Chapter 13, Problem 6PA

Using Ratios to Compare Loan Requests from Two Companies

The financial statements for Royale and Cavalier companies are summarized here:

	Royale Company	Cavalier Company
Balance Sheet
Cash	$ 25,000	$ 45,000
Accounts Receivable, Net	55,000	16,000
Inventory	110,000	25,000
Equipment, Net	550,000	160,000
Other Assets	140,000	46,000
Total Assets	$880,000	$292,000
Current Liabilities	$120,000	$ 15,000
Note Payable (long-term)	190,000	55,000
Common Stock (par $20)	480,000	210,000
Additional Paid-in Capital	50,000	4,000
Retained Earnings	40,000	8,000
Total Liabilities and Stockholders’ Equity	$880,000	$292,000
Income Statement
Sales Revenue	$800,000	$280,000
Cost of Goods Sold	480,000	150,000
Other Expenses	240,000	95,000
Net Income	$ 80,000	$ 35,000
Other Data
Per share price at end of year	$ 14.00	$ 11.00
Selected Data from Previous Year
Accounts Receivable, Net	$ 47,000	$ 14,000
Note Payable (long-term)	190,000	55,000
Equipment, Net	550,000	160,000
Inventory	95,000	38,000
Total Stockholders’ Equity	570,000	202,000

These two companies are in the same business and state but different cities. Each company has been in operation for about 10 years. Both companies received an unqualified audit opinion on the financial statements. Royale Company wants to borrow $75,000 cash and Cavalier Company is asking for $30,000. The loans will be for a two-year period. Both companies estimate bad debts based on an aging analysis, but Cavalier has estimated slightly higher uncollectible rates than Royale. Neither company issued stock in the current year. Assume the end-of-year total assets and net equipment balances approximate the year’s average and all sales are on account.

Required:

1. 1. Calculate the ratios in Exhibit 13.5 for which sufficient information is available. Round all calculations to two decimal places.
2. 2. Assume that you work in the loan department of a local bank. You have been asked to analyze the situation and recommend which loan is preferable. Based on the data given, your analysis prepared in requirement 1, and any other information (e.g., accounting policies and decisions), give your choice and the supporting explanation.

To determine

The Net profit margin ratio for Company R and Company C.

Explanation of Solution

Net Profit margin Ratio:

This ratio gauges the operating profitability by quantifying the amount of income earned from business operations from the sales generated.

Following is the calculation of Net profit margin ratio for Company R

$\begin{array}{c}\text{Net}\text{profit}\text{margin}\text{ratio=}\frac{\text{Net}\text{income}}{\text{Revenues}}\text{×100}\\ \text{=}\frac{\text{\$80,000}}{\text{\$800,000}}\text{×100}\\ \text{=10}\text{.00\%}\end{array}$

Following is the calculation of Net profit margin ratio for Company C

$\begin{array}{c}\text{Net}\text{profit}\text{margin}\text{ratio=}\frac{\text{Net}\text{income}}{\text{Revenues}}\text{×100}\\ \text{=}\frac{\text{\$35,000}}{\text{\$280,000}}\text{×100}\\ \text{=12}\text{.50\%}\end{array}$

Thus, the net profit margin ratio for Company R and Company C is 10.00% and 12.50% respectively.

To determine

The Gross profit percentage ratio for Company R and Company C

Explanation of Solution

Gross Profit Percentage:

Gross profit is the financial ratio that shows the relationship between the gross profit and net sales. It represents gross profit as a percentage of net sales. Gross Profit is the difference between the net sales revenue, and the cost of goods sold. It can be calculated by dividing gross profit and net sales.

