Given the income statements calculate the profitability ratios of Cute Camel Woodcraft Company

Given the income statements calculate the profitability ratios of Cute Camel Woodcraft Company

Given the income statements calculate the profitability ratios of Cute Camel Woodcraft Company

Transcribed Image Text:CENGAGE || MINDTAP Ch 03: Assignment- Financial Statements, Cash Flow, and Taxes The income statement, also known as the profit and loss (PSL) statement, provides a snapshot of the financial performance of a company during a specified period of time. It reports a firm's gross income, expenses, net income, and the income that is available for distribution to its preferred and common shareholders. The Income statement is prepared using the generally accepted accounting principles (GAAP) that match the firm's revenues and expenses to the period in which they were incurred, not necessarily when cash wasrecelved or paid. Investors and analysts use the information given in the income statement and other financial statements and reports to evaluate the company's financial performance and condition. Consider the following scenario: Cute Camel Woodcraft Company's income statement reports data for its first year of operation. The firm's CEO would lke sales to increase by 25% next year. 1. Cute Camel is able to achieve this level of increased sales, but its interest costs increase from 10% to 15% of earnings before interest and taxes (EBIT). 2. The company's operating costs (excluding depreciation and amortization) remain at 70% of net sales, and its depreciation and amortization expenses remein constant from year to year. 3. The company's tax rate remains constant at 25% of its pre-tax income or earnings before taxes (EBT). 4, In Year 2, Cute Camel expects to pay $200,000 and $1,261.375 of preferted and common atock dividends, respectively Cute Camel Woodcraft Company Icome Statement for Year Ending December 31 Year 1 Year 2 (Forecasted) Nat sales $20,000,000 250000 Less: Operating conts, except depreciation and amortization 14,000,000 Less: Depreciation and amortization expenses 800,000 BO0,000 Operating income (or EBIT) $5,200,000 is Less Interest expense 520,000 Pre-tex income (or EBT) 4,600,000 Less: Taves (25s) 1.170,000 Eamings after taves $3,510,000 Le Prefered stock dividends 200.000 Eamings available to common shareholders 3,310.000 Les: Comman stock dividends 1.053,000 Contribution to retained namings $2,257,000 $2,709.075 Given the ruts of the previous income statement calculations, camplete the following atatements Type here to search 857 PM 3//202 Given the resuits of the previous income statement calculations, complete the following statements: • In Year 2, if Cute Camel has 5,000 shares of preferred stock issued and outstanding, then each preferred share should expect to receive $40.00 v in annual dividends. If Cute Camel has 400,000 shares of common stock issued and outstanding, then the firm's earnings per share (EPS) is expected to change from $8.28 Y in Year 1 to v in Year 2. • Cute Camel's earnings before interest, texes, depreciation and amortization (EBITDA) value changed from in Year : to in Year 2 It is to say that Cute Camel's net inflows and outflows of cash at the end of Years 1 and 2 are equal to the company's annual contribution to retained earnings, $2,257,000 and $2,789,875, respectively. This is because statement involve payments and receipts of cash. of the items reported in the income

In order to continue enjoying our site, we ask that you confirm your identity as a human. Thank you very much for your cooperation.

In Year 2, if Cute Camel has 10,000 shares of preferred stock issued and outstanding, theneach preferred share should expect to receive$10.00in annual dividends.If Cute Camel has 500,000 shares of common stock issued and outstanding, then the firm’searnings per share (EPS) is expected to change from$8.17in Year 1 to$9.94Year 2.Cute Camel’s earnings before interest, taxes, depreciation and amortization (EBITDA) valuein

1. Ratio analysis A company reports accounting data in its financial statements. This data is used for financial analyses that provide insights into a company’s strengths, weaknesses, performance in specific areas, and trends in performance. These analyses are often used to compare a company’s performance to that of its competitors or to its past or expected future performance. Such insight helps managers and analysts improve their decision making. Consider the following scenario: You work for a brokerage firm. Your boss asked you to analyze Blue Parrot Manufacturing’s performance for the past three years and to write a report that includes a benchmarking of the company’s performance. Which of the following components would be best for you to include in your financial statement analysis? A comparison of the firm’s performance with other firms in the same industry based on their financial ratios Financial statements based solely on information given to analysts and brokerage firms Points: 1/1 Close Explanation Explanation: Financial statement analysis includes an analysis of a firm’s financial ratios, which includes calculating, comparing, and interpreting different data points from a company’s financial statements. Ratios are used to analyze a company’s performance over a certain time period. Analysts and brokerage firms use the information provided in a firm’s financial statements—including its balance sheet, income statement, statement of cash flows, and statement of stockholders’ equity—to calculate its financial ratios and perform a financial statement analysis. You’ve also been asked to compare that data with the ratios of other participants in the industry. The process of comparing a company with a set of other companies is called benchmarking. In your report, you would calculate the ratios of Blue Parrot Manufacturing’s competitors. Just computing ratios, however, is not sufficient for your report. Based on the indications provided by the ratios regarding the strengths and weaknesses of the industry participants, you must make inferences and comment on Blue Parrot Manufacturing’s position and performance compared to that of its competitors. There are several groups of ratios most decision makers and analysts use to examine different aspects of a company’s performance. Based on the descriptions of ratios listed, identify the relevant category of ratios. • Ratios that help determine whether a company can access its cash and pay its debts that mature in less than a year are called liquidity ratios. • These ratios, which help determine how efficiently a firm is using its assets to generate sales are called asset management or activity ratios. • Ratios that help assess a company’s ability to service the interest and repayment obligations on its long-term debt and the degree to which it uses borrowed versus invested financial capital are called • • debt or financial leverage management ratios. Profitability ratios help measure a company’s ability to generate income and profits based on its invested capital. Market value or market based ratios examine the market value of a company’s share price, its profits and cash dividends, and the book value of the firm’s assets and relate them to other data items to determine how the firm is perceived in the stock market. Points: 1/1 Close Explanation Explanation: Liquidity ratios help you analyze the liquidity position of the company—that is, whether the firm can pay off its short-term liabilities and still smoothly run its operations. Examples of liquidity ratios include the current ratio and the quick, or acid test, ratio. Asset management or activity ratios provide insights into how efficiently the company is using its assets to generate sales or collect cash from its receivables. Examples of these ratios include a company’s days sales outstanding or average collection period, the inventory turnover ratio, and the fixed assets and total assets turnover ratios. Debt or financial leverage ratios help you examine the firm’s ability to service its debt (that is, both pay the interest