Question

Lloyd Inc. has sales of $250,000, a net income of $20,000, and the following balance sheet: Cash $51,000 Accounts payable $63,600 Receivables 118,800 Notes payable to bank 40,800 Inventories 294,000 Total current liabilities $104,400 Total current assets $463,800 Long-term debt 82,800 Net fixed assets 136,200 Common equity 412,800 Total assets $600,000 Total liabilities and equity $600,000 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.

Answer 1

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 The ROE will be of 9.4%

The firm's new quick ratio is 3.95

Step-by-step explanation:

To calculate how much will the ROE change we have to calculate first the current ratio as follows:

Current ratio = Current assets / Current liabilities

2.5 times = (Cash + receivables + Inventories ) / (Accounts payable + Other current liabilities)

2.5 = ($51,000 + $118,800 + Inventories) / $104,400

$169,000 + inventories = $261,000

Inventories = $92,000

Therefore, $202,000 worth of inventories were sold off.

If the funds generated are used to reduce the common equity that is by repurchasing the equity at book value.

Hence, the common equity amounts to $210,800

Calculating the ROE before the inventory is sold off:

ROE = Net income / Steockholder's equity

= $20,000 / $412,800

= 0.048 or 4.8%

Calculating the ROE after selling off the inventory:

ROE = $20,000 / $210,800

= 0.094 or 9.4%

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 The ROE will be of 9.4%

The firm's new quick ratio is

Quick ratio = (Current assets - Inventories) / Current liabilities

= ($463,800 - $92,000) / $104,400

= 3.95