Chapter 13, Problem 2PB

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.

$\begin{array}{c}\text{Gross profit percentage = }\frac{\text{Net Sales Revenue }-\text{Cost of goods sold}}{\text{Net sales revenue}}\times \text{ 100}\\ =\frac{\text{\$185,000}-\text{\$111,000}}{\$185,000}\times \text{ 100}\\ =40.0\%\end{array}$

Compute the gross profit percentage for the current year.

$\begin{array}{c}\text{Gross profit percentage = }\frac{\text{Net Sales Revenue }-\text{Cost of goods sold}}{\text{Net sales revenue}}\times \text{ 100}\\ =\frac{\text{\$222,000}-\text{\$127,650}}{\$222,000}\times \text{ 100}\\ =42.5\%\end{array}$

By comparing the percentage gross profit percentage of Company TA during previous year (40.0%) with current year (42.5%), there is an increase in the gross profit percentage by 2.5 cents $\left(40.0\%-42.5\%\right)$ 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.

$\begin{array}{c}\text{Net profit margin =}\frac{\text{Net Income (1)}}{\text{Net Sale Revenue}}\times 100\\ =\frac{\$25,900}{\$185,000}\times 100\\ =14.0\text{\%}\end{array}$

Compute the net profit margin for the current year.

$\begin{array}{c}\text{Net profit margin =}\frac{\text{Net Income (1)}}{\text{Net Sale Revenue}}\times 100\\ =\frac{\$35,525}{\$222,000}\times 100\\ =16.0\text{\%}\end{array}$

When compared to the previous year net profit margin, the net profit margin of Company TA in the current year has been increased 2.0 %$\left(16\%-14\%\right)$ . Hence company TA did better job.

Working note (1):

Company TA
Financial statement
December 31
Particulars	Current year Amount ($)(A)	Previous year Amount   ($)(B)
			$\left(\text{C=A}-\text{B}\right)$ $	$\left(\text{D=C÷B}\right)$$
Income statement
Sales revenue	222,000	185,000	37,000	20.0%
Cost of goods sold	127,650	111,000	16,650	15.0%
Gross profit	94,350	74,000	20,350	27.5%
Operating expenses	39,600	33,730	5,850	17.4%
Interest expenses	4,000	3,270	730	22.3%
Income before income tax expense	50,750	37,000	13,750	37.2%
Income tax expense (30%)	15,225	11,100	4,125	37.2%
Net income	35,525	25,900	9,625	37.2%
Balance sheet
Cash	40,000	38,000	2,000	5.3%
Accounts receivable	18,500	16,000	2,500	15.6%
Inventory	25,000	22,000	3,000	13.6%
Property and equipment	127,000	119,000	8,000	6.7%
Total assets	210,500	195,000	15,500	7.9%
Accounts payable	27,000	25,000	15,500	8.0%
Income tax payable	3,000	2,800	2,000	7.1%
Note payable(long-term)	75,500	92,200	200	(18.1%)
Total liabilities	105,500	120,000	(16,700)	(12.7%)
Common stock(par $10)	25,000	25,000	(14,500)	0%
Retained earnings	80,000	50,000	0	60%
Total liabilities and stockholders’ equity	210,500	195,000	30,000	7.9%

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.

$\begin{array}{c}\text{EPS= }\frac{\text{Net Income }-\text{Preferred Dividends}}{\text{Average Number of shares of Common stock outstanding}}\\ =\frac{\$25,900-\$0}{\$25,000\text{(2)}}\\ =\text{1}\text{.04}\end{array}$

Calculate the earnings per share for the current year.

$\begin{array}{c}\text{EPS= }\frac{\text{Net Income }-\text{Preferred Dividends}}{\text{Average Number of shares of Common stock outstanding}}\\ =\frac{\$35,525-\$0}{\$25,000\text{(2)}}\\ =\text{1}\text{.42}\end{array}$

The Company has an EPS of ($1.42) which is comparatively higher than previous year earnings per share ($1.04), Hence, there is an increase in EPS by 0.38cents $\left(\$1.42-\$1.04\right)$. Increase in the EPS value shows a good profit for the stockholder’s.

Working note (2):

$\begin{array}{c}\begin{array}{l}\text{Average Number of shares of}\\ \text{ Common stock outstanding}\end{array}\}=\frac{\text{Common Stock Balance}}{\text{Per share value}}\\ =\frac{\$25,000}{1}\\ =\$25,000\end{array}$

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.

$\begin{array}{c}\text{Return on Equity(ROE) = }\frac{\text{Net Income }-\text{Preferred Dividends}}{\text{Average Common Stockholders' Equity}}\times \text{ 100}\\ =\frac{\text{\$25,900}-\text{\$0}}{\$70,000\text{ (3)}}\times \text{ 100}\\ =37.0\%\end{array}$

Calculate the return on equity for the current year.

