Question i.) Based on the information available to you, construct an income and
ID: 2333530 • Letter: Q
Question
Question
i.) Based on the information available to you, construct an income and expense schedule for the couple.
ii.) Create a net worth statement for the couple. Comment on whether they have a negative or positive net worth.
iii.) Using information from the above, calculate the following ratios (make sure you make a brief comment on each ratio).
a. Savings ratio
b. Liquidity ratio
c. Solvency ratio
d. Monthly debt service ratio
Date: 30 June 2018 (for completing relevant calculations)
Larry and Leslie Edwards recently read an article about personal finance in the local newspaper. The article discussed in detail common financial problems and dilemmas that
families face through different stages of their life cycles. After reading the article, both of them felt an urgent need to seek advice from a financial planner.
The couple met at a university in Brisbane ten years ago as undergraduates and have been happily married ever since. Exactly twelve months ago, they decided to move to East Sydney
when Larry agreed to take up a new position in the Sydney CBD. During your first meeting with them, he was quick to point out that he dislikes financial surprises. Leslie is willing to take
some risk if the associated returns are worthwhile. Both of them do not spend a great deal of time tracking and understanding their finances. Larry is currently 32 years old and works as a senior consulting engineer at a local telecommunication firm and earns a gross salary of $160,000 per year. Leslie, two years his junior, teaches at the local high school where she specialises in mathematics and science. She has a yearly gross income of $100,000. Their daughter, Hannah is 4 and their son, John is 2 years old. The children had their birthday about six months ago. They also have a polydactyl cat named Paws. The Edwards live in a three bedroom apartment which costs $5,000 per month to rent, but they are hoping to own a property in the next two to three years. In view of this, Larry has set aside a fund for their new home. The money is invested in a low risk managed fund earning stable returns for the last 5 years - the current balance is approximately $150,000. He also has a savings account balance of $85,000 that earns annual interest of 3 percent. They share a checking account that has a balance of $3,000 and the bank requires them to keep a minimum amount of $1,500 to earn annual interest of 1.5 percent. They took out a loan of $540,000 ten years ago to jointly own a house in Brisbane. The property currently generates a rental income of $500 per week. They are somewhat concerned about the amount of personal income tax and medical levy
withheld from them. They are not entirely convinced that the tax calculations are correct. In their regular weekend shopping, credit cards are often used. Their monthly balance always
seems to hover around $3,500 at all times and they repay only 15% of the outstanding amounts at the end of each month. They use their card to draw cash from the ATMs to cover
their daily household expenses even though they carry about $300 in cash between them. Education is highly valued by the couple. After talking to her close friend, Leslie thinks that
they should start thinking about saving for their children’s education expenses. To encourage their children to take up tertiary education, the parents are happy to set up an education fund
for their children. The tuition fee per person is estimated to cost $34,000 per year at the commencement of the study and other related annual expenses would cost another $12,000
per year. The tertiary program will take three years to complete. The couple believe they should save and be self-sufficient during retirement although they have yet to establish a retirement plan. To date, Leslie has accumulated $60,000 in her superannuation account while Larry has $83,000 in his account and has not named the beneficiary.
The following additional information is also available:
• Superannuation dividend payments are approximately 5% indefinitely. In general, an increment of 3% in salary is expected every year.
• The long-term return for equity investment is projected to be around 14% per year, whereas bond funds are expected to offer yield of 6% per annum. Investment in term deposits will
generate average return of 5% per annum over the next 35 years. Return from low risk managed fund is approximately 7% per year. Average yearly return on all other investments is
expected to be around 4% per year.
• The life expectancy for Larry and Leslie are 80 and 85 years old respectively. The children are expected to be dependent on their parents until they turn 24 years old.
• Tertiary education will commence when the children turn 19 years old.
• Larry and Leslie are Australian residents.
• For calculation of taxable income, use the relevant tax rates provided by the Australian Taxation Office (ATO).
• Larry has tallied his work-related expenses for the year to be $6,000, which includes $2,000 for return bus fare from home to work during the year. He has also donated $600 to CARE
Australia. Leslie has work-related expenses of $1,500, tax deductible gifts totalling $800 and paid $200 for tax return preparation.
