Lloyd Inc. has sales of $150,000, a net income of $13,500, and the following bal
ID: 2663531 • Letter: L
Question
Lloyd Inc. has sales of $150,000, a net income of $13,500, and the following balance sheet:Cash $19,380 Accounts payable $21,675
Receivables 46,410 Other current liabilities 14,790
Inventories 135,150 Long-term debt 43,095
Net fixed assets 54,060 Common equity 175,440
Total assets $255,000 Total liabilities and equity $255,000
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 either sales or net income.
a. 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? Round your answer to two decimal places.
b. What will be the firm's new quick ratio? Round your answer to two decimal places.
Explanation / Answer
a) From the given information, Total current assets = Cash + Receivables + Inventories = $19,380 + $46,410 + $135,150 = $200,940 Total current liabilities = Accounts payable + Other current liabilities = $21,675 + $14,790 = $36,465 Calculating the Current ratio Current ratio = Current assets / Current liabilities = $200,940 / $36,465 = 5.5 But new owner is thinking that inventories are excessive and can be reduced to the amount where current ratio is equal to its industry average of 2.5 Let us calculate the amount of current assets at current ratio (2.5) Current ratio = Current assets / Current liabilities 2.5 = Current assets / $36,465 Current assets = $36,465 * 2.5 = $91,162.5 Therefore, at current ratio = 2.5, the current assets are $91,162.5 Difference in the amount of current assets is ($200,940 - $91,162.5) = $109,77.5 This amount of inventory should be sold off to make the current ratio equal to 2.5 New inventory = Old inventory - Amount of inventory sold off = $135,150 - $109,77.5 = $25,372.5 The amount ($109,777.5) that is generated by selling off the inventory is used to repurchase the stock. New common equity = $175,440 - $109,777.5 = $65,662.5 Calculating the ROE before stock repurchase ROE = Net income / TOtal equity = $13,500 / $175,440 = 0.077 or 7.7% Calculating the ROE after stock repurchase ROE = $13,500 / $65,662.5 = 0.2055 or 20.55% Therefore, the ROE has changed by 12.85% b) The quick ratio is calculated as Quick ratio = (Current assets - Inventory)/ Current liabilities = ($91,162.5 - $25,372.5) / $36,465 = $65,790 / $36,465 = 1.8 Therefore, the quick ratio is 1.8
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