1. By looking at trends, an analyst hopes to get some idea of whether a
situation is improving, remaining the same, or deteriorating. Such
analyses can provide insight into what is likely to happen in the
future. Rather than looking at trends, an analyst may compare one
company to another or to industry averages using common-size financial
statements.
2. Ratios highlight relationships, movements, and trends that are very
difficult to perceive looking at the raw underlying data standing
alone. Also, ratios make financial data easier to grasp by putting
the data into perspective. As to the limitation in the use of ratios,
refer to page 129.
3. Price-earnings ratios are determined by how investors see a firm's
future prospects. Current reported earnings are generally considered
to be useful only so far as they can assist investors in judging what
will happen in the future. For this reason, two firms might have the
same current earnings, but one might have a much higher price-earnings
ratio if investors view it to have superior future prospects. In some
cases, firms with very small current earnings enjoy very high price-
earnings ratios. This is simply because investors view these firms as
having very favorable prospects for earnings in future years. By
definition, a stock with current earnings of P4 and a price-earnings
ratio of 20 would be selling for P80 per share.
4. A manager's financing responsibilities relate to the acquisition of
assets for use in his or her company. The acquisition of assets can
be financed in a number of ways, including through issue of ordinary
shares, through issue of preference shares, through issue of long-term
debt, through leasing, etc. A manager's operating responsibilities
relate to how these assets are used once they have been acquired. The
return on total assets ratio is designed to measure how well a manager
is discharging his or her operating responsibilities. It does this by
looking at a company's income before any consideration is given as to
how the income will be distributed among capital resources, i.e.,
before interest deductions.
5. Financial leverage, as the term is used in business practice, means
obtaining funds from investment sources that require a fixed annual
rate of return, in the hope of enhancing the well-being of the
ordinary shareholders. If the assets in which these funds are
invested earn at a rate greater that the return required by the
suppliers of the funds, then leverage is positive in the sense that
the excess accrues to the benefit of the ordinary shareholders. If
the return on assets is less than the return required by the suppliers
of the funds, then leverage is negative in the sense that part of the
earnings from the assets provided by the ordinary shareholders will
have to go to make up the deficiency.
6. How a shareholder would feel would depend in large part on the
stability of the firm and its industry. If the firm is in an industry
that experiences wide fluctuations in earnings, then shareholders
might be very pleased that no interest-paying debt exists in the
firm's capital structure. In hard times, interest payments might be
very difficult to meet, or earnings might be so poor that negative
leverage would result.
7. No, the stock is not necessarily overpriced. Book value represents
the cumulative effects on the balance sheet of past activities
evaluated using historical prices. The market value of the stock
reflects investors' beliefs about the company's future earning
prospects. For most companies market value exceeds book value because
investors anticipate future growth in earnings.
8. A company in a rapidly growing technological industry probably would
have many opportunities to invest its earnings at a high rate of
return; thus, one would expect it to have a low dividend payout ratio.
9. It is more difficult to obtain positive financial leverage from
preference shares than from long-term debt due to the fact that
interest on long-term debt is tax deductible, whereas dividends paid
on preference shares are not tax deductible.
10. The current ratio would probably be highest during January, when both
current assets and current liabilities are at a minimum. During peak
operating periods, current liabilities generally include short-term
borrowings that are used to temporarily finance inventories and
receivables. As the peak periods end, these short-term borrowings are
paid off, thereby enhancing the current ratio.
11. A 2-to-1 current ratio might not be adequate for several reasons.
First, the composition of the current assets may be heavily weighted
toward slow-turning inventory, or the inventory may consist of large
amounts of obsolete goods. Second, the receivables may be large and
of doubtful collectibility, or the receivables may be turning very
slowly due to poor collection procedures.
12. Expenses (including the cost of goods sold) have been increasing at
an even faster rate than net sales. Thus Sunday is apparently having
difficulty in effectively controlling its expenses.
