Financial Accounting, 8th Edition
Financial Accounting, 8th Edition
8th Edition
ISBN: 9780078025556
Author: Robert Libby, Patricia Libby, Daniel Short
Publisher: McGraw-Hill Education
Question
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Chapter 13, Problem 8P
To determine

Compute the appropriate ratios for Company P.

Expert Solution & Answer
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Answer to Problem 8P

Compute the appropriate ratios for Company P.

 RatioFormulaCalculationResult
 Profitability ratios
1Return on Equity (ROE)NetIncomeAverageTotalStockholder'Equity($14,000(($30,000+$12,000)+($30,000+$5,000))÷2)36.36%
2Return on Assets (ROA)NetIncomeAverageTotalAssets($14,000($103,000+$97,000)÷2)14.00%
3Financial leverage percentageROEROA36.3614.0021.64%
4Net profit marginNetIncomeNet Sales Revenue$14,000$190,0007.36%
5Earnings per share (EPS)NetIncome(Weighted Average Number of common Shares Outstanding)$14,0006,000shares$2.33
 Turnover ratios
6Fixed asset turnoverNetSalesRevenueAverageNetFixedAssets$190,000($45,000+$38,000)÷24.57 times
7Receivables turnover Net CreditSalesAverageNet Receivables$190,000×33.33%($14,000+$18,000)÷23.95  times
8Inventory turnoverCost of Goods SoldAverage Inventory$112,000($40,000+$34,000)÷23.02  times
 Liquidity ratios
9Current ratioCurrentAssetsCurrentLiabilities($4,000+$14,000+$$40,000)$16,0003.625  times
10Quick ratioQuickAssetsCurrentLiabilities($4,000+$14,000)$16,0001.125  times
11Cash ratioCash & Cash EquivalentsCurrentLiabilities$4,000$16,0000.25  times
 Solvency ratio
12Debt-to-equity ratioTotalLiabilitiesTotalStockholder'sEquity$61,000$42,0001.45  times
13Time interest earned ratioNet Income+Interest +Income Tax ExpenseInterest Expense($14,000+$$4,500+$8,000)$4,5005.8  times
 Market ratios
14Price/Earnings (P/E) ratioMarket Price per ShareEarningsper Share$28$2.3312.017  times

Table (1)

Explanation of Solution

1. Return on equity ratio:

Rate of return on equity ratio is used to determine the relationship between the net income available for the common stockholders’ and the average common equity that is invested in the company.

Return on Equity=NetIncomeAverageTotalStockholder'Equity

Return on equity ratio of Company P is 36.36%.

2. 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 Assets (ROA)=NetIncomeAverageTotalAssets

Return on assets ratio of the Company P is 14%.

3. Financial Leverage Percentage:

Financial Leverage Percentage is one of the profitability ratios. It measures that the assets held by a company proportionate to its common stock (Equity). It measures the advantages or disadvantages that occur due to variance between the return on equity and return on assets.

Financial Leverage Precentage=RateofReturnonEquityRateofReturnonAssets

Financial leverage percentage of the Company P is 21.64%.

4. Profit margin:

Profit margin ratio is used to determine the percentage of net income that is being generated per dollar of revenue or sales.

Net profit margin=NetIncomeNet Sales Revenue

Profit margin of the Company P is 7.37%.

5. Earnings per share:

Earnings per share help to measure the profitability of a company. Earnings per share are the amount of profit that is allocated to each share of outstanding stock.

EPS=NetIncome(Weighted Average Number of common Shares Outstanding)

Earnings per share of the Company P are $2.33.

6. Fixed Asset turnover:

Fixed 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.

Fixed Assets turnoverratio=NetSalesRevenueAverageNetFixedAssets

Fixed assets turnover of the Company P is 4.58 times.

7. 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.

Receivables Turnover Ratio=Net SalesAverageAccountsReceivables

Receivables turnover of the Company P is 3.96 times.

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

Inventory Turnover Ratio =Cost of Goods Sold Average Inventory

Inventory turnover of the Company P is 3.02 times.

9. 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. The ideal current ratio is 2:1. The following formula is used to calculate current ratio.

Current ratio=CurrentAssetsCurrentLiabilities

Current ratio of the Company P is 3.63 times.

10. 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.

Quick Ratio=QuickAssetsCurrentLiabilities

Quick ratio of the Company P is 1.13 times.

11. Cash ratio:

This ratio is used to measure the adequacy of the cash in the business.

Cash & Cash EquivalentsCurrentLiabilities

Cash ratio of the Company P is 0.25 times.

12. Debt-equity ratio:

The debt-to-equity ratio indicates that the company’s debt as a proportion of its stockholders’ equity.

Debt-equity ratio=TotalLiabilitiesTotalStockholder'sEquity

Debt-to-equity ratio of the Company P is 1.45 times.

13. Times Interest Earned Ratio:

It is one of the solvency ratios. It is a measure to evaluate the net income for interest payment on debt of a company. It is calculated as follows:

Times Interest earned ratio=Net Income+ Interest Expense+Income Tax ExpenseInterest Expense

Times interest earned ratio of the Company P is 5.88 times

14. Price/Earnings Ratio: It depicts the relation of market price of a share to earnings per share of that company. The price/earnings ratio presents the market value of the amount invested to earn $1 by a company. It is major tool to be used by investors before the decisions related to investments in a company.

Price/Earnings Ratio=Market Price per Share Earnings per Share

Price/earnings ratio of the Company P is 12.02 times

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