Chapter 13, Problem 2PA

1.

To determine

Compute the gross profit percentage for current and previous year.

Explanation of Solution

Financial Ratios

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

Compute the gross profit percentage for the previous year.

$\begin{array}{c}\text{Gross profit percentage = }\frac{\text{Net Sales Revenue }-\text{Cost of goods sold}}{\text{Net sales revenue}}\times \text{ 100}\\ =\frac{\text{\$99,000}-\text{\$48,000}}{\$99,000}\times \text{ 100}\\ =51.5\%\end{array}$

Compute the gross profit percentage for the current year.

$\begin{array}{c}\text{Gross profit percentage = }\frac{\text{Net Sales Revenue }-\text{Cost of goods sold}}{\text{Net sales revenue}}\times \text{ 100}\\ =\frac{\text{\$110,000}-\text{\$52,000}}{\$110,000}\times \text{ 100}\\ =52.7\%\end{array}$

By comparing the percentage gross profit percentage of Company PP during previous year (51.5%) with current year (52.7%), there is an increase in the gross profit percentage by 1.2 cents $\left(51.5\%-52.7\%\right)$ in current year, which is comparatively higher than previous year. Thus this indicates that company is earning high profit for per dollar of sales.

2.

To determine

Compute the net profit margin for current and previous year.

Explanation of Solution

Compute the net profit margin for previous year.

$\begin{array}{c}\text{Net profit margin =}\frac{\text{Net Income (1)}}{\text{Net Sale Revenue}}\times 100\\ =\frac{\$9,800}{\$99,000}\times 100\\ =9.9\text{\%}\end{array}$

Compute the net profit margin for the current year.

$\begin{array}{c}\text{Net profit margin =}\frac{\text{Net Income (1)}}{\text{Net Sale Revenue}}\times 100\\ =\frac{\$12,600}{\$110,000}\times 100\\ =11.5\text{\%}\end{array}$

When compared to the previous year net profit margin, the net profit margin of Company PP in the current year has been increased 1.6 %$\left(11.5\%-9.9\%\right)$ . Hence company PP did better job.

Working note (1):

Company PP
Financial statement
December 31
Particulars	Current year Amount ($)(A)	Previous year Amount   ($)(B)
			$\left(\text{C=A-B}\right)$ $	$\left(\text{D=C÷B}\right)$$
Income statement
Sales revenue	110,000	99,000	11,000	11.1
Cost of goods sold	52,000	48,000	4,000	8.3
Gross profit	58,000	51,000	7,000	13.7
Operating expenses	36,000	33,000	3,000	9.1
Interest expenses	4,000	4,000	0	0
Income before income tax expense	18,000	14,000	4,000	28.6
Income tax expense (30%)	5,400	4,200	1,200	28.6
Net income	12,600	9,800	2,800	28.6
Balance sheet
Cash	69,500	38,000	31,500	82.9
Accounts receivable	17,000	12,000	5,000	41.7
Inventory	25,000	38,000	(13,000)	(34.2)
Property and equipment	95,000	105,000	(10,000)	(9.5)
Total assets	206,500	193,000	13,500	7
Accounts payable	42,000	35,000	7,000	20
Income tax payable	1,000	500	500	100
Note payable(long-term)	40,000	40,000	0	0
Total liabilities	83,000	75,500	7,500	9.9
Common stock(par $10)	90,000	90,000	0	0
Retained earnings	33,500	27,500	6,000	21.8
Total liabilities and stockholders’ equity	206,500	193,000	13,500	7

Table (1)

3.

To determine

Compute the earnings per share for the current year and previous year.

Explanation of Solution

Calculate the earnings per share for the previous year.

$\begin{array}{c}\text{EPS}=\frac{\text{Net Income }-\text{Preferred Dividends}}{\text{Average Number of shares of Common stock outstanding}}\\ =\frac{\$9,800-\$0}{\$9,000\text{ (2)}}\\ =\text{1}\text{.09}\end{array}$

Calculate the earnings per share for the current year.

$\begin{array}{c}\text{EPS}=\frac{\text{Net Income }-\text{Preferred Dividends}}{\text{Average Number of shares of Common stock outstanding}}\\ =\frac{\$12,600-\$0}{\$9,000\text{ (2)}}\\ =\text{1}\text{.40}\end{array}$

The Company has an EPS of ($1.40) which is comparatively higher than previous year earnings per share ($1.09), Hence, there is an increase in EPS by 0.31cents $\left(\$1.40-\$1.09\right)$. Increase in the EPS value shows a good profit for the stockholder’s.

Working note (2):

$\begin{array}{c}\begin{array}{l}\text{Average Number of shares of}\\ \text{ Common stock outstanding}\end{array}\}=\frac{\text{Common Stock Balance}}{\text{Per share value}}\\ =\frac{\$90,000}{10}\\ =\$9,000\end{array}$

4.

To determine

Compute the return on equity for current and previous each year.

Explanation of Solution

Calculate the return on equity for the previous year.

$\begin{array}{c}\text{Return on Equity(ROE) = }\frac{\text{Net Income }-\text{Preferred Dividends}}{\text{Average Common Stockholders' Equity}}\times \text{ 100}\\ =\frac{\text{\$9,800}-\text{\$0}}{\$108,750\text{ (3)}}\times \text{ 100}\\ =9.0\%\end{array}$

Calculate the return on equity for the current year.

