Chapter 15, Problem 15.4APR

Nineteen measures of solvency and profitability

The comparative financial statements of Bettancort Inc. are as follows. The market price of Bettancort Inc. common stock was $71.25 on December 31, 2016.

Bettancort Inc. Comparative Retained Earnings Statement For the Years Ended December 31, 2016 and 2015
			2016			2015
Retained earnings. January 1.........................................			$2,655,000			$2,400,000
Add net income for year.............................................			300,000			280,000
Total...............................................................			$2,955,000			$2,680,000
Deduct dividends:
On preferred stock................................................			$ 15,000			$ 15,000
On common stock.................................................			10,000			10,000
Total...........................................................			$ 25,000			$ 25,000
Retained earnings. December 31.....................................			$2,930,000			$2,655,000
Bettancort Inc. Comparative Retained Earnings Statement For the Years Ended December 31, 2016 and 2015
	2016			2015
Sales......................	$1,200,000			$1,000,000
Cost of goods sold............	500,000			475,000
Gross profit...............	$ 700,000			$ 525,000
Selling expenses..........	$ 240,000			200,000
Administrative expenses......	180,000			150,000
Total operating expenses………..	$ 420,000			350,000
Income from operations……..	$ 280,000			175,000
Other income.............	166,000			225,000
	$ 446,000			400,000
Other expense (Interest)...	66,000			60,000
Income before income tax……	$ 380,000			340,000
Income tax expense.......	80,000			60,000
Net income...............	$ 300,000			280,000
Bettancort Inc. Comparative Retained Earnings Statement For the Years Ended December 31, 2016 and 2015
		Dec.31, 2016			Dec. 31, 2015
Assets
Current Assets:
Cash....................................		$ 450,000			$ 400,000
Marketable securities....................		300,000			260,000
Accounts receivable (net).................		130,000			110,000
Inventories..............................		67,000			58,000
Prepaid expenses........................		153,000			139,000
Total current assets.....................		$1,100,000			$ 967,000
Long-term investments....................		2,350,000			2,200,000
Property, plant and equipment (net).......		1,320,000			1,118,000
Total assets...............................		$4,770,000			$4,355,000
Liabilities
Current liabilities..........................		$440,000			$ 400,000
Long-term liabilities:
Mortgage note payable, 8.8%, due 2021...		$ 100,000			$ 0
Bonds payable, 9%, due 2017.............		1,000,000			1,000,000
Total long term liabilities...............		$1,100,000			$1,000,000
Total liabilities............................		$1,540,000			$1,400,000
Stockholders' equity
Preferred stock $0.90, $10 par…………..		$ 200,000			$ 200,000
Common stock. $5 par.....................		100,000			100,000
Retained earnings.........................		2,930,000			2,665,000
Total stockholders* equity...............		$3,230,000			$2,955,000
Total liabilities and stockholders' equity.....		$4,770,000			$4,355,000

Instructions

Determine the following measures for 2016, rounding to one decimal place:

1. 1. Working capital
2. 2. Current ratio
3. 3. Quick ratio
4. 4. Accounts receivable turnover
5. 5. Number of days' sales in receivables
6. 6. Inventory turnover
7. 7. Number of days' sales in inventory
8. 8. Ratio of fixed assets to long-term liabilities
9. 9. Ratio of liabilities to stockholders equity
10. 10. Number of times interest charges are earned
11. 11. Number of times preferred dividends are earned
12. 12. Ratio of sales to assets
13. 13. Rate earned on total assets
14. 14. Rate earned on stockholders' equity
15. 15. Rate earned on common stockholders' equity
16. 16. Earnings per share on common stock
17. 17. Price-earnings ratio
18. 18. Dividends per share of common stock
19. 19. Dividend yield

To determine

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

 The following ratios measures for 2016.

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

Explanation of Solution

1.  Working capital

$\begin{array}{c}\text{Working capital = Current assets – }\text{}\text{Current liabilities }\\ \text{= \$1,100,000 – \$440,000}\\ \text{= \$660,000}\end{array}$

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

Formula:

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

2. Current ratio

$\begin{array}{c}\text{Current ratio}=\frac{\text{Current assets}}{\text{Current}\text{liabilities}}\\ =\frac{\text{\$1,100,000}}{\text{\$440,000}}\\ =2.5\end{array}$

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:

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

3. Quick ratio

$\begin{array}{c}\text{Quick ratio }=\frac{\text{Quick assets }}{\text{Current}\text{liabilities}}\\ =\frac{\$880,000}{\$440,000}\\ =2.0\end{array}$

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:

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

4. Accounts receivable turnover

$\begin{array}{c}\begin{array}{l}\text{Accounts receivables}\\ \text{ turnover ratio}\end{array}\}=\frac{\text{Net credit sales}}{\text{Average accounts receivables}}\\ =\frac{\$1,200,000}{\$120,000}\\ =10.0\end{array}$

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:

$\begin{array}{c}\begin{array}{l}\text{Average accounts }\\ \text{receivables }\end{array}\}\text{= }\frac{\left(\begin{array}{l}\text{Opening accounts receivables }\\ \text{+ Closing accounts receivables }\end{array}\right)}{2}\\ =\frac{\$130,000+\$110,000}{2}\\ =\$120,000\end{array}$

5. Number of days’ sales in receivables

$\begin{array}{c}\begin{array}{l}\text{Number of days’ sales }\\ \text{in receivable }\end{array}\}=\frac{\text{Average accounts receivable }}{\text{Average daily sales}}\\ =\frac{\$120,000}{\text{\$3287}\text{.67}}\\ =36.5\text{days}\end{array}$

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.

$\begin{array}{c}\text{Average daily sales = }\frac{\text{Sales}}{\text{365}\text{days}}\\ =\frac{\$1,200,000}{365\text{days}}\\ =\$3,287.67\end{array}$

6. Inventory turnover ratio

$\begin{array}{c}\text{Inventory turnover ratio }=\frac{\text{Cost of goods sold}}{\text{Average inventory}}\\ =\frac{\$500,000}{\$62,500}\\ =8.0\text{times}\end{array}$

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:

$\begin{array}{c}\text{Average inventory = }\frac{\left(\text{Opening inventory + Closing inventory }\right)}{2}\\ =\frac{\$67,000+\$58,000}{2}\\ =\$62,500\end{array}$

7. Number of days sales in inventory ratio

$\begin{array}{c}\begin{array}{l}\text{Number of days’ }\\ \text{sales in inventory }\end{array}\}=\frac{\text{Average inventory }}{\text{Average daily cost of goods sold}}\\ =\frac{\$62,500}{\$1,369.86}\\ =45.6\text{days}\end{array}$

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:

$\begin{array}{c}\text{Average daily cost of goods sold= }\frac{\text{Cost of goods sold}}{\text{365}\text{days}}\\ =\frac{\$500,000}{365\text{days}}\\ =\$1369.86\end{array}$

8. Ratio of fixed assets to long-term liabilities

$\begin{array}{c}\text{Ratio of fixed assets to long-term liabilities}=\frac{\text{Fixed assets }}{\text{Long-term liabilities }}\\ =\frac{\$1,320,000}{\$1,100,000}\\ =1.2\end{array}$

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

Formula:

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

9.Ratio of liabilities to stockholders’ equity

$\begin{array}{c}\begin{array}{l}\text{Ratio of liabilities }\\ \text{to stockholders' equity }\end{array}\}=\frac{\text{Total liabilities}}{\text{Stockholders' equity}}\\ =\frac{\$1,540,000}{\$3,230,000}\\ =0.5\end{array}$

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

Formula:

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

10.Number of times interest charges are earned

$\begin{array}{c}\begin{array}{l}\text{Number of times }\\ \text{interest charges are }\\ \text{earned }\end{array}\}=\frac{\text{Income before income tax}+\text{Interest expense}}{\text{Interest expense}}\\ =\frac{\$380,000+\$66,000}{\$66,000}\\ =6.8\%\end{array}$

Number of times interest charges are 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:

$\begin{array}{l}\text{Number of times }\\ \text{interest charges are }\\ \text{earned }\end{array}\}=\frac{\text{Income before income tax}+\text{Interest expense}}{\text{Interest expense}}$

11. Number of times preferred dividends are earned

$\begin{array}{c}\begin{array}{l}\text{Number of times }\\ \text{preferred dividends }\\ \text{are earned }\end{array}\}\text{=}\frac{\text{Net income}}{\text{Preferred dividends}}\\ =\frac{\$300,000}{\$15,000}\\ =20.0\end{array}$

Number of times preferred dividends are determined by dividing net income and preferred dividends.

Formula: $\begin{array}{l}\text{Number of times }\\ \text{preferred dividends }\\ \text{are earned }\end{array}\}\text{=}\frac{\text{Net income}}{\text{Preferred dividends}}$

12. Ratio of sales to assets

$\begin{array}{c}\text{Ratio of sales to assets}=\frac{\text{Sales}}{\text{Average total assets}}\\ =\frac{\$1,200,000}{\$2,287,500}\\ =52.5\%\end{array}$

Ratio of sales to assets is used to determine the asset’s efficiency (excluding long-term investments) towards sales.