• Interest charged on the 20-year loan used to purchase their Brisbane property amounts to about $26,000 per year. Monthly loan repayment amounts to $4,187 (interest and principal). In
addition, they pay annual agent fees of $1,820 and rates to the local council amounts to around $2,400 each year. A recent valuation report suggests a market value of $890,000 for the
property.
• Both Larry and Leslie provide approximately 9% superannuation contributions via salary sacrifice and their respective employers provide another 10% contribution into their superannuation funds.
• For the use of credit cards, interest charged for unpaid balance is approximately 17% p.a. A yearly fixed rate of 7% will be incurred for all other types of loan.
• All debts are amortised over the period of the loan. Mortgage repayments are made at the end of each month.
Explanation / Answer
Many small and mid-sized companies are run by entrepreneurs who are highly skilled in some key aspect of theirbusiness—perhaps technology, marketing or sales—but are less savvy in financial matters. The goal of this document is to help you become familiar with some of the most powerful and widely-used tools for analyzing the financialhealth of your company.
Some of the names—"common size ratios" and "liquidity ratios," for example—may be unfamiliar. But nothing in the following pages is actually very difficult to calculate or very complicated to use. And the payoff to you can be enormous. The goal of this document is to provide you with some handy ways to look at how your company is doing compared to earlier periods of time, and how its performance compares to other companies in your industry. Once you get comfortable with these tools you will be able to turn the raw numbers in your company's financial statements into information that will help you to better manage your business.
WHAT YOU SHOULD KNOW BEFORE GETTING STARTED [top]
For most of us, accounting is not the easiest thing in the world to understand, and often the terminology used by accountants is part of the problem. "Financial ratio analysis" sounds pretty complicated. In fact, it is not. Think of it as "batting averages for business."
If you want to compare the ability of two Major League home-run sluggers, you are likely to look at their batting averages. If one is hitting .357 and the other's average is .244, you immediately know which is doing better, even if you don't know precisely how a batting average is calculated. In fact, this classic sports statistic is a ratio: it's the number of hits made by the batter, divided by the number of times the player was at bat. (For baseball purists, those are "official at-bats," which is total appearances at the plate minus walks, sacrifice plays and any times the player was hit by a pitch.)
You can think of the batting average as a measure of a baseball player's productivity; it is the ratio of hits made to the total opportunities to make a hit. Financial ratios measure your company's productivity. There are many ratios you can use, but they all measure how good a job your company is doing in using its assets, generating profits from each dollar of sales, turning over inventory, or whatever aspect of your company's operation that you are evaluating.
Financial Ratio Analysis
The use of financial ratios is a time-tested method of analyzing a business. Wall Street investment firms, bank loan officers and knowledgeable business owners all use financial ratio analysis to learn more about a company's current financial health as well as its potential.
Although it may be somewhat unfamiliar to you, financial ratio analysis is neither sophisticated nor complicated. It is nothing more than simple comparisons between specific pieces of information pulled from your company's balance sheet and income statement.
A ratio, you will remember from grammar school, is the relationship between two numbers. As your math teacher might have put it, it is "the relative size of two quantities, expressed as the quotient of one divided by the other." If you are thinking about buying shares of a publicly-traded company, you might look at its price-earnings ratio. If the stock is selling for $60 per share, and the company's earnings are $2 per share, the ratio of price ($60) to earnings ($2) is 30 to 1. In common usage, we would say the "P/E ratio is 30."
Financial ratio analysis can be used in two different but equally useful ways. You can use them to examine the current performance of your company in comparison to past periods of time, from the prior quarter to years ago. Frequently this can help you identify problems that need fixing. Even better, it can direct your attention to potential problems that can be avoided. In addition, you can use these ratios to compare the performance of your company against that of your competitors or other members of your industry.
Remember that the ratios you will be calculating are intended simply to show broad trends and thus to help you with your decision-making. They need only be accurate enough to be useful to you. Don't get bogged down calculating ratios to more than one or two decimal places. Any change that is measured in hundredths of a percent will almost certainly have no meaning. Make sure your math is correct, but don't agonize over it.
