Chapter 2, Problem 2.4AP

(a)

To determine

Net income: The bottom line of income statement which is the result of excess of earnings from operations (revenues) over the costs incurred for earning revenues (expenses) is referred to as net income. Net income is calculated as shown below:

$\text{Net}\text{income}\text{=}\text{Revenues-Expenses}$

Earnings per share (EPS): The amount of net income available to each shareholder per common share outstanding is referred to as earnings per share (EPS).

Use the following formula to compute EPS:

$\text{EPS =}\frac{\left(\text{ Net income}-\text{Preferred dividends}\right)}{\text{Weighted average common shares outstanding}}$

Debt to assets ratio: This financial ratio evaluates the ability of a company to pay off long-term debt obligations owed to creditors. This ratio assesses the solvency of a company.

Formula of debt to assets ratio:

$\text{Debt to assets ratio = }\frac{\text{Total liabilities}}{\text{Total assets}}$

Free cash flow: This measure evaluates the cash-generating capacity of a company from its operating activities, after paying capital expenditures and dividends.

Formula of free cash flow:

$\text{Free cash flow = }\left(\begin{array}{l}\text{Net cash provides by operating activities}\\ -\text{Capital expenditures}-\text{Dividends}\end{array}\right)$

To compute: (a) Net income, EPS, and comment on the profitability.

Explanation of Solution

Compute net income (loss) of Company L for 2017.

$\begin{array}{c}\text{Net income (loss) = Revenues}-\text{Expenses}\\ \text{=Net sales}-\left(\begin{array}{l}\text{Cost of goods sold + Operating expenses }\\ \text{+ Interest expense + Income tax expenses}\end{array}\right)\\ =\$1,800,000-\left(\begin{array}{l}\$1,175,000+\$283,000\\ +\$9,000+\$85,000\end{array}\right)\\ =\$1,800,000-\$1,552,000\\ =\$248,000\end{array}$

$$ (1)

Compute net income (loss) of Company B for 2017.

$\begin{array}{c}\text{Net income (loss) = Revenues}-\text{Expenses}\\ \text{=Net sales}-\left(\begin{array}{l}\text{Cost of goods sold + Operating expenses }\\ \text{+ Interest expense + Income tax expenses}\end{array}\right)\\ =\$620,000-\left(\begin{array}{l}\$340,000+\$98,000\\ +\$3,800+\$36,000\end{array}\right)\\ =\$620,000-\$477,800\\ =\$142,200\end{array}$ (2)

Compute EPS of Company L for 2017, if net income is $248,000 (From Equation (1)), preferred dividends are $0, and weighted common shares outstanding are 80,000 shares.

$\begin{array}{c}\text{EPS =}\frac{\left(\text{ Net income}-\text{Preferred dividends}\right)}{\text{Weighted average common shares outstanding}}\\ =\frac{\left(\text{ \$248,000}-\text{\$0}\right)}{\text{80,000 Shares}}\\ =\$3.1\text{Per share}\end{array}$

Compute EPS of Company B for 2017, if net income is $142,200 (From Equation (2)), preferred dividends are $0, and weighted common shares outstanding are 50,000 shares.

$\begin{array}{c}\text{EPS =}\frac{\left(\text{ Net income}-\text{Preferred dividends}\right)}{\text{Weighted average common shares outstanding}}\\ =\frac{\left(\text{ \$142,000}-\text{\$0}\right)}{\text{50,000 Shares}}\\ =\$2.84\text{Per share}\end{array}$

Comments: Net income of Company L is $248,000 and EPS is $3.1. Net income of Company B is $142,200 and EPS is $2.84. Based on net income, it can be inferred that the profitability of the Company L is more than Company B. The size of the company with respect to number of shares differs for each company. Hence, EPS of Company L cannot be compared to Company B.

(b)

To determine

Working capital: The measure which evaluates the ability of a company to pay off the short-term debt obligations, by computing the excess of current assets over current liabilities is referred to as working capital.

Formula of working capital:

$\text{Working capitla = Current assets}-\text{Current liabilities}$

Current ratio: The financial ratio which evaluates the ability of a company to pay off the debt obligations which mature within one year or within completion of operating cycle is referred to as current ratio. This ratio assesses the liquidity of a company.