Formula: $\text{Ratio of sales to assets}=\frac{\text{Sales}}{\text{Average total assets}}$

Working notes for average total assets are as follows:

$\begin{array}{c}\text{Average total assets =}\frac{\text{Beginning total assets + Ending total assets }}{2}\\ =\frac{\$2,420,000+\$2,155,000}{2}\\ =\$2,287,500\end{array}$

13. Rate earned on total assets

$\begin{array}{c}\text{Rate earned on total assets}=\frac{\text{Net}\text{income + Interest expense}}{\text{Average total assets}}\\ =\frac{\$300,000+\$66,000}{\$4,562,500}\\ =8.0\%\end{array}$

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

Working notes for average total assets are as follows:

$\begin{array}{c}\text{Average total assets =}\frac{\text{Beginning total assets + Ending total assets }}{2}\\ =\frac{\$4,770,000+\$4,355,000}{2}\\ =\$4,562,500\end{array}$

14. Rate earned on stockholders’ equity

$\begin{array}{c}\begin{array}{l}\text{Rate earned on }\\ \text{stockholders' equity}\end{array}\}=\frac{\text{Net income }}{\text{Average stockholder’s equity}}\\ =\frac{\$300,000}{\$2,892,500}\\ =9.7\%\end{array}$

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

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

Average stockholders’ equity is determined as follows:

$\begin{array}{c}\text{Average stockholders' equity =}\left(\frac{\begin{array}{l}\text{Beginning stockholders' equity }\\ \text{ + Ending stockholders' equity }\end{array}}{2}\right)\\ =\frac{\$3,030,000+\$2,755,000}{2}\\ =\$2,892,500\end{array}$

15. Rate earned on common stockholders’ equity

$\begin{array}{c}\begin{array}{l}\text{Rate earned on common }\\ \text{stockholders' equity}\end{array}\}=\frac{\text{Net income – Preferred dividends }}{\text{Average stockholder’s equity}}\\ =\frac{\$300,000–\$15,000}{\$2,892,500}\\ =9.9\%\end{array}$

Rate earned 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: $\begin{array}{l}\text{Rate earned }\\ \text{on common }\\ \text{stockholders' equtiy}\end{array}\}=\frac{\text{Net income – Preferred dividends }}{\text{Average common stockholder’s equity}}$

Average common stockholders’ equity is determined as follows:

$\begin{array}{c}\text{Average stockholders' equity =}\left(\frac{\begin{array}{l}\text{Beginning common stockholders' equity }\\ \text{ + Ending common stockholders' equity }\end{array}}{2}\right)\\ =\frac{\$3,030,000+\$2,755,000}{2}\\ =\$2,892,500\end{array}$

16. Earnings per share on common stock

$\begin{array}{c}\text{Earnings per share=}\left(\frac{\text{Net income }–\text{ Preferreddividends}}{\text{Weighted-average common shares outstanding}}\right)\\ =\frac{\$300,000-\$15,000}{10,000}\\ =\$28.50\end{array}$

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

Formula:

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

17. Price earnings ratio

$\begin{array}{c}\text{Price earnings ratio =}\frac{\text{Market price per share}}{\text{Earning per share}}\\ \text{=}\frac{\text{\$71}\text{.25}}{\text{\$28}\text{.50}}\\ \text{=2}\text{.5 times}\end{array}$

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

Formula:

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

18.Dividend per share of common stock

$\begin{array}{c}\begin{array}{l}\text{Dividend per }\\ \text{share of common stock}\end{array}\}=\frac{\text{Dividend per Common stock}}{\text{Shares of common stock}}\times 100\\ =\frac{\$10,000}{10,000\text{shares}}\\ =\$1.00\end{array}$

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

Formula:

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

19.Dividend yield ratio

$\begin{array}{c}\text{Dividend yield }=\frac{\text{Annual dividend per Share}}{\text{Market price per Share}}\times 100\\ =\frac{\$1.00}{\$71.25}\\ =1.4\%\end{array}$

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	$660,000
2.	Current ratio	2.5
3.	Acid test ratio	2.0
4.	Accounts receivable turnover ratio	10.0
5.	Number of days’ sales in receivables	36.5
6.	Inventory turnover ratio	8.0
7.	Number of days sales in inventory	45.6
8.	Ratio of fixed assets to  long-term liabilities	1.2
9.	Ratio of liabilities to stockholders’ equity	0.5
10.	Number of times interest charges are earned	6.8
11.	Number of times preferred dividends are earned	20.0
12.	Ratio of sales to assets	0.5 or 52.5%
13.	Rate earned on total assets	8.0%
14.	Rate earned  on stockholders’ equity	9.7%
15.	Rate earned on common stockholders’ equity	9.9%
16.	Earnings per share	$28.50
17.	Price earnings ratio	2.5
18.	Dividend  per share of common stock	$1.00
19.	Dividend yield	1.4%