Question

Use the below information to answer the following question.

Income Statement
For the Year
Sales $28,400
Cost of goods sold 21,200
Depreciation 2,700

Earnings before interest and taxes $ 4,500
Interest paid 850

Taxable income $ 3,650
Taxes 1,400

Net income $ 2,250

Dividends $900

Balance Sheet
End-of-Year
Cash $ 550
Accounts receivable 2,450
Inventory 4,700

Total current assets $ 7,700
Net fixed assets 16,900

Total assets $24,600

Accounts payable $ 2,700
Long-term debt 9,800
Common stock ($1 par value) 8,000
Retained earnings 4,100

Total Liab. & Equity $24,600

Assume the profit margin and the payout ratio for this firm are constant. If sales increase by 6 percent, what is the pro forma retained earnings?

Answer 1

To calculate the pro forma retained earnings after a 6 percent increase in sales, the new net income is determined by applying the constant profit margin to the increased sales, subtracting the dividends given the constant payout ratio, and adding the remainder to the existing retained earnings.

Step-by-step explanation:

If we assume that the profit margin and the payout ratio are constant, we can calculate the pro forma retained earnings after a 6 percent increase in sales. Since the net income is currently $2,250 and dividends are $900, the amount added to retained earnings is $2,250 - $900 = $1,350. A 6 percent increase in sales would increase sales to $28,400 * 1.06 = $30,104. Assuming the same profit margin, the new net income can be calculated and then the additional retained earnings can be found by subtracting the constant proportion of dividends paid out.

To reflect the pro forma retained earnings, we would therefore add the new retained earnings to the existing retained earnings of $4,100. The pro forma retained earnings would be: existing retained earnings + (new net income - dividends paid).To calculate the pro forma retained earnings, we need to first calculate the current retained earnings. Retained earnings can be calculated by subtracting dividends from the net income: $2,250 - $900 = $1,350. Next, we can calculate the new retained earnings by adding the net income from the increase in sales to the current retained earnings. Since the profit margin and payout ratio are constant, the increase in sales will result in an increase in net income. Let's calculate the increase in net income first. The increase in sales is 6% of $28,400 = $1,704. If the profit margin is constant, the increase in net income will be 6% of the current net income: 6% of $2,250 = $135. Now we can calculate the new retained earnings: $1,350 + $135 = $1,485.