Financial Ratios(Quick Test #5 with Coaching)

Working capital is an amount derived by the following subtraction: current assets minus current liabilities.

In this question, the current assets are cash (and cash equivalents) of $20,000 + temporary investments of $30,000 + accounts receivable of $50,000 + inventory of $150,000. Therefore, the total amount of current assets as of December 31 was $250,000.

The total amount of current liabilities was given as $200,000.

Based on the above amounts, CB Corporation's working capital is $50,000, calculated as follows: current assets of $250,000 minus current liabilities of $200,000.

The current ratio, which is sometimes referred to as the working capital ratio, is calculated by dividing the total amount of current assets by the total amount of the current liabilities.

The current ratio is a partial indicator of a company's ability to pay its current liabilities when they come due. Therefore, a larger current ratio is better than a smaller one.

In this question, the current assets are cash (and cash equivalents) of $30,000 + temporary investments of $10,000 + accounts receivable of $60,000 + inventory of $200,000. Therefore, the total amount of current assets as of December 31 was $300,000. The total amount of current liabilities was given as $150,000.

Therefore, MaxCorp's current ratio is 2 (or 2 to 1, or 2:1) calculated as follows: $300,000 of current assets divided by $150,000 of current liabilities.

The quick ratio is also known as the acid test ratio. This ratio assumes that a company's inventory cannot be converted to cash quickly. Therefore, the quick ratio compares a company's total amount of a company's cash and cash equivalents + temporary investments + accounts receivable to the total amount of current liabilities.

In this question, TopCorp's "quick" assets = $50,000 + $20,000 + $130,000 = $200,000.

The total amount of current liabilities was $300,000.

Therefore, the quick ratio is $200,000 divided by $300,000 = 0.67 (or 0.67 to 1).

The debt to equity ratio indicates the corporation's use of financial leverage. Debt is the total amount of current liabilities + noncurrent (long-term) liabilities. In other words, debt is the amount of money provided by creditors.

On December 31, Jake Corporation had debt of $1,100,000 consisting of $475,000 of current liabilities + $625,000 of noncurrent liabilities. Its stockholders' equity was given as $400,000.

Therefore, Jake Corporation's debt to equity ratio was $1,100,000 to $400,000 or $1,100,000 divided by $400,000 = 2.75. In other words, Jake Corporation is using a relatively large amount of creditors' money in relationship to its stockholders' money.

The debt to total assets ratio is another way to assess a company's use of financial leverage. It indicates the percent of a company's total assets that were provided by creditors. The amount owed to creditors is the sum of a company's current and noncurrent liabilities.

AMP Corporation's debt at December 31 was $2,200,000 consisting of current liabilities of $950,000 + noncurrent liabilities of $1,250,000. AMP's total assets were given at $3,000,000.

Therefore, AMP's debt to total assets ratio on December 31 was $2,200,000 to $3,000,000 or $2,200,000 divided by $3,000,000 = 0.73. This means that 73% of the assets' cost came from creditors (and the remaining 27% came from stockholders).

A company's gross profit is calculated by subtracting the cost of goods sold from net sales. For its recent year, JamCorp's gross profit was $150,000 (net sales of $500,000 minus the cost of goods sold of $350,000).

Gross margin is the gross profit expressed as a percent of net sales. JamCorp's gross margin last year was 30%, which is the $150,000 of gross profit divided by the net sales of $500,000.

A corporation's profit margin (after tax) expresses the corporation's net income after tax as a percent of net sales.

Using the amounts from KeyCorp's income statement, its net income after tax was $60,000 ($75,000 minus $15,000).

Therefore, KeyCorp's profit margin is its net income after tax of $60,000 divided by the net sales of $1,000,000 = 6%.

A regular U.S. corporation is a business entity which is separate from its owner(s). Therefore, the salary earned by a stockholder working in this corporation is an expense of the corporation and it will be reported on the corporation's income statement.

A company organized as a sole proprietorship is not separate from its owner. As a result, the owner's draws are NOT reported on the company's income statement. (The draws are reported as a deduction from the company's owner's equity account, and the balance in the owner's equity account is reported on the company's balance sheet.)

A regular U.S. corporation such as MarCorp is a business entity which is separate from its owner(s). This type of corporation must file a U.S. corporate income tax return and MarCorp is responsible for paying the corporate income taxes on its taxable income. As a result, the corporation's income tax expense is reported on the MarCorp's income statement. Any corporate income taxes that are owed are reported as a liability on MarCorp's balance sheet.

On the other hand, a sole proprietorship is a business entity which is not considered to be separate from its owner. Therefore, Joe must report the net income of JSP Company on his personal income tax return. The income statement for JSP Company will NOT report income tax expense, nor will its balance sheet report an income tax liability.

Here are some key points:

1. A corporation's earnings (net income) occurred throughout the entire year
2. The number of shares of common stock may have changed during the year
3. If shares of stock were issued, the corporation had more money to invest
4. If shares of its own stock were purchased by the corporation, the corporation had less money to invest

Given the above points, it is logical that the corporation's earnings per share for the year should be calculated using the (weighted) average number of shares of common stock outstanding during the year.

