Question

Chapter 3 problem #37.on pages 88-89 Ratio computation and analysis (LO2) Given the financial statements for Jones Corporation and Smith Corporation shown here:

  a. To which one would you, as credit manager for a supplier, approve the extension of (short-term) trade credit? Why? Compute all ratios before answering.

  b. In which one would you buy stock? Why?

JONES CORPORATION
Current Assets		Liabilities
Cash.............................................	$ 20,000	Accounts payable..................	$100,000
Accounts receivable.....................	80,000	Bonds payable (long-term)....	80,000
Inventory......................................	50,000
Long-Term Assets		Stockholders’ Equity
Fixed assets..................................	$500,000	Common stock.......................	$150,000
Less: Accumulated depreciation	(150,000)	Paid-in capital......................	70,000
Net fixed assets*..........................	350,000	Retained earnings.................	100,000
Total assets...............................	$500,000	Total liabilities and equity........	$500,000

Sales (on credit)....................................................................	$1,250,000
Cost of goods sold...............................................................	750,000
Gross profit..........................................................................	500,000
Selling and administrative expense†..................................	257,000
Less: Depreciation expense...............................................	50,000
Operating profit....................................................................	193,000
Interest expense....................................................................	8,000
Earnings before taxes...........................................................	185,000

Tax expense...........................................................................	$ 92,500
Net income............................................................................	$ 92,500

*Use net fixed assets in computing fixed asset turnover.

†Includes $7,000 in lease payments.

SMITH CORPORATION
Current Assets		Liabilities
Cash................................	$ 35,000	Accounts payable..................	$  75,000
Marketable securities......	7,500	Bonds payable (long-term)....	210,000
Accounts receivable........	70,000
Inventory........................	75,000
Long-Term Assets		Stockholders’ Equity
Fixed assets.....................	$500,000	Common stock......................	$75,000
Less: Accum. dep.........	(250,000)	Paid-in capital........................	30,000
Net fixed assets*............	250,000	Retained earnings..................	47,500
Total assets................	$437,500	Total liab. and equity...........	$437,500

*Use net fixed assets in computing fixed asset turnover.

SMITH CORPORATION
Sales (on credit)....................................................................	$1,000,000
Cost of goods sold................................................................	600,000
Gross profit...........................................................................	400,000
Selling and administrative expense†...................................	224,000
Less: Depreciation expense................................................	50,000
Operating profit....................................................................	126,000
Interest expense....................................................................	21,000
Earnings before taxes............................................................	105,000
Tax expense...........................................................................	52,500
Net income............................................................................	$52,500

†Includes $7,000 in lease payments.

Answer 1

a]

current ratio = current assets / current liabilities

Jones : (20,000 + 80,000 + 50,000) / 100,000 = 1.50

Smith : (35,000 + 7,500 + 70,000 + 75,000) / 75,000 = 2.50

quick ratio = (Cash equivalents + marketable securities + accounts receivables) / Current Liabilities

Jones : (20,000 + 80,000) / 100,000 = 1.00

Smith : ((35,000 + 7,500 + 70,000) / 75,000 = 1.50

Current ratio and quick ratio measure the liquidity position of the firm, and its ability to meet short-term obligations. Higher the current/quick ratio, better the liquidity position.

As credit manager for a supplier, I would approve the extension of (short-term) trade credit to Smith Corporation as its liquidity position is better as indicated by its higher current ratio and higher quick ratio

b]

Net profit margin = net income / sales

Jones : 92,500 / 1,250,000 = 7.4%

Smith : 52,500 / 1,000,000 = 5.25%

Return on assets = net income / total assets

Jones : 92,500 / 500,000 = 18.5%

Smith : 52,500 / 437,500 = 12%

Debt ratio = total debt / total assets

Jones : (100,000 + 80,000) / 500,000 = 36%

Smith : (75,000 + 210,000) / 437,500 = 65.14%

I would buy stock in Jones Corporation because :

• it has better profitability as indicated by net profit margin and return on assets
• lower financial risk as indicated by its debt ratio.