Question

Lloyd Inc. has sales of $450,000, a net income of $36,000, and the following balance sheet:...

Lloyd Inc. has sales of $450,000, a net income of $36,000, and the following balance sheet:

Cash $148,770    Accounts payable $117,450
Receivables 244,035    Notes payable to bank 71,775
Inventories 613,350    Total current liabilities $189,225
Total current assets $1,006,155    Long-term debt 207,495
Net fixed assets 298,845    Common equity 908,280
Total assets $1,305,000    Total liabilities and equity $1,305,000

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 sales or net income.

If inventories are sold 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? Do not round intermediate calculations. Round your answer to two decimal places.


What will be the firm's new quick ratio? Do not round intermediate calculations. Round your answer to two decimal places.

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Answer #1

Desired current asset for current ratio to be 2.5x = 2.5 x Total current liabilities = 2.5 x $ 189,225 = $  473,063

Hence, Reduction in equity = Reduction in current assets = Reduction in inventory = Old Current assets - New current assets = $1,006,155 - $ 473,063 = $  533,093

New book value of equity = Old book value - reduction in equity = 908,280 - 533,093 = $ 375,188

Hence, change in ROE = ROE now - ROE before = Net income / New book value of equity - Net income / Old book value of equity = 36,000 / 375,188 - 36,000 / 908,280 = 5.63%

Hence, ROE will increase by 5.63%

Firm's new quick ratio = (Cash + receivables ) / Current liabilities = (148,770 + 244,035) / 189,225 =  2.08

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