and repay the principal on its long-term debt obligations), as well as the extent to which it relies on debt and equity financing. Examples of these ratios include the debt ratio, the debtto-equity ratio, and the times-interest-earned ratio. Profitability ratios help you evaluate the profits that a company earns given its expenses and investments. They tell you how profitably company management is running the firm and using its assets and equity. Examples of these ratios include several different types of profit margins, return on assets, and return on equity. Market value or market based ratios help you determine what investors think about the firm’s growth prospects, using the company’s stock price, its cash dividends, and the book value of the company’s assets. Ratio analysis is an important component of evaluating company performance. It can provide great insights into how a company matches up against itself over time and against other players within the industry. However, like many tools and techniques, ratio analysis has a few limitations and weaknesses. Which of the following statements represent a weakness or limitation of ratio analysis? Check all that apply. Ratio analysis is conducted using benchmarking techniques. A firm’s ratios can lead to conflicting conclusions—some ratios might be “good” and some “bad.” Inflation can distort balance sheet data. Points: 1/1 Close Explanation Explanation: Inflation could be distorting balance sheet data. Market values and book values differ, and due to inflation, the difference may be larger. Market data would be the more appropriate values, but financial statements reflect book values, and book values are used in ratio analysis. A firm’s ratios may provide conflicting information and lead to contradictory conclusions. Some ratios may look good, and some ratios may look bad. This is one of the limitations of ratio analysis. It is therefore critical that an analyst be willing to further investigate these inconsistencies and reconcile the net effect of the ratios. Benchmarking helps compare firms against industry leaders and industry averages. This technique is used to help formulate policies that will lead to improved future performance. Benchmarking is not considered to be a limitation or weakness of ratio analysis. 2. Liquidity ratios A liquid asset can be converted quickly to cash with little sacrifice in its value. Which of the following asset classes is generally considered to be the least liquid? Cash Accounts receivable Inventories Points: 1/1 Close Explanation Explanation: In the event of a liquidation, inventories tend to recover the least amount of their stated value. Cash will not lose value, and accounts receivable are likely to retain their value if there are no bad debts. That is why the quick ratio adjusts current assets by subtracting inventories. Whereas the current ratio compares current assets expected to be converted to cash in the next year to current liabilities expected to be due in the next year, the quick ratio asks what would happen if the firm were liquidated today and whether it would have enough liquid assets to meet short-term creditors. The most recent data from the annual balance sheets of Free Spirit Industries Corporation and Zebra Paper Corporation are as follows: Balance Sheet December Zebra Paper Corporation 31st31st (Millions of dollars) Free Spirit Industries Corporation Assets Liabilities Current assets Current liabilities Zebra Paper Corporation Free Spirit Industries Corporation Cash $1,435 $922 Accounts payable $0 $0 Accounts receivable 525 338 Accruals 316 0 Inventories 1,540 990 Notes payable 1,793 1,687 Total current assets $3,500 $2,250 Total current liabilities $2,109 $1,687 Net fixed assets Net plant and equipment 2,750 2,750 Long-term bonds 2,578 2,063 Total debt $4,687 $3,750 Common stock $1,016 $813 Retained earnings 547 437 Total common equity $1,563 $1,250 Total liabilities and equity $6,250 $5,000 Common equity Total assets $6,250 $5,000 Free Spirit Industries Corporation’s quick ratio is 1.3337 ; Zebra Paper Corporation’s quick ratio is 1.6596 . 0.7469 , and its current ratio is 0.9294 , and its current ratio is Points: 1/1 Close Explanation Explanation: The quick ratio, also called the acid test ratio, measures a company’s ability to meet its short-term obligations, using its most liquid assets. Because inventories are considered to be the least liquid of a firm’s current assets, the quick ratio excludes inventories from current assets and is calculated as follows: Quick Ratio = (Current Assets – Inventories) / Current Liabilities Free Spirit Industries Corporation Quick Ratio = ($2,250 – $990) / $1,687 = 0.7469 Zebra Paper Corporation Quick Ratio = ($3,500 – $1,540) / $2,109 = 0.9294 The current ratio measures the extent to which a firm’s current liabilities are covered by the assets that the firm expects to be converted into cash in the next fiscal year, or its current assets. The current ratio is calculated as follows: Current Ratio = Current Assets / Current Liabilities Free Spirit Industries Corporation Zebra Paper Corporation Current Ratio Current Ratio = $2,250 / $1,687 = 1.3337 = $3,500 / $2,109 = 1.6596 Which of the following statements are true? Check all that apply. Zebra Paper Corporation has a better ability to meet its short-term liabilities than Free Spirit Industries Corporation. If a company’s current liabilities are increasing faster than its current assets, the company’s liquidity position is weakening. An increase in the quick ratio over time usually means that the company’s liquidity position is improving and that the company is managing its short-term assets well. Compared to Free Spirit Industries Corporation, Zebra Paper Corporation has less liquidity and a lower reliance on outside cash flow to finance its short-term obligations. An increase in the current ratio over time always means that the company’s liquidity position is improving. Points: 1/1 Close Explanation Explanation: Zebra Paper Corporation’s current ratio is 1.6596, which is higher than Free Spirit Industries Corporation’s current ratio of 1.3337. A high current ratio means that the firm has a strong and safe liquidity position and that it can finance its short-term liabilities using its current assets. Free Spirit Industries Corporation has a lower current ratio, less liquidity, and a relatively greater reliance on outside funds to finance its short-term obligations than Zebra Paper Corporation. The current ratio illustrates a company’s liquidity by evaluating its ability to cover short-term current liabilities with short-term current assets. If current liabilities are increasing faster than current assets, the company will have fewer current assets to liquidate to meet its short-term obligations, if needed. If this trend persists for too long, the company may have to borrow long-term debt to meet its shortterm liabilities. An increase in the quick ratio over time implies that the company’s most liquid assets have increased or that current liabilities have decreased. This means that the company will be able to pay off its short-term liabilities with its accounts receivable, cash, and equivalents, even if it has difficulty in liquidating its inventory. This indicates that the company’s liquidity position is improving. An increase in the current ratio does not always mean an improvement in the company’s liquidity position. If a company’s current assets are increasing, it could indicate that the firm has too much old inventory that will have to be written off or too many old accounts receivable that may turn into bad debts. A very high current ratio could also signal that the firm is not managing its assets efficiently. 