Problem 16-18 (continued)
2.
a.
Sabin Electronics
Common-Size Balance Sheets
This Year
Last Year
Current assets:
Cash ………………………………………………
2.3
%
%
Marketable securities …………………………
0.0
Accounts receivable, net …………………….
16.0
Inventory ………………………………………..
31.7
Prepaid expenses ……………………………..
0.7
Total current assets ……………………………..
50.7
Plant and equipment, net ……………………..
49.3
Total assets ……………………………………….
100.0
%
%
Current liabilities …………………………………
26.7
%
%
Bonds payable, 12% …………………………...
Total liabilities ………………………………….
Common stock, $10 par ……………………..
Retained earnings …………………………….
28.3
Total liabilities and equity ……………………..
%
%
Problem 16-18 (continued)
b.
Sabin Electronics
Common-Size Income Statements
This Year
Last Year
Sales ……………………………………………..
100.0
%
%
Cost of goods sold …………………………...
77.5
Gross margin …………………………..………
22.5
Selling and administrative expenses ……..
13.1
Net operating income ………………………..
Interest expense ………………………………
Net income before taxes …………………….
Income taxes …………………………………..
Net income ……………………………………..
%
%
and (2) above:
a. The company’s current position has deteriorated significantly since
last year. Both the current ratio of 1.9 and the acid-test ratio of 2.53
are well below the industry averages of 2.5 and 1.3, respectively, and
are trending downward. At the present rate, it will soon be impossible
for the company to pay its bills as they come due.
b. The drain on the cash account seems to be a result mostly of a large
buildup in accounts receivable and inventory. Notice that the average
Problem 16-18 (continued)
c. The inventory turned only 5.0 times this year as compared to 6.3
times last year. It takes nearly two weeks longer for the company to
turn its inventory than the average for the industry (73 days as
compared to 60 days for the industry). This suggests that inventory
stocks are higher than they need to be.
e. In the authors’ opinion, the loan should be approved only if the
company gets its accounts receivable and inventory back under
control. If the accounts receivable collection period is reduced to
Problem 16-19 (45 minutes)
This Year
Last Year
1.
a.
Net income (a) ……………………………….
$280,000
$196,000
Average number of common shares* (b)
50,000
50,000
Earnings per share (a) ÷ (b) ……………..
$5.60
$3.92
* $750,000 ÷ $15 par value per share = 50,000 shares
Dividends per share (a) ……………………
Dividend yield ratio (a) ÷ (b) …………….
Dividends per share (a) ……………………
$1.90
Earnings per share (b) ……………………..
$5.60
$3.92
Dividend payout ratio (a) ÷ (b) ………….
d.
Market price per share (a) ………………..
$40.00
$36.00
Earnings per share (b) ……………………..
$5.60
$3.92
Price-earnings ratio (a) ÷ (b) …………….
7.14
9.18
Problem 16-19 (continued)
This Year
Last Year
e.
Total stockholders’ equity (a) ………………..
$1,600,000
$1,430,000
Number of common shares outstanding
[see requirement 1(a)] (b) …………………
50,000
50,000
Book value per share (a) ÷ (b) ……………..
$32.00
$28.60
This Year
Last Year
2.
a.
Gross margin (a) ……………………………..
$1,125,000
$900,000
Sales (b) ………………………………………..
$5,000,000
$4,350,000
Gross margin percentage (a) ÷ (b) ………
22.5%
20.7%
b.
Net income (a) ………………………………..
$280,000
$196,000
Sales (b) ………………………………………..
$5,000,000
$4,350,000
Net profit margin percentage (a) ÷ (b) …
5.6%
4.5%
c.
Net income …………………………………….
Add after-tax cost of interest paid:
Total (a) …………………………………………
Average total assets (b) …………………….
$2,730,000
Return on total assets (a) ÷ (b) ………….
12.1%
d.
Net income (a) ………………………………..
$ 280,000
$ 196,000
Return on equity (a) ÷ (b) …………………
13.8%
Problem 16-19 (continued)
e. Financial leverage is positive in both years because the return on
equity is greater than the return on total assets. This positive financial
leverage is due to two factors: the bonds, which have an after-tax
interest cost of only 8.4% [12% interest rate × (1 – 0.30) = 8.4%];
and the accounts payable, which may bear no interest cost.
