Chapter 14, Problem 14.4BPR

Measures of liquidity, solvency and profitability

The comparative financial .statements of Stargel Inc. are as follows. The market price of Stargel common stock was $119.70 on December 31, 20Y2.

Stargel Inc. Comparative Retained Earnings Statement For the Years Ended December 31,20Y2 and 20Y1
	20Y2	20Y1
Retained earnings, January 1	$5,375,000	$4,545,000
Net income	900,000	925,000
Total	$6,275,000	$5,470,000
Dividends:
On preferred stock	$ 45,000	$ 45,000
On common stock	50,000	50,000
Total dividends	$ 95,000	$ 95,000
Retained earnings, December 31	$6,180,000	$5,375,000
Sales	$10,000,000	$9,400,000
Cost of goods sold	5,350,000	4,950,000
Gross profit	$ 4,650,000	54,450,000
Selling expenses	$ 2,000,000	$1,880,000
Administrative expenses	1,500,000	1,410,000
Total operating expenses	$ 3,500,000	$3,290,000
Income from operations	$ 1,150,000	$1,160,000
Other income	150,000	140,000
	$ 1,300,000	$1,300,000
Other expense (interest)	170,000	150,000
Income before income tax	$ 1,130,000	$1,150,000
Income tax expense	230,000	225,000
Net income	$ 900,000	$ 925,000

Stargel Inc Comparative Balance Sheet December 31,20Y2 and 20Y1
	20Y2	20Y1
Assets
Current assets:
	$ 500,000	$ 400,000
Marketable securities	1,010,000	1,000,000
Accounts receivable (net)	740,000	510,000
Inventories	1,190,000	950,000
Prepaid expenses	250,000	229,000
Total current assets	$3,690,000	$3,089,000
Long term investments	2,350,000	2,300,000
Property, plant, and equipment (net)	3,740,000	3,366,000
Total assets	$9,780,000	$8,755,000
Liabilities
Current liabilities	$ 900,000	$ 880,000
Long term liabilities:
Mortgage note payable. 10%	$ 200,000	$ 0
Bonds payable, 10%	1,500,000	1,500,000
Total long-term liabilities	$1,700,000	$1,500,000
Total liabilities	$2,600,000	$2,380,000
Stockholders' Equity
Preferred $0.90 stock. $10 par	$ 500,000	$ 500,000
Common stock. $5 par	500,000	500,000
Retained earnings	6,180,000	5,375,000
Total stockholders' equity	$7,180,000	$6,375,000
Total liabilities and stockholders' equity	$9,780,000	58,755,000

Instructions

Determine the following measures for 20Y2 (round to one decimal place including percentages, except for per-share amounts):

1. 1. Working capital
2. 2. Current ratio 5. Quick ratio
3. 4. Accounts receivable turnover
4. 5. Number of days^- sales in receivables
5. 6. Inventory turnover
6. 7. Number of days' sales in inventor)’
7. 8. Ratio of fixed assets to long-term liabilities
8. 9. Ratio of liabilities to stockholders' equity
9. 10. Times interest earned
10. 11. Asset turnover
11. 12. Return on total assets
12. 13. Return on stockholders’ equity
13. 14. Return on common stockholders' equity
14. 15. Earnings per share on common stock
15. 16. Price-earnings ratio
16. 17. Dividends per share of common stock
17. 18. Dividend yield

To determine

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

 To determine: Working capital

Explanation of Solution

Working capital

$\begin{array}{c}\text{Working capital = Current assets – }\text{}\text{Current liabilities }\\ \text{= \$3,690,000 – \$900,000}\\ \text{= \$2,790,000}\end{array}$

Working capital is determined as the difference between current assets and current liabilities.

Formula:

$\text{Working capital = Current assets – }\text{}\text{Current liabilities }$

To determine

To determine: Current ratio

Explanation of Solution

Current ratio

$\begin{array}{c}\text{Current ratio}=\frac{\text{Current assets}}{\text{Current}\text{liabilities}}\\ =\frac{\text{\$3,690,000}}{\text{\$900,000}}\\ =4.1\end{array}$

Current ratio is used to determine the relationship between current assets and current liabilities. The ideal current ratio is 2:1.  Current assets include cash and cash equivalents, short-term investments, net, accounts and notes receivables, net, inventories, and prepaid expenses and other current assets. Current liabilities include short-term obligations and accounts payable.

