A company has the following ratios: Current ratio: 0.85 Inventory to Sales Conve
ID: 2776642 • Letter: A
Question
A company has the following ratios:
Current ratio: 0.85
Inventory to Sales Conversion Period: 180 days
Sales to Cash Conversion Period: 40 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 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.
Explanation / Answer
Calculation of return on equity:
Return on equity = Net income / Shareholder’s Equity
Net income = Sales * Net profit Margin
=2500000 *3% =$75000
Shareholder’s Equity = equity + retained earnings
=1,000,000+120,000 = 1,120,000
Hence
Return on equity = 75000 / 1120000
= 0.0670
= 6.70%
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