Question

Company A uses straight-line depr. while Company B uses SYD depr. They have identical equipment with the same salvage value early in the asset’s life. Describe how the difference affects the ratios for both companies. Explore TIE, ROE, GPM, and average collection period. Describe Each Ratio in a separate paragraph.

Answer 1

TIE refers to times interest earned and it measures the relationship between the operating profit and interest expense.

Time interest earned = operating profit/Interest expense.

In case if company uses sum of year digit method of depreciation, in this higher amount of depreciation would be charged in early years which would results in lower operating profit in comparison to straight line method of depreciation which will use same amount of depreciation throughout the life of equipment so TIE would be low in case of compay which uses sum of year digit method in comparison to company which uses straight line depreciation.

ROE - return on equity refers to return earned on equity capital investment.

ROE = net income available to equity shareholders/total of average equity

net income available to equity shareholders would be low in case of sum of year digit method of depreciation as high amount of depreciation would be charged into early years in comparison to straight line method of depreciation which would results in low net income available to equity shareholders and low return on equity for the company uses sum of year digit method in comparison to straight line method of depreciation

Gross profit margin refers to profit earned over the cost of sales

gross profit margin = gross profit/sales

There would be no effect of depreciation expense whether it is straight line method of depreciation or sum of year digit method of depreciation because depreciation is a indirect cost which is not considered for calculation of gross profit or cost of sales. Both the companies would be indifferent on the ground of gross profit margin arising from different method of depreciation.

Average collection period refers to the time required to collect funds from the debtors

average collection period = 365/accounts receivable turnover ratio

As there is no requirement of depreciation expense to calculate the accounts receivable turnover ratio so in this case there would be no effect of method of depreciation expense on average collection period of both the companies.