Lloyd Inc. has sales of $ 200,000, a net income of $ 15,000, and the following b

Question

Lloyd Inc. has sales of $ 200,000, a net income of $ 15,000, and the following balance sheet: Cash $ 10,000 Accounts payable $ 30,000 Receivables 50,000 Other current liabilities 20,000 Inventories 150,000 Long- term debt 50,000 Net fixed assets 90,000 Common equity 200,000 Total assets $ 300,000 Total liabilities and equity $ 300,000 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, 2.5X, without affecting sales or net income. If inventories are sold off 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

According to the given data, Total current assets = $210,000 Total current liabilities = $50,000 Computing the current ratio: Current ratio = Total Current assets / Total current liabilities = $210,000 / $50,000 = 4.2 Computing the Quick ratio: Quick ratio = (Total Current assets – Inventories) / Current liabilities = ($210,000 - $150,000) / $50,000 = 1.2 Computing ROE: ROE = Net income / Stockholder’s equity = $15,000 / $200,000 = 0.075 or 7.5% These calculations are based on the given data. But the owner thinks that inventories are excessive and can be lowered to the point where the current ratio should equal 2.5X and the common equity should be reduced by repurchasing the stock at book value. If inventories are sold off and not replaced, what amount of inventories are sold to make the current ratio 2.5X To know this value, let us calculate the current ratio: Current ratio = Total Current assets / Total current liabilities 2.5 = TCA / $50,000 Since the desired current ratio is 2.5 and the total current liabilities is $50,000 TCA = $125,000 Therefore, the total current asset value should be $125,000 to make the current ratio equal to 2.5 We want to sell off some inventory to make the total current assets equals $125,000. Therefore, the total current liabilities equal Cash + Receivables + Inventory = $125,000 $10,000 + $50,000 + Inventory = $125,000 Inventory = $125,000 - $60,000 = $65,000 Therefore, out of the total inventory $150,000, only $65,000 worth inventory the firm should hold and the remaining $85,000 should be sold off. After the inventory is sold off total assets comes to $125,000 + $90,000 = $215,000 We want to reduce the common stock by repurchasing some stock at book value. The total liabilities and stockholder’s equity is therefore equal to $215,000 after repurchasing $85,000 worth of common stock. Now the common stock is worth only $115,000. Computing ROE: ROE = Net income / Stockholder’s equity = $15,000 / $115,000 = 0.13 or 13% Now, computing the new Quick ratio as: Quick ratio = (Total Current assets – Inventories) / Current liabilities = ($210,000 - $65,000) / $50,000 = 2.9 Therefore, the firm’s ROE will change by 5.5%

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