Question

Lloyd Inc. has sales of $400,000, a net income of $24,000, and the following balance sheet: Cash $ 72,960 Accounts payable $ 99,840 Receivables 155,520 Notes payable to bank 71,040 Inventories 345,600 Total current liabilities $170,880 Total current assets $574,080 Long-term debe 167,040 Net fixed assets 385,920 Common equity 622,080 Total assets $960,000 Total liabilities and equity $960,000 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, 1.75, without affecting sales or net income. If inventories are sold and not replaced thus reducing the current ratio to 1.75x), 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 ROE will let by percentage points What will be the firm's new quick ratio? Do not round intermediate calculations. Round your answer to two decimal places

Answer 1

The Current ratio is calculated as:

Current ratio = Current assets / Current Liabilities

1.75 times = (Cash + Receivables + Inventories) / (Accounts payable + Other liabilities)

1.75 = (72,960 + 155,520 + Inventories) / 170,880

1.75 =  2,28,480 + Inventories / 170,880

2,99,040 = 2,28,480 + Inventories

Inventories = $70,560

Therefore, $70,560 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 $5,51,520.

Calculating The ROE before the inventory sold off:

ROE = Net income / Stockholder's equity

= $24,000 / $622,080 = 0.39or 3.9%

Calculating The ROE after the inventory sold off:

= $24,000 / 551,520 = 0.04 or 4%

The firm's new quick ratio is:

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

= ($574,000 - $275,040) / 170880

= 1.75