13. If the company's earnings are very low, they may become almost
insignificant in relation to stock price. While this means that the
p/e ratio becomes very high, it does not necessarily mean that
investors are optimistic. In fact, they may be valuing the company at
its liquidation value rather than a value based upon expected future
earnings.
14. From the viewpoint of the company's shareholders, this situation
represents a favorable use of leverage. It is probable that little
interest, if any, is paid for the use of funds supplied by current
creditors, and only 11% interest is being paid to long-term
bondholders. Together these two sources supply 40% of the total
assets. Since the firm earns an average return of 16% on all assets,
the amount by which the return on 40% of the assets exceeds the fixed-
interest requirements on liabilities will accrue to the residual
equity holders – the ordinary shareholders – raising the return on
equity.
15. The length of operating cycle of the two companies cannot be
determined from the fact the one company's current ratio is higher.
The operating cycle depends on the relationships between receivables
and sales, and between inventories and cost of goods sold. The
company with the higher current ratio might have either small amounts
of receivables and inventories, or large sales and cost of sales,
either of which would tend to produce a relatively short operating
cycle.
16. The investor is calculating the rate of return by dividing the
dividend by the purchase price of the investment (P5 ( P50 = 10%). A
more meaningful figure for rate of return on investment is determined
by relating dividends to current market price, since the investor at
the present time is faced with the alternative of selling the stock
for P100 and investing the proceeds elsewhere or keeping the
investment. A decision to retain the stock constitutes, in effect, a
decision to continue to invest P100 in it, at a return of 5%. It is
true that in a historical sense the investor is earning 10% on the
original investment, but this is interesting history rather than
useful decision-making information.
17. A corporate net income of P1 million would be unreasonably low for
a large corporation, with, say, P100 million in sales, P50 million in
assets, and P40 million in equity. A return of only P1 million for a
company of this size would suggest that the owners could do much
better by investing in insured bank savings accounts or in government
bonds which would be virtually risk-free and would pay a higher
return.
On the other hand, a profit of P1 million would be unreasonably high
for a corporation which had sales of only P5 million, assets of, say,
P3 million, and equity of perhaps one-half million pesos. In other
words, the net income of a corporation must be judged in relation to
the scale of operations and the amount invested.
The changes from 2005 to 2006 are all favorable. Sales increased and
the gross profit per peso of sales also increased. These two factors led
to a substantial increase in gross profit. Although operating expenses
increased in peso amount, the operating expenses per peso of sales
decreased from 29 cents to 28 cents. The combination of these three
favorable factors caused net income to rise from 4 cents to 6 cents out
of each peso of sales.
Problem 2 (Measures of Liquidity)
Requirement (a)
Current assets:
Cash P 47,600
Marketable securities 175,040
Accounts receivable 230,540
Inventory 179,600
Unexpired insurance 4,500
Total current assets P637,280
Current liabilities:
Notes payable P 70,000
Accounts payable 125,430
Salaries payable 7,570
Income taxes payable 14,600
Unearned revenue 10,000
Total current liabilities P227,600
Requirement (b)
The current ratio is 2.8 to 1. It is computed by dividing the current
assets of P637,280 by the current liabilities of P227,600. The amount of
working capital is P409,680, computed by subtracting the current
liabilities of P227,600 from the current assets of P637,280.
The company appears to be in a strong position as to short-run debt-
paying ability. It has almost three pesos of current assets for each
peso of current liabilities. Even if some losses should be sustained in
the sale of the merchandise on hand or in the collection of the accounts
receivable, it appears probable that the company would still be able to
pay its debts as they fall due in the near future. Of course, additional
information, such as the credit terms on the accounts receivable, would
be helpful in a careful evaluation of the company's current position.
The company's major problem seems to be the increase in cost of goods
sold, which increased from 60.0% of sales in 2005 to 63.2% of sales in
2006. This suggests that the company is not passing the increases in
costs of its products on to its customers. As a result, cost of goods
sold as a percentage of sales has increased and gross margin has
decreased. Selling expenses and interest expense have both increased
slightly during the year, which suggests that costs generally are going
up in the company. The only exception is the administrative expenses,
which have decreased from 14.6% of sales in 2005 to 13.6% of sales in
2006. This probably is a result of the company's efforts to reduce
administrative expenses during the year.
