Chapter 20, Problem 36E

To determine

Calculate and interpret the financial ratios for company, W for both the years.

Explanation of Solution

Management benefit programs are manager-compensation policies and procedures. This contains one or more: pay, incentives, and benefits. The main objective of the company is to establish management compensation strategies that support its strategic priorities, as set out by management and owners.

• Motivate managers to demonstrate a high degree of commitment to meet the goals set by top management.
• To include opportunities for managers, to function independently and to make decisions in accordance with the priorities set by top management.
• Evaluate equally the bonuses managers receive for their contributions and abilities and the efficiency of their decision making.

Operational control is the power to carry out those functions of orders over subordinate forces concerning the organization and use of instructions and compels the assignment of tasks, the assignment of goals and the giving of the instructive path requisite for the task.

Business assessment values the firm by estimating its value total market value, which can be compared with the market value for previous periods or for comparable companies.

The market value of the firm is determined by multiplying the number of outstanding shares by the equity's current market price.

Calculate free cash flow from operations:

Cash Flow From Operations	2016	2015
Net Income	$325,000	$357,500
Plus Depreciation Expense	60,000	50,000
Add: Decrease (−Inc) in AccRec and Inv	(135,000)	—
Add: Increase (−Dec) in Cur. Liabl.	25,000	—
Cash Flow from Operations	$275,000	$407,500
Free Cash Flow
Less: Capital Expenditures	200,000	100,000
Less: Dividends	50,000	50,000
Free Cash Flow	$25,000	$257,500

Analysis of the financial ratio utilizes the ratios of financial statements to evaluate the performance of the firm. Two common performance measures include liquidity and profitability. Liquidity is the ability of the firm to pay its current operating expenses (usually for one year or less) and debt maturity. The six key liquidity measures are accounts receivable turnover, stock turnover, current ratio, quick ratio, and two cash flow ratios. The greater the ratio, the better a corporation's ability to pay off its obligations in a timely manner. The four key profitability ratios are the percentage of the gross margin, return on assets, return on equity, and profit per share.

Profitability ratios are a category of accounting measures that are calculated over period to measure the ability of a company to produce income compared to its sales, operating expenses, balance sheet assets, and shareholders' equity, using data from a particular point in time.

The cash flow ratio for operating is a calculation of how often current liabilities are protected by the funds generated from operations of a business. The ratio will help assess the profitability of a organization in the short run.

The financial ratios are as follows:

Financial Ratios	2016	2015	Industry
Liquidity Ratios
Accounts Receivable Turnover	18.67	16.00	11.10
Inventory Turnover	8.93	14.86	10.50
Current Ratio	3.98	3.06	2.30
Quick Ratio	2.05	2.06	1.90
Cash Flow Ratios
Cash Flow from Operations	1.38	2.33	1.20
Free Cash Flow	0.13	1.47	1.10
Profitability Ratios
Gross Margin Percentage	28.6%	27.8%	30%
Return on Assets (Net Book Value)	13.4	17.6%	20%
Return on Equity	24.34%	33.7%	30%
Earnings per Share	$ 0.181	$ 0.199	-

Working notes:

Liquidity ratios:

• Accounts receivable turnover is a productivity ratio or operation ratio that calculates how many times a company is capable of turning its receivable accounts into cash over a period. This shows how successful a company is in receiving its credit sales from customers.

The formula to calculate accounts Receivable Turnover ratio is:

$\text{Accounts receivable turnover ratio}=\frac{\text{Net credit sales}}{\text{Average AR}}$

For 2016:

Accounts receivable for 2016 is 150,000 and for 2015 is $225,000.

Net credit sales for 2016 are $3,500,000.

Calculate average AR:

$\begin{array}{c}\text{Average AR}=\frac{\$150,000+\$225,000}{2}\\ =\$187,500\end{array}$

$\begin{array}{c}\text{Accounts receivable turnover ratio for 2016}=\frac{\text{\$3,500,000}}{\text{\$187,500}}\\ =18.67\end{array}$

Hence, the accounts receivable turnover ratio for 2016 is 18.67.

For 2015:

Accounts receivable for 2015 is 225,000 and for 2014 is $225,000.

Net credit sales for 2015 are $3,600,000.

Calculate average AR:

$\begin{array}{c}\text{Average AR}=\frac{\$225,000+\$225,000}{2}\\ =\$225,000\end{array}$

$\begin{array}{c}\text{Accounts receivable turnover ratio for 2015}=\frac{\text{\$3,600,000}}{\text{\$225,000}}\\ =16.00\end{array}$

Hence, the accounts receivable turnover ratio for 2015 is 16.00.

