AA Electronics, which reports a net income equal to $9,200, has the following ba
ID: 2708874 • Letter: A
Question
AA Electronics, which reports a net income equal to $9,200, has the following balance sheet:
The company's new owner thinks that inventories, which are currently $70,000, are excessive and can be lowered to the point where the current ratio is equal to the industry average of 2.0
AA Electronics, which reports a net income equal to $9,200, has the following balance sheet: The company's new owner thinks that inventories, which are currently $70,000, are excessive and can be lowered to the point where the current ratio is equal to the industry average of 2.0 times without affecting either sales or net income. If inventories are sold off and not replaced so as to reduce the current ratio to 2.0 times , the funds generated would be used to reduce common equity (stock can be repurchased at book value). If everything else stays the same, including net income, by how much will the ROE change from such an inventory sell off?Explanation / Answer
If the current ratio is 2 to 1 that would mean that current assets are two times current liabilities or 2*27,500=55,000.
So inventories and equity would be reduced by 55,000. Equity would now become 90,000-55,000 or 35,000. So ROE would now be 9,200/35,000= 26.29% as opposed to previously 9,200/90,000= 10.22%