Problem 4 (Comparing Operating Results with Average Performance in the
Industry)
Ms. Freeze's operating results are significantly better than the average
performance within the industry. As a percentage of sales revenue, Ms.
Freeze's operating income and net income after nearly twice the average
for the industry. As a percentage of total assets, Ms. Freeze's profits
amount to an impressive 23% as compared to 14% for the industry.
The key to Ms. Freeze's success seems to be its ability to earn a
relatively high rate of gross profit. Ms. Freeze's exceptional gross
profit rate (51%) probably results from a combination of factors, such as
an ability to command a premium price for the company's products and
production efficiencies which lead to lower manufacturing costs.
As a percentage of sales, Ms. Freeze's selling expenses are five points
higher than the industry average (21% compared to 16%). However, these
higher expenses may explain Ms. Freeze's ability to command a premium
price for its products. Since the company's gross profit rate exceeds
the industry average by 8 percentage points, the higher-than-average
selling costs may be part of a successful marketing strategy. The
company's general and administrative expenses are significantly lower
than the industry average, which indicates that Ms. Freeze's management
is able to control expenses effectively.
Problem 5 (Common-Size Statements)
Requirement 1
The income statement in common-size form would be:
Note: Columns do not total down in all cases due to rounding
differences.
Requirement 2
The company's cost of goods sold has increased from 60 percent of sales
in 2005 to 65 percent of sales in 2006. This appears to be the major
reason the company's profits showed so little increase between the two
years. Some benefits were realized from the company's cost-cutting
efforts, as evidenced by the fact that operating expenses were only 26.3
percent of sales in 2006 as compared to 30.4 percent in 2005.
Unfortunately, this reduction in operating expenses was not enough to
offset the increase in cost of goods sold. As a result, the company's
net income declined from 5.6 percent of sales in 2005 to 5.3 percent of
sales in 2006.
"(1) Current ratio: " "
" Current assets (Req. a) "P1,514.8 "
" Current liabilities "P1,939.0 "
" Current ratio (P1,514.8 ( P1,939.0) "0.8 to 1 "
" " "
"(2) Quick ratio: " "
" Quick assets (Req. a) "P 227.5 "
" Current liabilities "P1,939.0 "
" Quick ratio (P227.5 ( P1,939.0) "0.1 to 1 "
" " "
"(3) Working capital: " "
" Current assets (Req. a) "P1,514.8 "
" Less: Current liabilities "P1,939.0 "
" Working capital "P(424.2) "
Requirement (c)
No. It is difficult to draw conclusions from the above ratios. Alabang
Supermarket's current ratio and quick ratio are well below "safe" levels,
according to traditional rules of thumb. On the other hand, some large
companies with steady ash flows are able to operate successfully with
current ratios lower than Alabang Supermarket's.
Requirement (d)
Due to characteristics of the industry, supermarkets tend to have
smaller amounts of current assets and quick assets than other types of
merchandising companies. An inventory of food has a short shelf life.
Therefore, the inventory of a supermarket usually represents only a few
weeks' sales. Other merchandising companies may stock inventories
representing several months' sales. Also, supermarkets sell primarily
for cash. Thus, they have relatively few receivables. Although
supermarkets may generate large amounts of cash, it is not profitable for
them to hold assets in this form. Therefore, they are likely to reinvest
their cash flows in business operations as quickly as possible.
Requirement (e)
In evaluating Alabang Supermarket's liquidity, it would be useful to
review the company's financial position in prior years, statements of
cash flows, and the financial ratios of other supermarket chains. One
might also ascertain the company's credit rating from an agency such as
Dun & Bradstreet.
Note to Instructor: Prior to the year in which the data for this problem
was collected, Alabang Supermarket had reported a negative retained
earnings balance in its balance sheet for several consecutive periods.
