Chapter 2, Problem 2.6AP

(a)

To determine

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).

Formula of EPS:

$\text{EPS = }\frac{\text{Net income – Preferred dividends}}{\text{Weighted average common shares outstanding}}$

To compute: (a) EPS.

Explanation of Solution

Compute EPS of Corporation D for 2017, if net income is $70,000, preferred dividends are $0, and weighted common shares outstanding are 33,000 shares.

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

Compute EPS of Corporation D for 2016, if net income is $60,000, preferred dividends are $0, and weighted common shares outstanding are 30,000 shares.

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

(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:

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

To compute: (b) Working capital.

Explanation of Solution

Compute working capital of Corporation D for 2017.

$\text{Free cash flow = }\left\{\begin{array}{l}\text{Net cash provided by operating activities–}\\ \text{Capital expenditures–}\\ \text{Dividends}\end{array}\right\}$

Compute working capital of Corporation D for 2016.

$\begin{array}{c}\text{EPS = }\frac{\text{Net income – Preferred dividends}}{\text{Weighted average common shares outstanding}}\\ \text{=}\frac{\text{\$70,000–\$0}}{\text{33,000 shares}}\\ \text{= \$2}\text{.12 per share}\end{array}$

(c)

To determine

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:

$\begin{array}{c}\text{EPS = }\frac{\text{Net income – Preferred dividends}}{\text{Weighted average common shares outstanding}}\\ \text{=}\frac{\text{\$60,000–\$0}}{\text{30,000 shares}}\\ \text{= \$2}\text{.00 per share}\end{array}$

To compute: (c) Current ratio.

Explanation of Solution

Compute current ratio of Corporation D for 2017.

$\begin{array}{c}\begin{array}{l}\text{Working}\\ \text{capital}\end{array}\}\text{= Current assets – Current liabilities}\\ \text{=}\left(\text{Cash+Receivables+Other current assets}\right)–\text{Current liabilities}\\ \text{=}\left(\text{\$28,000+70,000+\$90,000}\right)\text{–\$75,000}\\ \text{=\$113,000}\end{array}$

Compute current ratio of Corporation D for 2016.

$\begin{array}{c}\begin{array}{l}\text{Working}\\ \text{capital}\end{array}\}\text{= Current assets – Current liabilities}\\ \text{=}\left(\text{Cash+Receivables+Other current assets}\right)–\text{Current liabilities}\\ \text{=}\left(\text{\$20,000+62,000+\$73,000}\right)\text{–\$70,000}\\ \text{=\$85,000}\end{array}$

(d)

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:

$\begin{array}{c}\text{Current ratio = }\frac{\text{Current assets}}{\text{Current liabilities}}\\ =\frac{\left(\text{Cash+Receivables+Other current assets}\right)}{\text{Current liabilities}}\\ =\frac{\left(\text{\$28,000+70,000+\$90,000}\right)}{\$75,000}\\ =2.51:1\end{array}$

To compute: (d) Debt to assets ratio.

Explanation of Solution

Compute debt to assets ratio of Corporation D for 2017, if total assets are $760,000, current liabilities are $75,000, and long-term liabilities are $80,000.

$\begin{array}{c}\text{Current ratio = }\frac{\text{Current assets}}{\text{Current liabilities}}\\ =\frac{\left(\text{Cash+Receivables+Other current assets}\right)}{\text{Current liabilities}}\\ =\frac{\left(\text{\$20,000+62,000+\$73,000}\right)}{\$70,000}\\ =2.21:1\end{array}$

Compute debt to assets ratio of Corporation D for 2016, if total assets are $685,000, current liabilities are $70,000, and long-term liabilities are $90,000.

$\begin{array}{c}\text{Debt to assets ratio = }\frac{\text{Total liabilities}\left(\text{Current and long-term}\right)}{\text{Total assets}}\\ \text{=}\frac{\text{\$75,000+\$80,000}}{\text{\$760,000}}\\ \text{= 0}\text{.204 or 20}\text{.4\%}\end{array}$

(e)

To determine

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:

$\begin{array}{c}\text{Debt to assets ratio = }\frac{\text{Total liabilities}\left(\text{Current and long-term}\right)}{\text{Total assets}}\\ \text{=}\frac{\text{\$70,000+\$90,000}}{\text{\$685,000}}\\ \text{= 0}\text{.234 or 23}\text{.4\%}\end{array}$

To compute (e) Free cash flow of Corporation D for 2016 and 2017.

Explanation of Solution

Compute free cash flow of Corporation D for 2017, if net cash provided by operating activities is $82,000, capital expenditures are $45,000, and dividends paid are $20,000.

$\begin{array}{c}\text{Free cash flow = }\left\{\begin{array}{l}\text{Net cash provided by operating activities–}\\ \text{Capital expenditures–}\\ \text{Dividends}\end{array}\right\}\\ =\$82,000–\$45,000–\$20,000\\ =\$17,000\end{array}$

Compute free cash flow of Corporation D for 2016, if net cash provided by operating activities is $56,000, capital expenditures are $38,000, and dividends paid are $15,000.

$\begin{array}{c}\text{Free cash flow = }\left\{\begin{array}{l}\text{Net cash provided by operating activities–}\\ \text{Capital expenditures–}\\ \text{Dividends}\end{array}\right\}\\ =\$56,000–\$38,000–\$15,000\\ =\$3,000\end{array}$

(f)

To determine

To compute: (f) Discuss the financial position of the company based on the computed ratios.

Explanation of Solution

Analysis:

• Net income has increased, EPS has increased from 2016 to 2017. So, profitability increased.
• Working capital and current ratio also increased from 2016 to 2017. So, liquidity of the company has increased.
• Debt to assets ratio decreased and free cash flow increased. This is a sign of improvement in solvency.