3. Asset management ratios Asset management ratios are used to measure how effectively a firm manages its assets, by relating the amount a firm has invested in a particular type of asset (or group of assets) to the amount of revenues the asset is generating. Examples of asset management ratios include the average collection period (also called the days sales outstanding ratio), the inventory turnover ratio, the fixed asset turnover ratio, and the total asset turnover ratio. Consider the following case: Crawford Construction has a quick ratio of 2.00x, $32,175 in cash, $17,875 in accounts receivable, some inventory, total current assets of $71,500, and total current liabilities of $25,025. The company reported annual sales of $300,000 in the most recent annual report. Additionally, the company’s cost of goods sold is 75% of sales. Over the past year, how often did Crawford Construction sell and replace its inventory? 2.86x 8.01x 10.49x 11.54x Points: 1/1 Close Explanation Explanation: Begin by calculating the inventory level of Crawford Construction. Remember, the quick ratio is calculated by subtracting inventories from the firm’s current assets and then dividing the result by its current liabilities. Using the quick ratio’s value, solve for the inventories as follows: Quick Ratio = (Current Assets – Inventories)/Current Liabilities Therefore: InventoriesInvent = Current Assets – (Quick Ratio × Current Liabilities)Current Assets – (Quick Ratio × ories = Current Liabilities) = $71,500 – (2.00 × $25,025)$71,500 – ⁡2.00 × $25,025 = = $21,450$21,450 = Because Crawford Construction has no marketable securities, prepaid expenses, or other liquid assets, you can also simply calculate the inventories by subtracting the firm’s cash and accounts receivable from its total current assets, as follows: InventoriesInventor = =Current Assets – (Cash + Accounts Receivable)Current Assets – (Cash + Accounts ies Receivable) = = = = $71,500 − ($32,175 + $17,875)$71,500 − ⁡$32,175 + $17,875 $21,450$21,450 Next, calculate the company’s inventory turnover ratio by dividing its annual cost of goods sold by the inventory balance, as follows: Inventory Turnover Ratio = Cost of goods sold/Inventories That is: Inventory Turnover RatioInventory Turnover Ratio = = (0.75×$300,000)/$21,4500.75×$300,000/$21,450 = = 10.49x10.49x The inventory turnover ratio across companies in the construction industry is 8.9165x. Based on this information, which of the following statements is true for Crawford Construction? Crawford Construction is holding less inventory per dollar of sales compared with the industry average. Crawford Construction is holding more inventory per dollar of sales compared with the industry average. Points: 1/1 Close Explanation Explanation: Crawford Construction’s inventory turnover ratio (10.49x) is higher than the industry’s average (8.9165x). This means that Crawford Construction is either holding less average inventory per dollar of sales than the industry average or turning (selling and replacing) its inventory faster (or more times per year) than the industry average—everything else remaining constant—or both. This implies that the company has strong sales and is managing its inventory efficiently. Remember, in some cases, a very high inventory turnover ratio could also mean that the company is not purchasing sufficient inventory to support its sales volume—which might lead to some unintended lost sales and unhappy customers. In general, higher inventory levels are considered to be unhealthy, since the company’s financial resources are invested in inventories with a zero rate of return. You are analyzing two companies that manufacture electronic toys—Like Games Inc. and Our Play Inc. Like Games was launched eight years ago, whereas Our Play is a relatively new company that has been in operation for only the past two years. However, both companies have an equal market share with sales of $300,000 each. You’ve collected company data to compare Like Games and Our Play. Last year, the average sales for all industry competitors was $765,000. As an analyst, you want to make comments on the expected performance of these two companies in the coming year. You’ve collected data from the companies’ financial statements. This information is listed as follows: (Note: Assume there are 365 days in a year.) Data Collected (in dollars) Like Games Our Play Industry Average Accounts receivable 8,100 11,700 11,550 Net fixed assets 165,000 240,000 650,250 Total assets 285,000 375,000 703,800 Using this information, complete the following statements to include in your analysis. 1. Our Play has 14.24 days of sales tied up in receivables, which is much higher than the industry average. It takes Our Play its customers than it takes Like Games. 2. more time to collect cash from Like Games’s fixed assets turnover ratio is higher than that of Our Play. This is because Like Games was formed eight years ago, so the acquisition cost of its fixed assets is recorded at historic values when the company bought its assets and has been depreciated since then. Assuming that fixed assets prices (not book values) rose over the past six years due to inflation, Our Play paid a 3. higher amount for its fixed assets. The average total assets turnover in the electronic toys industry is means that assets. A $1.09 higher 1.09x , which of sales is being generated with every dollar of investment in total assets turnover ratio indicates greater efficiency. Both companies’ total assets turnover ratios are lower than the industry average. Points: 1/1 Close Explanation Explanation: Sales for both companies are $300,000 each, so average sales per day will be $300,000/365 days = $821.92 for both companies. Using the values given, first calculate the following ratios with the equations shown: Ratio Equations Ratio Ratio Calculations Formula Like Our Play Games Industry Average Days of Sales Outstanding = Receivables/Average Sales per Day 9.86 days 14.24 days 5.51 days Fixed Assets Turnover Ratio = Sales/Net Fixed Assets 1.82x 1.25x 1.18x Total Assets Turnover = Sales/Total Assets 1.05x 0.80x 1.09x Ratio The days of sales outstanding (DSO), also known as the average collection period (ACP), represents the average length of time that it takes for a company to receive cash after making a sale. Companies that have a lenient credit and collection policy have a high DSO, which could deprive the firm of critical funds and lead to cash flow problems. A low DSO represents an efficient credit and collection policy, but an extremely stringent credit and collection policy could lead to a loss of sales if competitors are offering more lenient terms. In this case, Like Games has a relatively more efficient collection policy than Our Play, but both firms offer more relaxed credit compared with the industry average. Remember, fixed assets are recorded at their historical acquisition cost and these values are not updated to reflect current market values. In fact, the value of net fixed assets decreases over time due to the recognition of the asset’s accumulated depreciation expense. Therefore, Like Games has very low net fixed assets, and because the fixed assets turnover ratio is calculated by dividing sales by net fixed assets, a low number in the denominator will lead to a higher fixed assets turnover ratio. Thus, Our Play has a lower fixed assets turnover ratio than Like Games. The total assets turnover ratio measures the company’s ability to generate revenues with a given level of total assets. Like Games has a higher total assets turnover ratio than Our Play, which means it is generating more revenues per dollar of investment in assets. However, both companies have a lower total assets turnover ratio than the industry; this means that, compared with other companies in the industry, either their management is not as efficient or these companies are relatively more capital intensive. Note that conclusions about a company’s performance cannot be made by just looking at individual ratios. Analysts interpret ratios by examining a set of relevant ratios to determine the efficiency of a company. 