The fact that Alabang Supermarket has only recently removed the deficit
from its financial statements is also worrisome.
Problem 7 (Balance Sheet Measures of Liquidity and Credit Risk)
"(1) Quick ratio: " "
" Quick assets (Req. a) "P127,003 "
" Current liabilities (Req. a) "P 55,306 "
" Quick ratio (P127,003 ( P55,306) "2.3 to 1 "
" " "
"(2) Current ratio: " "
" Current assets (Req. a) "P164,949 "
" Current liabilities (Req. a) "P 55,306 "
" Current ratio (P164,949 ( P55,306) "3.0 to 1 "
" " "
" " "
"(3) Working capital: " "
" Current assets (Req. a) "P164,949 "
" Less: Current liabilities (Req. a) " 55,306 "
" Working capital "P109,643 "
" " "
"(4) Debt ratio: " "
" Total liabilities (given) "P 81,630 "
" Total assets (given) "P353,816 "
" Debt ratio (P81,630 ( P353,816) "23.1% "
Requirement (c)
(1) From the viewpoint of short-term creditors, Bonbon Sweets' appear
highly liquid. Its quick and current ratios are well above normal
rules of thumb, and the company's cash and marketable securities alone
are almost twice its current liabilities.
(2) Long-term creditors also have little to worry about. Not only is
the company highly liquid, but creditors' claims amount to only 23.1%
of total assets. If Bonbon Sweets' were to go out of business and
liquidate its assets, it would have to raise only 23 cents from every
peso of assets for creditors to emerge intact.
(3) From the viewpoint of shareholders, Bonbon Sweets' appears overly
liquid. Current assets generally do not generate high rates of
return. Thus, the company's relatively large holdings of current
assets dilutes its return on total assets. This should be of concern
to shareholders. If Bonbon Sweets is unable to invest its highly
liquid assets more productively in its business, shareholders probably
would like to see the money distributed as dividends.
Problem 8 (Selected Financial Measures for Short-term Creditors)
* P100,000 total par value ÷ P5 par value per share = 20,000 shares
Problem 10 (Selected Financial Ratios for Ordinary Shareholders)
1. Earnings per share:
2. Dividend payout ratio:
3. Dividend yield ratio:
4. Price-earnings ratio:
Problem 11 (Selected Financial Ratios for Ordinary Shareholders)
1. Return on total assets:
2. Return on ordinary shareholders' equity:
3. Financial leverage was positive, since the rate of return to the
ordinary shareholders (13.8%) was greater than the rate of return on
total assets (10.5%). This positive leverage is traceable in part to
the company's current liabilities, which may carry no interest cost,
and to the bonds payable, which have an after-tax interest cost of
only 7%.
The following points can be made from the analytical work in parts (1)
and (2) above:
The company has improved its profit margin from last year. This is
attributable to an increase in gross margin, which is offset somewhat by
an increase in operating expenses. In both years the company's net
income as a percentage of sales equals or exceeds the industry average of
4%.
Although the company's working capital has increased, its current
position actually has deteriorated significantly since last year. Both
the current ratio and the acid-test ratio are well below the industry
average, and both are trending downward. (This shows the importance of
not just looking at the working capital in assessing the financial
strength of a company.) Given the present trend, it soon will be
impossible for the company to pay its bills as they come due.
The drain on the cash account seems to be a result mostly of a large
buildup in accounts receivable and inventory. This is evident both from
the common-size balance sheet and from the financial ratios. Notice that
the average age of the receivables has increased by 5 days since last
year, and that it is now 9 days over the industry average. Many of the
company's customers are not taking their discounts, since the average
collection period is 27 days and collection terms are 2/10, n/30. This
suggests financial weakness on the part of these customers, or sales to
customers who are poor credit risks. Perhaps the company has been too
aggressive in expanding its sales.
The inventory turned only 5 times this year as compared to over 6 times
last year. It takes three weeks longer for the company to turn its
inventory than the average for the industry (71 days as compared to 50
days for the industry). This suggests that inventory stocks are higher
than they need to be.