Formula:

$\text{Current ratio}=\frac{\text{Current assets}}{\text{Current}\text{liabilities}}$

To determine

To determine: Quick ratio

Explanation of Solution

Quick ratio

$\begin{array}{c}\text{Quick ratio }=\frac{\text{Quick assets }}{\text{Current}\text{liabilities}}\\ =\frac{\$2,250,000}{\$900,000}\\ =2.5\end{array}$

Acid-Test Ratio is the ratio denotes that this ratio is a more rigorous test of solvency than the current ratio. It is determined by dividing quick assets and current liabilities. The acceptable acid-test ratio is 0.90 to 1.00. It is referred as quick ratio. Use the following formula to determine the acid-test ratio:

$\text{Acid Ratio}=\frac{\text{Quick assets}}{\text{Current}\text{liabilities}}$

To determine

To determine: Accounts receivable turnover

Explanation of Solution

Accounts receivable turnover

$\begin{array}{c}\begin{array}{l}\text{Accounts receivables}\\ \text{ turnover ratio}\end{array}\}=\frac{\text{Net credit sales}}{\text{Average accounts receivables}}\\ =\frac{\$10,000,000}{\$625,000}\\ =16.0\end{array}$

Accounts 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. Main purpose of accounts receivable turnover ratio is to manage the working capital of the company. This ratio is determined by dividing credit sales and sales return.

Formula:

$\begin{array}{l}\text{Accounts receivables}\\ \text{ turnover ratio}\end{array}\}=\frac{\text{Net credit sales}}{\text{Average accounts receivables}}$

Average accounts receivable is determined as follows:

$\begin{array}{c}\begin{array}{l}\text{Average accounts }\\ \text{receivables }\end{array}\}\text{= }\frac{\left(\begin{array}{l}\text{Opening accounts receivables }\\ \text{+ Closing accounts receivables }\end{array}\right)}{2}\\ =\frac{\$740,000+\$510,000}{2}\\ =\$625,000\end{array}$

To determine

To determine: Number of days’ sales in receivables

Explanation of Solution

Number of days’ sales in receivables

$\begin{array}{c}\begin{array}{l}\text{Number of days’ sales }\\ \text{in receivable }\end{array}\}=\frac{\text{Average accounts receivable }}{\text{Average daily sales}}\\ =\frac{\$625,000}{27,397.26}\\ =22.8\text{days}\end{array}$

Number of days’ sales in receivables is used to determine the number of days a particular company takes to collect accounts receivables.

Formula:

$\text{Number of days’ sales in receivable}\text{=}\frac{\text{Average accounts receivable }}{\text{Average daily sales}}$

Average daily sales are determined by dividing sales by 365 days.

$\begin{array}{c}\text{Average daily sales = }\frac{\text{Sales}}{\text{365}\text{days}}\\ =\frac{\$10,000,000}{365\text{days}}\\ =\$27,397.26\end{array}$

To determine

To determine: Inventory turnover ratio

Explanation of Solution

Inventory turnover ratio

$\begin{array}{c}\text{Inventory turnover ratio }=\frac{\text{Cost of goods sold}}{\text{Average inventory}}\\ =\frac{\$5,350,000}{\$1,070,000}\\ =2.2\text{times}\end{array}$

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

Formula:

$\text{Inventory turnover}=\frac{\text{Cost of goods sold}}{\text{Average inventory}}$

Average inventory is determined as below:

$\begin{array}{c}\text{Average inventory = }\frac{\left(\text{Opening inventory + Closing inventory }\right)}{2}\\ =\frac{\$1,190,000+\$950,000}{2}\\ =\$1,070,000\end{array}$

To determine

To determine: Number of days sales in inventory ratio

Explanation of Solution

Number of days sales in inventory ratio

$\begin{array}{c}\begin{array}{l}\text{Number of days’ }\\ \text{sales in inventory }\end{array}\}=\frac{\text{Average inventory }}{\text{Average daily cost of goods sold}}\\ =\frac{\$1,070,000}{\$14,657.53}\\ =73.0\text{days}\end{array}$

Number of days’ sales in inventory is determined as the number of days a particular company takes to make sales of the inventory available with them.

