Question

A company's current assets are $ 300,000. Its current ratio is 2.4x, and its acid test ratio is 1.6x. Its total asset utilization is 1.85x, debt ratio is 40% and basic earning power is 27%. Half of the company's liabilities have an interest of 10% on them. Tax rate is 35%. Inventory utilization is 5x.

Compute the company's return on equity

Answer 1

ROE = Profit/Equity.

We proceed by using basic earning power which is = EBIT/Total Assets = 0.27. (EBIT is earnings before interest and taxes). EBIT = 0.27 x 300000 = 81000. Now we need to calculate the interest and taxes. Since debt ratio is 40%, liability = 0.4 x 300000 = 120000 and equity = 180000. Since half of liabilities have 10% interest, total interest = 60000 x 0.1 = 6000. We remove this from EBIT to calculate EBT = 81000 - 6000 = 75000. Now the tax will be =0.35 x 75000 = 26250 and hence the final profit will be 75000 - 26250 = 48750.

So, the ROE = 48750/180000 = 27.083%