Question

Lloyd Inc. has sales of $600,000, a net income of $60,000, and the following balance sheet: Cash $145,800 Accounts payable $192,780 Receivables 230,040 Notes payable to bank 108,540 Inventories 891,000 Total current liabilities $301,320 Total current assets $1,266,840 Long-term debt 270,540 Net fixed assets 353,160 Common equity 1,048,140 Total assets $1,620,000 Total liabilities and equity $1,620,000 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? Do not round intermediate calculations. Round your answer to two decimal places. % What will be the firm's new quick ratio? Do not round intermediate calculations. Round your answer to two decimal places. x

Answer 1

Answer:

The new quick ratio is 4.6

Explanation:

Current ratio = Current assets / Current liabilities

2 = (Cash + receivables + inventories) / (Accounts payable + other current liabilities

2 = ($145,800 + $230,040 + inventories ) / $192,780

2 = $375,840 + inventories / $192,780

$385,560 = $375,840 + inventories

Inventories = $385,560 - $375,840

Inventories = $9,720

This means that inventories worth of $881,280 [ $891,000 -$9,720] were sold.

Also, if the funds so gained are used to reduce common equity, meaning buying back the equity at book value, hence common equity is $166,860 [ $1,048,140 - $881,280]

ROE before selling off the inventory = Net income / Stockholder's equity

= $60,000 / $1,048,140

= 0.057 or 5.7%

ROE after selling off the inventory = Net income / Stockholder's equity

= $60,000 / $166,860

= 0.40 or 40%

The firm's new quick ratio

= [ Current assets - inventories] / Current liabilities

= [$1,266,840 - $9,720] / $270,540

= $1,257,140 / $270,540

= 4.6