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RETURN ON EQUITY AND QUICK RATIO Lloyd Inc. has sales of $300,000, a net income of...

RETURN ON EQUITY AND QUICK RATIO

Lloyd Inc. has sales of $300,000, a net income of $24,000, and the following balance sheet: Cash $78,000 Accounts payable $71,760 Receivables 101,400 Notes payable to bank 46,800 Inventories 374,400 Total current liabilities $118,560 Total current assets $553,800 Long-term debt 113,100 Net fixed assets 226,200 Common equity 548,340 Total assets $780,000 Total liabilities and equity $780,000 The new owner thinks that inventories are excessive and can be lowered to the point where the current ratio is equal to the industry average, 2.25x, without affecting sales or net income.

1. If inventories are sold and not replaced (thus reducing the current ratio to 2.25x); if the funds generated are used to reduce common equity (stock can be repurchased at book value); and if no other changes occur, by how much will the ROE change? Do not round intermediate calculations. Round your answer to two decimal places.

2. What will be the firm's new quick ratio? Do not round intermediate calculations. Round your answer to two decimal places.

Solutions

Expert Solution

Industries Current ratio = 2.25

Current ratio = Current Assets/Current Liabilities

Let us assuming new inventory as per Industries Current Assets be X.

Current ratio = (Current Assets - Old Inventory + New Inventory)/Current Liabilities

2.25 = (553,800 - 374,400 + X)/118,560

266,760 =179,400 + X

X = $87,360

So, new Inventory = $87,360

Decrease in Inventory = Old Inventory - New Inventory

=$374,400 - $87,360

=$287,040

Decrease in Inventory will occur with solding off and the funds generated out of it will be used to repurcahse Equity at book value.

Common Equity after repurchase = $548,340 - $287,040

= $261,300

- ROE before repurchase = Net Income/Common Equity

=$24,000/$548340

=4.38%

- ROE after repurchase = Net Income/Common Equity

=$24,000/$261,300

=9.18%

So, Change in ROE after Repurchase is 4.80% (9.18%-4.38%)

2. Firm's New Quick ratio:-

Quick ratio = Cash + Accounts Receivables/Current Liabilities

= (78,000 + 101400)/118560

= 1.51 times

Note- Decrease in inventory will not affect Cash as funds obtained by selling inventory will be paid as Repurchase of shares. Thus, Nill affect on Cash.

jeff jeffy answered 1 year ago

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