Question

Lloyd Inc. had sales of $200,000, a net income of //415,000, and the following balance sheet: Cash $10,000 Accounts Payable $30,000 Receivables 50,000 Notes Payable To Bank 20,000 Inventories 150,000 Total Current Liabilities $50,000 Total Current Assets $210,000 Long-Term Debt 50,000 Net Fixed Assets 90,000 Common Equity 200,000 Total Assets $300,000 Total Liabilities And Equity $300,000 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, 2.5x, without affecting sales or net income. If inventories are sold and not replaced (thus reducing the current ratio to 2.5x); 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? What will be the firm’s new quick ratio?

Answer 1

Answer:

The firm's new quick ratio is  2.9

Explanation:

The current ratio is calculated as  

Current ratio = Current assets / Current liabilities

2.5 times = (Cash + receivables + Inventories ) / (Accounts payable + Other current liabilities)

2.5 = ($10,000 + $50,000 + Inventories) / $50,000

$60,000 + inventories = $125,000

Inventories = $65,000

Therefore, $85,000 worth of inventories were sold off.

If the funds generated are used to reduce the common equity that is by repurchasing the equity at book value.

Hence, the common equity amounts to $115,000

Calculating the ROE before the inventory is sold off:

ROE = Net income / Stockholder's equity

= $15,000 / $200,000

= 0.075 or 7.5%

Calculating the ROE after selling off the inventory

ROE = $15,000 / $115,000

= 0.13 or 13%

The firm's new quick ratio is

Quick ratio = (Current assets - Inventories) / Current liabilities

= ($210,000 - $65,000) / $50,000

= 2.9