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Solutions for chapter 5

By Elizabeth Jones,2014-07-02 13:45
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Solutions for chapter 5

Solutions for Chapter 5

E56

a. Current Ratio = Current Assets ? Current Liabilities

2006 2005 2004

current assets 5029 5239 6304

current liabilities 2272 1942 2242

current ratio=

current assets/

current liabilities 2.21 2.70 2.81

b. Gross Profit as a % of Sales = Gross Profit ? Net Sales

2006 2005 2004

gross profit 5649 5869 6381

sales 15943 16023 16267

gross profit/sales 0.35 0.37 0.39

c. Inventory Turnover = Cost of Goods Sold ? Average Inventory

Average Days Supply of Inventory = 365 ? Inventory Turnover

2006 2005

COGS 10294 10154

beginning inventory 1696 1814

ending inventory 1796 1696

average inventory 1746 1755

inventory turnover 5.90 5.79

average days' supply 62 63

d. Over the three-year period, current ratio has decreased;solvency position may be

worsening, as has the profitability per sale. Inventory turnover has improved, reducing the

average shelf time of the inventory by one day.

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E57

a. Current Ratio = Current Assets ? Current Liabilities

2006: \$20,000 ? \$8,000 = 2.500

2007: \$24,000 ? \$13,000 = 1.846

2008: \$31,000 ? \$25,000 = 1.240

2009: \$35,000 ? \$30,000 = 1.167

Debt/Equity Ratio = average Total Liabilities ? average Total Stockholders' Equity

2006: (\$8,000 + \$15,000) ? (\$20,000 + \$10,000) = 0.7667

2007: ((\$13,000 + \$35,000+ \$8,000 + \$15,000)/2)/((\$20,000 + \$20,000+\$20,000 + \$10,000) /2)= 1.0143

2008: ((\$25,000 + \$40,000+ \$13,000 + \$35,000)/2) ? (\$20,000 + \$32,000 +\$20,000 + \$20,000)/2) = 1.2283

2009: ((\$30,000 + \$40,000+ \$25,000 + \$40,000)/2) ? (\$20,000 + \$38,000 +\$20,000 + \$32,000)/2) = 1.2273

Return on Assets = (Net Income + [Interest Expense (1 Tax Rate)]) ? Average Total

Assets

2006: (\$13,000 + [\$2,000 (1 - .3)]) ? [(\$53,000] = 0.272

2007: (\$14,000 + [\$4,000 (1 - .3)]) ? [(\$53,000 + \$88,000) ? 2] = 0.238

2008: (\$21,000 + [\$5,000 (1 - .3)]) ? [(\$88,000 + \$117,000) ? 2] = 0.239

2009: (\$24,000 + [\$5,000 (1 - .3)]) ? [(\$117,000 + \$128,000) ? 2] = 0.224

b. 2006 2005 2004 2003

Current assets 27.34% 26.50% 27.27% 37.74%

Noncurrent assets 72.66 73.50 72.73 62.26

Total assets 100.00% 100.00% 100.00% 100.00%

Current liabilities 23.44% 21.37% 14.77% 15.09%

Long-term liabilities 31.25 34.19 39.77 28.30

Capital stock 15.62 17.09 22.73 37.74

Retained earnings 29.69 27.35 22.73 18.87

Total liabilities and

stockholders' equity 100.00% 100.00% 100.00% 100.00%

c. Solvency measures a company's ability to meet its debts as they come due. The current ratio

provides one measure of a company's solvency. Based upon this ratio, Lotechnic has sufficient

current assets to meet its current obligations. However, the trend in its current ratio indicates

that the company's excess of current assets over current liabilities is decreasing. Therefore,

the company has relatively fewer current assets available to meet its current obligations. This

trend indicates that Lotechnic Enterprises' solvency position may be worsening.

The debt/equity ratio provides an indication of a company's capitalization, which, in turn,

indicates how risky a company is. Lotechnic is relying increasingly on debt relative to

stockholders' equity to finance operations. At some point in time, the company will have to

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repay this debt. The company will either have to repay this debt by (1) generating cash from operations, (2) selling assets, (3) borrowing additional cash, or (4) acquiring cash by issuing stock. From the statement of cash flows, the cash generated from operations has been decreasing and is now negative; therefore, it appears that the company cannot rely on operations to generate cash. The statement of cash flows also indicates that the company has been using cash for investment purposes every year. This implies that the company may have some assets that it could sell. But if these assets are used in operations, the company's operations may be adversely affected by selling them.

Since total assets equal the sum of total liabilities and stockholders' equity, the proportion of total liabilities to the sum of total liabilities and stockholders' equity reported on the common-size balance sheet equals the proportion of total liabilities to total assets. This measure indicates the proportion of total assets (based upon book value) that would have to be sold to satisfy all the company's obligations. To meet its obligations, Lotechnic Enterprises would have to sell approximately 55% of its total assets, which would virtually decimate its asset base.

Based upon the trend in the current ratio, the debt/equity ratio, cash flows from operations, and the proportion of total liabilities to total assets, it appears that Lotechnic Enterprises may face severe solvency problems as its long-term debt matures.

Earning power is defined as a company's ability to increase its wealth through operations and to generate cash from operations. Earning power and solvency are closely related. A company must have adequate resources to generate wealth. If a company experiences solvency problems, it will most likely have to divert its resources to paying its obligations. Therefore, due to its solvency problems, Lotechnic Enterprises may not have strong earning power. Although Lotechnic's net income has increased every year, the company's effectiveness at managing capital, as indicated by ROA, has decreased every year. This trend indicates that the company may have limited earning power. This conclusion is also supported by the trend in the company's cash flows from operations.

It must be remembered, however, that this analysis is based on very limited information. To adequately analyze a company, additional information would be needed. Complete financial statements, financial information for similar companies, and general economic information should all be considered when analyzing a company's earning power and solvency position.

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