\end{array}\right)\\ =\$26,249-\$12,184-\$4,217\\ =\$9,848\end{array}$

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:

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

Hence, free cash flow for T Company and W Company are $3,656 and $9,848 respectively.

(b)

To determine

To compare: The liquidity, solvency, and profitability ratios of the two companies.

Explanation of Solution

Given info: Income statement and Balance sheet

Comment on the liquidity ratios:

When current ratio is compared, T Company has better current ratio than the W Company. When accounts receivable turnover ratio and average collection period are compared, W Company’s ratios are better than the T Company. When inventory turnover ratio and days in inventory ratio are compared, W Company’s ratios are better than the T Company. Therefore, on the whole, W Company is better in liquidity.

Comment on the profitability ratios

When profit margin ratios of both the companies are compared, T Company has better ratio than the W Company. When asset turnover ratio of both the companies is compared, W Company has better ratio than the T Company. When returns on assets ratio of both the companies are compared, W Company has better ratio than the T Company. When returns on common stockholders’ equity ratio of both the companies are compared, T Company has better ratio than the W Company.

Comment on the solvency ratios.

When debt to assets ratio of both the companies is compared, W Company has better debt to assets ratio than the T Company. When the times interest earned ratio of both the companies are compared, W Company has better ratio than the T Company. When times free cash flow of both the companies are compared, W Company has better ratio than the T Company. Therefore, on the whole, T Company is better in solvency.