3. All profitability measures and the earnings per share are trending
Problem 16-20 (45 minutes)
1. The loan officer stipulated that the current ratio prior to obtaining the
loan must be higher than 2.0, the acid-test ratio must be higher than
1.0, and the interest on the loan must be less than four times net
operating income. These ratios are computed below:
Current assets
Current ratio =
Current liabilities
$290,000
= = 1.8 (rounded)
$164,000
Problem 16-20 (continued)
2. By reclassifying the $45 thousand net book value of the old machine as
inventory, the current ratio would improve, but the acid-test ratio would
be unaffected. Inventory is considered a current asset for purposes of
computing the current ratio, but is not included in the numerator when
computing the acid-test ratio.
Current assets
Current ratio =
Current liabilities
$290,000 + $45,000
= = 2.0 (rounded)
$164,000
Acid-test ratio =
Cash + Marketable securities + Accounts
receivables + Short – term notes receivable
Current liabilities
Problem 16-20 (continued)
Nevertheless, the old machine is an asset that could be turned into
cash. If this were done, the company would immediately qualify for the
loan because the $45,000 in cash would be included in the numerator in
both the current ratio and in the acid-test ratio.
Current assets
Current ratio =
Current liabilities
$290,000 + $45,000
= = 2.0 (rounded)
$164,000
Problem 16-21 (60 minutes or longer)
Pepper Industries
Income Statement
For the Year Ended March 31
Key to
Computation
Sales…………………………………………
$4,200,000
Cost of goods sold ……………………….
2,730,000
(h)
Gross margin ………………………………
1,470,000
(i)
Selling and administrative expenses …
930,000
(j)
Net operating income ……………………
540,000
(a)
Interest expense …………………………
Net income before taxes ……………….
460,000
(b)
Income taxes (30%) …………………….
138,000
Net income ………………………………..
(d)
Pepper Industries
Balance Sheet
March 31
Current assets:
Cash ………………………………………
$ 70,000
(f)
Accounts receivable, net ……………..
330,000
(e)
Inventory ………………………………..
480,000
(g)
Total current assets ……………………..
880,000
(g)
Plant and equipment …………………….
1,520,000
(q)
Total assets ………………………………..
$2,400,000
(p)
Current liabilities ………………………….
Bonds payable, 10% …………………….
800,000
(k)
Total liabilities …………………………….
1,120,000
Common stock, $5 par value………..
700,000
Retained earnings ……………………..
580,000
(o)
(n)
Total liabilities and equity ………………
$2,400,000
(p)
Problem 16-21 (continued)
Computation of missing amounts:
= 6.75
Therefore, the earnings before interest and taxes for the year must be
$540,000.
b. Net income before taxes = $540,000 – $80,000 = $460,000
e.
Sales on account
Accounts receivable =
turnover Average accounts receivable balance
$4,200,000
=
Average accounts receivable balance
= 14.0
Therefore, the average accounts receivable balance for the year must
f.
Cash + Marketable securities + Current receivables
Acid-test ratio= Current liabilities
Problem 16-21 (continued)
Therefore, the total quick assets must be $400,000. Because there are
no marketable securities, no short-term notes receivable, and the
accounts receivable are $330,000, the cash must be $70,000.
i. Gross margin = $4,200,000 – $2,730,000 = $1,470,000.
j.
Net operating income = Gross margin – Operating expenses
Operating expenses = Gross margin – Net operating income
= $1,470,000 – $540,000
= $930,000
Problem 16-21 (continued)
k. The interest expense for the year was $80,000 and the interest rate was
10%, the bonds payable must total $800,000.
l. Total liabilities = $320,000 + $800,000 = $1,120,000
Therefore, the total stockholders’ equity must be $1,280,000.
o.
Total stockholders’ equity = Common stock + Retained earnings
Retained earnings = Total stockholders’ equity – Common Stock
= $1,280,000 – $700,000 = $580,000
Problem 16-21 (continued)
p.
Total assets = Liabilities + Stockholders‘ equity
= $1,120,000 + $1,280,000 = $2,400,000
This answer can also be obtained using the return on total assets:
Net income + [Interest expense × (1 – Tax rate)]
Return on =
total assets Average total assets
Therefore, the average total assets must be $2,100,000. Since the total
assets at the beginning of the year were $1,800,000, the total assets at
the end of the year must have been $2,400,000 (which would also equal
the total of the liabilities and the stockholders’ equity).
q.
Total assets = Current assets + Plant and equipment