Chapter 4, Problem 7QP

Financial Ratios. Here are simplified financial statements for Phone Corporation in a recent year:

Calculate the following financial ratios for Phone Corporation using the methodologies listed for each part:

1. a. Return on equity (use average balance sheet figures)
2. b. Return on assets (use average balance sheet figures)
3. c. Return on capital (use average balance sheet figures)
4. d. Days in inventory (use start-of-year balance sheet figures)
5. e. Inventory turnover (use start-of-year balance sheet figures)
6. f. Average collection period (use start-of-year balance sheet figures)
7. g. Operating profit margin
8. h. Long-term debt ratio (use end-of-year balance sheet figures)
9. i. Total debt ratio (use end-of-year balance sheet figures)
10. j. Times interest earned
11. k. Cash coverage ratio
12. l. Current ratio (use end-of-year balance sheet figures)
13. m. Quick ratio (use end-of-year balance sheet figures)

Summary Introduction

To compute: Return on equity (ROE)

Explanation of Solution

The formula to calculate return on equity is as follows:

$\text{Return on equity}=\frac{\text{Net income}}{\left(\frac{\begin{array}{l}\text{Shareholders equity at the end of the year}\\ +\text{Share holders equity at thestart of the year}\end{array}}{2}\right)}$

The calculation of return on equity is as follows:

$\begin{array}{c}\text{Return on equity} =\frac{1223}{\left(\frac{9724+9121}{2}\right)}\\ =0.129796\\ =13\%\end{array}$

Hence, the ROE is 13%

Summary Introduction

To compute: Return on assets (ROA)

Explanation of Solution

The formula to calculate return on asset is as follows:

$\text{Return on asset}=\frac{\text{Net income}+\text{Interest expense}\left(1-\text{Tax rate}\right)}{\left(\frac{\text{Total assets at the start of the year}+\text{Total assets at the end of the year}}{2}\right)}$

The calculation of return on capital is as follows:

$\begin{array}{c} \text{ Return on assets}=\frac{1,223+685\times (1-.35)}{\left(\frac{27,714+27,503}{2}\right)}\\ =0.0604\\ =6.04\%\end{array}$

Hence, the ROA is 6.04%

Summary Introduction

To compute: Return on capital (ROC)

Explanation of Solution

The formula to calculate return on capital is as follows:

$\text{Return on capital}=\frac{\text{Net income}+\text{Interest expense}\times \left(1-\text{Tax rate}\right)}{\left(\frac{\begin{array}{l}\left[\begin{array}{l}\text{Long term debt and leases at the start of the year }+\\ \text{shareholders equity at the end of the year}\end{array}\right]+\\ \left[\begin{array}{l}\text{Long term debt and leases at the end of theyear}+\\ \text{shareholders equity at the end of theyear}\end{array}\right]\end{array}}{2}\right)}$

The calculation of return on equity is as follows:

$\begin{array}{c}\text{Return on capital}=\frac{1,223+685\times (1-.35)}{\frac{[(7,018+9,724)+(6,833+9,121)]}{2}}\\ =0.1020\\ =10.20\%\end{array}$

Hence, the ROC is 10.20%

Summary Introduction

To compute: Days in inventory.

Explanation of Solution

The formula to calculate days in inventory is as follows:

$\text{Days in inventory}=\frac{\text{Inventory in the start of the year}}{\left(\frac{\text{Cost of goods sold}}{365}\right)}$

.

