Question

This term you have learned to understand a company’s financial story using the language of accounting. The recording and reporting of information is essential to decision makers and other users of financial information; numbers on the various financial statements are used to help further understand the financial condition of the business. This process is known as financial ratio analysis and allows us to analyze the company’s financial position in relation to other organizations in the industry. In this final assignment, you will apply the concepts you have learned throughout the term to perform financial statement analysis and to offer some recommendations.

Assume that you are a health care consultant hired by the Dependable DME Company. DME is Durable Medical Equipment and includes all equipment that benefits patients who have certain medical conditions. The owner of the company, David Smith, is interested in applying for a loan to expand his business; he desires to open a second location in another city. He is preparing to apply to a local bank for a loan.

The bank will base its decision on the following averages for the DME industry:

Ratio	Industry Average
Current ratio	1.50
Quick ratio	0.80
Receivables turnover ratio	18.0
Inventory turnover ratio	20.0
Debt to assets ratio	0.56
Profit margin	10.25%

The balance sheet data for Dependable DME Company follows:

	December 31, 2017	December 31, 2016
Cash	$75,000	$60,000
Accounts receivable	40,000	20,000
Inventory	30,000	20,000
Prepaid insurance	5,000	5,000
Total current assets	140,000	105,000
Property and equipment	600,000	550,000
Accumulated depreciation	140,000	110,000
Total property and equipment	460,000	440,000
Total assets	$600,000	$545,000
Accounts payable	$60,000	$60,000
Other current liabilities	40,000	45,000
Total current liabilities	100,000	105,000
Bonds payable	150,000	150,000
Total liabilities	250,000	255,000
Common stock	250,000	250,000
Retained earnings	100,000	40,000
Total stockholders’ equity	350,000	290,000
Total liabilities and stockholders’ equity	$600,000	$545,000

The income statement data for Dependable DME Company follows:

Sales	$600,000
Cost of goods sold	350,000
Gross profit	$250,000
Operating expenses	100,000
Operating income	$150,000
Interest expense	25,000
Income before taxes	$125,000
Income tax expense	65,000
Net income	$60,000

Required:

Calculate the following six (6) ratios: Current Ratio, Quick Ratio, Receivables Turnover Ratio, Inventory Turnover Ratio, Profit Margin Ratio and Debt to Assets Ratio. Be sure to show the actual calculation as well as your final answer.

You are only required to calculate the ratios for 2017; however, for two of the ratios (Receivables Turnover Ratio and Inventory Turnover Ratio), you will need data from 2016 for the formula. When calculating the Quick Ratio, please note that Short-Term Investments are $0 in this scenario. (24 points; 4 points for each ratio calculation)

Below each ratio, comment on the interpretation of the ratio. In other words, what does the result tell you, specifically? (8 points)

Based upon the industry averages upon which the bank relies, should they approve the loan to Mr. Smith? Why or why not? (7 points)

In one-half page, comment on what financial aspect of Dependable DME Company looks good and where can Mr. Smith make some improvements. Specifically identify at least two recommendations to Mr. Smith that can be made to improve the financial position of his business. (8 points)

Answer 1

1. Current Ratio = current assets / current liabilities

=140,000/100,000 =1.40

The current ratio of industry is 1.50 and the same for the DME company is 1.40, which is less than the industry. This indicates the company has insufficient current assets to meet its current obligations. It need to increase its current assets to improve its liquidity position.

2. Quick ratio = (current assets - inventory - prepaid expenses) / current liabilities =(140000-30000-5000)/100000 =105000/100000 = 1.05

The quick ratio of industry is 0.80 and the same for the DME company is 1.05 which is higher than the industry. This indicates it has sufficient quick assets which are comparatively more liquid than current assets.

3. Receivables turnover ratio = sales / Average accounts receivable

Average accounts receivable =(accounts receivable beginning + accounts receivable ending) /2 =(20000+40000)/2=30000

Receivable turnover ratio =600000/30000 =20 times

The receivable turnover ratio of industry is 18 and the same for the DME company is 20 which is higher than the industry. This indicates is the company efficient credit policy and gives credit to customers for less period and cash collection is done quickly.

4. Inventory turnover ratio = cost of goods sold / Average inventory

Average inventory = (inventory beginning + inventory ending) /2 = (20000+30000)=25000

Inventory turnover ratio = 350000/25000 = 14 times

The inventory turnover ratio of the industry is 20 times and the same for the DME company is 14 times which is much less than the industry. This indicates that the company is takes much time to convert its inventory into sales. This adversely affects both the operating and cash conversion cycle adversely.

5. Profit margin Ratio = net income / sales * 100

= (60000/600000)*100 =10%

The profit margin ratio of the industry is 10.25% and the same for the DME company is 10% which is slightly less than the industry. This indicates company needs to control its operating expenses to raise its net income and ultimately its profit margin ratio.

6. Debt to assets ratio = total liabilities / total assets

=250000/600000 = 0.42

The debt to assets ratio of the industry is 0.56 and the same for the DME company is 0.42 which is lower than the industry. The lower debt to assets ratio which is good for the company indicates the there is lower proportion of debt in acquiring assets.

If we analyze all six ratios, the company should be granted loan as its quick ratio, profit margin ratio (almost equal), debt to assets ratio and receivables turnover ratio are good.

DME company needs to improve its current ratio, inventory turnover ratio and profit margin ratio to some extent to improve its financial position and to be competitive to industry ratios.