Following is the calculation of Gross profit percentage ratio for Company R

$\begin{array}{c}\text{Gross}\text{profit}\text{percentage}\text{ratio=}\frac{\left(\begin{array}{l}\text{Net}\text{sales}\text{revenue-}\\ \text{cost}\text{of}\text{goods}\text{sold}\end{array}\right)}{\text{Net}\text{sales}\text{revenue}}\text{×100}\\ \text{=}\frac{\left(\text{\$800,000-\$480,000}\right)}{\text{\$800,000}}\text{×100}\\ \text{=}\frac{\text{\$320,000}}{\text{\$800,000}}\text{×100}\\ \text{=40}\text{.00\%}\end{array}$

Following is the calculation of Gross profit percentage ratio for Company C

$\begin{array}{c}\text{Gross}\text{profit}\text{percentage}\text{ratio=}\frac{\left(\begin{array}{l}\text{Net}\text{sales}\text{revenue-}\\ \text{cost}\text{of}\text{goods}\text{sold}\end{array}\right)}{\text{Net}\text{sales}\text{revenue}}\text{×100}\\ \text{=}\frac{\left(\text{\$280,000-\$150,000}\right)}{\text{\$280,000}}\text{×100}\\ \text{=}\frac{\text{\$130,000}}{\text{\$280,000}}\text{×100}\\ \text{=46}\text{.43\%}\end{array}$

Thus, the gross profit percentage ratio for Company R and Company C is 40.00% and 46.43%

To determine

The fixed asset turnover ratio for Company R and Company C

Explanation of Solution

Fixed Asset turnover:

Fixed asset turnover is a ratio that measures the productive capacity of the fixed assets to generate the sales revenue for the company. Thus, it shows the relationship between the net sales and the average total fixed assets.

Following is the fixed asset turnover ratio for Company R

$\begin{array}{c}\text{Fixed}\text{asset}\text{trunover=}\frac{\text{Net}\text{revenue}}{\text{Average}\text{net}\text{fixed}\text{assets}}\\ \text{=}\frac{\text{\$800,000}}{\text{\$550,000}}\\ \text{=1}\text{.45}\end{array}$

Following is the fixed asset turnover ratio for Company C

$\begin{array}{c}\text{Fixed}\text{asset}\text{trunover=}\frac{\text{Net}\text{revenue}}{\text{Average}\text{net}\text{fixed}\text{assets}}\\ \text{=}\frac{\text{\$280,000}}{\text{\$160,000}}\\ \text{=1}\text{.75}\end{array}$

Thus, the fixed asset turnover ratio for company R and company C is 1.45 and 1.75.

To determine

The return on equity ratio for Company R and Company C

Explanation of Solution

Return on equity ratio:

Rate of return on equity ratio is used to determine the relationship between the net income available for the common stockholders’ and the average common equity that is invested in the company.

Following is the return on equity ratio for the Company R

$\begin{array}{c}\text{Return}\text{on}\text{equity=}\frac{\left(\begin{array}{l}\text{Net}\text{income-}\\ \text{preferred}\text{dividends}\end{array}\right)}{\text{Average}\text{common}\text{stockholders'}\text{equity}}\text{×100}\\ \text{=}\frac{\left(\text{\$80,000-0}\right)}{\text{\$570,000(1)}}\text{×100}\\ \text{=14}\text{.04\%}\end{array}$

Working note:

Calculate the average stockholders’ equity

$\begin{array}{c}\text{Average}\text{common}\text{stockholders'}\text{equity=}\frac{\left(\begin{array}{l}\text{Opening}\text{common}\text{stockholders'}\text{equity+}\\ \text{Closing}\text{common}\text{stock}\text{holders'}\text{equity}\end{array}\right)}{\text{2}}\\ \text{=}\frac{\text{\$570,000+\$570,000}}{\text{2}}\\ \text{=\$570,000}\end{array}$ (1)

Following is the return on equity ratio for the Company C

$\begin{array}{c}\text{Return}\text{on}\text{equity=}\frac{\left(\begin{array}{l}\text{Net}\text{income-}\\ \text{preferred}\text{dividends}\end{array}\right)}{\text{Average}\text{common}\text{stockholders'}\text{equity}}\text{×100}\\ \text{=}\frac{\left(\text{\$35,000-0}\right)}{\text{\$212,000(2)}}\text{×100}\\ \text{=16}\text{.51\%}\end{array}$

