Question

Lloyd Inc. has sales of $450,000, a net income of $36,000, and the following balance sheet:Cash $148,770 Accounts payable $117,450Receivables 244,035 Notes payable to bank 71,775Inventories 613,350 Total current liabilities $189,225Total current assets $1,006,155 Long-term debt 207,495Net fixed assets 298,845 Common equity 908,280Total assets $1,305,000 Total liabilities and equity $1,305,000The 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.

Answer 1

Desired current asset for current ratio to be 2.5x

=> 2.5*Total current liabilities

=> 2.5*$189,225

=> $473,063

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

New book value of equity = $908,280 - $533,093

New book value of equity = $375,188

Change in ROE = ROE now - ROE before

Change in ROE = (Net income / New book value of equity) - (Net income / Old book value of equity)

Change in ROE = (36,000 / 375,188) - (36,000 / 908,280)

Change in ROE = 0.0959519 - 0.0396354

Change in ROE = 0.0563165

Change in ROE = 5.63%

Hence, ROE will increase by 5.63%

Firm's new quick ratio = (Cash + Receivables ) / Current liabilities

Firm's new quick ratio = ($148,770 + $244,035) / $189,225

Firm's new quick ratio = $392,805 / $189,225

Firm's new quick ratio = 2.0758621

Firm's new quick ratio = 2.08