Chapter 4, Problem 26IC

a.

Summary Introduction

To explain: Usefulness of ratio and identify five major categories of ratio.

Ratio:

Ratio shows the relation between the two quantities. Ratio is calculated by dividing one quantity by another quantity.

Explanation of Solution

The usefulness of ratio are as follows:

Ratio gives various information about the business. On the basis of this information manager take decisions. Ratio help in understanding various aspect of the business like current ratio tells about the liquidity of the corporation, asset management ratio tells about how the asset is managed by the corporation and many others. On the basis of the information given by ratio management take various decisions which help them in managing the corporation.

Five major categories of ratios are:

• Liquidity ratio
• Asset management ratio
• Debt management ratio
• Profitability ratio
• Market value ratio

Conclusion

Therefore, ratio helps manager in understanding various aspects of the business.

b.

Summary Introduction

To explain: The current and quick ratios of Company D in 2020.

Current ratio:

It shows the ability of the corporation to pay of its current liabilities. It is calculated by dividing current assets from current liabilities.

Answer to Problem 26IC

The current ratio is 2.34 and quick ratio is 0.84.

Explanation of Solution

Compute the current ratio of 2020:

$\begin{array}{c}\text{Current ratio}=\left[\frac{\text{Current}\text{Assets}}{\text{Current}\text{Liabilities}}\right]\\ =\left[\frac{\$2,680,112}{\$1,144,800}\right]\\ =2.34\end{array}$

Therefore the current ratio for 2020 is 2.34.

Compute the quick ratio of 2020:

$\begin{array}{c}\text{Quick ratio}=\left[\frac{\left(\text{Current assets}-\text{Inventories}\right)}{\text{Current liabilities}}\right]\\ =\left[\frac{\$2,680,112-\$1,716,480}{\$1,144,800}\right]\\ =0.84\end{array}$

Therefore the quick ratio is 0.84.

Summary Introduction

To discuss: The interest of manager, banker and shareholder in the current ratio.

Explanation of Solution

The interest of manager, banker and shareholder in the current ratio are as follows:

• They all have interest in liquidity ratio but their interest is different.
• As manager is responsible for running the business, so he wants to know this information so that he can run the business successfully.
• As banker wants to know this information because they want to know whether bank will be able to recover its loan or not because if liquidity falls. Then, company may not be able to pay the monthly installment even after having profit.
• As shareholder wants to know because their interest lies in the company and if the company falls then their money will turn into nothing.

Conclusion

Therefore, it matter to all manager banker and shareholders but in different ways.

c.

Summary Introduction

To determine: Inventory turnover, day sales outstanding, fixed asset turnover, total assets turnover and the comparison of the ratio with the industry average.

Asset management ratio:

It consists of different kind of ratio which tells the manager how effectively they are managing the firm.

Answer to Problem 26IC

The Inventory turnover is 4.02, day sales outstanding is 46.44 days, fixed asset turnover is 8.45, total assets turnover is 1.97.

Explanation of Solution

Compute the inventory turnover:

$\begin{array}{c}{\text{Inventory turnover}}_{2020}=\left[\frac{Sales}{Inventory}\right]\\ =\left[\frac{\$6,900,000}{\$1,716,480}\right]\\ =4.019855or4.02\end{array}$

Therefore the inventory turnover is 4.02.

Compute the day sales outstanding:

$\begin{array}{c}{\text{Day sales outstanding}}_{2020}=\left[\left(\frac{\text{Account receivable}}{\text{Total credit sales}}\right)\right]\\ =\left[\left(\frac{\$878,000}{\left(\frac{\$6,900,000}{365}\right)}\right)\right]\\ =46.44493or46.44days\end{array}$

Therefore the days sales outstanding are 46.44 days.

