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Problem 14-15 Comprehensive Ratio Analysis [LO14-2, LO14-3, LO14-4, LO14-5, LO14-6]

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You have just been hired as a financial analyst for Lydex Company, a manufacturer of safety helmets. Your boss has asked you to perform a comprehensive analysis of the company’s financial statements, including comparing Lydex’s performance to its major competitors. The company’s financial statements for the last two years are as follows:

Lydex Company Comparative Balance Sheet
	This Year		Last Year
Assets
Current assets:
Cash	$	1,020,000	$	1,260,000
Marketable securities		0		300,000
Accounts receivable, net		2,940,000		2,040,000
Inventory		3,660,000		2,100,000
Prepaid expenses		270,000		210,000
Total current assets		7,890,000		5,910,000
Plant and equipment, net		9,640,000		9,110,000
Total assets	$	17,530,000	$	15,020,000
Liabilities and Stockholders' Equity
Liabilities:
Current liabilities	$	4,070,000	$	3,100,000
Note payable, 10%		3,700,000		3,100,000
Total liabilities		7,770,000		6,200,000
Stockholders' equity:
Common stock, $75 par value		7,500,000		7,500,000
Retained earnings		2,260,000		1,320,000
Total stockholders' equity		9,760,000		8,820,000
Total liabilities and stockholders' equity	$	17,530,000	$	15,020,000

Lydex Company Comparative Income Statement and Reconciliation
	This Year		Last Year
Sales (all on account)	$	15,920,000	$	14,180,000
Cost of goods sold		12,736,000		10,635,000
Gross margin		3,184,000		3,545,000
Selling and administrative expenses		1,014,000		1,628,000
Net operating income		2,170,000		1,917,000
Interest expense		370,000		310,000
Net income before taxes		1,800,000		1,607,000
Income taxes (30%)		540,000		482,100
Net income		1,260,000		1,124,900
Common dividends		320,000		562,450
Net income retained		940,000		562,450
Beginning retained earnings		1,320,000		757,550
Ending retained earnings	$	2,260,000	$	1,320,000

To begin your assignment you gather the following financial data and ratios that are typical of companies in Lydex Company’s industry:

Current ratio	2.3
Acid-test ratio	1.1
Average collection period	32	days
Average sale period	60	days
Return on assets	9.9	%
Debt-to-equity ratio	0.7
Times interest earned ratio	5.9
Price-earnings ratio	10

Problem 14-15 Part 3

3. You decide, finally, to assess the company’s liquidity and asset management. For both this year and last year, compute:

a. Working capital.

b. The current ratio. (Round your final answers to 2 decimal places.)

c. The acid-test ratio. (Round your final answers to 2 decimal places.)

d. The average collection period. (The accounts receivable at the beginning of last year totaled $1,730,000.) (Use 365 days in a year. Round your intermediate calculations and final answers to 2 decimal place.)

e. The average sale period. (The inventory at the beginning of last year totaled $2,090,000.) (Use 365 days in a year. Round your intermediate calculations and final answers to 2 decimal place.)

f. The operating cycle. (Round your intermediate calculations and final answers to 2 decimal place.)

g. The total asset turnover. (The total assets at the beginning of last year totaled $14,670,000.) (Round your final answers to 2 decimal places.)

Answer 1

Answer – 3

(a) Calculation showing working capital:

Working Capital                    = Current Assets - Current Liabilities

Working Capital (C.Y.)         = 7,890,000 - 4,070,000 = 3,820,000

Working Capital (P.Y.)         = 5,910,000 – 3,100,000 = 2,810,000

Analysis - From this calculation, we have positive net working capital with which to pay short-term debt obligations before you even calculate the current ratio. You should be able to see the relationship between the company's net working capital and its current ratio.