A ratio can be expressed in several ways. A ratio of two-to-one can be shown as:
2:1 2-to-1 2/1
In these pages, when we present a ratio in the text it will be written out, using the word "to." If the ratio is in a formula, the slash sign (/) will be used to indicate division.
Types of Ratios
As you use this guide you will become familiar with the following types of ratios:
COMMON SIZE RATIOS [top]
One of the most useful ways for the owner of a small business to look at the company's financial statements is by using "common size" ratios. Common size ratios can be developed from both balance sheet and income statement items. The phrase "common size ratio" may be unfamiliar to you, but it is simple in concept and just as simple to create. You just calculate each line item on the statement as a percentage of the total.
For example, each of the items on the income statement would be calculated as a percentage of total sales. (Divide each line item by total sales, then multiply each one by 100 to turn it into a percentage.) Similarly, items on the balance sheet would be calculated as percentages of total assets (or total liabilities plus owner's equity.)
This simple process converts numbers on your financial statements into information that you can use to make period-to-period and company-to-company comparisons. If you want to evaluate your cash position compared to the cash position of one of your key competitors, you need more information than what you have, say, $12,000 and he or she has $22,000. That's a lot less informative than knowing that your company's cash is equal to 7% of total assets, while your competitor's cash is 9% of their assets. Common size ratios make comparisons more meaningful;they provide a context for your data.
Common Size Ratios from the Balance Sheet
To calculate common size ratios from your balance sheet, simply compute every asset category as a percentage of total assets, and every liability account as a percentage of total liabilities plus owners' equity.
Here is what a common size balance sheet looks like for the mythical Doobie Company:
ABC Company
Common Size Balance Sheet
For the year ending December 31, 200x
Assets $$ % Current Assets Cash 12,000 6.6% Marketable Securities 10,000 5.5% Accounts Receivable (net of uncollectible accounts) 17,000 9.4% Inventory 22,000 12.2% Prepaid Expense 4,000 2.2% Total Current Assets 65,000 35.9% Fixed Assets Building and Equipment 105,000 58.3% Less Depreciation 30,000 16.6% Net Buildings and Equipment 75,000 41.6% Land 40,000 22.2% Total Fixed Assets 115,000 63.8% Total Assets 180,000 100.0% Liabilities Current Liabilities Wages Payable 3,000 1.6% Accounts Payable 25,000 13.8% Taxes Payable 12,000 6.6% Total Current Liabilities 40,000 22.2% Long-Term Liabilities Mortgage Payable 70,000 38.8% Note Payable 15,000 8.3% Deferred Taxes 15,000 8.3% Total Long-Term Liabilities 100,000 55.5% Total Liabilities 140,000 77.7% Owner's Equity 40,000 22.2% Total Liabilities and Owner's Equity 180,000 100.0%
In the example for Doobie Company, cash is shown as being 6.6% of total assets. This percentage is the result of the following calculation:
12,000/180,000 x 100
(Multiplying by 100 converts the ratio into a percentage.)
Common size ratios translate data from the balance sheet, such as the fact that there is $12,000 in cash, into the information that 6.6% of Doobie Company's total assets are in cash. Additional information can be developed by adding relevant percentages together, such as the realization that 11.7% (6.6% + 5.1%) of Doobie's total assets are in cash and marketable securities.
Common size ratios are a simple but powerful way to learn more about your business. This type of information should be computed and analyzed regularly.
As a small business owner, you should pay particular attention to trends in accounts receivables and current liabilities. Receivables should not be tying up an undue amount of company assets. If you see accounts receivables increasing dramatically over several periods, and it is not a planned increase, you need to take action. This might mean stepping up your collection practices, or putting tighter limits on the credit you extend to your customers.
As this example illustrates, the point of doing financial ratio analysis is not to collect statistics about your company, but to use those numbers to spot the trends that are affecting your company. Ask yourself why key ratios are up or down compared to prior periods or to your competitors. The answers to those questions can make an important contribution to your decision-making about the future of your company.