Working note:

$\begin{array}{c}\text{Average}\text{common}\text{stockholders'}\text{equity=}\frac{\left(\begin{array}{l}\text{Opening}\text{common}\text{stockholders'}\text{equity+}\\ \text{Closing}\text{common}\text{stock}\text{holders'}\text{equity}\end{array}\right)}{\text{2}}\\ \text{=}\frac{\text{\$202,000+\$222,000}}{\text{2}}\\ \text{=\$212,000}\end{array}$ (2)

Thus, the return on equity ratio for Company R and Company C is 14.04% and 16.51%

To determine

The earnings per share ratio of Company R and Company C

Explanation of Solution

Earnings per share ratio:

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.

Following is the Earnings per share ratio of Company R

$\begin{array}{c}\text{Earnings}\text{per}\text{share}\text{ratio=}\frac{\text{Net Income }-\text{Preferred dividend}}{\text{No of shares outstanding}}\\ \frac{\text{\$80,000 }-\text{ \$0}}{\text{24,000 shares(3)}}\\ \text{=\$3}\text{.33}\end{array}$

Working note:

Calculate the number of shares outstanding for company R

$\text{Number}\text{of}\text{shares}\text{outstanding=}\frac{\text{Total}\text{value}\text{of}\text{common}\text{stock}}{\begin{array}{l}\text{Par}\text{value}\text{of}\text{each}\text{stock}\\ \text{=}\frac{\text{\$480,000}}{\text{\$20}}\\ \text{=\$24,000}\end{array}}$ (3)

Following is the Earnings per share ratio of Company C

$\begin{array}{c}\text{Earnings}\text{per}\text{share}\text{ratio=}\frac{\text{Net Income }-\text{Preferred dividend}}{\text{No of shares outstanding}}\\ \frac{\text{\$35,000}-\$0}{\text{10,500shares(4)}}\\ \text{=\$3}\text{.33}\end{array}$

Working note:

Calculate the number of shares outstanding for Company C

$\text{Number}\text{of}\text{shares}\text{outstanding=}\frac{\text{Total}\text{value}\text{of}\text{common}\text{stock}}{\begin{array}{l}\text{Par}\text{value}\text{of}\text{each}\text{stock}\\ \text{=}\frac{\text{\$200,000}}{\text{\$10}}\\ \text{=\$20,000}\end{array}}$ (4)

Thus, the Earnings per share ratio of Company R and Company C is $3.33 and $3.33

To determine

The price/Earnings ratio of Company R and Company C

Explanation of Solution

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 to be used by investors before the decisions related to investments in a company.

Following is the price/earnings ratio of Company R

$\begin{array}{c}\text{Price/Earnings}\text{ratio=}\frac{\text{Stock}\text{price}}{\text{Earnings}\text{per}\text{share}}\\ \text{=}\frac{\text{\$14}\text{.00}}{\text{\$3}\text{.33}}\\ \text{=4}\text{.20}\end{array}$

Following is the price/earnings ratio of Company C

$\begin{array}{c}\text{Price/Earnings}\text{ratio=}\frac{\text{Stock}\text{price}}{\text{Earnings}\text{per}\text{share}}\\ \text{=}\frac{\text{\$11}}{\text{\$3}\text{.33}}\\ \text{=3}\text{.30}\end{array}$

Thus, the price/earnings ratio of Company R and Company C is 4.20 and 3.30

To determine

The receivables turnover ratio for Company R and C.

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.

Following is the receivables turnover ratio for Company R

$\begin{array}{c}\text{Receivables}\text{turnover}\text{ratio=}\frac{\text{Net}\text{sales}\text{revenue}}{\text{Average}\text{net}\text{receivables}}\\ \text{=}\frac{\text{\$800,000}}{\text{\$51,000(5)}}\\ \text{=15}\text{.69}\end{array}$

Following is the number of days a company R takes to collect accounts receivables.

