Question

In a previous homework assignment you were provided with the following information. A company has the following ratios: Current ratio -85 Inventory to Sales Conversion Period - 180 days Sales to Cash Conversion Period - 75 days Purchases to Payments Conversion Period - 7 days The accountant also reports that the gross profit margin is 15% and the next profit margin is 3%. Now you are being provided with this additional information on the company. The company also has a bank line of credit that allows the company to borrow any shortfall it might have in cash. Interest on the loan is 10%. Assume the loan remained constant throughout the year. The company likes to keep no less than $25,000 in its bank account. The company has $1,000,000 of equity and $120,000 in retained earnings at the end of the year. Sales in the most recent year were $2,500,000. Ignore income tax for purposes of this problem. Question: Based on all of the above information, will this company have a good return on equity or a poor return on equity? Build a balance sheet and income statement financial model to prove your answer. Bonus Points: What changes can managing make that will have the greatest impact on ROI?

Answer 1

Sales in the most recent year = $2,500,000

Gross Profit Margin = 15%

Gross Profit = 2,500,000*15% = $375,000

Gross profit = Sales - COGS(Cost of Goods Sold)

COGS = Sales - Gross Profit = 2,500,000 - 375,000 = $2,125,000

Inventory to Sales Conversion Period = 180 days

Inventory to Sales Conversion Period = (Inventory / COGS)*365

So, 180 days = (Inventory / 2,125,000) *365

Inventory = $1,047,945

Purchases to payments conversion period = 7 days

Purchases to payments conversion period = (Accounts Payable / COGS)*365

So, 7 = (Accounts Payable / 2125000)*365

Accounts Payable = $40,753

Sales to cash conversion period = 75 days

Sales to cash conversion period = (Accounts Receivables/Sales)*365

So, 75 = (Accounts Receivable / 2500000)*365

Accounts Receivable = $513,699

Bank account balance = $25,000

Total Current Assets = Inventories + Accounts Receivable + Bank Account = 1,047,945 + 513,699 + 25,000 = $1,586,644

Total Current Liabilities = Accounts Payable + Bank Loan(short term)= 40,753 + Bank Overdraft

Current Ratio = Total Current Assets / Total Current Liabilities = 1,586,644 / Total Current Liabilities

Current ratio = 0.85

So, 0.85 = 1,586,644 / Total Current Liabilities

Total Current Liabilities = $1,866,640

Bank Loan(short term)= Total Current Liabilities - Accounts Payable = 1866640 - 40753 = $1,825,887

Interest on Bank loan = 10% = $1,825,887*10% = $182,589

Eg Copy BI U - - ** Format Painter Clipboard Font N10 Income Statement min Nooo 3 Sales 4 COGS 5 Gross Profit 6 Expenses 7 Interest 8 Net Profit 25,00,000.00 -21,25,000.00 3,75,000.00 -1,17,411.00 -1,82,589.00 75,000.00 REGEUR = 6 Sheet Sheet Sheeta Sheet3

Calculation of expenses = Gross Profit - Interest - Net Profit = 375,000 - 182,589 - 75000 = 117,411

Balance sheet Assets 13,99,996.00 Liablities Equity Share capital 10,00,000.00 Fixed Assets Retained Earnings 1,20,000.00 Net worth 11,20,000.00 Current Liabilities Current Assets Accounts Payable 40,753.00 Accounts Receivable! 5,13,699.00 Short term bank loan | 18,25,887.00 Inventories 10,47,945.00 Bank 25,000.00 TOTAL 29,86,640.00 TOTAL 29,86,640.00

Net worth = Equity share capital + Retained Earnings

Fixed Assets = Total Assets - Current Assets

Return on Equity (ROE) = Net profit / Shareholders equity (Net worth) = 75000/1120000 = 0.067 or 6.7%

The company has a poor return on equity (ROE of 15-20% are generally considered good)

The management can make the following changes to have an impact on ROI:

Reduce the inventory to sales conversion period to reduce the Total Investment in Inventories thus increasing the ROI

Reduce the sales to cash conversion period to reduce the Total Investment in Accounts Receivables thus increasing the ROI

Reduce the minimum Bank Balance thus reducing the short term bank loan, which will decrease the interest amount thus increasing the net profit