Return on Equity and Quick Ratio Lloyd Inc. has sales of $450,000, a net income
ID: 2728632 • Letter: R
Question
Return on Equity and Quick Ratio
Lloyd Inc. has sales of $450,000, a net income of $22,500, and the following balance sheet: Cash $78,300 Accounts payable $120,060 Receivables 206,190 Other current liabilities 103,095 Inventories 626,400 Long-term debt 174,870 Net fixed assets 394,110 Common equity 906,975 Total assets $1,305,000 Total liabilities and equity $1,305,000 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, 2x, without affecting sales or net income.
If inventories are sold and not replaced (thus reducing the current ratio to 2x), if the funds generated are used to reduce common equity (stock can be repurchased at book value), and if no other changes occur, by how much will the ROE change? Round your answer to two decimal places. %
What will be the firm's new quick ratio? Round your answer to two decimal places. x
Explanation / Answer
Solution:
Calculation of ROE will increase by:
Return on Equity (ROE) = Net Income / Shareholder's equity
= 22,500/ 906,975
= 2.48%
The current ratio is to be set such that = 2
2 = Current Assets / Current Liabilities
Current Liabilities is $223,155 and since it will not change
2 = Current Assets/ 223,155
Current Assets = 2 * 223,155
= 446,310
At present, current assets amount to $910,890, so they can be reduced by $910,890 - $446,310 = $464,580.
If the $464,580 generated is used to retire common equity, then the new common equity balance will be $906,975 - $464,580 = $442,395.
Assuming that net income is unchanged, the new ROE will be ROE2 = 22,500/ 442,395
= 0.0509
= 5.09%
Therefore, ROE will increase by 5.09% - 2.48% = 2.61%
Calculation of firm's New Quick Ratio:
The new Current Assets level is 446,310
Current Liabilities remain at 223,155
The new Inventory level = 626,400 - 464,580 = 161,820
New Quick Ratio = (Current Assets – Inventory)/ Current Liabilities
= (446,310 – 161,820)/ 223,155
= 284,490/ 223,155
= 1.27
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