Current ratio analysis is also a very helpful way for you to evaluate how your company uses its cash.
Obviously it is vital to have enough cash to pay current liabilities, as your landlord and the electric company will tell you. The balance sheet for the Doobie Company shows that the company can meet current liabilities. The line items of "total current liabilities," $40,000, is substantially lower than "total current assets," $65,000.
But you may wonder, "How do I know if my current ratio is out of line for my type of business?" You can answer this question (and similar questions about any other ratio) by comparing your company with others. You may be able to convince competitors to share information with you, or perhaps a trade association for your industry publishes statistical information you can use. If not, you can use any of the various published compilations of financial ratios. (See the Resources section at the end of this document.)
Because financial ratio comparisons are so important for bank loan officers who make loans to businesses, RMA (formerly a bankers' trade association, Robert Morris Associates) has for many years published a volume called "Annual Statement Studies." These contain ratios for more than 300 industries, broken down by asset size and sales size. RMA's "Annual Statement Studies" are available in most public and academic libraries, or you may ask your banker to obtain the information you need.
Another source of information is "Industry Norms and Key Business Ratios," published by Dun and Bradstreet. It is compiled from D&B's vast databases of information on businesses. It lists financial ratios for hundreds of industries, and is available in academic and public libraries that serve business communities.
These and similar publications will give you an industry standard or "benchmark" you can use to compare your firm to others. The ratios described in this guide, and many others, are included in these publications. While period-to-period comparisons based on your own company's data are helpful, comparing your company's performance with other similar businesses can be even more informative.
Compute common size ratios using your company's balance sheet.
Common Size Ratios from the Income Statement
To prepare common size ratios from your income statement, simply calculate each income account as a percentage of sales. This converts the income statement into a powerful analytical tool.
Here is what a common size income statement looks like for the fictional Doobie Company:
$$ % Sales $ 200,000 100% Cost of goods sold 130,000 65% Gross Profit 70,000 35% Operating expenses Selling expenses 22,000 11% General e xpenses 10,000 5% Administrative expenses 4,000 2% Total operating expenses 36,000 18% Operating income 34,000 17% Other income 2,500 1% Interest expense 500 0% Income before taxes 36,000 18% Income taxes 1,800 1% Net profit 34,200 17%
Common size ratios allow you to make knowledgeable comparisons with past financial statements for your own company and to assess trends—both positive and negative—in your financial statements.
The gross profit margin and the net profit margin ratios are two common size ratios to which small business owners should pay particular attention. On a common size income statement, these margins appear as the line items "gross profit" and "net profit." For the Doobie Company, the common size ratios show that the gross profit margin is 35% of sales. This is computed by dividing gross profit by sales (and multiplying by 100 to create a percentage.)
$70,000/200,000 x 100 = 35%
Even small changes of 1% or 2% in the gross profit margin can affect a business severely. After all, if your profit margin drops from 5% of sales to 4%, that means your profits have declined by 20%.
Remember, your goal is to use the information provided by the common size ratios to start asking why changes have occurred, and what you should do in response. For example, if profit margins have declined unexpectedly, you probably will want to closely examine all expenses—again, using the common size ratios for expense line items to help you spot significant changes.
Compute common size ratios from your income statement.
Look at the gross profit and net profit margins as a percentage of sales. Compare these percentages with the same items from your income statement of a year ago. Are any fluctuations favorable or not? Do you know why they changed?
LIQUIDITY RATIOS [top]
Liquidity ratios measure your company's ability to cover its expenses. The two most common liquidity ratios are the current ratioand the quick ratio. Both are based on balance sheet items.
Current Ratio
The current ratio is a reflection of financial strength. It is the number of times a company's current assets exceed its current liabilities, which is an indication of the solvency of that business.
Here is the formula to compute the current ratio.
Current Ratio = Total current assets/Total current liabilities
Using the earlier balance sheet data for the mythical Doobie Company, we can compute the company's current ratio.
Doobie Company Current Ratio:
65,000/40,000 = 1.6
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