$\begin{array}{c}\text{Return on Equity(ROE) = }\frac{\text{Net Income }-\text{Preferred Dividends}}{\text{Average Common Stockholders' Equity}}\times \text{ 100}\\ =\frac{\$12,600-\text{\$0}}{\$120,500\text{ (3)}}\times \text{ 100}\\ =10.5\%\end{array}$

Company has generated more returns on equity in current year (10.5%) which is comparatively higher than the return on equity of previous year (9.0%). Increase in the return on equity increase the net profit margin of Company PP.

Working note (3):

Calculate the average stockholder’s equity for the previous year.

$\begin{array}{c}\text{Average stockholder's Equity = }\frac{\text{Opening stockholder' s equity + Closing Stockholder's equity}}{\text{2}}\\ =\frac{\$117,500+\$100,000}{2}\\ =\text{}\text{}\text{\$108,750}\end{array}$

Calculate the average stockholder’s equity for the current year.

$\begin{array}{c}\text{Average stockholder's Equity = }\frac{\text{Opening stockholder' s equity + Closing Stockholder's equity}}{\text{2}}\\ =\frac{\$123,500+\$117,500}{2}\\ =\text{}\text{}\text{\$120,500}\end{array}$

5.

To determine

Compute the fixed asset turnover for current and previous year.

Explanation of Solution

 Calculate the fixed asset turnover for the previous year.

$\begin{array}{c}\text{Fixed asset turnover = }\frac{\text{Net Revenue}}{\text{Average Net Fixed Assets}}\\ =\frac{\$99,000}{\$107,500\text{ (4)}}\\ =0.92\end{array}$

Calculate the fixed asset turnover for the current year.

$\begin{array}{c}\text{Fixed asset turnover = }\frac{\text{Net Revenue}}{\text{Average Net Fixed Assets}}\\ =\frac{\$110,000}{\$100,000\text{ (5)}}\\ =1.10\end{array}$

Company PP has utilized its fixed assets, better in the current year than in previous year, as the fixed asset turnover ratio of the current year is comparatively higher (1.10) than the previous year (0.92) for every dollar invested in fixed assets.

Working note (4):

Calculate the fixed asset turnover for the previous year.

$\begin{array}{c}\text{Average net fixed assets = }\frac{\text{Opening + Closing }}{\text{2}}\\ =\frac{\$110,000+\$105,000}{2}\\ =\text{}\text{}\text{\$107,500}\end{array}$

Working note (5):

Calculate the fixed asset turnover for the current year.

$\begin{array}{c}\text{Average net fixed assets = }\frac{\text{Opening + Closing }}{\text{2}}\\ =\frac{\$95,000+\$105,000}{2}\\ =\text{}\text{}\text{\$100,000}\end{array}$

6.

To determine

Compute the debt - to-asset for current and previous year.

Explanation of Solution

Compute the debt – to - asset for the previous year.

$\begin{array}{c}\text{Debt -to -asset = }\frac{\text{Total Liabilities}}{\text{Total Assets}}\\ =\frac{\$75,500}{\$193,000}\\ =0.39\end{array}$

Compute the debt – to - asset for the current year.

$\begin{array}{c}\text{Debt -to -asset = }\frac{\text{Total Liabilities}}{\text{Total Assets}}\\ =\frac{\$83,000}{\$206,500}\\ =0.40\end{array}$

Company has received a contribution of 40% from its creditors which is comparatively little higher than the contribution made by its creditors during previous year (39%). Company PP maintains a same debt and equity financing balance in the current year as same as previous year.

7.

To determine

Compute the time interest earned for current and previous year.

Explanation of Solution

Compute the time interest earned for previous year.

$\begin{array}{c}\text{Times Interest Earned = }\frac{\text{Net Income }+\text{ Interest Expense + Income tax expense}}{\text{Interest Expense}}\\ =\frac{\$9,800+\$4,000+\$4,200}{\$4,000}\\ =4.5\end{array}$

Compute the time interest earned for current year.

$\begin{array}{c}\text{Times Interest Earned = }\frac{\text{Net Income }+\text{ Interest Expense + Income tax expense}}{\text{Interest Expense}}\\ =\frac{\$12,600+\$4,000+\$5,400}{\$4,000}\\ =5.5\end{array}$

Company’s times interest earned ratio has been improved by 1.0 cents $\left(5.5-4.5\right)$. Company PP times interest earned ratio for the current year (5.5) shows that the company has enough net income which is earned before paying interest and income taxes to meet out their interest expense for the year.

8.

To determine

Compute the price earnings ratio for current and previous year.

Explanation of Solution

Compute the price earnings ratio for previous year.

$\begin{array}{c}\text{Price earning ratio = }\frac{\text{Stock Price (per share)}}{\text{Earnings per share (annual)}}\\ =\frac{\$15}{\$1.09}\\ =13.8\end{array}$

Compute the price earnings ratio for current year.

$\begin{array}{c}\text{Price earning ratio = }\frac{\text{Stock Price (per share)}}{\text{Earnings per share (annual)}}\\ =\frac{\$18}{\$1.40}\\ =12.9\end{array}$

Price earnings ratio of Company PP shows that investors have become less confident about the future success of the company. Because the company’s price earnings ratio has decreased from 13.8 to 12.9 in the current year, (by 0.9 cents) which is comparatively less than the price earnings ratio of previous year. Increase in the price earnings ratio shows that investors of the company have trust in company’s future performance and their increase in profits. Lower price earnings ratio shows that investors of the company do not expect effective financial performance.