In the authors' opinion, the loan should be approved on the condition
that the company take immediate steps to get its accounts receivable and
inventory back under control. This would mean more rigorous checks of
creditworthiness before sales are made and perhaps paring out of slow
paying customers. It would also mean a sharp reduction of inventory
levels to a more manageable size. If these steps are taken, it appears
that sufficient funds could be generated to repay the loan in a
reasonable period of time.
Case 2 (Financial Ratios for Ordinary Shareholders)
Investors regard Metro Building Supply less favorably than other firms
in the industry. This is evidenced by the fact that they are willing
to pay only 7.3 times current earnings for a share of the company's
stock, as compared to 9 times current earnings for the average of all
stocks in the industry. If investors were willing to pay 9 times
current earnings for Metro Building Supply's stock, then it would be
selling for about P55 per share (9 × P6.16), rather than for only P45
per share.
A market price in excess of book value does not mean that the price of
a stock is too high. Market value is an indication of investors'
perceptions of future earnings and/or dividends, whereas book value is
a result of already completed transactions and is geared to the past.
c. Financial leverage is positive in both years, since the return on
ordinary equity is greater than the return on total assets. This
positive financial leverage is due to three factors: the preference
shares, which has a dividend of only 8%; the bonds, which have an
after-tax interest cost of only 7.2% [12% interest rate × (1 – 0.40) =
7.2%]; and the accounts payable, which may bear no interest cost.
Requirement 3
We would recommend keeping the stock. The stock's downside risk seems
small, since it is selling for only 7.3 times current earnings as
compared to 9 times earnings for the average firm in the industry. In
addition, its earnings are strong and trending upward, and its return on
ordinary equity (16.6%) is extremely good. Its return on total assets
(10.4%) compares favorably with that of the industry.
The risk, of course, is whether the company can get its cash problem
under control. Conceivably, the cash problem could worsen, leading to an
eventual reduction in profits through inability to operate, a reduction
in dividends, and a precipitous drop in the market price of the company's
stock. This does not seem likely, however, since the company can easily
control its cash problem through more careful management of accounts
receivable and inventory. If this problem is brought under control, the
price of the stock could rise sharply over the next few years, making it
an excellent investment.
" "c."Leverage is positive for this year, since the "
" " "return on ordinary equity (9.2%) is greater than "
" " "the return on total assets (6.8%). For last year,"
" " "leverage is negative since the return on the "
" " "ordinary equity (4.9%) is less than the return on "
" " "total assets (5.1%). "
Notice from the data given in the problem that the average P/E ratio
for companies in Helix's industry is 10. Since Helix Company
presently has a P/E ratio of only 7.8, investors appear to regard it
less well than they do other companies in the industry. That is,
investors are willing to pay only 7.8 times current earnings for a
share of Helix Company's stock, as compared to 10 times current
earnings for a share of stock for the average company in the industry.
" " " " " "
" "e."Equity "P3,200,000 "P3,040,000"
" " "Less preference shares " " "
" " " " 600,000 " 600,000"
" " "Ordinary equity (a) "P2,600,000 "P2,440,000"
" " " " " "
" " "Number of ordinary shares "50,000 "50,000 "
" " "(b) " " "
" " "Book value per share (a) ÷ "P52.00 "P48.80 "
" " "(b) " " "
Note that the book value of Helix Company's stock is greater than the
market value for both years. This does not necessarily indicate that
the stock is selling at a bargain price. Market value is an
indication of investors' perceptions of future earnings and/or
dividends, whereas book value is a result of already completed
transactions and is geared to the past.