4. Debt (or leverage) management ratios Companies have the opportunity to use varying amounts of different sources of financing, including internal and external sources, to acquire their assets, debt (borrowed) funds, and equity funds. Which of the following is considered a financially leveraged firm? A company that uses debt to finance some of its assets A company that uses only equity to finance its assets Points: 1/1 Close Explanation Explanation: Companies that function without the use of borrowed money are said to have no leverage and are called unleveraged companies. Unleveraged companies are financed by equity alone and have no debt in their capital structures. Unleveraged firms are less risky, but they might also lose out on the opportunities that they could otherwise pursue if they used borrowed money. Companies that use debt funding are called leveraged companies and are riskier than unleveraged firms. Leverage allows a company to take advantage of investment opportunities that it could otherwise not afford. Borrowed money could be used to expand more quickly and to capture market share faster than if its business growth were financed solely with equity financing. Which of the following is true about the leveraging effect? Under economic growth conditions, firms with relatively more leverage will have higher expected returns. Under economic growth conditions, firms with relatively low leverage will have higher expected returns. Points: 1/1 Close Explanation Explanation: Using leverage actually increases potential gains but also increases the risk of potential loss. When the economy is growing and if the company is doing well, leverage helps firms benefit from lower taxable income and generates higher expected returns for its shareholders. When a firm takes on leverage (borrows funds), it has to make interest payments on its debt. This interest is deducted as an expense from a company’s earnings, or the earnings before interest and taxes (EBIT). This results in a lower taxable income than that exhibited by an otherwise identical unleveraged firm, as well as lower taxes. With leverage, however, the risk of defaulting on interest payments increases. If a company defaults on its interest, its credit rating goes down, obtaining a loan becomes more difficult and expensive, and it could go bankrupt. All these factors would destroy the firm’s shareholder value. Purple Panda Products Inc. has a total asset turnover ratio of 3.50x, net annual sales of $25 million, and operating expenses of $11 million (including depreciation and amortization). On its balance sheet and income statement, respectively, it reported total debt of $1.75 million on which it pays a 7% interest rate. To analyze a company’s financial leverage situation, you need to measure the firm’s debt management ratios. Based on the preceding information, what are the values for Purple Panda’s debt management ratios? Ratio Debt ratio Value 24.51% Ratio Value Times-interest-earned ratio 114.29x Points: 1/1 Close Explanation Explanation: To find the value of the debt management ratio, first find out how much Purple Panda Products Inc. has in total assets. You know that Purple Panda Products Inc.’s total assets turnover is 3.50 times. Using this information, find the total assets that the company owns. Solve as follows: Total Asset Turnover Ratio = Sales / Total Assets 3.50 times = $25 million / Total Assets Total Assets = $25 million / 3.50 times = $7.14million Now, use Purple Panda Products Inc.’s total debt and total assets (which are financed by the sum of the firm’s financial capital) to calculate its debt ratio, using the following formula: Debt Ratio = Total Debt / Total Assets = Total Debt / Total Debt & Equity = $1.75 million / $7.14 million = 24.51% Solve as follows: Debt Ratio To calculate the times-interest-earned (TIE) ratio, you need to know the firm’s operating income (earnings before interest and taxes, or EBIT) and its annual interest expense. You are given neither, but you can infer them from the given data. First, find the operating income. Purple Panda Products Inc. has annual sales of $25 million and total expenses (or costs), including depreciation and amortization, of $11 million. Therefore, the EBIT will be: EBIT = = Total Sales – Total Operating Costs = = $25 million – $11 million = = $14.00million Interest Charges = Interest Rate × Debt Outstanding = 7% × $1.75million = $0.1225million Use the EBIT and interest charges to solve for the TIE ratio, using the following formula: TIE Ratio = EBIT / Interest Charges Solve as follows: TIE Ratio = $14.00 million / $0.1225 million = 114.29 x The US tax structure influences a firm’s willingness to finance with debt. The tax structure encourages more debt. Points: 1/1 Close Explanation Explanation: The US tax structure encourages the use of debt as a source of financing. Interest paid on debt is tax deductible; that is, interest can be removed from the earnings before taxes are calculated. Lower earnings before taxes lead to lower taxes and thus higher cash flows. Thus, the system encourages the use of debt. 5. Profitability ratios Profitability ratios help in the analysis of the combined impact of liquidity ratios, asset management ratios, and debt management ratios on the operating performance of a firm. Your boss has asked you to calculate the profitability ratios of Triptych Food Corp. and make comments on its second-year performance as compared with its first-year performance. The following shows Triptych Food Corp.’s income statement for the last two years. The company had assets of $11,750 million in the first year and $18,796 million in the second year. Common equity was equal to $6,250 million in the first year, and the company distributed 100% of its earnings out as dividends during the first and the second years. In addition, the firm did not issue new stock during either year. Triptych Food Corp. Income Statement For the Year Ending on December 31 (Millions of dollars) Year 2 Year 1 Net Sales 6,350 5,000 Operating costs except depreciation and amortization 1,120 1,040 Depreciation and amortization 318 200 Year 2 Year 1 Total Operating Costs 1,438 1,240 Operating Income (or EBIT) 4,912 3,760 Less: Interest 663 489 Earnings before taxes (EBT) 4,249 3,271 Less: Taxes (25%) 1,062 818 Net Income 3,187 2,453 Calculate the profitability ratios of Triptych Food Corp. in the following table. Convert all calculations to a percentage rounded to two decimal places. Ratio Value Year 2 Operating margin 77.35% Profit margin Year 1 75.20% 50.19% Return on total assets 16.96% Return on common equity 50.99% Basic earning power 49.06% 20.88% 39.25% 26.13% 32.00% Points: 1/1 Close Explanation Explanation: Profitability ratios will help you determine the company’s ability to generate earnings compared to the expenses and other costs incurred to support these earnings. Calculate the ratios for Triptych Food Corp. by using the numbers given in the previous table: Triptych Food Corp. Ratio Calculations Ratio Formula Year 2 Year 1 Operating Margin = EBIT / Sales = 77.35% 75.20% Profit Margin = Net Income / Sales = 50.19% 49.06% Return on Total Assets = Net Income / Total Assets = 16.96% 20.88% Return on Common Equity = Net Income / Common Equity = 50.99% 39.25% Basic Earning Power = EBIT / Total Assets = 26.13% 32.00% Decision makers and analysts look deeply into profitability ratios to identify trends in a company’s profitability. Profitability ratios give insights into both the survivability of a company and the benefits that shareholders receive. Identify which of the following statements are true about profitability ratios. Check all that apply. If a company has a profit margin of 10%, it means that the company earned a net income of $0.10 for each dollar of sales. If a company’s operating margin increases but its profit margin decreases, it could mean that the company paid more in interest or taxes. An increase in the return on assets ratio implies an increase in the assets a firm owns. If a company issues new common shares but its net income does not increase, return on common equity will increase. Points: 1/1 Close Explanation Explanation: Profit margin is the ratio of a company’s net income and its sales. Profit margin tells you approximately how much earnings a company generated for each dollar of sales. A profit margin of 10% means that the company earned $0.10 for each dollar of sales. Return on