Chapter 4, Problem 11EYK

To determine

Compute the following ratios

1. a) Return on sales
2. b) Current ratio
3. c) Debt-to-total-assets ratio
4. d) Free cash flows, and

Comment on the trend in Company T’s profitability, liquidity, solvency, and free cash flows.

Explanation of Solution

a) Return on sales ratio: The ratio which evaluates the amount of net income earned for every dollar of net sales is referred to as return on sales ratio.

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

Compute the return on sales ratio for Company T for the year 2010.

Net income = £2,336 million

Net sales = £56,910 million

$\begin{array}{c}\text{Return on sales ratio = }\frac{\text{Net income}}{\text{Net sales}}\\ \text{= }\frac{\pounds 2,336\text{ million}}{\pounds 56,910\text{ million}}\\ \text{= 0}\text{.041 or 4}\text{.1\%}\end{array}$

Compute the return on sales ratio for Company T for the year 2011.

Net income = £2,671 million

Net sales = £60,931 million

$\begin{array}{c}\text{Return on sales ratio = }\frac{\text{Net income}}{\text{Net sales}}\\ \text{= }\frac{\pounds 2,671\text{ million}}{\pounds 60,931\text{ million}}\\ \text{= 0}\text{.044 or 4}\text{.4\%}\end{array}$

b) Current ratio: Current ratio is one of the liquidity ratios, which measures the capacity of the company to meet its short-term obligations using its current assets. The ideal current ratio is 2:1. The following formula is used to calculate current ratio.

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

Compute current ratio for Company T for the year 2010.

Current assets = £11,765 million

Current liabilities = £16,015 million

$\begin{array}{c}\text{Current ratio=}\frac{\text{Current assets}}{\text{Current}\text{liabilities}}\\ \text{=}\frac{\pounds 11,765\text{ million}}{\pounds 16,015\text{ million}}\\ \text{=}\text{0}\text{.73 times}\end{array}$

Compute current ratio for Company T for the year 2011.

Current assets = £11,869 million

Current liabilities = £17,731 million

$\begin{array}{c}\text{Current Ratio=}\frac{\text{Current assets}}{\text{Current}\text{liabilities}}\\ \text{=}\frac{\pounds 11,869\text{ million}}{\pounds 17,731\text{ million}}\\ \text{=}\text{0}\text{.67 times}\end{array}$

c) Debt to Asset Ratio: Debt to asset ratio is the ratio between total asset and total liability of the company. Debt ratio reflects the finance strategy of the company. It is used to evaluate company’s ability to pay its debts. Higher debt ratio implies the higher financial risk.

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

Compute debt-to-total-assets ratio for Company T for the year 2010.

Total assets = £46,023 million

Total liabilities = £31,342 million

$\begin{array}{c}\text{Debt-to-total-assets ratio = }\frac{\text{Total liabilities}}{\text{Total assets}}\\ \text{=}\frac{\pounds 31,342\text{ million}}{\pounds 46,023\text{ million}}\\ \text{= 0}\text{.681 or 68}\text{.1\%}\end{array}$

Compute debt-to-total-assets ratio for Company T for the year 2011.

Total assets = £47,206 million

Total liabilities = £30,583 million

$\begin{array}{c}\text{Debt-to-total-assets ratio = }\frac{\text{Total liabilities}}{\text{Total assets}}\\ \text{=}\frac{\pounds 30,583\text{ million}}{\pounds 47,206\text{ million}}\\ \text{= 0}\text{.648 or 64}\text{.8\%}\end{array}$

d) Free cash flow: Free cash flow describes the net cash provided from operating activities after making required adjustments for capital expenditures. In other words, it is the cash flow arrived after making payment for capital expenditures.

$\text{Free cash flow = Cash flows from operations – Capital expenditures}$

Compute free cash flow for Company T for the years 2010 and 2011.

Particulars	2010	2011
	In millions
Cash flow from operating activities	£4,745	£3,992
Less: Cash investment in property and equipment	2,855	3,178
Free cash flow	$1,890	$814

Table (1)

Comments:

Trends in Company T’s profitability:

• Profitability of Company T is measured by return on sales ratio.
• The ratio is has increased a little from 4.1% in 2010 to 4.4% in 2011.
• This shows that the company’s profitability is stable.

Trends in Company T’s liquidity:

• Liquidity of Company T is evaluated by current ratio.
• The ratio shows a decreasing trend from 0.73 in 2010 to 0.67 in 2011.
• This shows that the capacity to pay for short-term liabilities has decreased.

Trends in Company T’s solvency:

• Liquidity of Company T is measured by debt-to-total assets ratio.
• The ratio shows a decreasing trend from 68.1% in 2010 to 64.8% in 2011.
• This shows that the repaying capacity of the corporation has increased.

Trends in Company T’s free cash flow:

• The computation shows a decreasing trend from £1,890 in 2010 to £814 in 2011.
• But yet Company T has a healthy free cash flow in the years to repay its lenders, pay dividends to stockholders.