Formula:

$\text{ Number of days’ sales in invenotry}=\frac{\text{Average inventory }}{\text{Average daily cost of goods sold}}$

Average daily cost of goods sold are determined by dividing cost of goods sold by 365 days. Thus, average daily cost of goods sold are determined as follows:

$\begin{array}{c}\text{Average daily cost of goods sold= }\frac{\text{Cost of goods sold}}{\text{365}\text{days}}\\ =\frac{\$5,350,000}{365\text{days}}\\ =\$14,657.53\end{array}$

To determine

To determine: Ratio of fixed assets to long-term liabilities

Explanation of Solution

Ratio of fixed assets to long-term liabilities

$\begin{array}{c}\text{Ratio of fixed assets to long-term liabilities}=\frac{\text{Fixed assets }}{\text{Long-term liabilities }}\\ =\frac{\$3,740,000}{\$1,700,000}\\ =2.2\end{array}$

Ratio of fixed assets to long-term liabilities is determined by dividing fixed assets and long-term liabilities.

Formula:

$\text{Ratio of fixed assets to long-term liabilities}=\frac{\text{Fixed assets }}{\text{Long-term liabilities }}$

To determine

To determine: Ratio of liabilities to stockholders’ equity

Explanation of Solution

$\begin{array}{c}\begin{array}{l}\text{Ratio of liabilities }\\ \text{to stockholders' equity }\end{array}\}=\frac{\text{Total liabilities}}{\text{Stockholders' equity}}\\ =\frac{\$2,600,000}{\$7,180,000}\\ =0.4\end{array}$

Ratio of liabilities to stockholders’ equity is determined by dividing liabilities and stockholders’ equity.

Formula:

$\text{ Ratio of liabilities to stockholders' equity}=\frac{\text{Total liabilities}}{\text{Stockholders' equity}}$

To determine

To determine: Times interest earned ratio

Explanation of Solution

Times interest earned ratio

$\begin{array}{c}\begin{array}{l}\text{Times-interest-}\\ \text{earned ratio }\end{array}\}=\frac{\text{Income before income tax}+\text{Interest expense}}{\text{Interest expense}}\\ =\frac{\$1,130,000+\$170,000}{\$170,000}\\ =7.6\%\end{array}$

Times interest earned ratio quantifies the number of times the earnings before interest and taxes can pay the interest expense. First, determine the sum of income before income tax and interest expense. Then, divide the sum by interest expense.

Formula:

$\begin{array}{l}\text{Times-interest-}\\ \text{earned ratio }\end{array}\}=\frac{\text{Income before income tax}+\text{Interest expense}}{\text{Interest expense}}$

To determine

To determine: Asset turnover ratio

Explanation of Solution

Asset turnover ratio

$\begin{array}{c}\text{Asset turnover ratio }=\frac{\text{Sales}}{\text{Average total assets}}\\ =\frac{\$10,000,000}{\$9,267,500}\\ =1.1\end{array}$

Asset turnover ratio is used to determine the asset’s efficiency towards sales.

Formula: $\text{Asset turnover }=\frac{\text{Net}\text{revenue}}{\text{Average total assets}}$

Working notes for average total assets are as follows:

$\begin{array}{c}\text{Average total assets =}\frac{\text{Beginning total assets + Ending total assets }}{2}\\ =\frac{\$9,780,000+\$8,755,000}{2}\\ =\$9,267,500\end{array}$

To determine

To determine: Return on total assets

Explanation of Solution

$\begin{array}{c}\text{Return on total assets}=\frac{\text{Net}\text{income + Interest expense}}{\text{Average total assets}}\\ =\frac{\$900,000+\$170,000}{\$9,267,500}\\ =11.5\%\end{array}$

Return on assets determines the particular company’s overall earning power. It is determined by dividing sum of net income and interest expense and average total assets.

Formula:

$\text{Rate of return on assets}=\frac{\text{Net}\text{income + Interest expense}}{\text{Average total assets}}$

To determine

To determine: Return on stockholders’ equity

Explanation of Solution

 Return on stockholders’ equity

$\begin{array}{c}\begin{array}{l}\text{Return on }\\ \text{stockholders' equity}\end{array}\}=\frac{\text{Net income }}{\text{Average stockholder’s equity}}\\ =\frac{\$900,000}{\$6,777,500}\\ =13.3\%\end{array}$

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

Formula: $\text{Rate of return on stockholders' equtiy }=\frac{\text{Net income}}{\text{Average stockholder’s equity}}$

Average stockholders’ equity is determined as follows:

$\begin{array}{c}\text{Average stockholders' equity =}\left(\frac{\begin{array}{l}\text{Beginning stockholders' equity }\\ \text{ + Ending stockholders' equity }\end{array}}{2}\right)\\ =\frac{\$7,180,000+\$6,375,000}{2}\\ =\$6,777,500\end{array}$