assets (ROA) is calculated by dividing the net income by the total assets. Because total assets is the denominator, an increase in the total assets with no increase in the net income would actually lead to a decrease in ROA. An increase in ROA indicates an increase in the net income, a reduction in the total assets, or both. An increase in the operating margin would mean that either sales increased, operating costs decreased, or both. However, if the profit margin decreased, it would mean that higher deductions were made from the operating income. (Refer to the preceding income statement.) These deductions could either be higher interest expenses or higher taxes. Thus, if a company’s operating margin increased but its profit margin decreased, it could mean that the company paid more in interest or taxes. Return on common equity (ROE) is the ratio of net income and a company’s common equity. If a company issues new common shares, its total shares outstanding will increase, which means that the equity base (denominator in the ROE ratio) increases. Net income staying the same will now be available for a larger number of common equity claims, thus leading to a decline in the company’s ROE. 6. Market value ratios Ratios are mostly calculated using data drawn from the financial statements of a firm. However, another group of ratios, called market value ratios, relate to a firm’s observable market value, stock prices, and book values, integrating information from both the market and the firm’s financial statements. Consider the case of Cute Camel Woodcraft Company: Cute Camel Woodcraft Company just reported earnings after tax (also called net income) of $9,250,000 and a current stock price of $39.50 per share. The company is forecasting an increase of 25% for its after-tax income next year, but it also expects it will have to issue 3,000,000 new shares of stock (raising its shares outstanding from 5,500,000 to 8,500,000). If Cute Camel’s forecast turns out to be correct and its price/earnings (P/E) ratio does not change, what does the company’s management expect its stock price to be one year from now? (Round any P/E ratio calculation to four decimal places.) $31.98 per share $39.50 per share $23.99 per share $39.98 per share Points: 1/1 Close Explanation Explanation: First, calculate Cute Camel’s current earnings per share (EPS) and its P/E ratio. Solve for EPS as follows: EPS = Net Income/Shares Outstanding = $9,250,000/5,500,000shares = $1.68 The P/E ratio is calculated using the following formula: P/E Ratio = Price per Share/EPS Therefore, Cute Camel’s P/E ratio is solved as: P/E Ratio = $39.50/$1.68 = 23.5119× Next, calculate the expected EPS based on the expected net income. Remember, Cute Camel’s net income is expected to increase by 25% to $11,562,500 ($9,250,000 x 1.25) next year. In addition, the company will issue 3,000,000 new shares, such that the total number of outstanding shares next year will be 8,500,000 (5,500,000 + 3,000,000) shares. Now, calculate the expected EPS, as follows: Expected EPS = Expected Net Income/Outstanding Shares Next Year = $11,562,500/8,500,000 = $1.36 You can assume that Cute Camel’s P/E ratio remains constant. Use the expected EPS to calculate the expected price of Cute Camel’s stock one year from now by multiplying the expected EPS and the P/E ratio: Expected Stock Price = Expected EPS × P/E Ratio = $1.36 × 23.5119 = $31.98 per share One year later, Cute Camel’s shares are trading at $55.80 per share, and the company reports the value of its total common equity as $54,366,000. Given this information, Cute Camel’s market-tobook (M/B) ratio is 8.72 x . Points: 1/1 Close Explanation Explanation: To calculate the M/B ratio, first calculate the book value per share (BVPS) of Cute Camel’s stock, as follows: BVPS = Common Equity/Shares Outstanding = $54,366,000/8,500,000 shares = $6.40 Now divide the market price of Cute Camel’s shares by its BVPS. That is: M/B Ratio = Market Price per Share/BVPS = $55.80 per share/$6.40 = 8.72 × Can a company’s shares exhibit a negative P/E ratio? No Yes Points: 1/1 Close Explanation Explanation: Yes, a company’s shares can exhibit a negative P/E ratio. You know that the P/E ratio is equal to the market price of a company’s shares divided by the shares’ EPS. For a negative P/E ratio to exist, either the share price must be less than zero or the shares’ EPS must be negative. Remember, share prices cannot be negative, but companies can incur negative earnings (a loss). This can lead to a negative EPS, and therefore, a negative P/E ratio. A negative P/E ratio means that investors are willing to buy a share of a company that has been losing money on every share of its stock. Which of the following statements is true about market value ratios? Companies with high research and development (R&D) expenses tend to have low P/E ratios. Companies with high research and development (R&D) expenses tend to have high P/E ratios. Points: 1/1 Close Explanation Explanation: Companies, especially those in the pharmaceutical and biotech sectors, make money by inventing and selling new products; as a result, they invest heavily in R&D. These companies expense their investment in R&D. Arguably, this investment in R&D is actually what will create value for their shareholders. Companies in other sectors consider investments as assets and depreciate these investments over time, whereas R&D is treated as an expense. So companies with high R&D expenses will tend to realize lower earnings, a lower EPS, and therefore a higher P/E ratio. However, it is important to note that investments in R&D don’t always lead to stable future earnings. 7. More on ratio analysis Analysts and investors often use return on equity (ROE) to compare profitability of a company with other firms in the industry. ROE is considered a very important measure, and managers strive to make the company’s ROE numbers look good. If a firm takes steps that increase its expected future ROE, its stock price will necessarily not increase. Points: 1/1 Based on your understanding of the uses and limitations of ROE, which of the following projects should be chosen if they have the same risk and cost of capital? Project Y, with 40% ROE and a small investment, generating low expected cash flows Project X, with 35% ROE and a large investment, generating high expected cash flows Points: 1/1 Close Explanation Explanation: An increase in ROE would sometimes, but not always, imply an increase in shareholder wealth. Additionally, an increase in ROE does not necessarily mean that the firm’s stock price will increase. This is because of certain limitations of ROE: • ROE does not incorporate the component of risk. • The amount of invested capital is not considered in ROE calculations. • Managers may turn down profitable projects because they focus too much on generating a higher ROE. ROE is calculated by dividing net income by shareholders’ equity. The calculation does not consider the amount of invested capital. Managers should choose to invest in project X because it would add more value to shareholder wealth. Although project X has lower ROE, the project has a larger investment and high expected cash flows. It would thus add more value to shareholder wealth than a relatively smaller project with a higher ROE. Thus, it is important to remember that shareholder value depends on ROE, risk, and capital invested. Suppose you are trying to decide whether to invest in a company that generates a high expected ROE, and you want to conduct further analysis on the company’s performance. If you wanted to conduct a trend analysis, you would: Analyze the firm’s financial ratios over time Compare the firm’s financial ratios with other firms in the industry for a particular year Points: 1/1 Close Explanation Explanation: If you were conducting a trend analysis, you would analyze the firm’s financial ratios over time, which would help in estimating the likelihood of improvement or deterioration in its financial condition. If you were conducting a comparative analysis, on the other hand, you would compare the