Chapter 4, Problem 15SP

a)

Summary Introduction

To determine: Required ratios.

Explanation of Solution

Calculation of current ratio:

$\begin{array}{c}\text{Current}\text{ratio}=\frac{\text{Current}\text{assets}}{\text{Current}\text{liabilities}}\\ =\frac{\$2,000}{\$800}\\ =2.5\end{array}$

Hence, current ratio is 2.5

Calculation of Acid-test ratio:

$\begin{array}{c}\text{Acid-test}\text{ratio}=\frac{\text{Current}\text{assets}-\text{inventory}-\text{prepaid expenses}}{\text{Current}\text{liabilities}}\\ =\frac{\$2,000-\$900}{\$800}\\ =1.38\end{array}$

Hence, acid-test ratio is 1.38

Calculation of times interest earned:

$\begin{array}{c}\text{Times interest earned}=\frac{\text{Earnings before interest and taxes}}{\text{interest expenses}}\\ =\frac{\$500}{\$60}\\ =8.33\end{array}$

Hence, times interest earned is 8.33

Calculation of inventory turnover:

$\begin{array}{c}\text{Inventory turnover}=\frac{\text{Cost}\text{of}\text{goods}\text{sold}}{\text{Inventory}}\\ =\frac{\$2,800}{\$900}\\ =3.11\end{array}$

Hence, inventory turnover 3.11

Calculation of total assets turnover:

$\begin{array}{c}\text{Total assets turnover}=\frac{\text{Sales}}{\text{Total assets}}\\ =\frac{\$4,500}{\$3,300}\\ =1.36\end{array}$

Hence, total assets turnover is 1.36

Calculation of operating profit margin:

$\begin{array}{c}\text{Operating}\text{profit}\text{margin}=\frac{\text{Operating profits}}{\text{sales}}\\ =\frac{\$500}{\$4,500}\times 100\\ =11.1\%\end{array}$

Hence, operating profit margin is 11.1%

Calculation of days in receivables:

$\begin{array}{c}\text{Collection period}=\frac{\text{Receivables}\times \text{365}}{\text{sales}}\\ =\frac{\$600\times 365}{\$4,500}\\ =48.67\text{days}\end{array}$

Hence, collection period is 48.67 days

Calculation of operating return on assets:

$\begin{array}{c}\text{Operating return on assets}=\frac{\text{Operating}\text{income}}{\text{Assets}}\\ =\frac{\$500}{\$3,300}\times 100\\ =15.15\%\end{array}$

Hence, operating return on assets is 15.15%

Calculation of debt ratio:

$\begin{array}{c}\text{Debt ratio}=\frac{\text{Total debt}}{\text{Total assets}}\\ =\frac{\$1,200}{\$3,300}\\ =36.4\%\end{array}$

Hence, debt ratio is 36.4%

Calculation of return on equity:

$\begin{array}{c}\text{Return on equity}=\frac{\text{Net income}}{\text{Equity}}\\ =\frac{\$348}{\$2,100}\times 100\\ =16.57\%\end{array}$

Hence, return on equity is 16.57%

Calculation of fixed assets turnover:

$\begin{array}{c}\text{Fixed assets turnover}=\frac{\text{Sales}}{\text{Fixed assets}}\\ =\frac{\$4,500}{\$1,300}\\ =3.46\end{array}$

Hence, fixed assets turnover is 3.46

b)

1)

Summary Introduction

To discuss: Liquidity of the firm.

Explanation of Solution

Company A, is certainly less liquid than industry’s average company. Both the current ratio and the acid test ratio are lower, suggesting that Company A has less liquid assets than the market in comparison to the maturing commitments of the company (current liabilities).

In fact, both the receivable accounts and the inventory move more slowly through the working capital process than is true for the industry’s typical company.

b)

2)

Summary Introduction

To discuss: Whether company managers are generating attractive operating profits on its assets.

Explanation of Solution

In terms of generating returns on the company’s assets, management performs better than the industry 15.2% operating return on assets compared to 12.5% for the industry. The reason for the higher return on assets is due to the higher operating profit margin.

Company A 11.1% against the industry 8%, thus, the company keeps its costs and expenses lower per sales dollar. On the other hand, as shown by the lower total asset turnover, Company A is less effective in controlling its assets.

b)

3)

Summary Introduction

To discuss: Ways should the firm financing its assets.

Explanation of Solution

The company uses significantly more leverage than the industry’s average company, indicating a little more financial risk to Company A, but higher equity returns than normal.

Two factors affect the interest rate obtained ratio,

1. 1) The operating profit level and,
2. 2) The debt level.

Company A has a higher return on assets which raises the interest rate earned, but requires more debt, resulting in higher interest costs and a lower interest rate earned ratio.

Company A’s case, the net results is a higher rate of interest earned, that is, the higher operating return on assets increases the time interest earned more than the higher amount of debt decreases it.

b)

4)

Summary Introduction

To discuss: Whether managers generating the good returns on equity.

Explanation of Solution

Company A delivers higher equity returns than the industry, resulting from 1) a higher operating return on assets, and 2) a higher amount of debt financing.