Chapter 5, Problem 5.17P

Requirement – 1

To determine

Condensed financial statement:

Condensed financial statements are statements which are prepared in addition to the traditional financial statement. It is viewed by the auditing team at the time of audit the condensed financial statements along with full financial statements for a full picture of the company’s financial status.

Ratio analysis:

Ratio analysis is a tool to analyze the financial statements of a company which helps to express a mathematical relationship among the items of financial statements.

To Determine: The more efficient company out of the two companies in rate of return on assets.

Explanation of Solution

Return on assets:

Rate of return on assets indicates the company’s overall profitability by excluding specific sources of finance.

$\begin{array}{c}\text{Rate of return on assets =}\frac{\text{Net income}}{\text{Total assets}}\\ \text{Company M = }\frac{\$593.8}{\$4,021.5}\\ =14.8\%\\ \text{Company R = }\frac{\$424.6}{\$4,008.0}\\ =10.6\%\end{array}$

Conclusion

Hence, Company M’s profitability exceeds the profitability of the Company R.

Requirement – 2

To determine

The more efficient company out of the two companies with combinations of profit margin and assets turnover.

Explanation of Solution

Profitability is achieved through a high profit margin or a high turnover or a combination of both.

Determine the rate of return on assets with combinations of profit margin and turnover:

$\begin{array}{c}\text{Rate of return on assets = }\left[\begin{array}{l}\text{profit margin on sales }\times \\ \text{asset turnover}\end{array}\right]\\ \text{= }\frac{\text{Net income}}{\text{Net sales}}\times \frac{\text{Net sales}}{\text{Total assets}}\\ \text{Company M=}\frac{\$593.8}{\$5,698.0}\times \frac{\$5,698.0}{\$4,021.5}\\ =10.4\%\times 1.42\text{times}\\ \text{=14}\text{.8\%}\\ \text{Company R=}\frac{\$424.6}{\$7,768.2}\times \frac{\$7,768.2}{\$4,008.0}\\ =5.5\%\times 1.94\text{times}\\ \text{=10}\text{.7\%}\end{array}$

Conclusion

Hence, Company R profit margin is less than that of Company M.

Requirement – 3

To determine

To Calculate: The rate of return on shareholders’ equity of two firms.

Explanation of Solution

Return on shareholders’ equity:

Rate of return on shareholders’ equity reveals the profit of the company generates with the money shareholders’ have invested.

$\begin{array}{c}\text{Rate of return on shareholders' equity =}\frac{\text{Net income}}{\text{Shareholders' equity}}\\ \text{Company M}=\frac{\$593.8}{\$144.9+\$2,476.9-\$904.7}\\ =34.6\%\\ \text{Company R=}\frac{\$424.6}{\$335.0+\$1,601.9-\$964.1}\\ =43.6\%\end{array}$

Conclusion

Hence, Company R provides greater return to common shareholders than Company M.

Requirement – 4

To determine

To calculate: The financial leverage (or) equity multiplier of two firms.

Answer to Problem 5.17P

$\begin{array}{c}\text{Equity multiplier =}\frac{\text{Total assets}}{\text{Shareholders' equity}}\\ \text{Company M=}\frac{\$4,021.5}{\$144.9+\$2,476.9-\$904.7}\\ =2.34\\ \text{Company R=}\frac{\$4,008.0}{\$335.0+\$1,601.9-\$964.1}\\ =4.12\end{array}$

Explanation of Solution

When the return on shareholders’ equity is greater than the return on assets, management is using debt funds to enhance the earnings for stockholders. Both firms do this. Company R has higher leverage than Company M which is used to provide a higher return to shareholders, even though its return on assets is less.

Conclusion

Company R increased its return to shareholders 4.07 times (43.6% ÷ 10.7%) the return on assets.   Company M increased its return to shareholders 2.34 times (34.6% ÷ 14.8%) the return on assets. 

Requirement – 5

To determine

To identify: Which company appears riskier in terms of its ability to pay short-term obligations.

Explanation of Solution

Current ratio and acid test ratio reveals the ability to pay short term obligation.

$\begin{array}{c}\text{Current ratio=}\frac{\text{Current assets}}{\text{Current liabilities}}\\ \text{Company M}=\frac{\$1,203.0}{\$1,280.2}\\ =0.94\\ \text{Company R=}\frac{\$1,478.7}{\$1,787.1}\\ =0.83\\ \text{Acid test ratio=}\frac{\text{Quick assets}}{\text{Current liabilities}}\\ \text{Company M}=\frac{\$1,203.0-\$466.4-\$134.6}{\$1,280.2}\\ =0.47\\ \text{Company R=}\frac{\$1,478.7-\$635.2-\$476.7}{\$1,787.1}\\ =0.21\end{array}$

Conclusion

The current ratios of the two firms are comparable and within the range of the rule-of-thumb standard of 1 to 1. Acid-test ratio reveals that Company M is more liquid than Company R.

Requirement – 6

To determine

To identify: The efficient management of current assets.

Explanation of Solution

Receivables turnover ratio indicates how quickly a company is able to collect its accounts receivable.

Inventory turnover ratio is used to determine the number of times inventory used or sold during the particular accounting period.

$\begin{array}{c}\text{Receivables turnover ratio =}\frac{\text{Sales}}{\text{Accounts receivable}}\\ \text{Company M}=\frac{\$5,698.0}{\$422.7}\\ =13.5\text{times}\\ \text{Company R=}\frac{\$7,768.2}{\$325.0}\\ =23.9\text{times}\\ \text{Inventory turnover ratio=}\frac{\text{Cost of goods sold}}{\text{Inventory}}\\ \text{Company M=}\frac{\$2,909.0}{\$466.4}\\ =6.2\text{times}\\ \text{Company R=}\frac{\$4,481.7}{\$635.2}\\ =7.1\text{times}\end{array}$

Conclusion

Company R receivables turnover is more rapid than Company M. Hence, its relative liquidity is not as bad as its acid-test ratio indicated.

Requirement – 7

To determine

To identify: The creditor point of view, which company offers the most suitable margin of safety in terms of its ability to pay fixed interest charges.

Explanation of Solution

Times interest earned ratio:

Times interest earned ratio quantifies the number of times the earnings before interest and taxes the business pay for the interest expense.

$\begin{array}{c}\text{Times interest earned ratio =}\frac{\text{Net income plus interest plus taxes}}{\text{Interest}}\\ \text{Company M=}\frac{\$593.8+\$56.8+\$394.7}{\$56.8}\\ =18.4\text{times}\\ \text{Company R=}\frac{\$424.6+\$46.6+\$276.1}{\$46.6}\\ =16.0\text{times}\end{array}$

Conclusion

Hence, Company M and Company R provides an adequate margin of safety in terms of its ability to pay fixed interest charges.