Chapter 13, Problem 24BP

To determine

Compute the ratios of Company B for Year 4.

Answer to Problem 24BP

Compute ratios of Company B for Year 4.

Ratios and Formula	Year 4
a. Current ratio	$\begin{array}{l}=\frac{\text{Current Assets}}{\text{Current Liabilities}}\\ =\frac{\$112,000,000}{\$28,000,000}\\ =4:1\end{array}$
b. Quick ratio	$\begin{array}{l}=\frac{\text{Quick Assets}}{\text{Current Liabilities}}\\ =\frac{\$60,000,000}{\$28,000,000}\\ =2.14:1\end{array}$
c. Average days to collect accounts receivable	$\begin{array}{l}=\frac{\text{365}}{\text{Receivables turnover }\left(\text{Refer Table (2)}\right)}\\ =\frac{365}{3.96}\\ =92.17\text{ days}\end{array}$
d. Inventory turnover	$\begin{array}{l}=\frac{\text{Cost of goods sold}}{\text{Average inventory}}\\ =\frac{\$147,000,000}{\$55,000,000\left(\text{1}\right)}\\ =2.67\text{ times}\end{array}$
e. Book value per share of common stock	$\begin{array}{l}=\frac{\left[\begin{array}{l}\text{Stockholders' }\\ \text{equity}\end{array}\right]-\left[\begin{array}{l}\text{Preferred }\\ \text{stock}\end{array}\right]}{\text{Outstanding common shares}}\\ =\frac{\$107,000,000-\$20,000,000}{5,000,000\text{ shares}}\\ =\$17.40\text{ per share}\end{array}$
f. Earnings per share	$\begin{array}{l}=\frac{\text{Net income}-\text{Preferred dividend}}{\left[\begin{array}{l}\text{Average common }\\ \text{shares outstanding}\end{array}\right]}\\ =\frac{\$6,000,000-\$1,000,000}{5,000,000\text{ shares}}\\ =\$1.00\text{ per share}\end{array}$
g. Price-earnings ratio	$\begin{array}{l}=\frac{\text{Market price per share}}{\text{ Earnings per share}\left(\text{f}\text{.}\right)}\\ =\frac{\$16.00\left(\text{Given}\right)}{\$1.00}\\ =\$16.00\end{array}$
h. Debt to assets ratio	$\begin{array}{l}=\frac{\text{Total liabilities }}{\text{Total assets}}\\ =\frac{\$113,000,000}{\$220,000,000}\\ =51.36\%\end{array}$
i. Return on investment	$\begin{array}{c}=\frac{\text{Net income }}{\text{Average total assets}}\\ =\frac{\$6,000,000}{\$225,000,000\left(2\right)}\\ =2.67\%\end{array}$
j. Return on equity	$\begin{array}{l}=\frac{\text{Net income }}{\left[\begin{array}{l}\text{Average stockholders'}\\ \text{ equity}\end{array}\right]}\\ =\frac{\$6,000,000}{\$105,500,000\left(3\right)}\\ =5.69\%\end{array}$

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. 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. Average days to collect accounts receivable: This ratio is used to determine the number of days a particular company takes to collect accounts receivables. It is calculated by using the formula:

$\begin{array}{l}\text{Average days to collect}\\ \text{ accounts receivable}\end{array}\}=\frac{\text{365}}{\text{Receivables turnover}}$

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. Book value per share of common stock: This ratio is a measure of a share of common stock that is used to determine the value of per share based on the equity available to the common stockholders. This ratio is calculated by using the formula:

$\begin{array}{l}\text{Book value per share }\\ \text{of common stock}\end{array}\}\text{=}\frac{\text{Stockholders' equity}-\text{Preferred stock }}{\text{Outstanding common shares}}$

1. f. Earnings per Share: 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.

$\text{Earnings per share}=\frac{\text{Net earnings available for common stock}}{\text{Average number of outstanding common shares}}$

1. g. Price/Earnings Ratio: The price/earnings ratio shows the market value of the amount invested to earn $1 by a company. It is major tool used by investors for making decisions related to the investment in a company.

$\text{Price/Earnings Ratio}\text{=}\frac{\text{Market Price per Share }}{\text{Earnings per Share}}$

1. h. 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. i. 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:

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

1. j. Return on 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:

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

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

Working Note:

Determine the receivable turnover ratio for Year 4.

Ratio	Year 4
Receivables turnover: $\frac{\text{}\text{Net credit sales}}{\left(\begin{array}{l}\text{Average accounts }\\ \text{receivables}\end{array}\right)}$ Average accounts receivable: $\frac{\left(\begin{array}{l}\text{Ending Net }\\ \text{Receivables}\end{array}\right)+\left(\begin{array}{l}\text{Beginning Net }\\ \text{Receivables}\end{array}\right)}{2}$		$\begin{array}{l}=\frac{\$180,000,000}{\$45,500,000}\\ =3.96\text{ times}\end{array}$ $\begin{array}{l}=\frac{\$47,000,000+\$44,000,000}{2}\\ =\frac{\$51,000,000}{2}\\ =\$45,500,000\end{array}$

Table (2)

Determine the amount of average inventory for year 4.

$\begin{array}{c}\text{Average inventory =}\frac{\left(\text{Ending Inventory}\right)+\left(\text{Beginning Inventory}\right)}{2}\\ =\frac{\$50,000,000+\$60,000,000}{2}\\ =\frac{\$110,000,000}{2}\\ =\$55,000,000\end{array}$ (1)

Determine the amount of average total assets for Year 4.

$\begin{array}{c}\text{Average total assets =}\frac{\left(\begin{array}{l}\text{Ending }\\ \text{total assets}\end{array}\right)+\left(\begin{array}{l}\text{Beginning }\\ \text{total assets}\end{array}\right)}{2}\\ =\frac{\$220,000,000+\$230,000,000}{2}\\ =\frac{\$450,000,000}{2}\\ =\$225,000,000\end{array}$ (2)

Determine the amount of average total stockholders’ equity for Year 4.

$\begin{array}{c}\begin{array}{l}\text{Average total }\\ \text{stockholders' equity }\end{array}\}\text{=}\frac{\left(\begin{array}{l}\text{Ending total }\\ \text{stockholders' equity}\end{array}\right)+\left(\begin{array}{l}\text{Beginning total }\\ \text{stockholders' equity}\end{array}\right)}{2}\\ =\frac{\$107,000,000+\$104,000,000}{2}\\ =\frac{\$211,000,000}{2}\\ =\$105,500,000\end{array}$ (3)