• Inventory turnover shows how many times a company is selling and replacing its stock of goods over a given period. The inventory turnover ratio formula is the cost of the goods sold divided over the same time period by the average inventory.

Calculate inventory turnover ratio for 2016:

For 2016,

Inventory for 2016 is 385,000 and for 2015 is $175,000.

Cost of goods sold for 2016 is $2,500,000.

Calculate average inventory:

$\begin{array}{c}\text{Average Inventory}=\frac{\$385,000+\$175,000}{2}\\ =\$280,000\end{array}$

$\begin{array}{c}\text{Inventory turnover ratio for 2016}=\frac{\text{Cost of goods sold}}{\text{Average inventory}}\\ =\frac{\$2,500,000}{\$280,000}\\ =8.93\end{array}$

Hence, the inventory turnover ratio for 2016 is 8.93.

For 2015,

Inventory for 2015 is 175,000 and for 2014 is $175,000.

Cost of goods sold for 2015 is $2,600,000.

Calculate average inventory:

$\begin{array}{c}\text{Average Inventory}=\frac{\$175,000+\$175,000}{2}\\ =\$175,000\end{array}$

$\begin{array}{c}\text{Inventory turnover ratio for 2015}=\frac{\text{Cost of goods sold}}{\text{Average inventory}}\\ =\frac{\$2,600,000}{\$175,000}\\ =14.86\end{array}$

Hence, the inventory turnover ratio for 2015 is 14.86

• The current ratio is a liquidity ratio that measures the ability of a corporation to pay short-term or due obligations within one year. It allows investors to understand how a firm can significantly increase the current assets on its balance sheet to meet its current debt and other payables.

The formula to calculate the current ratio is:

$\text{Current Ratio}=\frac{\text{Current Assets}}{\text{Current Liabilities}}$

Calculate current ratio for 2016:

Total current assets for 2016 are $795,000.

Total current liabilities for 2016 are $200,000.

$\begin{array}{c}\text{Current Ratio}=\frac{\text{\$795,000}}{\text{\$200,000}}\\ =3.98\end{array}$

Hence, the current ratio for 2016 is 3.98.

Calculate current ratio for 2015:

Total current assets for 2015 are $535,000.

Total current liabilities for 2015 are $175,000.

$\begin{array}{c}\text{Current Ratio}=\frac{\text{\$535,000}}{\text{\$175,000}}\\ =3.06\end{array}$

Hence, the current ratio for 2015 is 3.18.

• The quick ratio is an indicator of the short-term liquidity position of a company and measures the ability of a company with its most liquid assets to fulfill its short-term obligations. Since it shows the ability of the company to instantly use its near-cash assets (assets that can be swiftly converted to cash) to pay down its current liabilities, it is also called the acid test ratio.

The formula to calculate the quick ratio is:

$\text{Quick Ratio}=\frac{\text{Cash + AR}}{\text{Current Liabilities}}$

Calculate quick ratio for 2016:

Cash and short-term investments for 2016 is $260,000.

Accounts receivable for 2016 is $150,000.

Total current liabilities for 2016 are $200,000.

$\begin{array}{c}\text{Quick Ratio}=\frac{\text{\$260,000}+\text{\$150,000}}{\text{\$200,000}}\\ =2.05\end{array}$

Hence, the quick ratio for 2016 is 2.05.

The formula to calculate the quick ratio is:

$\text{Quick Ratio}=\frac{\text{Cash + AR}}{\text{Current Liabilities}}$

Calculate quick ratio for 2015:

Cash and short-term investments for 2015 is $135,000.

Accounts receivable for 2015 is $225,000.

Total current liabilities for 2015 are $175,000.

$\begin{array}{c}\text{Quick Ratio}=\frac{\text{\$135,000}+\text{\$225,000}}{\text{\$175,000}}\\ =2.06\end{array}$

Hence, the quick ratio for 2015 is 2.06.

Cash Flow Ratios

The operating cash flow ratio calculates the appropriateness of the funds generated by a company from operating activities to pay its current liabilities. This is determined by dividing the cash flow from operations by total business's current liabilities.

The formula to calculate cash flow from operations ratio is:

$\text{Operating cash flow ratio}=\frac{\text{Cash flow operations}}{\text{Current liabilties}}$

For 2016:

Cash flow from operations for 2016 is 275,000.

Current liabilities for 2016 are $200,000.