$\begin{array}{c}\text{Return on Equity(ROE) = }\frac{\text{Net Income }-\text{Preferred Dividends}}{\text{Average Common Stockholders' Equity}}\times \text{ 100}\\ =\frac{\$35,525-\text{\$0}}{\$90,000\text{ (3)}}\times \text{ 100}\\ =39.5\%\end{array}$

Company has generated more returns on equity in current year (39.5%) which is comparatively higher than the return on equity of previous year (37.0%). Increase in the return on equity increase the net profit margin of Company TA.

Working note (3):

Calculate Average stockholder’s equity for the previous year.

$\begin{array}{c}\text{Average stockholder's Equity = }\frac{\text{Opening stockholder' s equity + Closing Stockholder's equity}}{\text{2}}\\ =\frac{\$75,00+\$65,000}{2}\\ =\text{}\text{}\text{\$70,000}\end{array}$

Calculate Average stockholder’s equity for the current year.

$\begin{array}{c}\text{Average stockholder's Equity = }\frac{\text{Opening stockholder' s equity + Closing Stockholder's equity}}{\text{2}}\\ =\frac{\$105,000+\$75,000}{2}\\ =\text{}\text{}\text{\$90,000}\end{array}$

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.

$\begin{array}{c}\text{Fixed asset turnover = }\frac{\text{Net Revenue}}{\text{Average Net Fixed Assets}}\\ =\frac{\$185,000}{\$117,000\text{ (4)}}\\ =1.58\end{array}$

Calculate the fixed asset turnover for the current year.

$\begin{array}{c}\text{Fixed asset turnover = }\frac{\text{Net Revenue}}{\text{Average Net Fixed Assets}}\\ =\frac{\$222,000}{\$123,000\text{ (5)}}\\ =1.80\end{array}$

Company TA has utilized its fixed assets, better in the current year than in previous year, as the fixed asset turnover ratio of the current year (1.80) is comparatively higher than the previous year (1.58) for every dollar invested in fixed assets.

Working note (4):

Calculate the fixed asset turnover for the previous year.

$\begin{array}{c}\text{Average net fixed assets = }\frac{\text{Opening + Closing }}{\text{2}}\\ =\frac{\$119,000+\$115,000}{2}\\ =\text{}\text{}\text{\$117,000}\end{array}$

Working Note (5):

Calculate the fixed asset turnover for the current year.

$\begin{array}{c}\text{Average net fixed assets = }\frac{\text{Opening fixed assets + Closing fixed assets }}{\text{2}}\\ =\frac{\$127,000+\$119,000}{2}\\ =\text{}\text{}\text{\$123,000}\end{array}$

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.

$\begin{array}{c}\text{Debt -to -asset = }\frac{\text{Total Liabilities}}{\text{Total Assets}}\\ =\frac{\$120,000}{\$195,000}\\ =0.62\end{array}$

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

$\begin{array}{c}\text{Debt -to -asset = }\frac{\text{Total Liabilities}}{\text{Total Assets}}\\ =\frac{\$105,500}{\$210,500}\\ =0.50\end{array}$

Company has received a contribution of 50% from its creditors which is comparatively less than the contribution made by its creditors during the previous year (62%). Therefore, Company TA shows a less risky financing strategy in the current year than the 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.

$\begin{array}{c}\text{Times Interest Earned = }\frac{\text{Net Income }+\text{ Interest Expense + Income tax expense}}{\text{Interest Expense}}\\ =\frac{\$25,900+\$3,270+\$11,100}{\$3,270}\\ =12.3\end{array}$

Compute the time interest earned for current year.

$\begin{array}{c}\text{Times Interest Earned = }\frac{\text{Net Income }+\text{ Interest Expense + Income tax expense}}{\text{Interest Expense}}\\ =\frac{\$35,525+\$4,000+\$15,225}{\$4,000}\\ =13.7\end{array}$

Company’s times interest earned ratio has improved by 1.4 cents $\left(13.7-12.3\right)$ . Company TA times interest earned ratio for the current year (13.7) 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.

$\begin{array}{c}\text{Price earning ratio = }\frac{\text{Stock Price (per share)}}{\text{Earnings per share (annual)}}\\ =\frac{\$12}{\$1.04}\\ =11.5\end{array}$

Compute the price earnings ratio for current year.

$\begin{array}{c}\text{Price earning ratio = }\frac{\text{Stock Price (per share)}}{\text{Earnings per share (annual)}}\\ =\frac{\$17}{\$1.42}\\ =12.0\end{array}$

Price earnings ratio of Company TA shows that investors have become more confident about the future success of the company. Because the company price earnings ratio has increased from 11.5 to 12.0 in the current year, (by 0.5 cents) which is comparatively more 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.