Chapter 2, Problem 5PA

Summary Introduction

To determine:

Net worth, income available for savings, current ratio, savings ratio, months living expense covered ratio, debt ratio, long term debt covering ratio, interpretation and advice of the ratios.

Introduction:

Net worth is that part of the assets that exceed liabilities. It is calculated by subtracting borrowing or debt from total assets.

Current ratio shows whether the business has enough funds to meet current liabilities or not. It is calculated by dividing monetary asset from current liabilities.

Saving ratio shows the how much they are saving with the amount of money that they have for their living expenditure. It is calculated by dividing income available for savings and investment from income available for living expenditure.

Monthly living expense covered ratio shows whether a person have enough liquidity to meet emergencies or not. It is calculated by dividing monetary assets by monthly living expenditure.

Debt ratio shows the ability of the household whether they can pay their debt or liability or not. It is calculated by dividing total debt or total liability from total assets.

Long-term debt coverage ratio shows the ability of the person to pay its long term debt. It is calculated by dividing total income available for living expenses and total long term debt payments.

Explanation of Solution

Personal balance sheet of F:

Balance Sheet of F
Assets (What You Own)
	Particulars	Amount ($)
A	Stocks	5,500
B	Temple Mutual Fund	2,100
C	401(K) Retirement Account	4,500
D	Savings Account	2,300
E	Checking Account	825
F	Inherited Coin Collection	3,250
G	Condominium	65,000
H	Auto	9,000
I	Furnishings	5,500
J	Other Personal Property	8,000
K	Total Assets	105,975
	Liabilities or Debt (What You Owe)
L	Visa Bill	355
M	MasterCard Bill	245
N	Total Monthly Utilities	275
O	Mortgage Outstanding	50,000
P	Auto Loan Outstanding	4,225
Q	Total Liabilities	55,100
	Net Worth
K	Total Assets	105,975
Q	Less: Total Debt	55,100
R	Equals: Net Worth	50,875

Net worth of F is $50,875.

Prepare income statement.

Income Statement for F
	Particulars	Amount ($)
	Take-Home Pay
A	Monthly Paycheck, Net	2,400
	Living Expenses
B	Visa Bill	355
C	MasterCard Bill	245
D	Total Monthly Utilities	275
E	Monthly Medical Expenses	22
F	Mortgage Payment, Monthly	530
E	Car Payment, Monthly	265
F	Clothing Expenses, Monthly	45
G	Monthly Auto Insurance (not due)	150
H	Food, Monthly	225
I	Other Expenses, Monthly	150
J	Total Living Expenses	2,262
	Total Available for Savings and Investments
A	Monthly Paycheck, Net	2,400
J	Total Living Expenditure	2,262
K	Income Available for Savings and Investment	138

Total amount available for savings and investment is $138.

Current Ratio:

Given,

Monetary assets are $3,125.

Current liabilities are $875.

Formula to calculate saving ratio is,

$\text{Current ratio}=\frac{\text{Monetary asset}}{\text{Current liabilities}}$

Substitute $3,125 for monetary assets and $875 for current liabilities in the above formula.

$\begin{array}{c}\text{Current ratio}=\frac{\$3,125}{\$875}\\ =3.57\end{array}$

This shows that F has enough assets to pay her current liabilities, approximately 3.6 times its value.

Working notes:

Calculation for monetary assets,

$\begin{array}{c}\text{Monetary}\text{assets}=\text{Savings}\text{account}+\text{Checking}\text{accounts}\\ =\$2,300+\$825\\ =\$3,125\end{array}$

Savings Ratio:

Given,

Income available for savings and investment is $138.

Income available for living expenditure is $2,400

Formula to calculate saving ratio is,

$\text{Saving ratio}=\frac{\text{Income available for savings and investment}}{\text{Income available for living expenditure}}$

Substitute $138 for income available for savings and investment and $2,400 for income available for living expenditure in the above formula.

$\begin{array}{c}\text{Savings ratio}=\frac{\$138}{\$2,400}\\ =0.0575\end{array}$

This means F is saving 0.0575 part or 5.75% of the amount he has available for living expenditure. F can increase her savings as this is low.

Monthly’s Living ExpenseCovered Ratio:

Given,

Monetary assets are $3,125.

Monthly living expenditure is $2,262.

Formula to calculate monthly’s living expense ratio is,

$\text{Monthly’s living expense covered ratio}=\frac{\text{Monetary assets}}{\text{Monthly living expenditure}}$

Substitute $3,125 for monetary assets and $2,262 for monthly living expense in the above formula.

$\begin{array}{c}\text{Monthly’s living expense covered ratio}=\frac{\text{\$3,125}}{\$2,262}\\ =1.38\end{array}$

This shows that F has enough balance to pay for one month expenditure but a usual person should have a balance to cover five to six month of expenditure but he does not have. Hence, he should to try to create its monetary asset.

Debt Ratio:

Given,

Total debt is $55,100.

Total assets are $105,975.

Formula to calculate debt ratio is,

$\text{Debt ratio}=\frac{\text{Total debt}}{\text{Total assets}}$

Substitute $55,100 for total debt and $105,975 for total assets in the above formula.

$\begin{array}{c}\text{Debt ratio}=\frac{\$55,100}{\$105,975}\\ =0.52\end{array}$

This shows that 52% of the asset if financed through borrowing. He should try to keep it down because it is too high.

Long-Term Debt Coverage Ratio:

Given,

Total income available for living expenses is $2,400.

Total long term debt payment is $795.

Formula to calculate long-term debt coverage ratio is,

$\text{Long-term debt coverage ratio}=\frac{\text{Total income available for living expenses}}{\text{Total long-term debt payments}}$

Substitute $$2,400 for total income available for living expense and $795 for total long-term debt payments in the above formula.

$\begin{array}{c}\text{Long-term debt coverage ratio}=\frac{\text{\$2,400}}{\text{\$795}}\\ =3.02\end{array}$

Debt coverage ratio of 3.02 is good. It shows He has enough amounts to cover her long term obligations.

Advice to F is:

• She should increase her savings.
• She should try to reduce her expense.
• Try to keep liabilities as low as possible.

Conclusion

Hence, she should try to keep those ratios within its limit and also try to follow the advice.