Compute the fixed asset turnover:

$\begin{array}{c}{\text{Fixed asset turnover}}_{2020}=\left[\frac{\text{Sales}}{\text{Net fixed assets}}\right]\\ =\left[\frac{\$6,900,000}{\$817,040}\right]\\ =8.445119or8.45\end{array}$

Therefore the fixed asset turnover is 8.45.

Compute the total asset turnover.

$\begin{array}{c}{\text{Total asset turnover}}_{2020}=\left[\frac{\text{Sales}}{\text{Net fixed assets}}\right]\\ =\left[\frac{\$6,900,000}{\$3,497,152}\right]\\ =1.973034or1.97\end{array}$

Therefore total asset turnover is 1.97.

Conclusion

Therefore, the ratio of the company matches with the industry average.

d.

Summary Introduction

To determine: Debt to capital, times interest earned ratios and its comparison with industry average.

Debt management ratio:

It shows how good a company is, in managing its debt. It is calculated by dividing total debt from total capital.

Answer to Problem 26IC

The debt to capital is 26.39%, times interest earned is 5.11 times.

Explanation of Solution

Compute the debt to capital.

$\begin{array}{c}{\text{Debt to capital}}_{2020}=\left[\frac{\text{Total debt}}{\text{Total invested}\text{capital}}\right]\\ =\left[\frac{\$400,000+\$300,000}{\$400,000+\$300,000+\$1,952,352}\right]\\ =\left[\frac{\$700,000}{\text{\$2,652,352}}\right]\\ =0.26391\text{or}26.39\%\end{array}$

Therefore the debt to capital is 26.39%.

Compute the times interest earned ratio.

$\text{Operating margin}=$

$\begin{array}{c}{\text{Times interest earned ratio}}_{2020}=\left[\frac{\text{EBIT}}{\text{Interest charges}}\right]\\ =\frac{\$357,648}{\$70,008}\\ =5.108673\text{or}5.11\end{array}$

Therefore the times earned ratio is 5.11 times.

Conclusion

Therefore, it matches with the respective industry standards.

e.

Summary Introduction

To determine: The operating margin, profit margin, basic earning power, return on assets, return on equity, return on invested capital and explain their performance.

Profitability ratio:

This ratio shows the total effect of other ratios on the operating results. It includes ratios like operating margin, profit margin and many others.

Answer to Problem 26IC

The operating margin is 5.18%, profit margin is 3.71%, basic earning power is 10.23%, return on assets is 7.31%, return on equity is 13.10%, return on invested capital is 10.11%.

Explanation of Solution

Compute the operating margin:

$\begin{array}{c}{\text{Operating margin}}_{2020}=\left[\frac{\text{EBIT}}{\text{Sales}}\right]\\ =\left[\frac{\$357,648}{\$6,900,600}\right]\\ =0.051829\text{or}5.18\%\end{array}$

Therefore the operating margin is 5.18%.

Compute the profit margin:

$\begin{array}{c}{\text{Profit margin}}_{2020}=\left[\frac{\text{Net income}}{\text{Sales}}\right]\\ =\left[\frac{\$255,774}{\$6,900,600}\right]\\ =0.037065\text{or}3.71\%\end{array}$

Therefore the operating margin is 3.71%.

Compute the basic earning power:

$\begin{array}{c}{\text{Basic earning power}}_{2020}=\left[\frac{\text{EBIT}}{\text{Total assets}}\right]\\ =\left[\frac{\$357,648}{\$3,497,152}\right]\\ =0.102268or10.23\%\end{array}$

Therefore the basic earning power is 10.23%.

Compute the return on assets:

$\begin{array}{c}{\text{Return on asset}}_{2020}=\left[\frac{\text{Net income}}{\text{Total assets}}\right]\\ =\left[\frac{\$255,774}{\$3,497,152}\right]\\ =0.073138\text{or}7.31\%\end{array}$

Therefore the return on assets is 7.31%.