firm’s financial ratios with other firms in the industry. You decide also to conduct a qualitative analysis based on the factors summarized by the American Association of Individual Investors (AAII). According to your understanding, a company with one key customer is considered to be more risky than companies with several customers. Points: 1/1 Close Explanation Explanation: A company with one key customer is considered to be more risky than companies with multiple customers. This is because the company’s earnings will drastically decline if the key customer decides to take its business to another company. The American Association of Individual Investors (AAII) has identified several qualitative factors that should also be considered when evaluating a company’s likely future financial performance. Consider the scenario and indicate how you would expect the described event or situation to affect the described business organization. Southern Supply Inc. To date, Southern has been a one-product company. It manufactures, sells, and services only one product, AM-FM radios, and that item is in the market-saturation stage of its product life cycle. As a result, Southern’s profits are declining due to increased competition from new products and competing firms. For several reasons, attempts to develop and introduce new products have not been successful. How would you expect this situation to affect the assessment of Southern’s financial condition and performance? Its one-product strategy increases Southern’s efficiency and will ensure its long-term financial success. Although its profits are declining now, these efficiencies will ensure the company’s long-term success. Southern’s profits will continue to decline, and the company’s survival is in jeopardy if it does not create a new product with more potential for market growth. Although nonquantitative factors may be relevant to a company’s financial evaluation in general terms, the details of this specific situation are not relevant to the firm’s financial condition or performance. Points: 1/1 Close Explanation Explanation: Southern’s one-product strategy introduces both efficiency and riskiness into the firm’s operations and financial performance. Southern’s profits will continue to decline, and the company’s survival is in jeopardy if it does not create a new product with more potential for market growth. 8. The DuPont equation Corporate decision makers and analysts often use a particular technique, called a DuPont analysis, to better understand the factors that drive a company’s financial performance, as reflected by its return on equity (ROE). By using the DuPont equation, which disaggregates the ROE into three components, analysts can see why a company’s ROE may have changed for better or worse and identify particular company strengths and weaknesses. The DuPont Equation A DuPont analysis is conducted using the DuPont equation, which helps to identify and analyze three important factors that drive a company’s ROE. Complete the following equations, which are needed to conduct a DuPont analysis: ROE = = Profit Margin Net Income × × / Sales Total Assets Turnover Sales / Total Assets × × Equity Multiplier Total Assets / Total Common Equity Points: 1/1 Close Explanation Explanation: A DuPont analysis is performed using the following equation: ROE = Profit Margin × Total Assets Turnover × Equity Multiplier Net Income/Sales × Sales/Total Assets × Total Assets/Total Common Equity = The DuPont equation consists of three terms: • The first term, the company’s net profit margin, or earnings after taxes, tells you about the firm’s operational efficiency, which means how much after-tax income a firm is making on each dollar of sales earned. It is calculated by dividing net income by the corresponding year’s net sales. • The second term, the firm’s total assets turnover, tells you how efficiently the company is using its total assets to generate sales. Remember, this ratio is calculated by dividing the company’s net sales by its corresponding total assets. • The third term, the equity multiplier, reflects the company’s financial leverage. Also called the adjustment factor, this ratio is calculated by dividing the company’s total assets by its total common equity. Most investors and analysts in the financial community pay particular attention to a company’s ROE. The ROE can be calculated simply by dividing a firm’s net income by the firm’s shareholder’s equity, and it can be subdivided into the key factors that drive the ROE. Investors and analysts focus on these drivers to develop a clearer picture of what is happening within a company. An analyst gathered the following data and calculated the various terms of the DuPont equation for three companies: ROE Company = Profit Margin x Total Assets Turnover x Equity Multiplier 12.0% 57.3% 9.8 2.14 Company B 15.5% 58.2% 10.2 2.61 Company C 21.5% 58.0% 10.3 3.60 A Referring to these data, which of the following conclusions will be true about the companies’ ROEs? The main driver of Company A’s inferior ROE, as compared with that of Company C’s ROE, is its higher total asset turnover ratio. The main driver of Company C’s superior ROE, as compared with that of Company A’s and Company B’s ROE, is its operational efficiency. The main driver of Company C’s superior ROE, as compared with that of Company A’s and Company B’s ROE, is its greater use of debt financing. Points: 1/1 Close Explanation Explanation: Company C has an equity multiplier of 3.60, which is greater than the equity multiplier of the other companies. An increase in an equity multiplier can be due to two factors: an increase in the firm’s total assets or an increase in its use of debt financing. Company C’s increased use of financial leverage (borrowed financial capital) leads to a reduced reliance on equity financing. Since Company C’s profit margin and total asset turnover ratio are very close to those of Companies A and B, then it is reasonable to conclude that all three companies are performing at the same general level of operational efficiency. Therefore, Company C’s significantly higher ROE is the result of its increased use of financial leverage when purchasing its assets. 9. An analysis of company performance using DuPont analysis A sheaf of papers in his hand, your friend and colleague, Jason, steps into your office and asked the following. JASON: Do you have 10 or 15 minutes that you can spare? YOU: Sure, I’ve got a meeting in an hour, but I don’t want to start something new and then be interrupted by the meeting, so how can I help? JASON: I’ve been reviewing the company’s financial statements and looking for ways to improve our performance, in general, and the company’s return on equity, or ROE, in particular. Anja, my new team leader, suggested that I start by using a DuPont analysis, and I’d like to run my numbers and conclusions by you to see whether I’ve missed anything. Here are the balance sheet and income statement data that Anja gave me, and here are my notes with my calculations. Could you start by making sure that my numbers are correct? YOU: Give me a minute to look at these financial statements and to remember what I know about the DuPont analysis. Balance Sheet Data Income Statement Data Cash $800,000 Accounts payable $960,000 Sales $16,000,000 Accounts receivable 1,600,000 Accruals 320,000 Cost of goods sold 9,600,000 Inventory 2,400,000 Notes payable 1,280,000 Gross profit 6,400,000 Current assets 4,800,000 Current liabilities 2,560,000 Operating expenses 4,000,000 Balance Sheet Data Net fixed assets Total assets Income Statement Data 4,800,000 $9,600,000 Long-term debt 2,720,000 EBIT 2,400,000 Total liabilities 5,280,000 Interest expense 480,000 Common stock 1,080,000 EBT 1,920,000 Retained earnings 3,240,000 Taxes 480,000 Total equity 4,320,000 Net income $1,440,000 Total debt and equity $9,600,000 If I remember correctly, the DuPont equation breaks down our ROE into three component ratios: the net profit margin , the total asset turnover ratio, and the equity multiplier . Points: 1/1 And, according to my understanding