A company has the following ratios: Current ratio - .85 Inventory to Sales Conve

Question

A company has the following ratios:

Current ratio - .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%.  

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

The current ration must be greater than 1 ,current ratio of 0.85 says that the companies current assets are short to pay the current liabilities So it wll need to borrow short term at a high interest rate to continue its daily operation without any issues. Number of days it will take to convert inventory to sales is 180 days is quite high Sales 2500000 Gross profit margin is sales-cogs/ sales 375000 is sales -cogs COGS is 2125000 Gross profit 375000 Net profit 75000 Shares holders equity 1000000 Equity 12000 Retained earnings 75000 Profit 1087000 Closing balance of shareholders equity Return on equity is netincome/common equity 7.50% It is good return on equity Income statement Sales 2500000 COGS 2125000 Gross Profit(EBITDA) 375000 Net Profit(PAT) 75000

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