Requirement 3
" " " "This Year "Last Year "
" "a."Current assets "P2,600,000 "P1,980,000"
" " "Current liabilities " 1,300,000" "
" " " " " 920,000"
" " "Working capital "P1,300,000 "P1,060,000"
" " " " " "
" "b."Current assets (a) "P2,600,000 "P1,980,000"
" " "Current liabilities (b) "P1,300,000 "P920,000 "
" " "Current ratio (a) ÷ (b) "2.0 to 1 "2.15 to 1 "
" " " " " "
" "c."Quick assets (a) "P1,220,000 "P1,120,000"
" " "Current liabilities (b) "P1,300,000 "P920,000 "
" " "Acid-test ratio (a) ÷ (b) "0.94 to 1 "1.22 to 1 "
" " " " " "
" "d."Sales on account (a) "P5,250,000 "P4,160,000"
" " "Average receivables (b) "P750,000 "P560,000 "
" " "Accounts receivable "7.0 times "7.4 times "
" " "turnover (a) ÷ (b) " " "
" " "Average age of receivables,"52 days "49 days "
" " "365 ÷ turnover " " "
" " " " " "
" "e."Cost of goods sold (a) "P4,200,000 "P3,300,000"
" " "Average inventory (b) "P1,050,000 "P720,000 "
" " "Inventory turnover (a) ÷ "4.0 times "4.6 times "
" " "(b) " " "
" " "Number of days to turn "91 days "79 days "
" " "inventory, " " "
" " "365 days ÷ turnover " " "
" " "(rounded) " " "
" " " " " "
" "f."Total liabilities (a) "P2,500,000 "P1,920,000"
" " "Equity (b) "P3,200,000 "P3,040,000"
" " "Debt-to-equity ratio (a) ÷ "0.78 to 1 "0.63 to 1 "
" " "(b) " " "
" " " " " "
" "g."Net income before interest "P520,000 "P340,000 "
" " "and taxes (a) " " "
" " "Interest expense (b) "P120,000 "P100,000 "
" " "Times interest earned (a) ÷"4.3 times "3.4 times "
" " "(b) " " "
Requirement 4
As stated by Meri Ramos, both net income and sales are up from last year.
The return on total assets has improved from 5.1% last year to 6.8% this
year, and the return on ordinary equity is up to 9.2% from 4.9% the year
before. But this appears to be the only bright spot in the company's
operating picture. Virtually all other ratios are below the industry
average, and, more important, they are trending downward. The
deterioration in the gross margin percentage, while not large, is
worrisome. Sales and inventories have increased substantially, which
should ordinarily result in an improvement in the gross margin percentage
as fixed costs are spread over more units. However, the gross margin
percentage has declined.
Notice particularly that the average age of receivables has lengthened to
52 days—about three weeks over the industry average—and that the
inventory turnover is 50% longer than the industry average. One wonders
if the increase in sales was obtained at least in part by extending
credit to high-risk customers. Also notice that the debt-to-equity ratio
is rising rapidly. If the P1,000,000 loan is granted, the ratio will
rise further to 1.09 to 1.
In the author's opinion, what the company needs is more equity—not more
debt. Therefore, the loan should not be approved. The company should be
encouraged to make another issue of ordinary stock in order to provide a
broader equity base on which to operate.
Case 4 (Statement Reconstruction Using Ratios)
Bulacan Company
Income Statement
For the Year Ended December 31, 2005
Sales P140,800
Less: Cost of Sales (4) 84,480
Gross Profit P 56,320
Less: Expenses 46,320
Net Income (1) P 10,000
Bulacan Company
Balance Sheet
December 31, 2005
A s s e t s
Current Assets:
Cash P 27,720
Accounts Receivable (5) 28,160
Merchandise Inventory (3) 21,120
Total Current Assets (2) P 77,000
Fixed Assets (8) 55,000
Total Assets P132,000
Liabilities and Equity
Current Liabilities:
Accounts Payable (2) P 44,000
Equity:
Share Capital (issued 20,000
shares) (6) P40,000
Retained Earnings 48,000 88,000
Total Liabilities and Equity P132,000
Supporting Computations:
(1) Earnings Per Share =
P0.50 =
X (Net Income) = P10,000
(2) Current Assets Pxx 1.75
Current Liabilities xx 1
Working Capital P33,000 0.75
Current Liabilities = P33,000 ( 0.75
= P44,000
(3) Current Ratio =
1.27 =
X (Current Assets) = P77,000
Quick Ratio =
1.27 =
X (Current Assets) = P55,880
Current Assets P77,000
Quick Assets 55,800
Inventory P21,120
(4) Inventory turnover =
4 =
X (Cost of Sales) = P84,480
(5) Average age of outstanding =
Accounts Receivable
= 73 days (Average age of
receivables)
= 5
= 5
X (Receivables) = P28,160
Another Method:
= 73 days = P28,160 Accounts receivable
(6) Earnings for the year as a percentage of Share Capital
= 25%
Share Capital = P40,000
(7) Current Fixed Current Liabilities +
Assets Assets = Equity
P77,000 + 0.625X = P44,000 + X
0.375X = P33,000
X = P88,000 Equity
(8) Fixed Assets to Equity
= 0.625
= 0.625
X (Fixed Assets) = P55,000
Case 5 (Ethics and the Manager)
Requirement 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 no more than four times net
operating income. These ratios are computed below:
The company would fail to qualify for the loan because both its current
ratio and its acid-test ratio are too low.
