Lloyd Inc. has sales of $650,000, a net income of $39,000, and the following bal

Question

Lloyd Inc. has sales of $650,000, a net income of $39,000, and the following balance sheet:

The new owner thinks that inventories are excessive and can be lowered to the point where the current ratio is equal to the industry average, 2.5x, without affecting sales or net income.

Please show calculation. Thanks.

Cash $131,560    Accounts payable $168,740 Receivables 180,180    Other current liabilities 77,220 Inventories 700,700    Long-term debt 270,270 Net fixed assets 417,560    Common equity 913,770 Total assets $1,430,000    Total liabilities and equity $1,430,000

Explanation / Answer

Current ROE = net income/common equity = 39,000/913,770 = 4.268%

Current ratio should be brought down to 2.5x.

So new current assets = 2.5*current liabilities = 2.5*(168,740+77,220) = 614,900

Decrease in inventory = old current assets-new current assets = (131,560+180,180+700,700)-614,900 = 397,540

This amount of common equity is bought back. So new common equity = 913,770-397,540=516,230

New ROE = net income/new common equity = 39,000/516,230 = 7.555%

Change in ROE = 7.555%-4.268% = 3.287%

New quick ratio = (cash+receivables)/current liabilities = (131,560+180,180)/(168,740+77,220) = 1.27x

Hope this helped ! Let me know in case of any queries.

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