The calculation of days in inventory is as follows:

 $\begin{array}{c}\text{Days in inventory}==\frac{238}{\left(\frac{4,060}{365}\right)}\\ =21.40\text{ days}\end{array}$

Hence, the days in inventory is 21.40 days

Summary Introduction

To compute: Inventory turn over

Explanation of Solution

The formula to calculate inventory turnover is as follows:

$\text{Inventory turnover}=\frac{\text{Cost of goods sold}}{\text{Inventory at start of year}}$

The calculation of inventory turnover is as follows:

$\begin{array}{c}\text{Inventory turnover}==\frac{4,060}{\frac{(187+238)}{2}}\\ =19.11\end{array}$

Hence, the inventory turnover is 19.11

Summary Introduction

To compute: Average collection period(ACP)

Explanation of Solution

The formula to calculate average collection period is as follows:

$\text{Average collection period }=\frac{\text{Receivables at start of year}}{\text{Average daily sales}}$

The calculation of average collection period is as follows:

$\begin{array}{c} \text{Average collection period}=\frac{2,490}{\left(\frac{13,193}{365}\right)}\\ =68.89\text{ days}\end{array}$

Hence, the ACP is 68.89 days.

Summary Introduction

To compute: Operating profit margin (OPM)

Explanation of Solution

The formula to calculate operating profit margin is as follows:

$\text{Operating profit margin}==\frac{\text{Net income }+\text{ After-tax interest}}{\text{Sales}}$

The calculation of operating profit margin is as follows:

$\begin{array}{c}\text{Operating profit margin}=\frac{1,223+685\times (1-.35)}{13,193}\\ =0.1264\\ =12.64\%\end{array}$

Hence, the OPM is 12.64%

Summary Introduction

To compute: Long term debt ratio

Explanation of Solution

The formula to calculate operating profit margin is as follows:

$\text{Long term debt ratio}=\frac{\text{Long term debt and leases at the end of the year}}{\left(\begin{array}{l}\text{long term debt and leases at the end of the year }\\ +\text{shareholders equity at the end of the year}\end{array}\right)}$

The calculation of long term debt ratio is as follows:

$\begin{array}{c} \text{Long-term debt ratio}=\frac{7,018}{7,018+9,724}\\ =0.42\end{array}$

Hence the long term debt ratio is 0.42

Summary Introduction

To compute: Total debt ratio

Explanation of Solution

The formula to calculate total debt ratio is as follows:

$\text{Total debt ratio}=\left(\frac{\begin{array}{l}\text{Total current liabilities at the end of the year}+\\ \text{Long term debt and leases at the end of the year}+\\ \text{Other long term liabilities at the end of the year}\end{array}}{\text{Total assets at the end of the year}}\right)$

The calculation of total debt ratio is as follows:

$\begin{array}{c} \text{Total debt ratio}=\frac{4,794+7,018+6,178}{27,714}\\ =0.65\end{array}$

Hence the total debt ratio is 0.65

Summary Introduction

To compute: Times interest earned

Explanation of Solution

The formula to calculate times interest earned is as follows:

$\text{Times interest earned}=\frac{\text{EBIT}}{\text{Interest expense}}$

The calculation of times interest earned is as follows:

$\begin{array}{c}\text{Times interest earned}=\frac{2,566}{685}\\ =3.75\end{array}$

Hence the time interest earned is 3.75

Summary Introduction

To compute: Cash coverage ratio

Explanation of Solution

The formula to calculate cash coverage ratio is as follows:

$\text{Cash coverage ratio}=\frac{\left(\text{EBIT+Depreciation}\right)}{\text{Interest expense}}$

The calculation of cash coverage ratio is as follows:

$\begin{array}{c} \text{ Cash coverage ratio}==\frac{2,566+2,518}{685}\\ =7.42\end{array}$

Hence the cash coverage ratio is 7.42

Summary Introduction

To compute: Current ratio

Explanation of Solution

The formula to calculate current ratio is as follows:

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

The calculation of current ratio is as follows:

$\begin{array}{c} \text{ Current ratio}=\frac{3,525}{4,794}\\ =0.74\end{array}$

Hence the current ratio is 0.74

Summary Introduction

To compute: Quick ratio

Explanation of Solution

The formula to calculate quick ratio is as follows:

$\text{Quick ratio}=\frac{\text{Cash + Marketable securities + Receivables}}{\text{Current liabilities}}$

The calculation of quick ratio is as follows:

$\begin{array}{c} \text{Quick ratio}=\frac{89+2,382}{4,794}\\ =0.52\end{array}$

Hence the quick ratio is 0.52