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 2016.

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 2016.

Given,

Current assets are $2,680,112.

Current liabilities are $1,144,800.

Formula to calculate current ratio,

$\text{Current ratio}=\frac{\text{Current assets}}{\text{Current liabilities}}$

Substitute, $2,680,112 for current assets and $1,144,800 for current liabilities.

$\begin{array}{c}\text{Current ratio}=\frac{\$2,680,112}{\$1,144,800}\\ =2.34\end{array}$

Therefore the current ratio for 2016 is 2.34.

Compute the quick ratio of 2016.

Given,

Current assets are $2,680,112.

Inventories are $1,716,480

Current liabilities are $1,144,800.

Formula to calculate current ratio:

$\text{Quick ratio}=\frac{\left(\text{Current assets}-\text{Inventories}\right)}{\text{Current liabilities}}$

Substitute $2,680,112 for current assets, $1,716,480 for inventories and $1,144,800 for current liabilities.

$\begin{array}{c}\text{Quick ratio}=\frac{\$2,680,112-\$1,716,480}{\$1,144,800}\\ =0.84\end{array}$

Therefore the quick ratio is 0.84.

Summary Introduction

To discuss: The liquidity position of the company.

Explanation of Solution

The liquidity position of the company is as follows:

The current ratio of the company in 2014, 2015 and 2016 is 2.33, 1.16 and 2.34 respectively. It shows that the company’s ability was 2.33 times in 2014, 1.16 times in 2015 and 2.34 times in projected 2016 balance sheet to pay its current liabilities. The company is liquid in both 2014 and 2016 but in 2015 it was less liquid which was a troublesome sign.

Working Notes:

Calculation for current ratio of 2014:

$\begin{array}{c}\text{Current ratio}=\frac{\text{Current assets}}{\text{Current liabilities}}\\ =\frac{\$1,124,000}{\$481,600}\\ =2.33\end{array}$

Calculation for current ratio of 2015:

$\begin{array}{c}\text{Current ratio}=\frac{\text{Current assets}}{\text{Current liabilities}}\\ =\frac{\$1,926,802}{\$1,650,568}\\ =1.16\end{array}$

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 4.10, day sales outstanding is 45.54 days, fixed asset turnover is 8.61, total assets turnover is 2.01.

Explanation of Solution

Compute the inventory turnover:

Given,

Sales is $7,035,600

Inventory is $1,716,480.

Formula to calculate inventory turnover,

$\text{Inventory turnover}=\frac{Sales}{Inventory}$

Substitute, $7,035,600 for sales and $1,716,480 for inventory,

$\begin{array}{c}{\text{Inventory turnover}}_{2016}=\frac{\$7,035,600}{\$1,716,480}\\ =4.0988or4.10\end{array}$

Therefore the inventory turnover is 4.10.

Compute the day sales outstanding:

Given,

Account receivable is $878,000.

Annual sales are $7,035,600.

Number of days is 365

Formula to calculate day sale outstanding,

$\text{Day sales outstanding}=\frac{\text{Account receivable}}{\text{Total credit sales}}\times \text{Number of days}$

Substitute, $878,000.for account receivable and $7,035,600 for annual sales.

$\begin{array}{c}{\text{Day sales outstanding}}_{2016}=\frac{\$878,000}{\$7,035,600}\times 365\\ =45.54\end{array}$

Therefore the days sales outstanding are 45.54.

Compute the fixed asset turnover.

Given,

Sales are $7,035,600.

Net fixed assets are $817,040.

Formula to calculate fixed asset turnover,

$\text{Fixed asset turnover}=\frac{\text{Sales}}{\text{Net fixed assets}}$

Substitute, $7,035,600 for sales and $7,035,600 for net fixed assets.

$\begin{array}{c}{\text{Fixed asset turnover}}_{2016}=\frac{\$7,035,600}{\$817,040}\\ =8.61\end{array}$

Therefore the fixed asset turnover is 8.61.

Compute the total asset turnover.

Given,

Sales are $7,035,600.

Total assets are $3,497,152.

Formula to calculate total asset turnover,

$\text{Total asset turnover}=\frac{\text{Sales}}{\text{Net fixed assets}}$

Substitute, $7,035,600 for sales and $3,497,152 for total assets.

$\begin{array}{c}{\text{Total asset turnover}}_{2016}=\frac{\$7,035,600}{\$3,497,152}\\ =2.01\end{array}$

Therefore total asset turnover is 2.01.

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 7.04 times.

Explanation of Solution

Compute the debt to capital.

Given,

Total debt is $700,000.

Total invested capital is $2,652,352.

Formula to calculate debt to capital,

$\text{Debt to capital}=\frac{\text{Total debt}}{\text{Total invested}\text{capital}}$

Substitute, $400,000 for total debt and $2,652,352 for total invested capital.

$\begin{array}{c}{\text{Debt to capital}}_{2016}=\frac{\$400,000+\$300,000}{\$400,000+\$300,000+\$1,952,352}\\ =\frac{\$700,000}{\text{\$2,652,352}}\\ =0.26391or26.39\%\end{array}$

Therefore the debt to capital is 26.39%.

Compute the times interest earned ratio.

Given,

EBIT is $492,648

Interest charges are $70,008.

Formula to calculate operating margin,

$\text{Operating margin}=\frac{\text{EBIT}}{\text{Interest charges}}$

Substitute, $70,008 for interest and $492,648 for EBIT.

