Chapter 13, Problem 11EYK

To determine

Compute the ratios of Company T for 2010 and 2011 and comment on the results.

Answer to Problem 11EYK

Computation of ratios of Company T for 2010 and 2011:

Ratios and Formula	2010 (in million £)	2011 (in million £)
a. Current ratio: $\frac{\text{Current Assets}}{\text{Current Liabilities}}$	$\begin{array}{c}=\frac{\pounds 11,392}{\pounds 16,015}\\ =\text{0}\text{.71 times}\end{array}$	$\begin{array}{c}=\frac{\pounds 11,438}{\pounds 17,731}\\ =\text{0}\text{.65 times}\end{array}$
b. Quick ratio: $\frac{\text{Quick Assets}}{\text{Current Liabilities}}$	$\begin{array}{c}=\frac{\left[\begin{array}{l}\pounds 2,819+\pounds 1,314\\ +\pounds 1,888\end{array}\right]}{\pounds 16,015}\\ =\text{0}\text{.38 times}\end{array}$	$\begin{array}{c}=\frac{\left[\begin{array}{l}\pounds 1,870+\pounds 1,022\\ +\pounds 2,314\end{array}\right]}{\pounds 17,731}\\ =\text{0}\text{.29 times}\end{array}$
c. Receivables turnover: $\frac{\text{}\text{Net credit sales}}{\left(\begin{array}{l}\text{Average accounts }\\ \text{receivables}\end{array}\right)}$ Average accounts receivable: $\frac{\left(\begin{array}{l}\text{Beginning Net }\\ \text{Receivables}\end{array}\right)+\left(\begin{array}{l}\text{Ending Net }\\ \text{Receivables}\end{array}\right)}{2}$	$\begin{array}{c}=\frac{\pounds 56,910}{\pounds 1,854}\\ =30.69\text{ times}\end{array}$ $\begin{array}{c}=\frac{\pounds 1,820+\pounds 1,888}{2}\\ =\pounds 1,854\end{array}$	$\begin{array}{c}=\frac{\pounds 60,931}{\pounds 2,101}\\ =29\text{ times}\end{array}$ $\begin{array}{c}=\frac{\pounds 1,888+\pounds 2,314}{2}\\ =\pounds 2,101\end{array}$
d. Inventory turnover: $\frac{\text{Cost of goods sold}}{\text{Average inventory}}$ Average inventory: $\frac{\left(\begin{array}{l}\text{Beginning}\\ \text{ Inventory}\end{array}\right)+\left(\begin{array}{l}\text{Ending }\\ \text{Inventory}\end{array}\right)}{2}$	$\begin{array}{c}=\frac{\pounds 52,303}{\pounds 2,699}\\ =19.38\text{ times}\end{array}$ $\begin{array}{c}=\frac{\pounds 2,669+\pounds 2,729}{2}\\ =\pounds 2,699\end{array}$	$\begin{array}{c}=\frac{\pounds 55,871}{\pounds 2,946}\\ =18.97\text{ times}\end{array}$ $\begin{array}{c}=\frac{\pounds 2,729+\pounds 3,162}{2}\\ =\pounds 2,946\end{array}$
e. Debt to equity ratio: $\frac{\text{Total liabilities }}{\left(\begin{array}{l}\text{Total stockholders' }\\ \text{equity}\end{array}\right)}$	$\begin{array}{c}=\frac{\text{£15,327 }}{\text{£14,681 }}\\ =1.04\end{array}$	$\begin{array}{c}=\frac{\text{£12,852 }}{\text{£16,623 }}\\ =0.77\end{array}$
f. Number of times interest was earned: $\frac{\left[\begin{array}{l}\text{Earnings before interest}\\ \text{ and tax expense}\end{array}\right]}{\text{Interest expense}}$	$\begin{array}{c}=\frac{\text{£3,}755\left(1\right)}{\text{£579 }}\\ =6.49\end{array}$	$\begin{array}{c}=\frac{\text{£}4,018\left(2\right)}{\text{£483 }}\\ =8.31\end{array}$
g. Return on sales: $\frac{\text{Net income}}{\text{Net sales}}$	$\begin{array}{c}=\frac{\pounds 2,336}{\pounds 56,910}\\ =4.10\%\end{array}$	$\begin{array}{c}=\frac{\pounds 2,671}{\pounds 60,931}\\ =4.38\%\end{array}$
h. Return on assets: $\frac{\text{Net income }}{\text{Average total assets}}$ Average total assets: $\frac{\left(\begin{array}{l}\text{Beginning }\\ \text{total assets}\end{array}\right)+\left(\begin{array}{l}\text{Ending }\\ \text{total assets}\end{array}\right)}{2}$	$\begin{array}{c}=\frac{\pounds 2,336}{\pounds 45,794}\\ =5.10\%\end{array}$ $\begin{array}{c}=\frac{\pounds 45,564+\pounds 46,023}{2}\\ =\pounds 45,794\end{array}$	$\begin{array}{c}=\frac{\pounds 2,671}{\pounds 46,615}\\ =5.73\%\end{array}$ $\begin{array}{c}=\frac{\pounds 46,023+\pounds 47,206}{2}\\ =\pounds 46,615\end{array}$
i. Return on common stockholders’ equity: $\frac{\text{Net income }-\text{Preferred dividends}}{\left[\begin{array}{l}\text{Average common }\\ \text{stockholders' equity}\end{array}\right]}$	$\begin{array}{c}=\frac{\pounds 2,336-\pounds 0}{\pounds 13,794\left(3\right)}\\ =16.93\%\end{array}$	$\begin{array}{c}=\frac{\pounds 2,671-\pounds 0}{\pounds 15,652\left(4\right)}\\ =17.06\%\end{array}$

