Chapter 13, Problem 1ATC

a.

To determine

Compute the ratios for the companies’ 2014 fiscal years.

Answer to Problem 1ATC

Compute ratios for Company K and Incorporation WF.

Ratios and Formula	Company K	Incorporation WF
(1) Current ratio: $\frac{\text{Current Assets}}{\text{Current Liabilities}}$	$\begin{array}{l}=\frac{\$8,911}{\$11,403}\\ =0.78:1\end{array}$	$\begin{array}{l}=\frac{\$1,756}{\$1,257}\\ =1.40:1\end{array}$
(2) Average days to sell inventory: $\frac{\text{365}}{\left[\begin{array}{l}\text{Inventory turnover }\\ \left(\text{Refer Table (2)}\right)\end{array}\right]}$	$\begin{array}{l}=\frac{365}{10.6\text{ times}}\\ =\text{3}4\text{ days}\end{array}$	$\begin{array}{l}=\frac{365}{21.4\text{ times}}\\ =17\text{ days}\end{array}$
(3) Debt to assets ratio: $\frac{\text{Total liabilities }}{\text{Total assets}}$	$\begin{array}{l}=\frac{\$25,114}{\$30,556}\\ =82.2\%\end{array}$	$\begin{array}{l}=\frac{\$1,931}{\$5,744}\\ =33.6\%\end{array}$
(4) Return on investment: $\frac{\left[\begin{array}{l}\text{Earnings from }\\ \text{continuing operations}\end{array}\right]}{\left[\begin{array}{l}\text{Average total assets}\\ \left(\text{Refer Table (3)}\right)\end{array}\right]}$	$\begin{array}{l}=\frac{\$2,649}{\$29,918.5}\\ =8.9\%\end{array}$	$\begin{array}{l}=\frac{\$946}{\$5,641}\\ =16.8\%\end{array}$
(5) Gross margin percentage: $\frac{\text{Gross profit}}{\text{Net sales}}\times 100$	$\begin{array}{l}=\frac{\$22,953}{\$108,465}\\ =21.16\%\end{array}$	$\begin{array}{l}=\frac{\$5,044}{\$14,194}\\ =35.5\%\end{array}$
(6) Asset turnover: $\frac{\text{Net sales }}{\left[\begin{array}{l}\text{Average total assets}\\ \left(\text{Refer Table (3)}\right)\end{array}\right]}$	$\begin{array}{l}=\frac{\$108,465}{\$29,918.5}\\ =3.62\text{ times}\end{array}$	$\begin{array}{l}=\frac{\$14,194}{\$5,641}\\ =2.5\text{ times}\end{array}$
(7) Return on sales: $\frac{\left[\begin{array}{l}\text{Earnings from }\\ \text{continuing operations}\end{array}\right]}{\text{Net sales}}$	$\begin{array}{l}=\frac{\$2,649}{\$108,465}\\ =2.4\%\end{array}$	$\begin{array}{l}=\frac{\$946}{\$14,194}\\ =6.67\%\end{array}$
(8) Plant assets to long-term debt: $\frac{\text{Plant assets}}{\text{Long-term debt}}$	$\begin{array}{l}=\frac{\$17,912}{\$13,711}\\ =1.30:1\end{array}$	$\begin{array}{l}=\frac{\$2,923}{\$674}\\ =4.30:1\end{array}$

Table (1)

Explanation of Solution

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

1. 1) 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. 2) Average days to sell inventory: This ratio is determined as the number of days a particular company takes to make sales of the inventory available with them. It is calculated by using the formula:

$\begin{array}{l}\text{Average days }\\ \text{to sell inventory}\end{array}\}=\frac{\text{365}}{\text{Inventory turnover}}$

1. 3) Debt to assets ratio: The debt to asset ratio shows the relationship between total asset and the total liability of the company. Debt ratio reflects the financial strategy of the company. It is used to measure the percentage of company’s assets that are financed by long term debts.  Debt to assets ratio is calculated by using the formula:

$\text{Debt-to-assets ratio}=\frac{\text{Total Liabilities}}{\text{Total Assets }}$

1. 4) Return on investments (assets): Return on investments (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:

$\text{Return on investments}=\frac{\left[\begin{array}{l}\text{Earnings from }\\ \text{continuing operations}\end{array}\right]}{\text{Average total assets}}$

1. 5) Gross margin percentage: It is one of the profitability ratios. Gross margin ratio is used to measure the percentage of gross profit that is being generated per dollar of revenue or sales. It is calculated by  using the formula::

$\text{Gross margin percentage}=\frac{\text{Gross profit}}{\text{Net sales}}\times 100$

1. 6) Asset turnover: Turnover of assets is a ratio that measures the productive capacity of the total assets to generate the sales revenue for the company. Thus, it shows the relationship between the net sales and the average total assets. Turnover of assets is calculated as follows:

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

1. 7) 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. It is calculated by  using the formula:

$\text{Return on sales}=\frac{\text{Net income}}{\text{Net sales}}$

1. 8) Plant assets to long term debt: Plant assets to long term debt ratio measure the value of assets per each dollar of long term liabilities. It is calculated by  using the formula:

$\begin{array}{l}\text{Plant assets to }\\ \text{long term debt}\end{array}\}=\frac{\text{Plant assets}}{\text{Long term liabilities}}$

Working Note:

Determine the average inventory for both the companies.

