Chapter 13, Problem 4AP

1.

To determine

Compute the appropriate ratios for 2015 and explain the meaning of each.

Answer to Problem 4AP

Compute the appropriate ratios for 2015.

Ratio	Formula	Calculation	Result
Turnover ratios
Receivables turnover	$\frac{\text{Net Credit}\text{Sales}}{\text{Average}\text{Net Receivables}}$	$\frac{\$453,000\times 40\%}{\left(\$42,000+\$29,000\right)÷2}$	5.1 times
Inventory turnover	$\frac{\text{Cost of Goods Sold}}{\text{Average Inventory}}$	$\frac{\$250,000}{\left(\$25,000+\$18,000\right)÷2}$	11.6 times
Liquidity ratios
Current ratio	$\frac{\text{Current}\text{Assets}}{\text{Current}\text{Liabilities}}$	$\frac{\$74,000}{\$18,000}$	4.1 times
Quick ratio	$\frac{\text{Quick}\text{Assets}}{\text{Current}\text{Liabilities}}$	$\frac{\$48,800}{\$18,000}$	2.7 times
Cash ratio	$\frac{\text{Cash \& Cash Equivalents}}{\text{Current}\text{Liabilities}}$	$\frac{\$6,800}{\$18,000}$	0.38 times
Solvency ratio
Debt-to-equity ratio	$\frac{\text{Total}\text{Liabilities}}{\text{Total}\text{Stockholder's}\text{Equity}}$	$\frac{\$88,000}{\$116,000}$	0.76
Time interest earned ratio	$\frac{\text{Net Income}\text{+}\text{Interest +}\text{Income Tax Expense}}{\text{Interest Expense}}$	$\frac{\$25,200+\$10,800+\$7,000}{\$7,000}$	6.1 times
Market ratios
Price/Earnings (P/E) ratio	$\frac{\text{Market Price per Share}}{\text{Earnings}\text{per Share}}$	$\frac{\$18}{\$25,200÷10,000\text{shares}}$	7.1 times
Dividend yield ratio	$\frac{\text{Dividend per Share}}{\text{ Market Price per Share}}$	$\frac{\$9,000÷10,000\text{Shares}}{\$18}$	5%

Table (1)

Explanation of Solution

Receivables turnover ratio:

Receivables 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. This ratio is determined by dividing credit sales and sales return.

$\text{Receivables Turnover Ratio}\text{=}\frac{\text{Net Sales}}{\text{Average}\text{Accounts}\text{Receivables}}$

Receivables turnover of the Corporation S is 5.1 times and the average collection period is 71.6 days$\left(\frac{365\text{days}}{5.1\text{times}}\right)$.

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

$\text{Inventory Turnover Ratio =}\frac{\text{Cost of Goods Sold }}{\text{Average Inventory}}$

Inventory turnover of the Corporation S is 11.6 times and the average days’ supply is 31.4 days$\left(\frac{365\text{days}}{11.6\text{times}}\right)$.

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

$\text{Current ratio}\text{=}\frac{\text{Current}\text{Assets}}{\text{Current}\text{Liabilities}}$

Current ratio of the Corporation S is 4.1 times.

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.

$\text{Quick Ratio}\text{=}\frac{\text{Quick}\text{Assets}}{\text{Current}\text{Liabilities}}$

Quick ratio of the Corporation S is 2.7 times.

Cash ratio: This ratio is used to measure the adequacy of the cash in the business.

$\frac{\text{Cash \& Cash Equivalents}}{\text{Current}\text{Liabilities}}$

Cash ratio of Corporation S for Year 2015 is 0.38 times.

Debt-equity ratio: The debt-to-equity ratio indicates that the company’s debt as a proportion of its stockholders’ equity.

$\text{Debt-equity ratio}\text{=}\frac{\text{Total}\text{Liabilities}}{\text{Total}\text{Stockholder's}\text{Equity}}$

Debt-to-equity ratio of the Corporation S is 0.76 times.

Times Interest Earned Ratio:

It is one of the solvency ratios. It is a measure to evaluate the net income for interest payment on debt of a company. It is calculated as follows:

$\text{Times Interest earned ratio}\text{=}\frac{\text{Net Income}\text{+ Interest Expense}\text{+}\text{Income Tax Expense}}{\text{Interest Expense}}$

Times interest earned ratio of the Corporation S is 6.1 times.

Price/Earnings Ratio: It depicts the relation of market price of a share to earnings per share of that company. The price/earnings ratio presents the market value of the amount invested to earn $1 by a company. It is major tool to be used by investors before the decisions related to investments in a company.

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

Price/Earnings ratio of the Corporation S is 7.10 times.

Dividend yield: This is the ratio which measures the amount of dividends paid relative to the market price.

$\text{Dividend Yield Ratio}\text{=}\frac{\text{Dividends per Share}}{\text{ Market Price per Share}}$

Dividend yield ratio of the Corporation S is 5%.

2.

To determine

Explain the given requirements for 2015 based on the given information.

Explanation of Solution

1. (a) Financial leverage percentage: Financial Leverage Percentage is one of the profitability ratios. It measures that the assets held by a company proportionate to its common stock (Equity). It indicates an advantage was earned for the stockholders because the company earned a higher return on the total resources used that is compared to the interest paid on debt (after tax).
2. (b) Net profit margin: It is one of the profitability ratios. It explains the relationship between the net income and net sales as a percentage. The profit margin was more than 5% of net sales. This means that the business earned more than $.05 profit on each sales dollar.
3. (c) 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. The current ratio is high and is more than the quick ratio because the latter ratio is a much more severe test of liquidity (it excludes inventory and prepaid expenses). However, there appears to be a severe liquidity problem that these two ratios do not divulge; that is, the extremely low amount of cash.
4. (d) Average collection period: This ratio is used to determine the number of days a particular company takes to collect accounts receivables. There appears to be a credit and collection deficiency. The receivable collection period for the Corporation S is 71.6 days. It indicates that there are more uncollected accounts than expected.