Chapter 5, Problem 5.14P

Requirement – 1

To determine

Financial ratio:

The financial ratios examine the performance of the company, and used in comparing own business with other same business. It indicates the relationship of two or more items of financial statements.

To calculate: The inventory turnover ratio of Company A for the year 2016.

Explanation of Solution

Inventory Turnover:

It is a part of liquidity ratios used during the process of ratio analysis. It reflects the number of times a company’s inventory is converted into sale during a particular period.

Given, ($ in millions)

Cost of goods sold is $6,300

Opening inventory is $800

Closing inventory is $600

$\begin{array}{c}\text{Inventory turnover ratio}=\frac{\text{Cost of goods sold}}{\left(\frac{\text{Opening inventory - Closing inventory}}{2}\right)}\\ \text{ =}\frac{\$\text{6},\text{3}00}{\left(\frac{\$\text{8}00+\$\text{6}00}{2}\right)}\\ \text{=}\frac{\$\text{6},\text{3}00}{\$700}\\ =9\text{ times}\end{array}$

Hence, the inventory turnover ratio of Company A is 9 times.

Requirement – 2

To determine

To calculate: The average days in inventory of Company A for the year 2016.

Explanation of Solution

Average days in inventory:

Days’ in inventory are used to determine number of days a particular company takes to make sales of the inventory available with them.

Here,

Inventory turnover ratio is 9 times (Refer to requirement (1))

Number of days in the year are 365

$\begin{array}{c}\text{Average days in inventory}=\frac{\text{Number of days in the year}}{\text{Inventory turnover ratio }}\\ =\frac{365}{9}\\ =\text{40}\text{.56 days}\end{array}$

Hence, the average days in inventory of Company A are 40.56 days.

Requirement – 3

To determine

To calculate: The receivable turnover ratio of Company A for the year 2016.

Explanation of Solution

Accounts Receivable Turnover:

The accounts receivable turnover ratio determines the efficiency of a company to use its assets and issue the credit to the customers and collects the funds from them. The accounts receivable turnover is determined by dividing the credit sales by the average accounts receivable of that accounting period.

Given, ($ in millions)

Sale is $9,000

Opening account receivable is $600

Closing account receivable is $400

$\begin{array}{c}\text{Receivables turnover ratio}=\frac{\text{Sales}}{\left(\frac{\left(\begin{array}{l}\text{Opening account receivable }\\ \text{- Closing account receivable}\end{array}\right)}{2}\right)}\\ \text{ =}\frac{\$9,000}{\left(\frac{\$600+\$400}{2}\right)}\\ \text{=}\frac{\$9,000}{\$500}\\ =18\text{ times}\end{array}$

Hence, the receivables turnover ratio of Company A is 18 times.

Requirement – 4

To determine

To calculate: The average collection period of Company A for the year 2016.

Explanation of Solution

Average collection period:

Average collection period is used to determine the number of days a particular company takes to collect accounts receivables.

Here,

Receivables turnover ratio is 18 times (Refer to requirement (3))

Number of days in the year are 365

$\begin{array}{c}\text{Average collection period =}\frac{\text{Number of days in the year}}{\text{Receivables turnover ratio }}\\ \text{=}\frac{\text{365}}{18}\\ \text{=20}\text{.28 days}\end{array}$

Hence, the average collection period of Company A is 20.28 days.

Requirement – 5

To determine

To calculate: The asset turnover ratio of Company A for the year 2016.

Explanation of Solution

Assets Turnover:

Asset turnover is a ratio that measures the productive capacity of the fixed assets to generate the sales revenue for the company. Thus, it shows the relationship between the net sales and the average total fixed assets.

Here, ($ in millions)

Sale is $9,000

Opening assets is $4,000

Closing assets is $3,600

$\begin{array}{c}\text{Receivables turnover ratio}=\frac{\text{Sales}}{\left(\frac{\left(\begin{array}{l}\text{Openingassets }\\ -\text{ Closing assets}\end{array}\right)}{2}\right)}\\ \text{ =}\frac{\$9,000}{\left(\frac{\$\text{4},000+\$\text{3},\text{6}00}{2}\right)}\\ \text{=}\frac{\$9,000}{\$3,800}\\ =2.37\text{ times}\end{array}$

Hence, the assets turnover ratio of Company A is 2.37 times.

Requirement – 6

To determine

To calculate: The profit margin on sales of Company A for the year 2016.

Explanation of Solution

Profit Margin:

Profit margin reflects the portion of net income in the net sales. It is a profitability measure tool that is used to evaluate the net income a business earns on every dollar of net sales.

Given, ($ in millions)

Net income is $300

Sales are $9,000

$\begin{array}{c}\text{Profit margin on sales=}\frac{\text{Net income}}{\text{Sales}}\\ \text{=}\frac{\$\text{3}00}{\$\text{9},000}\\ \text{=3}\text{.33\%}\end{array}$

Hence, the profit margin on sales of Company A is 3.33%.