To determine

To determine: Return on common stockholders’ equity

Explanation of Solution

$\begin{array}{c}\begin{array}{l}\text{Return on common }\\ \text{stockholders' equity}\end{array}\}=\frac{\text{Net income – Preferred dividends }}{\text{Average stockholder’s equity}}\\ =\frac{\$900,000–\$45,000}{\$6,277,500}\\ =13.6\%\end{array}$

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

Formula: $\text{Rate of return on common stockholders' equtiy }=\frac{\text{Net income – Preferred dividends }}{\text{Average common stockholder’s equity}}$

Average common stockholders’ equity is determined as follows:

$\begin{array}{c}\text{Average stockholders' equity =}\left(\frac{\begin{array}{l}\text{Beginning common stockholders' equity }\\ \text{ + Ending common stockholders' equity }\end{array}}{2}\right)\\ =\frac{\$6,680,000+\$5,875,000}{2}\\ =\$6,277,500\end{array}$

To determine

To determine: Earnings per share on common stock

Explanation of Solution

$\begin{array}{c}\text{Earnings per share=}\left(\frac{\text{Net income }–\text{ Preferreddividends}}{\text{Weighted-average common shares outstanding}}\right)\\ =\frac{\$900,000-\$45,000}{100,000}\\ =\$8.55\end{array}$

A portion of profit that an individual earns from each share is referred to earnings per share.

Formula:

$\begin{array}{l}\text{Earnings }\\ \text{per share}\end{array}\}=\frac{\text{Net income }-\text{Preferred dividends}}{\text{Weighted average number of common shares outstanding}}$

To determine

To determine: Price earnings ratio

Explanation of Solution

$\begin{array}{c}\text{Price earnings ratio =}\frac{\text{Market price per share}}{\text{Earning per share}}\\ \text{=}\frac{\text{\$119}\text{.70}}{\text{\$8}\text{.55}}\\ \text{=14}\text{.0 times}\end{array}$

Price/earnings ratio is used to determine the profitability of a company. This ratio is abbreviated as P/E.

Formula:

$\text{Price/earnings ratio}=\frac{\text{Market price per share of common stock}}{\text{Earnings per share}}$

To determine

To determine: Dividend per share of common stock

Explanation of Solution

$\begin{array}{c}\begin{array}{l}\text{Dividend per }\\ \text{share of common stock}\end{array}\}=\frac{\text{Dividend per Common stock}}{\text{Shares of common stock}}\times 100\\ =\frac{\$50,000}{100,000\text{shares}}\\ =\$0.50\end{array}$

Dividend per share of commons stock is determined by dividing dividend per common stock and shares of common stock.

Formula:

$\begin{array}{l}\text{Dividend per }\\ \text{share of common stock}\end{array}\}=\frac{\text{Dividend per Common stock}}{\text{Shares of common stock}}\times 100$

To determine

To determine: Dividend yield ratio

Explanation of Solution

$\begin{array}{c}\text{Dividend yield }=\frac{\text{Annual dividend per Share}}{\text{Market price per Share}}\times 100\\ =\frac{\$0.50}{\$119.70}\\ =0.4\%\end{array}$

Dividend yield ratio is determined to evaluate the relationship between the annual dividend per share and the market price per share.

Formula:

$\text{Dividend yield }=\frac{\text{Annual dividend per Share}}{\text{Market price per Share}}\times 100$

Conclusion

Thus, summary table of determined ratios are below:

S.No	Particulars	Ratios
1.	Working capital	$2,790,000
2.	Current ratio	4.1
3.	Acid test ratio	2.5
4.	Accounts receivable turnover ratio	16.0
5.	Number of days’ sales in receivables	22.8
6.	Inventory turnover ratio	5.0
7.	Number of days sales in inventory	73.0
8.	Ratio of fixed assets to  long-term liabilities	2.2
9.	Ratio of liabilities to stockholders’ equity	0.4
10.	Times interest earned ratio	7.6
11.	Asset turnover ratio	1.1
12.	Return on total assets	11.5%
13.	Return on stockholders’ equity	13.3%
14.	Return on common stockholders’ equity	13.6%
15.	Earnings per share	$8.55
16.	Price earnings ratio	14.0
17.	Dividend  per share of common stock	$0.50
18.	Dividend yield	0.4%