Balance Sheet cash 14,000 receivables 70,000 inventories 280,000 total cur. asse

Question

Balance Sheet
cash 14,000
receivables 70,000
inventories 280,000
total cur. assets 364,000
net fix assets 126000
TOTAL ASSETS 490000
sales 280000
Net income 21000

Income statement:
account payable 42,000
other cur. liab. 28,000
total cur liab 70,000
long term debt 140,000
Current Equity 280,000
total L&E 490,000
The new CFO thinks that inventories are excessive and could be lowered sufficiently to cause the current ratio to equal the industry average, 2.75, without affecting either sales or net income. Assuming that inventories are sold off and not replaced to get the current ratio to the target level, and that the funds generated are used to buy back common stock at book value, by how much would the ROE change?

Explanation / Answer

Let the value of inventory sold equals x
Current ratio = current asset/current liability
2.75 = (364,000-x)/70,000
x= 171,500

A buyback of common stock reduces equity
because there is less stock available for public purchase.

Decrease in equity = 171,500
Final equity = 280,000-171,500 = 108,500

Current ROE = Net income/Equity = 21,000/280,000 = 0.0750

ROE after inventory sold off = 21,000/108,500 = 0.1935

Change in ROE = ROE(new)-ROE(old)=0.1185=11.85%

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