Table (1)

Note: Quick assets include cash, short term investments and accounts receivable (net).

Analysis of trends:

1. a. The current ratio of Company T has slightly decreased in the year 2011.
2. b. The quick ratio of Company T has decreased drastically in the year 2011.
3. c. The receivables turnover ratio of Company T has decreased from 30.69 times in 2010 to 29 times in 2011.
4. d. The inventory turnover ratio of Company T has decreased from 19.38 times in 2010 to 18.97 times in 2011.
5. e. The Debt equity ratio of Company T has declined in 2011(0.77) as compared in 2010 (1.04).
6. f. The number of times interest earned ratio has increased drastically in 2011 (8.31) as compared in 2010 (6.49).
7. g. The return on sales of Company T has slightly increased from 4.10% in 2010 to 4.38% in 2011.
8. h. The return on assets of Company T has increased drastically from 5.10% in 2010 to 5.73% in 2011.
9. i. The return on common stockholders’ equity of Company T has increased from 16.93% in 2010 to 17.06% in 2011.

Explanation of Solution

Financial Ratios: Financial ratios are the tools used to evaluate the liquidity, capabilities, profitability, and overall performance of a company.

1. a. Current ratio: Current ratio is one of the liquidity ratios, which measures the capacity of the company to meet its short-term obligations using its current assets. Current ratio is calculated by using the formula:

$\text{Current ratio}=\frac{\text{Current Assets}}{\text{Current Liabilities}}$

1. b. Quick ratio: It is a ratio used to determine a company’s ability to pay back its current liabilities by liquid assets that are current assets except inventory and prepaid expenses.

$\text{Quick ratio}=\frac{\text{Quick Assets}}{\text{Current Liabilities}}$

1. c. Receivables turnover ratio: Receivables turnover ratio is mainly used to evaluate the collection process efficiency. It helps the company to know the number of times the accounts receivable is collected in a particular time period. This ratio is determined by dividing credit sales and sales return.