The interest coverage ratio is also known as the times interest earned. It is one indicator of a company's ability to make the required interest payments on its loans.

The first step in calculating this ratio is to determine the company's net income before interest expense and income tax expense.

One way is to start with the company's net income after tax and then add back the interest expense and income tax expense that had been deducted.

In the case of JEL Corporation, we begin with its $90,000 of net income after tax and then add back the $20,000 of interest expense and $10,000 of income tax expense. The resulting amount is $120,000.

JEL Corporation's interest coverage ratio is calculated by dividing the $120,000 by the $20,000 of interest expense. The result is an interest coverage ratio of 6.

This tells a lender that in its recent year, JEL Corporation earned its interest expense of $20,000 six times over.

The receivables turnover ratio is calculated by dividing the net credit sales for a year by the average amount of accounts receivable throughout the year.

Since ABC Corp's accounts receivable increased steadily from $85,000 at the beginning of the year to $115,000 at the end of the year, the average balance was approximately $100,000.

Therefore, ABC's receivables turnover ratio is the $800,000 of credit sales divided by the $100,000 average of the accounts receivable. The result is a receivables turnover ratio of 8.

The average collection period is also known as the days' sales in receivables. A simple way to calculate this ratio is to divide 360 or 365 days in a year by the receivables turnover ratio.

In this question, the receivables turnover ratio is 8, computed by dividing the year's credit sales of $800,000 by the average accounts receivable of $100,000.

The average collection period = 360 or 365 days divided by 8 (the receivables turnover ratio) = approximately 45 days.

Net sales are based on units sold times each unit's selling price. On the other hand, inventory is based on each unit's cost. Therefore, when calculating the inventory turnover ratio the cost of goods sold (not net sales) for the year is divided by the average cost of the inventory during the year.

Since PAL's cost of inventory increased consistently from $90,000 to $110,000, the average cost of the inventory throughout the year was approximately $100,000.

Next, PAL's cost of goods sold of $400,000 is divided by $100,000 of average inventory cost to arrive at an inventory turnover ratio of 4.

The days' sales in inventory is also known as days to sell. This is calculated by dividing 360 or 365 days in a year by the inventory turnover ratio.

ZEB Corporation's inventory turnover ratio is 4, calculated by dividing the cost of goods sold of $800,000 by $200,000, which was the average cost of inventory throughout the year.

The days' sales in inventory = 360 or 365 days in the year divided by the inventory turnover ratio of 4 = approximately 90 days.

MoCorp's earnings of $800,000 were earned throughout the entire year.

MoCorp's stockholders' equity (a section of MoCorp's balance sheet) can change during the year for the following reasons:

• It increases by the amount of MoCorp's earnings
• It decreases by the amount of dividends declared
• It increases by the amount received when issuing new shares of stock
• It decreases by the amount spent to repurchase shares of its own common stock

Stockholders' equity does not reflect nor is it adjusted for changes in the market value of MoCorp's common stock.

Therefore, the return on MoCorp's stockholders' equity is 10%, calculated by dividing the earnings of $800,000 by the average amount of stockholders' equity which was $8,000,000.

Free cash flow is defined as the following: Net cash provided (used) by operating activities minus the amount of capital expenditures (that were required).

The net cash provided (used) by operating activities is the total for the first section of the statement of cash flows (SCF or cash flow statement).

Capital expenditures are amounts spent to add or improve property, plant and equipment (PPE). The amount is reported on the SCF within the section entitled cash flows from investing activities.

A corporation's annual financial statements are published approximately one month after the accounting year has ended. Hence, any amounts taken from the corporation's income statement and/or balance sheet reflect transactions that occurred prior to the start of the current year.

Financial ratios are NOT valuable when compared to the financial ratios of corporations in different industries.

A common-size income statement is created by dividing every amount on a company's income statement by the amount of its net sales.

Net sales is the amount of gross sales minus the amount of sales returns, sales allowances, and discounts for early payment. For example, gross sales might be 104.6% and sales returns, allowances and discounts might be (4.6%), and net sales would be presented as 100.0%.

Further, the common-size income statement will automatically present the cost of goods sold, gross profit, selling, general and administrative expense, interest expense, profit margin, etc. as a percent of net sales. The percentages allow management to quickly review the results for the period indicated on the income statement.

Another benefit of a common-size income statement is that management can compare the company's percentages to other companies' percentages in its industry regardless of the size of the other companies.

A common-size balance sheet is created by dividing every amount on the balance sheet by the amount reported as total assets.

This allows a person to quickly see that the company's property, plant and equipment is perhaps 60% of its total assets. It also allows the reader to see that the company's total stockholders' equity is a certain percent of total assets.

A common-size balance sheet allows management to compare its balance sheet to other companies' balance sheets in its industry, regardless of the size of the companies.