Requirement – 7

To determine

To calculate: The return on assets of Company A for the year 2016.

Explanation of Solution

Return on Assets:

It evaluates the efficiency of company’s assets. It reports the profit earned as the percentage of total assets used in the business. A company’s rate of return on total assets reflects its ability to optimize the use of total assets.

Given, ($ in millions)

Net profit is $300

Opening assets is $4,000

Closing assets is $3,600

$\begin{array}{c}\text{Return on assets=}\frac{\text{Net profit}}{\left(\frac{\left(\begin{array}{l}\text{Openingassets }\\ -\text{ Closing assets}\end{array}\right)}{2}\right)}\\ \text{ =}\frac{\$300}{\left(\frac{\$\text{4},000+\$\text{3},\text{6}00}{2}\right)}\\ \text{=}\frac{\$300}{\$3,800}\\ =7.89\%\end{array}$

Hence, the return on assets of Company A is 7.89%.

Requirement – 8

To determine

To calculate: The return on shareholders’ equity of Company A for the year 2016.

Explanation of Solution

Return on shareholder’s equity:

It measures the net income available to common shareholders of the company. A company’s rate of return on equity shows the amount earned for each dollar invested by the common shareholders.

Given, ($ in millions)

Sale is $9,000

Opening paid-in-capital is $600

Opening retained earnings is $900

Closing paid-in-capital is $600

Closing retained earnings is 7500

$\begin{array}{c}\text{Return on shareholders’ equity }=\frac{\text{Sales}}{\left(\frac{\begin{array}{l}\left(\begin{array}{l}\text{Opening paid}-\text{in}-\text{capital }\\ \text{+Openingretained earnings}\end{array}\right)\\ +\left(\begin{array}{l}\text{Closing paid}-\text{in}-\text{capital }\\ \text{+Closing retainedearnings}\end{array}\right)\end{array}}{2}\right)}\\ \text{ =}\frac{\$9,000}{\left(\frac{\left(\$600+\$900\right)+\left(\$600+\$750\right)}{2}\right)}\\ \text{=}\frac{\$9,000}{\left(\frac{\$1,500+\$1,350}{2}\right)}\\ =\frac{\$9,000}{\$1,425}\\ =21\%\end{array}$

Hence, the return on shareholders’ equity of Company A is 21%.

Requirement – 9

To determine

To calculate: The equity multiplier of Company A for the year 2016.

Explanation of Solution

Given, ($ in millions)

Opening assets is $4,000

Closing assets is $3,600

Opening paid-in-capital is $600

Opening retained earnings is $900

Closing paid-in-capital is $600

Closing retained earnings is 7500

$\begin{array}{c}\text{Equity multiplier}=\frac{\left(\frac{\left(\begin{array}{l}\text{Openingassets }\\ -\text{ Closing assets}\end{array}\right)}{2}\right)}{\left(\frac{\begin{array}{l}\left(\begin{array}{l}\text{Opening paid}-\text{in}-\text{capital }\\ \text{+Openingretained earnings}\end{array}\right)\\ +\left(\begin{array}{l}\text{Closing paid}-\text{in}-\text{capital }\\ \text{+Closing retainedearnings}\end{array}\right)\end{array}}{2}\right)}\\ \text{=}\frac{\left(\frac{\$\text{4},000+\$\text{3},\text{6}00}{2}\right)}{\left(\frac{\left(\$600+\$900\right)+\left(\$600+\$750\right)}{2}\right)}\\ \text{=}\frac{\$3,800}{\left(\frac{\$1,500+\$1,350}{2}\right)}\\ \text{ =}\frac{\$3,800}{\$1,425}\\ =2.67\end{array}$

Hence, the equity multiplier of Company A is 2.67.

Requirement – 10

To determine

To calculate: The return on shareholders’ equity under DuPont framework of Company A for the year 2016.

Explanation of Solution

Here,

Profit margin on sales is 3.33% (Refer to requirement (6))

Assets turnover ratio is 2.37 (Refer to requirement (5))

Equity multiplier is 2.67 (Refer to requirement (9))

$\begin{array}{c}\begin{array}{l}\text{Return on shareholder's equity}\\ \left(\text{DuPont framework}\right)\end{array}\}\text{ =}\left(\begin{array}{l}\text{Profit margin on sales}\\ \times \text{Assets turnoverratio}\\ \times \text{Equity multiplier}\end{array}\right)\\ =\left(\text{3}.\text{33}\%\times \text{2}.\text{37}\times \text{2}.\text{67}\right)\\ =21.1\%\end{array}$

Hence, the return on shareholder’s equity under DuPont framework of Company A is 21.1%.