$\begin{array}{c}\text{Days}\text{to}\text{collect=}\frac{\text{365}}{\text{Receivables}\text{turnover}\text{ratio}}\\ \text{=}\frac{\text{365}}{\text{15}\text{.69}}\\ \text{=23}\text{.26 days}\end{array}$

Working note:

Calculate the average net receivables

$\begin{array}{c}\text{Average}\text{net}\text{receivables=}\frac{\left(\begin{array}{l}\text{Opening}\text{net}\text{receivables+}\\ \text{Closing}\text{net}\text{receivables}\end{array}\right)}{\text{2}}\\ \text{=}\frac{\text{\$47,000+\$55,000}}{\text{2}}\\ \text{=\$51,000}\end{array}$ (5)

Following is the receivables turnover ratio for Company C

$\begin{array}{c}\text{Receivables}\text{turnover}\text{ratio=}\frac{\text{Net}\text{sales}\text{revenue}}{\text{Average}\text{net}\text{receivables}}\\ \text{=}\frac{\text{\$280,000}}{\text{\$15,000(6)}}\\ \text{=18}\text{.67}\end{array}$

Following is the number of days a company C takes to collect accounts receivables.

$\begin{array}{c}\text{Days}\text{to}\text{collect=}\frac{\text{365}}{\text{Receivables}\text{turnover}\text{ratio}}\\ \text{=}\frac{\text{365}}{18.67}\\ \text{=19}\text{.55Days}\end{array}$

Working note:

Calculate the average net receivables

$\begin{array}{c}\text{Average}\text{net}\text{receivables=}\frac{\left(\begin{array}{l}\text{Opening}\text{net}\text{receivables+}\\ \text{Closing}\text{net}\text{receivables}\end{array}\right)}{\text{2}}\\ \text{=}\frac{\text{\$14,000+\$16,000}}{\text{2}}\\ \text{=\$15,000}\end{array}$ (6)

Thus, the receivables turnover ratio for company R and company C is 15.69 and 18.67

To determine

The inventory turnover ratio for Company R and Company C

Explanation of Solution

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.

Following is the inventory turnover ratio for Company R

$\begin{array}{c}\text{Inventory}\text{turnover}\text{ratio=}\frac{\text{Cost}\text{of}\text{goods}\text{sold}}{\text{Average}\text{inventory}}\\ \text{=}\frac{\text{\$480,000}}{\text{\$102,500(7)}}\\ \text{=4}\text{.68}\end{array}$

Following is the number of days a company R takes to sell its inventory

$\begin{array}{c}\text{Days}\text{to}\text{sell=}\frac{\text{365}}{\text{Inventory}\text{turnover}\text{ratio}}\\ \text{=}\frac{\text{365}}{4.68}\\ \text{=77}\text{.99days}\end{array}$

Working note:

Calculate the average inventory

$\begin{array}{c}\text{Average}\text{inventory=}\frac{\left(\begin{array}{l}\text{Opening}\text{inventory+}\\ \text{Closing}\text{inventory}\end{array}\right)}{\text{2}}\\ \text{=}\frac{\text{\$95,000+\$110,000}}{\text{2}}\\ \text{=}\frac{\text{\$205,000}}{\text{2}}\\ \text{=\$102,500}\end{array}$ (7)

Following is the inventory turnover ratio for Company C

$\begin{array}{c}\text{Inventory}\text{turnover}\text{ratio=}\frac{\text{Cost}\text{of}\text{goods}\text{sold}}{\text{Average}\text{inventory}}\\ \text{=}\frac{\text{\$150,000}}{\text{\$31,500(8)}}\\ \text{=4}\text{.76}\end{array}$

Following is the number of days a company C takes to sell its inventory

$\begin{array}{c}\text{Days}\text{to}\text{sell=}\frac{\text{365}}{\text{Inventory}\text{turnover}\text{ratio}}\\ \text{=}\frac{\text{365}}{4.76}\\ \text{=76}\text{.68}\end{array}$

Working note:

