Question

Redcorp, Inc. manufactures a variety of consumer products. The company’s founders have run the company for 30 years and are now interested in retiring. Consequently, they are seeking a purchaser who will continue its operations, and a group of investors, Stewart Inc, is looking into the acquisition of Redcorp. To evaluate its financial stability and operating efficiency, Redcorp was requested to provide the latest financial statements and selected financial ratios. Summary information provided by Recorp is as follows:

Redcorp Inc.
Income Statement
For the Year Ended November 30, 2015
(in thousands)
Sales (net) 30,500
Interest income 500
Total Revenue 31,000
Cost and expenses
Cost of goods sold 17,600
Selling and general administrative expenses 3,550
Depreciation and amortization expenses 1,890
Interest Expense 900
Total costs and expenses 23,940
Income before taxes 7,060
Income taxes 2,800
Net income 4,260
Redcorp Inc.Balance SheetAs of November 30, 2015(in thousands)
2015 2014Cash 400 500Short-term investments 300 200Accounts receivable (net) 3,200 2,900Inventory 6,000 5,400Total current assets 9,900 9,000Property, plant, and equipment 7,100 7,000Total assets 17,000 16,000Accounts payable 3,700 3,400Income taxes payable 900 800Accrued expenses 1,700 1,400Total current liabilities 6,300 5,600Long-term debt 2,000 1,800Total liabilities 8,300 7,400Common stock ($1 par value) 2,700 2,700Paid-in capital in excess in par 1,000 1,000
Retained earnings 5,000 4,900
Total stockholders’ equity 8,700 8,600Total liabilities and equity 17,000 16,000
Selected Financial Ratios for Redcorp, Inc.
2014 2013 Current Industry AverageCurrent Ratio 1.61 1.62 1.63Acid Test Ratio .64 .63 .68Times Interest Earned 8.55 8.50 8.45Profit margin on sales 13.2% 12.1% 13.0%Asset turnover 1.84 1.83 1.84Inventory turnover 3.17 3.21 3.18
Requirement:1. In Microsoft Word (or other word processing document), please discuss the following:A. Calculate a new set of ratios for the fiscal year 2015 for Redcorp based on the financial statements presented.B. Explain the analytical use of each of the six ratios presented, describing what the investors can learn about Redcorp’s financial stability and operating efficiency.C. Identify and discuss three limitations of ratio analysis

Answer 1

A)

• Current Ratio = current assets / current liabilities = 9,900 / 6,300 = 1.57
• Acid Test Ratio = (current assets - inventory) / current liabilities = (9,600 - 6,000) / 6,300 = 0.57
• Times Interest Earned = EBIT / interest expense = 7,960 / 900 = 8.84
• Profit margin on sales = net income / net sales = 4,260 / 30,500 = 13.97%
• Asset turnover = net sales / average assets = 30,500 / [(17,000 + 16,000)/2] = 1.85
• Inventory turnover = COGS / average inventory = 17,600 / [(6,000 + 5,400)/2] = 3.09

B)

2014 2013 Industry Ave. 2015

Current Ratio 1.61 1.62 1.63 1.57

Acid Test Ratio .64 .63 .68 0.57

Times Interest Earned 8.55 8.50 8.45 8.84

Profit margin on sales 13.2% 12.1% 13.0% 13.97%

Asset turnover 1.84 1.83 1.84 1.85

Inventory turnover 3.17 3.21 3.18 3.09

Some of the company's ratios have improved a little, while others have actually worsen a little. but on general terms, they follow the industry's average.

E.g. times interest earned, profit margin and asset turnover improved a little and they tell investors that the company is more efficient and is actually working better and being more profitable.

While the current ratio, acid test ratio and inventory turnover show us that the company is a little bit more exposed to market risks and general economic conditions. But the change has not been substantial.

C)

The basic limitations of ratio analysis are:

1. That they do not consider inflation, and depending on the inflation rate, that may be a problem. E.g. last year's inflation rate was relatively high for the US (2.3%), but it is not high in absolute terms for an economy.
2. They are based on historical costs and do not represent future performance or cash flows.
3. Different companies use different accounting methods which may result in different ratios. Some accounting ratio may be manipulated, although that can be done only for certain periods since at the end they must be adjusted.

Step-by-step explanation:

Redcorp Inc.

Income Statement

For the Year Ended November 30, 2015 (in thousands)

Sales (net) 30,500

Interest income 500

Total Revenue 31,000

Cost and expenses

Cost of goods sold 17,600

S&A expenses 3,550

Dep. and amort. exp. 1,890

Interest Expense 900

Total costs and expenses (23,940 )

Income before taxes 7,060

Income taxes 2,800

Net income 4,260

Redcorp Inc.

Balance Sheet

As of November 30, 2015 (in thousands)

2015 2014

Cash 400 500

Short-term investments 300 200

Accounts receivable (net) 3,200 2,900

Inventory 6,000 5,400

Total current assets 9,900 9,000

Property, plant, and equipment 7,100 7,000

Total assets 17,000 16,000

Accounts payable 3,700 3,400

Income taxes payable 900 800

Accrued expenses 1,700 1,400

Total current liabilities 6,300 5,600

Long-term debt 2,000 1,800

Total liabilities 8,300 7,400

Common stock ($1 par value) 2,700 2,700

Paid-in capital in excess in par 1,000 1,000

Retained earnings 5,000 4,900

Total stockholders’ equity 8,700 8,600

Total liabilities and equity 17,000 16,000

Selected Financial Ratios for Redcorp, Inc.

2014 2013 Current Industry Average

Current Ratio 1.61 1.62 1.63

Acid Test Ratio .64 .63 .68

Times Interest Earned 8.55 8.50 8.45

Profit margin on sales 13.2% 12.1% 13.0%

Asset turnover 1.84 1.83 1.84

Inventory turnover 3.17 3.21 3.18