of the DuPont equation and its calculation of ROE, the three ratios provide insights into the company’s use of debt versus equity financing effectiveness in using the company’s assets, and control over its expenses , . Points: 1/1 Now, let’s see your notes with your ratios, and then we can talk about possible strategies that will improve the ratios. I’m going to check the box to the side of your calculated value if your calculation is correct and leave it unchecked if your calculation is incorrect. Cepeus Manufacturing Inc. DuPont Analysis Ratios Value Correct/Incorrect Profitability ratios Gross profit margin (%) Ratios Value Correct/Incorrect Asset management ratio 40.00 Correct Total assets turnover 1.67 Correct Ratios Value Operating profit margin (%) 12.00 Net profit margin (%) 15.00 Return on equity (%) 45.59 Correct/Incorrect Ratios Value Correct/Incorrect Incorrect Incorrect Financial ratios Incorrect Equity multiplier 1.82 Incorrect Points: 1/1 JASON: OK, it looks like I’ve got a couple of incorrect values, so show me your calculations, and then we can talk strategies for improvement. YOU: I’ve just made rough calculations, so let me complete this table by inputting the components of each ratio and its value: Do not round intermediate calculations and round your final answers up to two decimals. Cepeus Manufacturing Inc. DuPont Analysis Ratios Calculation Profitability ratios Numerator Gross profit margin (%) 6,400,000 / 16,000,000 = 40.00 Operating profit margin (%) 2,400,000 / 16,000,000 = 15.00 Net profit margin (%) Return on equity (%) 1,440,000 1,440,000 Value Denominator / / 16,000,000 4,320,000 = = 9.00 33.33 Asset management ratio Total assets turnover 16,000,000 / 9,600,000 = 1.67 Financial ratios Equity multiplier Points: 1/1 9,600,000 / 4,320,000 = 2.22 JASON: I see what I did wrong in my computations. Thanks for reviewing these calculations with me. You saved me from a lot of embarrassment! Anja would have been very disappointed in me if I had showed her my original work. So, now let’s switch topics and identify general strategies that could be used to positively affect Cepeus’s ROE. YOU: OK, so given your knowledge of the component ratios used in the DuPont equation, which of the following strategies should improve the company’s ROE? Check all that apply. Use more debt financing in its capital structure and increase the equity multiplier. Increase the interest rate on its notes payable or long-term debt obligations because it will reduce the company’s net profit margin. Increase the efficiency of its assets so that it generates more sales with each dollar of asset investment and increases the company’s total assets turnover. Decrease the amount of debt financing used by the company, which will decrease the total assets turnover ratio. Points: 1/1 JASON: I think I understand now. Thanks for taking the time to go over this with me, and let me know when I can return the favor. Close Explanation Explanation: According to a DuPont analysis of Cepeus Manufacturing Inc., the company’s return on equity (ROE) is 33.33%, which is calculated as follows: ROE = Net Profit Margin × Total Assets Turnover × Equity Multiplier = Net Income/Sales × Sales/Total Assets × Total Assets/Total Common Equity = $1,440,000/$16,000,000×$16,000,000/$9,600,000×$9,600,000/$4,320,000 = 9.00% × 1.67 × 2.22 = 33.33% The evaluation of Jason’s calculations indicates several errors, including his computation of the company’s operating profit margin, net profit margin, equity multiplier, and return on equity. These ratios—and the others in the table—are correctly calculated as follows: Cepeus Manufacturing Inc. DuPont Analysis Ratios Calculation Value Profitability ratios Numerator Gross profit margin (%) 6,400,000 / 16,000,000 = 40.00 Operating profit margin (%) 2,400,000 / 16,000,000 = 15.00 Net profit margin (%) 1,440,000 / 16,000,000 = 9.00 Return on equity (%) 1,440,000 / 4,320,000 = 33.33 16,000,000 / 9,600,000 = 1.67 9,600,000 / 4,320,000 = 2.22 Denominator Asset management ratio Total assets turnover Financial ratios Equity multiplier The DuPont equation suggests that a company’s ROE—or the current after-tax dollar return available (or owed) to the firm’s shareholders expressed as a percentage of the investment made by these shareholders and any previously accumulated retained earnings—is a function of: • The ability of the company’s management to manage its costs, including its cost of goods sold, operating expenses, interest expense, and taxes, as indicated by its net profit margin. • The management’s ability to efficiently use the company’s current and long-term assets to generate sales, as reflected by its total assets turnover. • The company’s use of leverage, or borrowed financial capital, as indicated by its equity multiplier. Remember, the equity multiplier is the reciprocal of the equity ratio, which is the equivalent of the company’s debt ratio but based on the amount of total common equity. Therefore, if the amount of debt financing is increased, then the amount of equity ratio will decrease, and its reciprocal (the equity multiplier) will increase. Given the composition of the net profit margin, total assets turnover, and equity multiplier ratios, the strategies that can be used to increase Cepeus’s ROE are those that would: • Reduce the company’s operating expenses, its cost of goods sold, and/or the interest rate on its borrowed funds because this will increase the company’s net profit margin. • Use more debt financing in its capital structure and increase the equity multiplier. • Increase the efficiency of its assets so that it generates more sales with each dollar of asset investment and increases the company’s total assets turnover. • Increase the firm’s bottom-line profitability for the same volume of sales. 10. Analyzing ratios One of the most important applications of ratio analysis is to compare a company’s performance with that of other players in the industry or to compare its own performance over a period of time. Such analyses are referred to as a comparative analysis and trend analysis, respectively. A common size analysis requires the representation of financial statement data in terms of a single financial statement item (or base account or value). What is the most commonly used base item for a common size income statement? Total liabilities Stockholders’ equity Net sales Total assets Points: 1/1 Close Explanation Explanation: Common size analysis involves creating a ratio using a common item as the denominator for all items in the balance sheet. It also involves creating an income statement to analyze a company’s performance over time and compare its performance with the industry average. Most analysts use total assets as the base item for all balance sheet items and revenues or net sales for all income statement items. In essence, everything in the balance sheet is represented as a percentage of the total assets. Everything in the income statement is represented as a percentage of net sales. Suppose you are conducting an analysis of the financial performance of Green Caterpillar Garden Supplies Inc. over the past three years. The company did not issue new shares during these three years and has faced some operational difficulties. The company has thus pilot tested some new forecasting strategies for better operations management. You have collected the company’s relevant financial data, made reasonable assumptions based on the information available, and calculated the following ratios. Ratios Calculated Year 1 Year 2 Year 3 Price-to-cash-flow 6.20 8.06 9.03 Inventory turnover 12.40 14.88 16.67 Debt-to-equity 0.30 0.32 0.38 Based on the preceding information, your calculations, and your assumptions, which of the following statements can be included in your analysis report? Check all that apply. An improvement in the inventory turnover ratio could likely be explained by the new salesforecasting strategies that led to better inventory management. The company’s creditworthiness has improved over these three years as evidenced by the increase in its debt-to-equity