Chapter 3, Problem 37P

Given the financial statements for Jones Corporation and Smith Corporation shown here:

a. To which one would you, as credit manager for a supplier, approve the extension of (short-term) trade credit? Why? Compute all ratios before answering.

b. In which one would you buy stock? Why?

Summary Introduction

To calculate: The relevant ratios so that the decision for the extension of short term trade credit can be taken.

Introduction:

Shortterm trade credit:

It is the type of credit that is granted to a business or an individual or a fixed loan for a period of not more than 12 months or 1 year.

Answer to Problem 37P

The Smith Corporation would get the extension of the short term trade credit as their liquidity ratios are better than those of the Jones Corporation; the suppliers and lenders are most concerned with the liquidity ratios.

Explanation of Solution

Calculation of ratios for the Smith Corporation:

Calculation of current ratio:

$\begin{array}{c}\text{Current ratio}=\frac{\text{Current Assets}}{\text{Current Liabilities}}\\ =\frac{\$187,500}{\$75,000}\\ =2.5\end{array}$

Calculation of quick ratio:

$\begin{array}{c}\text{Quick ratio}=\frac{\text{Quick Assets}}{\text{Current Liabilities}}\\ =\frac{\$112,500}{\$75,000}\\ =1.5\end{array}$

Calculation of debt to total asset ratio:

$\begin{array}{c}\text{Debt to Total Asset ratio}=\frac{\text{Total debt}}{\text{Total assets}}\\ =\frac{\$285,000}{\$437,500}\\ =65.1\%\end{array}$

Calculation of times interest ratio:

$\begin{array}{c}\text{Times interest ratio}=\frac{\text{Operating profit}}{\text{Interest expense}}\\ =\frac{\$126,00}{\$21,000}\\ =6\end{array}$

Calculation of fixed charge ratio:

$\begin{array}{c}\text{Fixed charge ratio}=\frac{\$133,000}{\$28,000}\\ =4.75\end{array}$

Calculation of ratios for the Jones Corporation:

Calculation of current ratio:

$\begin{array}{c}\text{Current ratio}=\frac{\text{Current Assets}}{\text{Current Liabilities}}\\ =\frac{\$150,000}{\$100,000}\\ =1.5\end{array}$

Calculation of quick ratio:

$\begin{array}{c}\text{Quick ratio}=\frac{\text{Quick Assets}}{\text{Current Liabilities}}\\ =\frac{\$100,000}{\$100,000}\\ =1\end{array}$

Calculation of debt to total asset ratio:

$\begin{array}{c}\text{Debt to Total Asset ratio}=\frac{\text{Total debt}}{\text{Total assets}}\\ =\frac{\$180,000}{\$500,000}\\ =36\%\end{array}$

Calculation of times interest ratio:

$\begin{array}{c}\text{Times interest ratio}=\frac{\text{Operating profit}}{\text{Interest expense}}\\ =\frac{\$193,00}{\$8,000}\\ =24.13\end{array}$

Calculation of fixed charge ratio:

$\begin{array}{c}\text{Fixed charge ratio}=\frac{\$200,000}{\$15,000}\\ =13.33\end{array}$

Summary Introduction

To determine: The company whose stock should be bought.

Introduction:

Stock:

Also termed as ordinary shares, it is a type of security that represents the corporate equity ownership. It is the best means to earn real rate of return ahead of inflation in the long run.

Answer to Problem 37P

The stocks of the Jones Corporation should be bought as their profit margin and return on assets are higher compared to the Smith Corporation; shareholders are mostly concerned with profitability.

But the return on equity is more for the Smith Corporation because it has taken a bigger financial risk. The times interest ratio and fixed charges ratio are higher for the Jones Corporation, which clearly reflects that their interest and fixed charges are well covered.

Explanation of Solution

Calculation of ratios for the Smith Corporation:

Calculation of profit margin:

$\begin{array}{c}\text{Profit margin}=\frac{\text{Earning after tax}}{\text{Sales}}\\ =\frac{\$52,500}{\$1,000,000}\\ =5.25\%\end{array}$

Calculation of return on assets:

$\begin{array}{c}\text{Return on assets}=\frac{\text{Earning after tax}}{\text{Total liabilities and shareholder's equity}}\\ =\frac{\$52,500}{\$437,500}\\ =12\%\end{array}$

Calculation of return on equity:

$\begin{array}{c}\text{Return on equity}=\frac{\text{Earning after tax}}{\text{Total shareholder's equity}}\\ =\frac{\$52,500}{\$152,500}\\ =34.4\%\end{array}$

Calculation of debt to total asset ratio:

$\begin{array}{c}\text{Debt to Total Asset ratio}=\frac{\text{Total debt}}{\text{Total assets}}\\ =\frac{\$285,000}{\$437,500}\\ =65.1\%\end{array}$

Calculation of times interest ratio:

$\begin{array}{c}\text{Times interest ratio}=\frac{\text{Operating profit}}{\text{Interest expense}}\\ =\frac{\$126,00}{\$21,000}\\ =6\end{array}$

Calculation of fixed charge ratio:

$\begin{array}{c}\text{Fixed charge ratio}=\frac{\text{EBIT}+\text{Interest}+\text{Lease Payments}}{\text{Interest}+\text{Lease Payments}}\\ =\frac{\$105,000+\$21,000+\$7,000}{\$21,000+\$7,000}\\ =\frac{\$133,000}{\$28,000}\\ =4.75\end{array}$

Calculation of ratios for the Jones Corporation:

Calculation of profit margin:

$\begin{array}{c}\text{Profit margin}=\frac{\text{Earning after tax}}{\text{Sales}}\\ =\frac{\$92,500}{\$1,250,000}\\ =7.4\%\end{array}$

Calculation of return on assets:

$\begin{array}{c}\text{Return on assets}=\frac{\text{Earning after tax}}{\text{Total liabilities and shareholder's equity}}\\ =\frac{\$92,500}{\$500,000}\\ =18.5\%\end{array}$

Calculation of return on equity:

$\begin{array}{c}\text{Return on equity}=\frac{\text{Earning after tax}}{\text{Total shareholder's equity}}\\ =\frac{\$92,500}{\$320,000}\\ =28.9\%\end{array}$

Calculation of debt to total asset ratio:

$\begin{array}{c}\text{Debt to Total Asset ratio}=\frac{\text{Total debt}}{\text{Total assets}}\\ =\frac{\$180,000}{\$500,000}\\ =36\%\end{array}$

Calculation of times interest ratio:

$\begin{array}{c}\text{Times interest ratio}=\frac{\text{Operating profit}}{\text{Interest expense}}\\ =\frac{\$193,00}{\$8,000}\\ =24.13\end{array}$

Calculation of fixed charge ratio:

$\begin{array}{c}\text{Fixed charge ratio}=\frac{\text{EBIT}+\text{Interest}+\text{Lease Payments}}{\text{Interest}+\text{Lease Payments}}\\ =\frac{\$185,000+\$8,000+\$7,000}{\$8,000+\$7,000}\\ =\frac{\$200,000}{\$15,000}\\ =13.33\end{array}$