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 L’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 L for the year 2013.

Net income = €3,436 million

Net sales = €29,016 million

$\begin{array}{c}\text{Return on sales ratio = }\frac{\text{Net income}}{\text{Net sales}}\\ \text{= }\frac{€3,436\text{ million}}{€29,016\text{ million}}\\ \text{= 0}\text{.1184 or 11}\text{.84\%}\end{array}$

Compute the return on sales ratio for Company L for the year 2014.

Net income = €5,648 million

Net sales = €30,638 million

$\begin{array}{c}\text{Return on sales ratio = }\frac{\text{Net income}}{\text{Net sales}}\\ \text{= }\frac{€5,648\text{ million}}{€30,638\text{ million}}\\ \text{= 0}\text{.1843 or 18}\text{.43\%}\end{array}$

b) Current ratio: Current ratio is one of the liquidity ratios, which measures the capacity of the Company Lo 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 L for the year 2013.

Current assets = €15,971 million

Current liabilities = €11,639 million

$\begin{array}{c}\text{Current Ratio=}\frac{\text{Current assets}}{\text{Current}\text{liabilities}}\\ \text{=}\frac{€15,971\text{ million}}{€11,639\text{ million}}\\ \text{=}\text{1}\text{.37 times}\end{array}$

Compute current ratio for Company L for the year 2014.

Current assets = €18,110 million

Current liabilities = €12,175 million

$\begin{array}{c}\text{Current Ratio}=\frac{\text{Current assets}}{\text{Current}\text{liabilities}}\\ =\frac{€18,110\text{ million}}{€12,175\text{ million}}\\ =\text{1}\text{.48 times}\end{array}$

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 Incorporation G for the year 2013.

Total assets = €56,176 million

Total liabilities = €28,269 million

$\begin{array}{c}\text{Debt-to-total-assets ratio = }\frac{\text{Total liabilities}}{\text{Total assets}}\\ \text{=}\frac{€28,269\text{ million}}{€56,176\text{ million}}\\ \text{= 0}\text{.5032 or 50}\text{.32\%}\end{array}$

Compute debt-to-total-assets ratio for Incorporation G for the year 2014.

Total assets = €53,362 million

Total liabilities = €30,359 million

$\begin{array}{c}\text{Debt-to-total-assets ratio = }\frac{\text{Total liabilities}}{\text{Total assets}}\\ \text{=}\frac{€30,359\text{ million}}{€53,362\text{ million}}\\ \text{= 0}\text{.5689 or 56}\text{.89\%}\end{array}$

Note: Total liabilities include current liabilities and non-current liabilities.

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 L for the years 2013 and 2014.

Particulars	2013	2014
	In millions
Cash flow from operating activities	£4,714	£4,607
Less: Cash investment in property and equipment	1,657	1,775
Free cash flow	£3,057	£2,832

Table (1)

Comments:

Trends in Company L’s profitability:

• Profitability of Company L is measured by return on sales ratio.
• The ratio is has increased a little from 11.84% in 2013 to 18.43% in 2014.
• This shows that the company’s profitability is improved.

Trends in Company L’s liquidity:

• Liquidity of Company L is evaluated by current ratio.
• The ratio shows a decreasing trend from 1.37 in 2013 to 1.48 in 2014.
• This shows that the capacity to pay for short-term liabilities has decreased.

Trends in Company L’s solvency:

• Liquidity of Company L is measured by debt-to-total assets ratio.
• The ratio shows a decreasing trend from 50.32% in 2013 to 56.89% in 2014.
• This shows that the repaying capacity of the corporation has increased.

Trends in Company L’s free cash flow:

• The computation shows a decreased to £2,832 in 2014 from £3,057 in 2013.
• But yet Company L has a healthy free cash flow in the years to repay its lenders, pay dividends to stockholders.