Requirement 2
By reclassifying the P45 thousand net book value of the old machine as
inventory, the current ratio would improve, but there would be no effect
on the acid-test ratio. This happens because inventory is considered to
be a current asset but is not included in the numerator when computing
the acid-test ratio.
Even if this tactic had succeeded in qualifying the company for the
loan, we strongly advise against it. Inventories are assets the company
has acquired for the sole purpose of selling them to outsiders in the
normal course of business. Used production equipment is not considered to
be inventory—even if there is a clear intention to sell it in the near
future. Since the loan officer would not expect used equipment to be
included in inventories, doing so would be intentionally misleading.
Nevertheless, the old equipment is an asset that could be turned into
cash. If this were done, the company would immediately qualify for the
loan since the P45 thousand in cash would be included in the numerator in
both the current ratio and in the acid-test ratio.
However, other options may be available. After all, the old machine is
being used to relieve bottlenecks in the plastic injection molding
process and it would be desirable to keep this standby capacity. We
would advise Rome to fully and honestly explain the situation to the loan
officer. The loan officer might insist that the machine be sold before
any loan is approved, but he might instead grant a waiver of the current
ratio and acid-test ratio requirements on the basis that they could be
satisfied by selling the old machine. Or he may approve the loan on the
condition that the equipment is pledged as collateral. In that case, Rome
would only have to sell the machine if he would otherwise be unable to
pay back the loan.
V. Multiple Choice Questions
"A "C "B "C "41. C " "
"C "A "D "D " " "
"D "C "A "C " " "
"B "B "C "A " " "
"A "D "A "A " " "
"D "B "C "C " " "
"C "A "D "A " " "
"D "C "A "A " " "
"A "A "D "C " " "
"B "C "A "C " " "
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= 1.8 (rounded)
P290,000
P164,000
Current rate =
Current assets
Current liabilities
Current ratio =
Acid-test ratio =
Cash + Marketable securities + Accounts receivable
Current liabilities
Acid-test ratio =
P80,000 + P0 + P460,000
P520,000
= 1.04 to 1 (rounded)
= 2.9 to 1 (rounded)
P1,200,000
P420,000
Current rate =
Current assets
Current liabilities
Current ratio =
Gross margin
Sales
= 40%
P840,000
P2,100,000
=
=
= 2.45 to 1
P490,000
P200,000
Current assets
Current liabilities
=
= 0.91 to 1 (rounded)
P181,000
P200,000
Quick assets
Current liabilities
=
= 14 times
P2,100,000
P150,000
Sales
Average accounts receivables
= 26.1 days (rounded)
365 days
14 times
= 81.1 days to turn (rounded)
365 days
4.5 times
=
= 4.5 times
P1,260,000
P280,000
Cost of goods sold
Average inventory
=
= 0.63 to 1 (rounded)
P500,000
P800,000
Total liabilities
Total equity
=
= 6.0 times
P180,000
P30,000
Earnings before interest
and income taxes
Interest expense