Ratios and Formula	Company K	Incorporation WF
Inventory turnover: $\frac{\text{Cost of goods sold}}{\text{Average inventory}}$ Average inventory: $\frac{\left(\begin{array}{l}\text{Ending }\\ \text{Inventory}\end{array}\right)+\left(\begin{array}{l}\text{Beginning}\\ \text{ Inventory}\end{array}\right)}{2}$	$\begin{array}{l}=\frac{\$85,512}{\$8,064.5}\\ =10.6\text{ times}\end{array}$ $\begin{array}{l}=\frac{\$8,178+\$7,951}{2}\\ =\frac{\$16,129}{2}\\ =\$8,064.5\end{array}$	$\begin{array}{l}=\frac{\$9,150}{\$427.5}\\ =21.4\text{ times}\end{array}$ $\begin{array}{l}=\frac{\$441+\$414}{2}\\ =\frac{\$855}{2}\\ =\$427.5\end{array}$

Table (2)

Determine the average total assets for both the companies.

Ratios and Formula	Company K	Incorporation WF
Average total assets: $\frac{\left(\begin{array}{l}\text{Ending }\\ \text{Inventory}\end{array}\right)+\left(\begin{array}{l}\text{Beginning}\\ \text{ Inventory}\end{array}\right)}{2}$	$\begin{array}{c}=\frac{\$30,556+\$29,281}{2}\\ =\frac{\$59,837}{2}\\ =\$29,918.5\end{array}$	$\begin{array}{l}=\frac{\$5,744+\$5,538}{2}\\ =\frac{\$11,282}{2}\\ =\$5,641\end{array}$

Table (3)

b.

To determine

Identify the company that appears to be more profitable. Identify the ratio that reveals the profitability using requirement a. and justify the conclusion.

Explanation of Solution

The ratios that are most relevant for determining profitability are as follows:

1. 1) Return on investment: Return on investments (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.
2. 2) 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.

As per Table (1), the return on investment and return on sales of Incorporation WF is 16.8% and 6.67% respectively, which is substantially higher than the profitability ratios of Company K.

c.

To determine

Identify the company that has higher level of financial risk. Identify the ratio that reveals the financial risk using requirement a. and justify the conclusion.

Explanation of Solution

The ratios that are most relevant for determining profitability are as follows:

1. 1) 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.
2. 2) Debt to assets ratio: The debt to asset ratio shows the relationship between total asset and the total liability of the company. Debt ratio reflects the financial strategy of the company. It is used to measure the percentage of company’s assets that are financed by long term debts. 
3. 3) Plant assets to long term debt: Plant assets to long term debt ratio measure the value of assets per each dollar of long term liabilities.

As per Table (1), the current ratio, Debt to assets ratio and plant assets to long term debt of Incorporation WF is 1.40:1,33.6% and 4.3:1 respectively,  which indicates that Incorporation WF is having higher level of financial risk .

d.

To determine

Identify the company that charges higher prices for the goods. Identify the ratio that reveals the information using requirement a. and justify the conclusion.

Explanation of Solution

The ratios that are most relevant for determining the cost of goods of both the companies is the gross margin percentage. The gross margin ratio is used to measure the percentage of gross profit that is being generated per dollar of revenue or sales. The gross margin of Incorporation WF is 35.5% which is significantly higher than Company K. higher gross margin indicates that Incorporation WF is charging the most of its goods with respect to what it pays for the items it sells.

e.

To determine

Identify the company that is efficiently using its assets. Identify the ratio that reveals the profitability using requirement a. and justify the conclusion.

Explanation of Solution

The ratios that are most relevant for determining the efficient utilization of assets are as follows:

1. 1) Average days to sell inventory: This ratio is determined as the number of days a particular company takes to make sales of the inventory available with them.
2. 2) Asset turnover: Turnover of assets is a ratio that measures the productive capacity of the total assets to generate the sales revenue for the company. Thus, it shows the relationship between the net sales and the average total assets

As per Table (1), the average days to sell inventory of Incorporation WF is 17 days which indicates that Incorporation WF is utilizing the inventory efficiently than Company K. However, the asset turnover of Company K is 3.62 times whereas of Incorporation WF is 2.5 times, that indicates the efficiency of Company K to earn higher turnover using its total assets.