Compute the return on equity:

$\begin{array}{c}{\text{Return on equity}}_{2020}=\left[\frac{\text{Net income}}{\text{Equity}}\right]\\ =\left[\frac{\$255,774}{\$1,952,352}\right]\\ =0.131008\text{or}13.10\%\end{array}$

Therefore the return on equity is 13.10%.

Compute the return on invested capital:

$\begin{array}{c}{\text{Return on invested capital}}_{2020}=\left[\frac{\text{EBIT}\times \text{(1}-\text{T)}}{\text{Total invested capital}}\right]\\ =\left[\frac{\$357,648\times \left(1-25\%\right)}{\$1,952,352+\$300,000+\$400,000}\right]\\ =\left[\frac{\$268,236}{\$2,652,352}\right]\\ =0.101131\text{or}10.11\%\end{array}$

Therefore the return on invested capital is 10.11%.

Conclusion

Therefore, company is performing far below its industry average.

f.

Summary Introduction

To determine: Price/earnings ratio, market/book ratio and the effect of it on investor’s perception

Profitability ratio:

This ratio shows the total effect of other ratios on the operating results. It includes ratios like operating margin, profit margin and many others.

Answer to Problem 26IC

The Price/earnings ratio is 11.90 and market/book ratio is 1.56.

Explanation of Solution

Compute the price/earnings ratio.

$\begin{array}{c}{\text{Price/earnings ratio}}_{2020}=\left[\frac{\text{Price per share}}{\text{Earnings per share}}\right]\\ =\left[\frac{\$12.17}{\left(\frac{\$255,774}{250,000}\right)}\right]\\ =\left[\frac{\$12.17}{1.023096}\right]\\ =11.89527\text{or}11.90\end{array}$

Therefore the price/earnings ratio is 11.90.

Compute the market/book ratio.

$\begin{array}{c}{\text{Market/book ratio}}_{2020}=\left[\frac{\text{Market price per share}}{\text{Book value per share}}\right]\\ =\left[\frac{\$12.17}{\left(\frac{\$1,952,352}{250,000}\right)}\right]\\ =\left[\frac{\$12.17}{7.809408}\right]\\ =1.558377\text{or}1.56\end{array}$

Therefore the market/book ratio is 1.56.

Conclusion

Therefore, it is below the respective industry standard.

g.

Summary Introduction

To determine: The summary or overview of D using DuPont Analysis

Profitability ratio:

This ratio shows the total effect of other ratios on the operating results. It includes ratios like operating margin, profit margin and many others.

Answer to Problem 26IC

The ROE is 13.09%.

Explanation of Solution

Compute the DuPont Analysis

$\begin{array}{c}\text{ROE}=\left[\text{Profit}\text{Margin}\times \text{Total}\text{Assets}\text{Tunover}\times \frac{\text{Total}\text{Assets}}{\text{Average}\text{shareholder}\text{equity}}\right]\\ =\left[3.71\%\times 1.97\times \left(\frac{\$3,497,152}{\$1,952,352}\right)\right]\\ =0.130917or13.09\%\end{array}$

Therefore the ROE is 13.09%.

Summary Introduction

To discuss: The strength and the weakness of the company.

Explanation of Solution

The strength and the weakness of the company are as follows:

• Efficient utilization of resources is the strength of the company because they are generating twice the size of sale then their assets.
• Their profit margin is low because they are able to generate good amount of sales but they are not able to hold much profit because of poor profit margin.

Conclusion

Therefore, it can be said that ROE and DuPont both gives the correct information regarding the company.

h.

Summary Introduction

To explain: Affect of reduction in DSO on stock price

Profitability ratio:

This ratio shows the total effect of other ratios on the operating results. It includes ratios like operating margin, profit margin and many others.

Answer to Problem 26IC

It will move the stock price to increase.

Explanation of Solution

If DSO reduces to 32 from 46.44 days then it will increase the efficiency of the operations, which will increase the profits of the company and if the profit increased, it will increase the price of the stock.

