Question

The following information is taken from the financial statements of Knights, Inc.

From the balance sheet:
Cash		$ 30,000
Accounts receivable		150,000
Inventory		200,000
Plant assets (net of accumulated depreciation)		500,000
Current liabilities		150,000
Total stockholders’ equity		300,000
Total assets		1,000,000
From the income statement:
Net sales		$1,500,000
Cost of goods sold		1,080,000
Operating expenses		315,000
Interest expense		84,000
Income tax expense		6,000
Net income		15,000
From the statement of cash flows:
Net cash provided by operating activities (including interest paid of $79,000)		$ 40,000
Net cash used in investing activities		(46,000)
Financing activities:
Amounts borrowed	$ 50,000
Repayment of amounts borrowed	(14,000)
Dividends paid	(20,000)
Net cash provided by financing activities		16,000
Net increase in cash during the year		$ 10,000

Instructions

Explain how the interest expense shown in the income statement could be $84,000, when the interest payment appearing in the statement of cash flows is only $79,000.

Compute the following (round to one decimal place):

Current ratio

Quick ratio

Working capital

Debt ratio

Comment on these measurements and evaluate Knights, Inc.’s short-term debt-paying ability.

Compute the following ratios (assume that the year-end amounts of total assets and total stockholders’ equity also represent the average amounts throughout the year).

Return on assets

Return on equity

Comment on the company’s performance under these measurements. Explain why the return on assets and return on equity are so different.

Discuss (1) the apparent safety of long-term creditors’ claims and (2) the prospects for Knights, Inc., continuing its dividend payments at the present level.

Answer 1

1 . Interest expense shown in income statement is $84000 whereas interest payment appearing in statement of Cash flow is only $79000 because interest exp in income statement is shown on accrual basis, whereas interest paid shown in cash flow statement is shown on cash basis, this, any outstanding interest for the year will not be shown in statement of Cash whereas it will be shown in income statement , Since, it has occurred. Thus, if interest paid is $79000 and interest exp is $84000 then it means outstanding interest for the year would have increased by $5000.

2. Current ratios = current asset / current liabilities

= (30000+150000+200000)/150000

= 380000/150000 = 2.53

3. Quick ratio = quick assets (current assets-inventory)/current liabilities

= (380000-200000)/150000

= 180000/150000 = 1.2

4 . Working capital = current assets - current liabilities

= 380000-150000 = $230000.

5 . Debt ratio = total liabilities /total assets

Here total liabilities = Total assets - stockholders equity = 1000000-300000 = 700000

= 700000/1000000 = 0.7

Clearly , we can see that current ratios and quick ratios of them company is above which shows that for every 1 dollar of current liability company has more than 1 dollar of current assets. Also we can see that working capital of the company is positive.

Concluding all these facts we can say short term debt paying ability of company is strong.

6. Return on total assets = net income / total assets

= (15000/1000000)x100 = 1.5%

7 . Return on equity = net income / stockholder equity

= (15000/300000)x100 = 5%

Company is able to give 1.5% return on total assets invested by it.

Company is able to give 5% return to equityholder

Both the ratios are not very exceptional and are pretty ordinary.

Return on total assets and return on equity is so different because both the ratios present different perspective. Return on assets shows how efficiently assets have been used by the company and shows how much Return company is able to generste from The total assets invested in the business whereas return on equity shows how much Return company is able to give to it's stockholders. That is why both the ratios are different

(1); we can see that debt ratio of the company is 0.7 which means share of debt in total assets of the company is 70% . Also it shows that company has sufficient total assets to cover its longit's long term debt obligation

(2) . Current dividend payment by the company is $20000. Whereas current availability of cash with the company is around $30000 only. However, company has Cash more than the amount of dividend that it has distributed in previous year but it has to keep sufficient reserve of cash with it to meet future uncertainties. Thus it may reduce its current level of dividend in order to safeguard itself from any future uncertainties.

i