Chapter 5, Problem 22E

To determine

Ascertain the following ratios of Company B:

1. 1. Earnings per share.
2. 2. Gross profit margin.
3. 3. Operating profit margin.
4. 4. Net profit margin.
5. 5. Total assets turnover ratio.
6. 6. Return on assets ratio.
7. 7. Return on common equity.
8. 8. Receivables turnover ratio.
9. 9. Interest coverage.

Explanation of Solution

Earnings per share (EPS): The amount of net income available to each shareholder per common share outstanding is referred to as earnings per share (EPS).

Gross margin (gross profit): Gross margin is the amount of revenue earned from goods sold over the costs incurred for the goods sold.

Net margin: This ratio gauges the operating profitability by quantifying the amount of income earned from business operations from the sales generated.

Asset turnover ratio:

The Asset turnover is a contrast to the profit margin ratio and it is calculated to determine the net sales and average total assets. Use the following formula to calculate the asset turnover ratio:

$\text{Asset turnover =}\frac{\text{Net}\text{sales}}{\text{Average total assets}}$

Return on assets:

Return on assets is the ratio of the net income, and interest expense to the average total assets. The rate of return on total assets measures the efficiency of the business. It measures how efficiently the business is using its total assets in generating the income.

$\left\{\begin{array}{l}\text{Return }\\ \text{on assets}\end{array}\right\}=\frac{\text{Net income}}{\text{Total assets}}$

Accounts receivable turnover:

Accounts receivable turnover is a liquidity measure of accounts receivable in times, which is calculated by dividing the net credit sales by the average amount of net accounts receivables. In simple, it indicates the number of times the average amount of net accounts receivables has been collected during a particular period.

Average collection period:

Average collection period indicates the number of days taken by a business to collect its outstanding amount of accounts receivable on an average. It is otherwise known as days to collect.

Compute the ratio as follows:

1. 1.      Calculate the earnings per share of Company B:

$\begin{array}{c}\text{Earnings per share = }\frac{\text{Net income}-\text{Preferred dividends}}{\text{Average common shares outstanding}}\\ =\frac{\text{\$24,000}-\$0}{\text{10,000}}\\ =\$2.40\end{array}$

1. 2.      Calculate the gross profit margin of company B:

$\begin{array}{c}\text{Gross profit margin}=\frac{\text{Gross profit}}{\text{Net sales}}\\ =\frac{\text{\$107,000}}{\text{\$267,000}}\times 100\\ =40.07\%\end{array}$

1. 3.      Calculate the operating profit margin of company B:

$\begin{array}{c}\text{operating profit margin}=\frac{\text{Operating income}}{\text{Net sales}}\\ =\frac{\text{\$45,000}}{\text{\$267,000}}\times 100\\ =16.85\%\end{array}$

1. 4.      Calculate the net profit margin of company B:

$\begin{array}{c}\text{Net profit margin}=\frac{\text{Net income}}{\text{Net sales}}\\ =\frac{\text{\$24,000}}{\text{\$267,000}}\times 100\\ =8.99\%\end{array}$

1. 5.      Calculate the total asset turnover ratio of Company B:

$\begin{array}{c}\text{Total Assets turnover ratio}=\frac{\text{Net sales}}{\text{Average total assets}}\\ =\frac{\text{\$267,000}}{\text{\$390,000 (1)}}\\ =0.68\end{array}$

Working note (1):

Calculate the value of average total assets.

$\begin{array}{c}\text{Average total assets}=\frac{\left[\begin{array}{l}\text{Total assets in balance sheet}\\ +\text{Total assets in adjustments}\end{array}\right]}{2}\\ =\frac{\text{\$400,000}+\$380,000}{2}\\ =\frac{\text{\$780,000}}{2}\\ =\$390,000\end{array}$

1. 6.      Calculate the return on total assets of Company B:

$\begin{array}{c}\text{Return on total assets}=\frac{\text{Net income}+\text{Interest expense}}{\text{Average total assets}}\\ =\frac{\text{\$24,000}+\text{\$7,810 (2)}}{\text{\$390,000 (1)}}\\ =8.16\%\end{array}$

Working note (2):

Calculate the value of interest expense.

$\begin{array}{c}\text{Interest expense}=\text{Interest }\exp \text{ense}\times \left(\text{1}-\text{Effective tax rate}\right)\\ =\$11,000\times \left(\text{1}-\frac{\text{\$10,000 (Income taxes)}}{\text{\$34,000}}\right)\\ =\$11,000\times \left(\text{1}-0.29\right)\\ =\$7,810\end{array}$

1. 7.      Calculate the return on common equity of Company B:

$\begin{array}{c}\text{Return on commmon equity}=\frac{\text{Net income}}{\text{Average sahreholder's equity}}\\ =\frac{\text{\$24,000}}{\text{\$245,500 (3)}}\\ =9.78\%\end{array}$

Working note (3):

Calculate the average shareholder’s equity.

$\begin{array}{c}\text{Average shareholder's equity}=\frac{\left[\begin{array}{l}\text{Common stock}+\text{Paid in }\\ \text{capital}+\text{Retained earnings}\end{array}\right]+\text{Shareholder's equity}}{2}\\ =\frac{\left(\text{\$100,000}+\text{\$95,000}+\text{\$55,000}\right)+241,000}{2}\\ =\frac{\$491,000}{2}\\ =\$245,500\end{array}$

1. 8.      Calculate the receivable turnover of Company B:

$\begin{array}{c}\text{Return on commmon equity}=\frac{\text{Net credit sales}}{\text{Average net receivables}}\\ =\frac{\text{\$208,260 (4)}}{\text{\$23,000 (5)}}\\ =9.05\text{times}\end{array}$

Working note (4):

Compute the net credit sales:

$\begin{array}{c}\text{Net credit sales}=\text{Net sales}\times \text{Credit percentage}\\ =\text{\$267,000}\times \frac{78}{100}\\ =\$208,260\end{array}$

Working note (5):

Compute the average net receivable:

$\begin{array}{c}\text{Average net receivable}=\frac{\text{\$24,000}+\text{\$22,000}}{2}\\ =\frac{\text{\$46,000}}{2}\\ =\$23,000\end{array}$

1. 9.      Calculate the interest coverage of Company B:

$\begin{array}{c}\text{Return on commmon equity}=\frac{\text{Pretax operating income}}{\text{Interest expense}}\\ =\frac{\text{\$24,000}+\text{\$10,000}+\text{\$11,0000}}{\text{\$11,000}}\\ =4.09\text{ times}\end{array}$