Need help with equity and quick ratio problem. Finance 3100 Return on Equity and
ID: 2729589 • Letter: N
Question
Need help with equity and quick ratio problem. Finance 3100
Return on Equity and Quick Ratio Lloyd Inc. has sales of $300, 000, a net income of $21,000, and the following balance sheet: 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?Explanation / Answer
Currently, ROE is ROE1 = $21,000/$478,860 = 4.39%.
The current ratio will be set such that 2.5 = CA/CL. CL is $50,000, and it will not change, so we can solve to find the new level of current assets: CA = 2.5(CL) = 2.5($115230) = $288,070. This is the level of current assets that will produce a current ratio of 2.5´.
At present, current assets amount to $410,550, so they can be reduced by $410,550 – $288,070 = $122,480. If the $122,480 generated is used to retire common equity, then the new common equity balance will be $478,860 – $122,480 = $356,380.
Assuming that net income is unchanged, the new ROE will be ROE2 = $21,000/$356,380 = 5.89%. Therefore, ROE will increase by 5.89% – 4.39% = 1.5%.
The new CA level is $288,070; CL remain at $115230; and the new Inventory level = $269,100 – $122480 = $146,620. Thus, the new quick ratio is calculated as follows:
New quick ratio =( CA-Inv)/CL =(288070-146620)/115230 =1.22x