Calculate the average inventory

$\begin{array}{c}\text{Average}\text{inventory=}\frac{\left(\begin{array}{l}\text{Opening}\text{inventory+}\\ \text{Closing}\text{inventory}\end{array}\right)}{\text{2}}\\ \text{=}\frac{\text{\$38,000+\$25,000}}{\text{2}}\\ \text{=}\frac{\text{\$63,000}}{\text{2}}\\ \text{=\$31,500}\end{array}$ (8)

Thus, the inventory turnover ratio for company R and company C is 4.68 and 4.76

To determine

The current ratio of Company R and C

Explanation of Solution

Current ratio:

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

Following is the current ratio of Company R

$\begin{array}{c}\text{Current}\text{ratio=}\frac{\text{Current}\text{assets}}{\text{Current}\text{liabilities}}\\ \text{=}\frac{\text{\$190,000(9)}}{\text{\$120,000}}\\ \text{=1}\text{.58}\end{array}$

Working note:

Calculate the current assets of Company R

$\begin{array}{c}\text{Current}\text{assets=Cash+Accounts}\text{receivables+Inventory}\\ \text{=\$25,000+\$55,000+\$110,000}\\ \text{=\$190,000}\end{array}$ (9)

Following is the current ratio of Company C

$\begin{array}{c}\text{Current}\text{ratio=}\frac{\text{Current}\text{assets}}{\text{Current}\text{liabilities}}\\ \text{=}\frac{\text{\$86,000(10)}}{\text{\$15,000}}\\ \text{=5}\text{.73}\end{array}$

Working note:

Calculate the current assets of Company C

$\begin{array}{c}\text{Current}\text{assets=Cash+Accounts}\text{receivables+Inventory}\\ \text{=\$45,000+\$16,000+\$25,000}\\ \text{=\$86,000}\end{array}$ (10)

Thus, the current ratio of Company R and Company C is 1.58 and 5.73

To determine

The debt-to-assets ratio of Company R and Company C

Explanation of Solution

Debt to Asset Ratio:

Debt to asset ratio is the ratio between total asset and total liability of the company. Debt ratio reflects the finance strategy of the company. It is used to evaluate company’s ability to pay its debts. Higher debt ratio implies the higher financial risk.

Following is the debt-to-asset ratio of Company R

$\begin{array}{c}\text{Debt-to-asset}\text{ratio=}\frac{\text{Total}\text{liabilities}}{\text{Total}\text{assets}}\\ \text{=}\frac{\text{\$310,000}}{\text{\$880,000}}\\ \text{=0}\text{.35}\end{array}$

Following is the debt-to-asset ratio of Company C

$\begin{array}{c}\text{Debt-to-asset}\text{ratio=}\frac{\text{Total}\text{liabilities}}{\text{Total}\text{assets}}\\ \text{=}\frac{\text{\$70,000}}{\text{\$292,000}}\\ \text{=0}\text{.24}\end{array}$

Thus, the debt-to-asset ratio of Company R and Company C is 0.35 and 0.24.

To determine

To State: which company is preferable for receive loan.

Explanation of Solution

Following is the comparison of the Company R and C profitability and liquidity which helps in deciding which company is preferable to receive loan:

Particulars	Company R	Company C
Profitability:
Net profit margin ratio	10%	12.50%
Gross profit percentage ratio	40.00%	46.43%
Fixed asset turnover ratio	1.45	1.75
Earnings per share	$3.33	$3.33
Return on equity	14.04%	16.51%
Liquidity:
Receivable turnover	15.69	18.67
Inventory Turnover	4.68	4.76
Current ratio	1.58	5.73

Table (1)

From the above table it is concluded that Company C is more preferable than Company R as its profitability and liquidity ratios are higher.

Company C is preferable to receive loan from loan bank because by analysing there profitability and liquidity and solvency of both the Companies R and C though Company C solvency position is less risky its profitability and liquidity is comparatively higher than Company R, but on the basis of loan requirement Company C needs $30,000 which is lesser to Company R $75,000.