(b) Calculation showing Current Ratio:

Current Ratio = Current Assets/Current Liabilities

Current Ratio (C.Y.) = 7,890,000/4,070,000 = 1.94

Current Ratio (P.Y.) = 5,910,000/3,100,000 = 1.91

Analysis - The current ratio shows how many times over the firm can pay its current debt obligations based on its assets. This means that the firm can meet its current (short-term) debt obligations 1.94 times over. In order to stay solvent, the firm must have a current ratio of at least 1.0, which means it can exactly meet its current debt obligations. So, this firm is solvent.

In this case, however, the firm is a little more liquid than that. It can meet its current debt obligations and have a little left over. If we look at the current ratio for the previous year, we will see that the current ratio was 1.91. So, the firm improved its liquidity in the current year which, in this case, is good since it is operating with relatively low liquidity.

(c) Calculation showing Acid Test Ration or Quick Ratio:

Acid Test Ratio or Quick Ratio = (Total Current Assets – Inventory-Prepaid Exp)/Current Liabilities

Acid Test Ratio (C.Y.) = (7,890,000 – 3,660,000 – 270,000) / 4,070,000 = 0.97

Acid Test Ratio (P.Y.) = (5,910,000 – 2,100,000 – 210,000) / 3,100,000 = 1.07

Analysis - The quick ratio is a more stringent test of liquidity than is the current ratio. It looks at how well the company can meet its short-term debt obligations without having to sell any of its inventories to do so Inventory is the least liquid of all the current assets because you have to find a buyer for your inventory. Finding a buyer, especially in a slow economy, is not always possible. Therefore, firms want to be able to meet their short-term debt obligations without having to rely on selling inventory.

The Acid test ratio for the current year is 0.97 which is less than 1.0. It means that the firm cannot meet its current (short-term) debt obligations without selling inventory. In order to stay solvent and pay its short-term debt without selling inventory, the quick ratio must be at least 1.0, which it is not.

In this case, however, the firm will have to sell inventory to pay its short-term debt.

(d) Calculation showing Average collection period:

Average collection period = 365/Account receivable turnover ratio

Average collection period (C.Y.) = 365/6.36 = 57.12 days (see further calculation below)

Average collection period (P.Y.) = 365/7.52 = 48.54 days (see further calculation below)

Calculation of Account receivable turnover ratio for current year

ARTR or Activity Ratio = Net credit sales/ Average account receivable

ARTR or Activity Ration = 15,920,000 / [(2,940,000+2,040,000)/2] = 6.39

Calculation of Account receivable turnover ratio for previous year

ARTR or Activity Ratio = Net credit sales/ Average account receivable

ARTR or Activity Ration = 14,180,000 / [(2,040,000+1,730,000)/2] = 7.52

(e) Calculation showing Average sales period:

Average sales period = 365/Inventory turnover ratio

Average sales period (C.Y.) = 365/4.52 = 82.58 days (see further calculation below)

Average sales period (P.Y.) = 365/5.08 = 71.85 days (see further calculation below)

Calculation of Inventory turnover ratio for current year

Inventory turnover ratio = Cost of goods sold / Average Inventory

Inventory turnover ratio = 12,736,000/ [(3,660,000+2,100,000)/2] = 4.42

Calculation of Inventory turnover ratio for previous year

Inventory turnover ratio = Cost of goods sold / Average Inventory

Inventory turnover ratio = 10,635,000/ [(2,100,000+2,090,000)/2] = 5.08

(f) Calculation showing operating cycle period:

Operating cycle period = Inventory Period (365/Inventory Turnover) + Account Receivable Period (365/Receivable Turnover)

Operating Cycle (C.Y.) = 82.58 days + 57.12 days = 139.70 days

Operating Cycle (P.Y.) = 71.85 days + 48.54 days = 120.39 days

(g) Calculation showing asset turnover ratio:

Total Asset Turnover Ratio = Net Sales / Average Total Assets

Total Asset Turnover Ratio (C.Y.) = 1,592,000/[(17,530,000+15,020,000)/2] = 0.98

Total Asset Turnover Ratio (P.Y.) = 14,180,000/[(15,020,000+14,670,000)/2] = 0.96