$\text{Receivables turnover}=\frac{\text{}\text{Net credit sales}}{\text{Average accounts receivables}}$

1. d. Inventory Turnover Ratio: This ratio is a financial metric used by a company to quantify the number of times inventory is used or sold during the accounting period. It is calculated by using the formula:

$\text{Inventory turnover}=\frac{\text{Cost of goods sold}}{\text{Average inventory}}$

1. e. Debt–to-equity ratio: The debt-to-equity ratio indicates that the company’s debt as a proportion of its stockholders’ equity. The debt-to-equity ratio is calculated using the formula:
   
   

$\text{Debt-to-equity ratio}=\frac{\text{Total liabilities}}{\text{Total stockholders' equity}}$

1. f. Number of times interest was earned: Number of times interest is earned quantifies the number of times the earnings before interest and taxes can pay the interest expense. First, determine the sum of income before income tax and interest expense. Then, divide the sum by interest expense.

$\begin{array}{l}\text{Number of times }\\ \text{interest is earned}\end{array}\}=\frac{\text{Earnings before interest and taxes expense}}{\text{Interest expense}}$

1. g. Return on sales: It is one of the profitability ratios. Profit margin ratio is used to measure the percentage of net income that is being generated per dollar of revenue or sales.

$\text{Net margin}=\frac{\text{Net income}}{\text{Net sales}}$

1. h. Return on assets: Return on assets is the financial ratio which determines the amount of net income earned by the business with the use of total assets owned by it. It indicates the magnitude of the company’s earnings with relative to its total assets. Return on investment is calculated as follows:

$\text{Return on investments}=\frac{\text{Net income }}{\text{Average total assets}}$

1. i. Return on common stockholders’ equity ratio: It is a profitability ratio that measures the profit generating ability of the company from the invested money of the shareholders. The formula to calculate the return on equity is as follows:

$\text{Return on equity}=\frac{\text{Net income}}{\text{Average stockholders' equity}}\times 100$

Working Note:

Determine the amount of earnings before interest and expenses for 2010.

$\begin{array}{c}\begin{array}{l}\text{Earnings before income }\\ \text{tax and interest}\end{array}\}=\left(\begin{array}{l}\text{Profits }\\ \text{after tax}\end{array}\right)+\left(\begin{array}{l}\text{Tax}\\ \text{ expense}\end{array}\right)\\ =\text{£3,176 million}+\text{ £579 million}\\ =\text{£3,755 million}\end{array}$ (1)

Determine the amount of earnings before interest and expenses for Year 2011.

$\begin{array}{c}\begin{array}{l}\text{Earnings before income }\\ \text{tax and interest}\end{array}\}=\left(\begin{array}{l}\text{Profits }\\ \text{after tax}\end{array}\right)+\left(\begin{array}{l}\text{Tax}\\ \text{ expense}\end{array}\right)\\ =\text{£3,535 million}+\text{ £483 million}\\ =\text{£4,018 million}\end{array}$ (2)

Determine the average common stockholders’ equity for Year 2010.

$\begin{array}{c}\begin{array}{l}\text{Average Common }\\ \text{Stockholders' Equity }\end{array}]=\frac{\left(\begin{array}{l}\text{Beginning Common Stockholders' Equity }\\ +\text{Ending Common Stockholders' Equity}\end{array}\right)}{2}\\ =\frac{\text{£12,906}+\text{£14,681}}{2}\\ =\text{£}13,794\end{array}$ (3)

Determine the average common stockholders’ equity for Year 2011.

$\begin{array}{c}\begin{array}{l}\text{Average Common }\\ \text{Stockholders' Equity }\end{array}]=\frac{\left(\begin{array}{l}\text{Beginning Common Stockholders' Equity }\\ +\text{Ending Common Stockholders' Equity}\end{array}\right)}{2}\\ =\frac{\pounds 14,681+\pounds 16,623}{2}\\ =\pounds 15,652\end{array}$ (4)