Formula of current ratio:

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

To compute: (b) Working capital, current ratio, and comment on the liquidity.

Explanation of Solution

Compute working capital of Company L, if current assets is $407,200 and current liabilities is $66,325.

$\begin{array}{c}\text{Working capitla = Current assets}-\text{Current liabilities}\\ \text{=\$407,200}-\$66,325\\ =\$340,875\end{array}$

Compute working capital of Company B, if current assets is $190,336 and current liabilities is $33,716.

$\begin{array}{c}\text{Working capitla = Current assets}-\text{Current liabilities}\\ \text{=\$190,336}-\$33,716\\ =\$156,620\end{array}$

Compute current ratio of Company L, if current assets is $407,200 and current liabilities is $66,325.

$\begin{array}{c}\text{Current ratio =}\frac{\text{ Current assets}}{\text{Current liabilities}}\\ =\frac{\$407,200}{\$66,325}\\ =6.15:1\end{array}$

Compute current ratio of Company B, if current assets is $190,336 and current liabilities is $33,716.

$\begin{array}{c}\text{Current ratio =}\frac{\text{ Current assets}}{\text{Current liabilities}}\\ =\frac{\$190,336}{\$33,716}\\ =5.65:1\end{array}$

Comments: Working capital of Company L is $340,875 and current ratio is 6.14:1. Working capital of Company L is $156,620 and current ratio is 5.65:1. Based on these two ratios, it can be inferred that the Company L is more liquid than Company B.

(c)

To determine

Debt to assets ratio: This financial ratio evaluates the ability of a company to pay off long-term debt obligations owed to creditors. This ratio assesses the solvency of a company.

Formula of debt to assets ratio:

$\text{Debt to assets ratio = }\frac{\text{Total liabilities}}{\text{Total assets}}$

Free cash flow: This measure evaluates the cash-generating capacity of a company from its operating activities, after paying capital expenditures and dividends.

Formula of free cash flow:

$\text{Free cash flow = }\left(\begin{array}{l}\text{Net cash provides by operating activities}\\ -\text{Capital expenditures}-\text{Dividends}\end{array}\right)$

To compute: (c) Debt to assets ratio, Free cash flow and comment on the solvency of Company L and Company B

Explanation of Solution

Compute debt to assets ratio of Company L.

$\begin{array}{c}\text{Debt to assets ratio = }\frac{\text{Total liabilities}}{\text{Total assets}}\\ =\frac{\text{Current liabilities + Long-term liabilities}}{\text{Current assets + Plant assets}}\\ =\frac{\text{\$66,325 + \$108,500}}{\text{\$407,200+ \$532,000}}\\ =0.186\text{ or 18}\text{.6\%}\end{array}$

Compute debt to assets ratio of Company B.

$\begin{array}{c}\text{Debt to assets ratio = }\frac{\text{Total liabilities}}{\text{Total assets}}\\ =\frac{\text{Current liabilities + Long-term liabilities}}{\text{Current assets + Plant assets}}\\ =\frac{\text{\$33,716 + \$40,684}}{\text{\$190,336+ \$139,728}}\\ =0.225\text{ or 22}\text{.5\%}\end{array}$

Compute free cash flow of Company L, if net cash provided by operating activities is $138,000, capital expenditures are $90,000, and dividends paid are $36,000.

$\begin{array}{c}\text{Free cash flow = }\left(\begin{array}{l}\text{Net cash provides by operating activities}\\ -\text{Capital expenditures}-\text{Dividends}\end{array}\right)\\ =\$138,000-\$90,000-\$36,000\\ =\$12,000\end{array}$

Compute free cash flow of Company B, if net cash provided by operating activities is $36,000, capital expenditures are $20,000, and dividends paid are $15,000.

$\begin{array}{c}\text{Free cash flow = }\left(\begin{array}{l}\text{Net cash provides by operating activities}\\ -\text{Capital expenditures}-\text{Dividends}\end{array}\right)\\ =\$36,000-\$20,000-\$15,000\\ =\$41,000\end{array}$

Comments: Debt to assets ratio of Company L is 18.6% and free cash flow is $12,000. Debt to assets ratio of Company L is 22.5% and free cash flow is $1,000. Based on these two ratios, it can be inferred that the Company L is more solvent than Company B.