Conclusion

Therefore, it will increase the stock price.

i.

Summary Introduction

To determine: The reasons of the inventory on adjustment on the profitability and stock price of the company.

Profitability ratio:

This ratio shows the total effect of other ratios on the operating results. It includes ratios like operating margin, profit margin and many others.

Answer to Problem 26IC

Yes, there will be affect on the profitability and stock price on the adjustment of the inventory

Explanation of Solution

If the inventory of the company is not used properly then the profitability of the company will decrease and it will affect the stock price of the company because due to decrease in the profit of the company investor will not be ready to invest in the company

Conclusion

Therefore, improper adjustment of the inventory will decrease the profit of the company and will affect the profitability and stock price of the company.

j.

Summary Introduction

To determine: Bank manager action related to the loan renewal

Profitability ratio:

This ratio shows the total effect of other ratios on the operating results. It includes ratios like operating margin, profit margin and many others.

Answer to Problem 26IC

Yes, the banker will allow the new loan and repayment of the loan.

Explanation of Solution

Here, the D is showing that its company is going to raise more $1.2 million of new equity due to which profit of the company will increase and will be capable to retune the loan at a time.

Conclusion

Therefore, D is going to raise the new equity of $1.2 million due to which working capacity of the company will increase and will be capable to return no loan on demanding of the repayment.

k.

Summary Introduction

To explain: The action taken by the D in the 2018.

Profitability ratio:

This ratio shows the total effect of other ratios on the operating results. It includes ratios like operating margin, profit margin and many others.

Answer to Problem 26IC

• D should take the bill receivable from the debtors.
• D should take the loan from the bank on the basis of the mortgage.

Explanation of Solution

• Bill receivable should be taken by the D and should be discounted from the bank and so that he can pay to their supplier.
• D take loan on the basis of the mortgage if incase D is not payable to bank then bank will be have option to take the loan amount for the mortgage.

Conclusion

Therefore, the above both actions should be taken by the D in the 2018.

l.

Summary Introduction

To determine: Problem and limitations of financial ratios.

Ratio:

Ratio shows the relation between the two quantities. Ratio is calculated by dividing one quantity by another quantity.

Answer to Problem 26IC

There are some limitations such as inflated figure due to inflation, aggregate economy and many others.

Explanation of Solution

Problem and limitations of financial ratios are:

• One needs to calculate ratio of a company for whole cycle to understand the trend. One ratio of one time alone is not sufficient to tell the company’s ability.
• One could find that a company has some good and bad ratio. So it become hard to tell whether company is doing good or not.
• Generally a ratio is compared with industry average to know whether company is doing good or not but it may possible that industry average in itself is wrong.
• Every company adopts different accounting practices, so it becomes difficult for them within the industry.
• Due to inflation it may happen that some item on the balance sheet is inflated, which may led to distortion in balance sheet.

Conclusion

Therefore, these are some limitations and disadvantages of using ratio analysis.

m.

Summary Introduction

To determine: Qualitative factors that analyst should consider while evaluating company’s future prospect.

Qualitative factors:

Qualitative factors are those factors which cannot be measured but have significant effect on company’s performance.

Answer to Problem 26IC

Qualitative factors are business modal, competitive advantage, management and corporate governance.

Explanation of Solution

Qualitative factors are:

• Business modal: Business model affects the future prospect of the company because a good investor rarely invests in a company that does not know how it works.
• Competitive advantage: It refers the feature the one’s product that sets it apart from its competitor.
• Management: Management also affects the profitability aspect of the business. A happy employee always work with his heart and soul in the work which lead to more profit and management is responsible for leading employee in a way that does not depress him.
• Corporate governance: Corporate governance affects the profit of the firm. A firm with bad corporate governance may invite government intervention which can further declines it profit.

Conclusion

Therefore, business model, competitive advantage, management and corporate governance affect future prospects of the company.