ratio over time. A plausible reason why Green Caterpillar Garden Supplies Inc.’s price-to-cash-flow ratio has increased is that investors expect higher cash flow per share in the future. Green Caterpillar Garden Supplies Inc.’s ability to meet its debt obligations has worsened since its debt-to-equity ratio increased from 0.30 to 0.38. Points: 1/1 Close Explanation Explanation: The price-to-cash-flow ratio represents the market’s expectations for a firm’s future reflected through the market price of its share and the cash flow per share that the firm is expected to generate. It is calculated as follows: Price / Cash Flow = Price per Share / Cash Flow per Share Green Caterpillar Garden Supplies Inc.’s price-to-cash-flow ratio has increased from year 1 to year 3. This implies that investors expected more cash flow per share from the company. This is reflected through the market price of Green Caterpillar Garden Supplies Inc.’s stock. An increase in the stock price will lead to an increase in the price-to-cash-flow ratio. Mathematically, the price-to-cash-flow ratio will increase with a decrease in cash flow per share. But remember that the stock price of a firm reflects the present value of expected future cash flows that the firm can generate. So, a decline in the expected cash flow per share will also lead to a decline in the intrinsic value of the firm’s stock and thus a decline in the firm’s stock price. The debt-to-equity ratio represents the firm’s total liabilities as compared to its total stockholders’ equity. An increase in the debt-to-equity ratio implies that the firm is taking on more debt per dollar of equity. This means that the firm’s liabilities are increasing, thus becoming more risky and less solvent. The firm does not issue new shares, but the firm’s liabilities are increasing, making it more risky. Thus, the firm’s creditworthiness will deteriorate. Sales forecasts help firms decide the level of inventory required to support sales. If actual sales are close to forecasted sales, the firm can churn its inventory faster and have a higher inventory turnover rate. In this case, Green Caterpillar Garden Supplies Inc. is piloting new sales-forecasting strategies, which lead to better inventory management and thus a trend of higher inventory turnover ratios. 2. Liquidity ratios A liquid asset can be converted to cash quickly without significantly impacting the asset’s value. Which of the following asset classes is generally considered to be the most liquid? Accounts receivable Inventories Cash Points: 1/1 Close Explanation Explanation: In the event of a liquidation, inventories tend to recover the least amount of their stated value. Accounts receivable are likely to retain their value if there are no bad debts. But cash is already liquid, so it will not lose value. That is why the quick ratio adjusts current assets by subtracting inventories. Whereas the current ratio compares current assets expected to be converted to cash in the next year to current liabilities expected to be due in the next year, the quick ratio asks what would happen if the firm were liquidated today and whether it would have enough liquid assets to meet short-term creditors. The most recent data from the annual balance sheets of Pellegrini Southern Corporation and Jing Foodstuffs Corporation are as follows: Balance Sheet December 31st31st (Millions of dollars) Jing Pellegrini Jing Pellegrini Foodstuffs Corporation Southern Corporation Foodstuffs Corporation Southern Corporation $0 $0 Assets Liabilities Current assets Current liabilities Cash $4,879 $3,136 Accounts payable Accounts receivable 1,785 1,148 Accruals 1,076 0 Inventories 5,236 3,366 Notes payable 6,096 5,737 Total current assets $11,900 $7,650 Total current liabilities $7,172 $5,737 Long-term bonds 8,765 7,013 Total debt $15,937 $12,750 Common stock $3,453 $2,763 Retained earnings 1,860 1,487 Total common equity $5,313 $4,250 Total liabilities and equity $21,250 $17,000 Net fixed assets Net plant and equipment 9,350 9,350 Common equity Total assets $21,250 $17,000 Pellegrini Southern Corporation’s current ratio is 1.3334 0.7467 ; Jing Foodstuffs Corporation’s current ratio is 0.9292 . Note: Round your values to four decimal places. , and its quick ratio is 1.6592 , and its quick ratio is Points: 1/1 Close Explanation Explanation: The current ratio measures the extent to which a firm’s current liabilities are covered by the assets that the firm expects to be converted into cash in the next fiscal year, or its current assets. The current ratio is calculated as follows: Current Ratio = Current Assets / Current Liabilities Pellegrini Southern Corporation Jing Foodstuffs Corporation Current Ratio Current Ratio = $7,650 / $5,737 = 1.3334 = $11,900 / $7,172 = 1.6592 The quick ratio, also called the acid test ratio, measures a company’s ability to meet its short-term obligations using its most liquid assets. Because inventories are considered to be the least liquid of a firm’s current assets, the quick ratio excludes inventories from current assets and is calculated as follows: Quick Ratio = (Current Assets – Inventories) / Current Liabilities Pellegrini Southern Corporation Quick Ratio = ($7,650 – $3,366) / $5,737 = 0.7467 Jing Foodstuffs Corporation Quick Ratio = ($11,900 – $5,236) / $7,172 = 0.9292 Which of the following statements are true? Check all that apply. Pellegrini Southern Corporation has less liquidity but also a greater reliance on outside cash flow to finance its short-term obligations than Jing Foodstuffs Corporation. If a company’s current liabilities are increasing faster than its current assets, the company’s liquidity position is weakening. If a company has a quick ratio of less than 1 but a current ratio of more than 1 and if the difference between the two ratios is large, then the company depends heavily on the sale of its inventory to meet its short-term obligations. Pellegrini Southern Corporation has a better ability to meet its short-term liabilities than Jing Foodstuffs Corporation. An increase in the current ratio over time always means that the company’s liquidity position is improving. Points: 0.8 / 1 Close Explanation Explanation: Pellegrini Southern Corporation’s current ratio (1.3334) is lower than Jing Foodstuffs Corporation’s current ratio (1.6592), which means that Pellegrini Southern Corporation’s ability to finance its shortterm liabilities is less than Jing Foodstuffs Corporation’s ability to finance its short-term liabilities. Pellegrini Southern Corporation has a greater reliance on outside funds to finance its short-term obligations than Jing Foodstuffs Corporation. The current ratio illustrates a company’s liquidity by evaluating its ability to cover short-term current liabilities with short-term current assets. If current liabilities are increasing faster than current assets, the company will have fewer current assets to liquidate to meet its short-term obligations, if needed. If this trend persists for too long, the company may have to borrow long-term debt to meet its shortterm liabilities. A quick ratio of less than 1 means that the company does not have enough assets, excluding its inventory, to meet its short-term obligations. The quick ratio does not take into account the value of the company’s inventory. The quick ratio is calculated by subtracting inventory from current assets and then dividing that value by current liabilities. If this ratio is less than 1 and the current ratio is more than 1, then the inventory constitutes a major part of the company’s current assets. The company would have to depend on liquidating its inventory to meet its short-term obligations. An increase in the current ratio does not always mean an improvement in the company’s liquidity position. If a company’s current assets are increasing, it could indicate that the firm has too much old inventory that will have to be written off or too many old accounts receivable that may turn into bad debts. A very high current ratio could also signal that the firm is not managing its assets efficiently. Name: Description: ...