Question

RETURN ON EQUITY AND QUICK RATIO

Lloyd Inc. has sales of $650,000, a net income of $78,000, and the following balance sheet:

Cash	$130,390		Accounts payable	$110,500
Receivables	218,790		Notes payable to bank	88,400
Inventories	430,950		Total current liabilities	$198,900
Total current assets	$780,130		Long-term debt	204,425
Net fixed assets	324,870		Common equity	701,675
Total assets	$1,105,000		Total liabilities and equity	$1,105,000

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, 2x, without affecting sales or net income.

1. If inventories are sold and not replaced (thus reducing the current ratio to 2x); 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.
   
   %
   
2. What will be the firm's new quick ratio? Do not round intermediate calculations. Round your answer to two decimal places.
   
   x

Answer 1

a]

Current ratio = current assets / current liabilities

Current ratio before inventories are sold  = $780,130 / $198,900 = 3.92

To reduce current ratio to 2, required value of current assets = current liabilities * 2 = $198,900 * 2 = $397,800

Required reduction in inventory = current assets before inventories are sold - required value of current assets

Required reduction in inventory = $780,130 - $397,800 = $382,330

ROE = net income / common equity = $78,000 / $701,675 = 11.12%

If inventories sold are used to reduce common equity, new value of common equity = $701,675 - $382,330 = $319,345

ROE = net income / common equity = $78,000 / $319,345 = 24.42%

ROE changes from 11.12% to 24.42%, which is an increase of 13.30%

b]

Quick Ratio = (cash + receivables) / Current Liabilities

Quick Ratio = ($130,390 + $218,790) / $198,900 = 1.76