$\begin{array}{c}{\text{Times interest earned ratio}}_{2016}=\frac{\$492,648}{\$70,008}\\ =7.037or7.04\end{array}$

Therefore the times earned ratio is 7.04.

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 7%, profit margin is 3.60%, basic earning power is 14.09%, return on assets is 7.25%, return on equity is 12.98%, return on invested capital is 11.14%.

Explanation of Solution

Compute the operating margin.

Given,

EBIT is $492,648.

Sales are $7,035,600.

Formula to calculate operating margin,

$\text{Operating margin}=\frac{\text{EBIT}}{\text{Sales}}$

Substitute, $492,648 for EBIT and $7,035,600 for sales.

$\begin{array}{c}{\text{Operating margin}}_{2016}=\frac{\$492,648}{\$7,035,600}\\ =0.07\text{or 7}\%\end{array}$

Therefore the operating margin is 7%.

Compute the profit margin.

Given,

Net income is $253,584.

Sales are $7,035,600.

Formula to calculate profit margin,

$\text{Profit margin}=\frac{\text{Net income}}{\text{Sales}}$

Substitute, $253,584 for net income and $7,035,600 for sales.

$\begin{array}{c}{\text{Profit margin}}_{2016}=\frac{\$253,584}{\$7,035,600}\\ =0.036or3.60\%\end{array}$

Therefore the operating margin is 3.60%.

Compute the basic earning power.

Given,

EBIT is $492,648.

Total assets are $3,497,152.

Formula to calculate operating basic earning power,

$\text{Basic earning power}=\frac{\text{EBIT}}{\text{Total assets}}$

Substitute, $492,648 for EBIT and $3,497,152 for total assets

$\begin{array}{c}{\text{Basic earning power}}_{2016}=\frac{\$492,648}{\$3,497,152}\\ =0.14087or14.09\%\end{array}$

Therefore the basic earning power is 14.09%.

Compute the return on assets.

Given,

Net income is $253,584.

Total assets are $3,497,152.

Formula to calculate return on assets,

$\text{Return on asset}=\frac{\text{Net income}}{\text{Total assets}}$

Substitute, $253,584 for net income and $3,497,152 for total assets.

$\begin{array}{c}{\text{Return on assets}}_{2016}=\frac{\$253,584}{\$3,497,152}\\ =0.07251or7.25\%\end{array}$

Therefore the return on assets is 7.25%.

Compute the return on equity.

Given,

Net income is $253,584.

Equity is $1,952,352.

Formula to calculate return on equity,

$\text{Return on equity}=\frac{\text{Net income}}{\text{Equity}}$

Substitute, $253,584 for net income and $1,952,352 for equity.

$\begin{array}{c}{\text{Return on equity}}_{2016}=\frac{\$253,584}{\$1,952,352}\\ =0.12988or12.98\%\end{array}$

Therefore the return on equity is 12.98%.

Compute the return on invested capital.

Given,

EBIT is $492,648.

Total invested capital is $2,652,352.

Formula to calculate return on invested capital,

$\text{Return on invested capital}=\frac{\text{EBIT(1}-\text{T)}}{\text{Total invested capital}}$

Substitute $492,648 for EBIT and $1,952,352 for total invested capital.

$\begin{array}{c}{\text{Return on invested capital}}_{2016}=\frac{\$492,648\times (1-0.4)}{\$1,952,352+\$300,000+\$400,000}\\ =\frac{\$295,588.80}{\$2,652,352}\\ =0.11144or11.14\%\end{array}$

Therefore the return on invested capital is 11.14%.

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 12 and market/book ratio is 1.56.

Explanation of Solution

Compute the price/earnings ratio.

Given,

Price per share is $12.17

Earnings per share are $1.014336.

Formula to calculate price/earnings ratio,

$\text{Price/earnings ratio=}=\frac{\text{Price per share}}{\text{Earnings per share}}$

Substitute, $7.809 for price per share and $1,014 for earning per share.

$\begin{array}{c}{\text{Price/earnings ratio}}_{2016}=\frac{\$12.17}{\left(\frac{\$253,584}{250,000}\right)}\\ =\frac{\$12.17}{\text{\$1}\text{.014336}}\\ =11.9979or12\end{array}$

Therefore the price/earnings ratio is 12.

Compute the market/book ratio.

Given,

Market price per share is $12.17.

Book value per share is $7.809

Formula to calculate market/book ratio,

${\text{Market/book ratio}}_{2016}=\frac{\text{Market price per share}}{\text{Book value per share}}$

Substitute, $12.17 for market price per share and $7.809 for book value per share.

$\begin{array}{c}{\text{Market/book ratio}}_{2016}=\frac{\$12.17}{\text{\$7}\text{.809}}\\ =1.5584or1.56\end{array}$

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 12.96%.

Explanation of Solution

Compute the DuPont Analysis

Formula to calculate the return on equity by DuPont equation:

$\text{ROE}=\text{Profit}\text{Margin}\times \text{Total}\text{Assets}\text{Tunover}\times \frac{\text{Total}\text{Assets}}{\text{Average}\text{shareholder}\text{equity}}$

Substitute, 3.60% for the profit margin, 2.01 for the total assets turnover,$3,497,152 for the total assets and $1,952,352 for the average shareholder equity,

$\begin{array}{c}\text{ROE}=3.60\%\times 2.01\times \frac{\$3,497,152}{\$1,952,352}\\ =0.12961or12.96\%\end{array}$

Therefore the ROE is 12.96%.

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 45.6 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: Affect 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 2014.

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 2014.

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.