Calculate cash flow from operations ratio for 2016:

$\begin{array}{c}\text{Cash flow from operations ratio}=\frac{\text{\$275,000}}{\text{\$200,000}}\\ =1.38\end{array}$

Hence, the cash flow from operations ratio for 2016 is 1.38.

For 2015:

Cash flow from operations for 2015 is 407,500.

Current liabilities for 2015 are $175,000.

Calculate cash flow from operations ratio for 2015:

$\begin{array}{c}\text{Cash flow from operations ratio}=\frac{\text{\$407,500}}{\text{\$175,000}}\\ =2.33\end{array}$

Hence, the cash flow from operations ratio for 2016 is 1.38.

• Free cash flow is the cash that a company produces from its activities, minus the cost of asset spending.

Profitability Ratios:

Gross margin is the difference divided by sales between income and cost of sold products (COGS). The gross margin ratio is a percentage which results from dividing the amount of the gross profit of a business by the amount of its net sales.

The formula to calculate gross margin ratio is:

$\text{Gross margin ratio}=\frac{\text{Gross profit}}{\text{Net sales}}$

For 2016:

Gross margin for 2016 is $1,000,000.

Net sales for 2016 are $3,500,000.

$\begin{array}{c}\text{Gross margin ratio}=\frac{\text{\$1,000,000}}{\text{\$3,500,000}}\times 100\\ =28.6\%\end{array}$

Hence, the gross margin ratio for 2016 is 28.6%.

For 2015:

Gross margin for 2015 is $1,000,000.

Net sales for 2015 are $3,600,000.

$\begin{array}{c}\text{Gross margin ratio}=\frac{\text{\$1,000,000}}{\text{\$3,600,000}}\times 100\\ =27.8\%\end{array}$

Hence, the gross margin ratio for 2015 is 27.8%.

• Return on assets is a profitability ratio which provides how much profit a firm can generate from its assets. It is calculated by dividing a company’s net income by total assets.

The formula to calculate return on assets ratio is:

$\text{Return on assets ratio}=\frac{\text{Net income}}{\text{Total assets}}$

For 2016:

Net income for 2016 is $325,000.

Total assets for 2016 are $2,435,000.

$\begin{array}{c}\text{Return on assets ratio}=\frac{\text{\$325,000}}{\text{\$2,435,000}}\\ =13.4\%\end{array}$

Hence, the return on assets ratio for 2016 is 13.4%.

For 2015:

Net income for 2015 is $357,500.

Total assets for 2015 are $2,035,000.

$\begin{array}{c}\text{Return on assets ratio}=\frac{\text{\$357,500}}{\text{\$2,035,000}}\\ =17.6\%\end{array}$

Hence, the return on assets ratio for 2015 is 17.6%.

• Return on equity (ROE) is a calculation of financial performance measured by the division of net income by equity of the shareholders.

The formula to calculate return on equity ratio is:

$\text{Return on equity ratio}=\frac{\text{Net income}}{\text{Shareholder's equity}}$

For 2016:

Net income for 2016 is $325,000.

Shareholder’s equity for 2016 is $1,335,000.

$\begin{array}{c}\text{Return on equity ratio}=\frac{\text{\$325,000}}{\$1,335,000}\\ =24.34\%\end{array}$

Hence, the return on assets ratio for 2016 is 24.34%.

For 2015:

Net income for 2015 is $357,500.

Shareholder’s equity for 2015 is $1,060,000.

$\begin{array}{c}\text{Return on equity ratio}=\frac{\text{\$357,500}}{\$1,060,000}\\ =33.7\%\end{array}$

Hence, the return on assets ratio for 2015 is 33.7%.

• Earnings per share or EPS are a significant financial measure which shows a company's profitability. This is determined by dividing the net income of the company with the total number of outstanding shares

The formula to calculate earnings per share is:

$\text{EPS}=\frac{\text{Net income}}{\text{No}\text{. of outstanding shares}}$

For 2016:

Net income for 2016 is $325,000.

Number of outstanding shares for 2016 is 1,800,000.

$\begin{array}{c}\text{EPS}=\frac{\text{\$325,000}}{\text{1,800,000}}\\ =0.181\end{array}$

Hence, the earning per share for 2016 is 0.181.

For 2015:

Net income for 2015 is $357,500.

Number of outstanding shares for 2015 is 1,800,000.

$\begin{array}{c}\text{EPS}=\frac{\text{\$357,500}}{\text{1,800,000}}\\ =0.199\end{array}$

Hence, the earning per share for 2015 is 0.199.