Midwest Inc. is a medium-size company that has been in business for 20 years. Th
ID: 2601745 • Letter: M
Question
Midwest Inc. is a medium-size company that has been in business for 20 years. The industry has become very competitive in the last few years, and Midwest has decided that it must grow if it is going to survive. It has approached the bank for a sizable five-year loan, and the bank has requested Midwest’s most recent financial statements as part of the loan package.
The industry in which Midwest operates of approximately 20 companies relatively equal in size. The trade association to which all the competitors belong publishes an annual survey of the industry, including industry averages for selected ratios for the competitors. All companies voluntarily submit their statements to the association for this purpose.
Midwest’s controller is aware that the bank has access to this survey and is very concerned about how the company fared this past year compared with the rest of the industry. The ratios included in the publication and the averages for the past year are as follows:
Ratio
Industry Average
Current ratio
1.20
Acid-test (quick) ratio
0.50
Debt-to-equity ratio
0.50
Times Interest earned
25 times
Returns on sales
3%
Asset Turnover
3.50 times
Inventory Turnover
35 times
Return on common stockholder’s equity
20%
Midwest Inc.
Comparative Statements of Financial Position
(thousands omitted)
December 31, 2017
December 31, 2016
Assets
Current Assets:
Cash
$1,790
$2,600
Marketable Securities
1,200
1,700
Accounts Receivable, net of allowances
400
600
Inventories
8,700
7,400
Prepaid items
350
400
Total Current assets
$12,440
$12,700
December 31, 2017
December 31, 2016
Long-term investments
$560
$400
Property, plant, and equipment:
Land
$12,000
$12,000
Buildings and equipment, net of accumulated depreciation
87,000
82,900
Total property, plant, and equipment
$99,000
$94,900
Total assets
$112,000
$108,000
Liabilities and Stockholders’ Equity
Current Liabilities:
Short-term notes
$800
$600
Accounts payable
6,040
6,775
Salaries and wages payable
1,500
1,200
Income taxes payable
1,560
1,025
Total current liabilities
$9,900
$9,600
Long-term bonds payable
$36,000
$36,000
Stockholders’ equity:
Common stock, no par
$50,000
$50,000
Retained earnings
16,100
12,400
Total stockholders’ equity
$66,100
$62,400
Total liabilities and stockholders’ equity
$112,000
108,000
Midwest Inc.
Statement of Income and Retained Earnings
For the Year Ended December 31, 2017
(thousands omitted)
Sales revenue
$420,500
Cost of Goods sold
(300,000)
Gross profit
$120,500
Selling, general, and administrative expenses
(85,000)
Income before interest and taxes
$35,500
Interest expense
(8,600)
Income before taxes
$26,900
Income tax expense
(12,000)
Net Income
$14,900
Retained earnings, January 1, 2017
12,400
$27,300
Dividends paid on common stock
(11,200)
Retained earnings, December 31, 2017
$16,100
Required
Prepare a columnar report for the controller of Midwest Inc. comparing the industry averages for the ratios published by the trade association with the comparable ratios for Midwest. For Midwest, compute the ratios as of December 31, 2017, or for the year ending December 31, 2017, whichever is appropriate.
Briefly evaluate Midwest’s ratios relative to the industry averages.
Do you think that the bank will approve the loan? Explain your answer.
Ratio
Industry Average
Current ratio
1.20
Acid-test (quick) ratio
0.50
Debt-to-equity ratio
0.50
Times Interest earned
25 times
Returns on sales
3%
Asset Turnover
3.50 times
Inventory Turnover
35 times
Return on common stockholder’s equity
20%
Explanation / Answer
Solution 1- Coloumnar Comparative ratio report
4.13 Times
(Note 4)
4.68%
(Note 5)
3.82 Times
(Note 6)
37.27 Times
(Note 7)
23.19%
(Note 8)
Note 1 - Current ratio
Current ratio = Current Assets/Current Liabilities
Current ratio = $12440/$9900 = 1.26
Note 2 - Acid test ratio
Acid test ratio =
(Current assets - Prepaid items - Inventory)/Current Liability
Acid test ratio = ($12440 - $350 - $8700)/$9900 = 0.34
Part 3 - Debt equity ratio
Debt equity ratio =
(Short term Debts + Long term Debts)/Total Equity
Debt equity ratio = ($36000 + $9900)/$66100 = 0.69
Part 4 - Times interest earned
Times Interest earned =
Earning before Interest and tax/Interest Expenses
Times interest earned = $35500/$8600 = 4.13 Times
Part 5 - Return on sales
Return on sales = (Net income + Interest Net of tax)/Sales
Tax rate = ($12000/$26900)*100 = 44.61%
Return on sales = [$14900 + (8600 - 44.61%)]/$420500*100
= ($14900 + $4764)/$420500*100
=$19664/$420500*100 = 4.68%
Note 6 - Asset Turnover
Asset Turnover = Sales/(Average Assets)
Average Assets = ($112000+$108000)/2 = $110000
Asset Turnover = $420500/$110000 = 3.82 Times
Note 7 - Inventory Turnover
Inventory Turnover = Cost of goods sold/Average Inventory
Average Inventory = ($8700 + $7400)/2 = $8050
Inventory Turnover = $300000/$8050 = 37.27 Times
Note 8 - Return on common stockholders equity
Return on common stockholders equity =
Net Income/Common stockholders equity
Common Stock holders equity = ($66100 + $62400)/2 = $64250
Return on common stockholders equity = $14900/$64250 = 23.19%
Solution 2 - On evaluating the ratios of midwest with the Industry Average, analysis is that for Current, Debt-Equity and Acid test ratio, Midwest has higher debt equity ratio which means that midwest has debt and finance cost.
Midwest has higher current ratio which results in more liquidity but lower Acid test ratio which directly indicatss that Current assets of Midwest are more difficult to liquidate.
Now in other ratios like Return on sales, Asset turnover, Inventory Turnover, Return on common stockholders equity, Midwest is in better position from every aspect with slight margin.
In solvency criteria, Midwest is not as solvent as Industry Average since it has very lower Times Interest earned ratio. Since it shows that Midwest has difficulty in meeting Interest Payments
Solution 3 - Looking at The liquidity and solvency position of Midwest, Bank would not approve loan. Since Industry is far better than Midwest in Liquidity and solvency ratio. But in case of other ratios, Midwest is better but not with higher margin. Even if bank approve the loan, Bank Interest rates would be very higher.
Mkdwest has underperformed as compared to its Industry Peers as per Liquidation, Solvency analysis & Financial Leverage.
Particulars Industry Average Midwest Inc. Current ratio 1.2 1.26 (Note 1) Acid test ratio 0.5 0.34 (Note 2) Debt to equity ratio 0.5 0.69 (Note 3) Times Interest earned 25 Times4.13 Times
(Note 4)
Return on sales 3%4.68%
(Note 5)
Asset Turnover 3.5 Times3.82 Times
(Note 6)
Inventory Turnover 35 Times37.27 Times
(Note 7)
Common stockholders equity 20%23.19%
(Note 8)