AFM101 Chapter Notes - Chapter 10: Current Liability, Contingent Liability, Working Capital
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This term you have learned to understand a companyâs financial story using the language of accounting. The recording and reporting of information is essential to decision makers and other users of financial information; numbers on the various financial statements are used to help further understand the financial condition of the business. This process is known as financial ratio analysis and allows us to analyze the companyâs financial position in relation to other organizations in the industry. In this final assignment, you will apply the concepts you have learned throughout the term to perform financial statement analysis and to offer some recommendations.
Assume that you are a health care consultant hired by the Dependable DME Company. DME is Durable Medical Equipment and includes all equipment that benefits patients who have certain medical conditions. The owner of the company, David Smith, is interested in applying for a loan to expand his business; he desires to open a second location in another city. He is preparing to apply to a local bank for a loan.
The bank will base its decision on the following averages for the DME industry:
| Ratio | Industry Average |
| Current ratio | 1.50 |
| Quick ratio | 0.80 |
| Receivables turnover ratio | 18.0 |
| Inventory turnover ratio | 20.0 |
| Debt to assets ratio | 0.56 |
| Profit margin | 10.25% |
The balance sheet data for Dependable DME Company follows:
| December 31, 2017 | December 31, 2016 | |
| Cash | $75,000 | $60,000 |
| Accounts receivable | 40,000 | 20,000 |
| Inventory | 30,000 | 20,000 |
| Prepaid insurance | 5,000 | 5,000 |
| Total current assets | 140,000 | 105,000 |
| Property and equipment | 600,000 | 550,000 |
| Accumulated depreciation | 140,000 | 110,000 |
| Total property and equipment | 460,000 | 440,000 |
| Total assets | $600,000 | $545,000 |
| Accounts payable | $60,000 | $60,000 |
| Other current liabilities | 40,000 | 45,000 |
| Total current liabilities | 100,000 | 105,000 |
| Bonds payable | 150,000 | 150,000 |
| Total liabilities | 250,000 | 255,000 |
| Common stock | 250,000 | 250,000 |
| Retained earnings | 100,000 | 40,000 |
| Total stockholdersâ equity | 350,000 | 290,000 |
| Total liabilities and stockholdersâ equity | $600,000 | $545,000 |
The income statement data for Dependable DME Company follows:
| Sales | $600,000 |
| Cost of goods sold | 350,000 |
| Gross profit | $250,000 |
| Operating expenses | 100,000 |
| Operating income | $150,000 |
| Interest expense | 25,000 |
| Income before taxes | $125,000 |
| Income tax expense | 65,000 |
| Net income | $60,000 |
Required:
Calculate the following six (6) ratios: Current Ratio, Quick Ratio, Receivables Turnover Ratio, Inventory Turnover Ratio, Profit Margin Ratio and Debt to Assets Ratio. Be sure to show the actual calculation as well as your final answer.
You are only required to calculate the ratios for 2017; however, for two of the ratios (Receivables Turnover Ratio and Inventory Turnover Ratio), you will need data from 2016 for the formula. When calculating the Quick Ratio, please note that Short-Term Investments are $0 in this scenario. (24 points; 4 points for each ratio calculation)
Below each ratio, comment on the interpretation of the ratio. In other words, what does the result tell you, specifically? (8 points)
Based upon the industry averages upon which the bank relies, should they approve the loan to Mr. Smith? Why or why not? (7 points)
In one-half page, comment on what financial aspect of Dependable DME Company looks good and where can Mr. Smith make some improvements. Specifically identify at least two recommendations to Mr. Smith that can be made to improve the financial position of his business. (8 points)
QUESTION 1
Determine the cost of sales for a firm with the following financial ratios and data:
Current ratio = 3.0; Quick ratio = 2.0; Current liabilities $1,000,000; Inventory turnover 6 times
| a. | $6,000,000 | |
| b. | $3,000,000 | |
| c. | $2,000,000 | |
| d. | $1,000,000 |
8.3 points
QUESTION 2
What would be the times interest earned of a company, if its total interest charges are $20,000, sales are $220,000, and its net profit margin is 6 percent? Assume a tax rate of 40 percent.
| a. | 2.65 | |
| b. | 2.1 | |
| c. | 1.1 | |
| d. | 1.2 |
8.3 points
QUESTION 3
A firm's current ratio is 1.5 and its quick ratio is 1.0. If its current liabilities are $10,000, what are its inventories?
| a. | $20,000 | |
| b. | $ 5,000 | |
| c. | $10,000 | |
| d. | $15,000 |
8.3 points
QUESTION 4
If a firm wishes to retain the same return on equity when its net profit margin and total asset turnover has declined, it must
| a. | increase its equity multiplier | |
| b. | increase sales and increase assets | |
| c. | decrease its equity multiplier | |
| d. | reduce sales and increase assets |
8.3 points
QUESTION 5
The sales-to-inventory ratio:
| a. | is technically inferior to other commonly used ratios. | |
| b. | is superior to the inventory turnover ratio. | |
| c. | as a determination of financial performance, is good comparison tool. | |
| d. | was developed by the Dupont Corporation and is satisfactory when used to make comparisons between the firm and the industry as a whole. |
8.5 points
QUESTION 6
Primary sources of comparative financial data include
| a. | Dun and Bradstreet | |
| b. | Richard Moore, Inc. | |
| c. | Framingham Financial Library | |
| d. | New York Times |
8.3 points
QUESTION 7
____ indicate the ability of the firm to meet its short-term financial obligations
| a. | Leverage ratios | |
| b. | Profitability ratios | |
| c. | Activity ratios | |
| d. | Liquidity ratios |
8.3 points
QUESTION 8
If a firmâs common size income statement shows that the earnings after tax percentage is too low, the firm may have spent too much money:
| a. | on total assets as a percentage of long-term liabilities. | |
| b. | on cost of goods sold as a percentage of sales. | |
| c. | on taxes paid as a percentage of stockholdersâ equity. | |
| d. | on expenses as a percentage of current assets. |
8.3 points
QUESTION 9
The ____ ratio indicates the percentage of a firm's earnings that are distributed as dividends.
| a. | payout | |
| b. | earnings | |
| c. | return on earnings | |
| d. | dividend yield |
8.3 points
QUESTION 10
The work of the external independent auditor includes a letter that states that the financial information represents fairly the financial position of the company and that these statements were:
| a. | based on the company's accounting information system (AIS) | |
| b. | constructed in conformity with generally accepted accounting principles | |
| c. | developed using management's choice of accounting enhancement techniques | |
| d. | an accurate picture of the company's market position |
8.3 points
QUESTION 11
The greater the amount of financial leverage used by a firm, the greater its ____, all other things being equal.
| a. | liquidity | |
| b. | profitability | |
| c. | size | |
| d. | risk |
8.3 points
QUESTION 12
The type of ratio that indicates the firmâs ability to provide adequate returns in the form of dividends and share price appreciation is:
| a. | Profitability ratios | |
| b. | Asset management ratios | |
| c. | Financial leverage management ratios | |
| d. | Liquidity ratios |
8.5 points
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