Two-Rivers Inc. (TRI) manufactures a variety of consumer products. The company's founders have run the company for thirty years and are now interested in retiring. Consequently, they are seeking a purchaser, and a group of investors is looking into the acquisition of TRI. To evaluate its financial stability, TRI was requested to provide its latest financial statements and selected financial ratios. Summary information provided by TRI is presented below.TRIStatement of IncomeFor the Year Ended November 30, Year 2(In thousands)Sales (net)$31,000 Costs and expenses: Cost of goods sold 17,600 Selling and administrative expense 3,550 Depreciation and amortization expense 1,890 Interest expense 900 Total costs and expenses 23,940 Income before taxes 7,060 Income

Question

taxes 2,900 Net income$4,160 TRIBalance SheetAs of November 30(in thousands) Year 2Year 1Cash$400 $500 Marketable securities 500  200 Accounts receivable, net 3,200  2,900 Inventory 5,800  5,400 Total current assets 9,900  9,000 Property, plant, & equipment, net 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 Additional paid-in capital 1,000  1,000 Retained earnings 5,000  4,900 Total stockholders' equity 8,700  8,600 Total liabilities and stockholders' equity$17,000 $16,000 Selected Financial Ratios TRITRIIndustry Year 1Year 0AverageCurrent ratio 1.62  1.61  1.63 Acid-test (quick) ratio 0.63  0.64  0.68 Times interest earned ratio 8.50  8.55  8.45 Debt to equity ratio 1.02  0.94  1.03 Inventory turnover 3.21  3.17  3.18 Required:a. Calculate the select financial ratios for the fiscal year Year 2.b. Interpret what each of these financial ratios means in terms of TRI's financial stability and operating efficiency.

What will be an ideal response?

Answer 1

a.

The calculation of selected financial ratios for TRI for Year 2 follows.

 

• Current ratio = Current assets ÷ Current liabilities

= $9,900 ÷ $6,300 = 1.57

 

• Acid-test (quick) ratio = (Cash + Marketable securities+ Accounts receivable) ÷ Current liabilities

= ($400 + $500 + $3,200) ÷ $6,300 = 0.65

 

• Times interest earned ratio = Income before interest expense and income taxes ÷ Interest expense

= ($7,060 + $900) ÷ $900 = 8.8

 

• Debt-to-equity ratio = Total liabilities ÷ Stockholders' equity

= $8,300 ÷ $8,700 = 0.95

 

• Inventory turnover = Cost of goods sold ÷ Average Inventory

= $17,600 ÷ [($5,800 + $5,400)/2]  = 3.14

 

b.

Interpretations of the financial ratios:

• TRI's current ratio has declined over the last three years. This declining trend, coupled with the fact that the current ratio is below the industry average, is probably not yet a major concern. However, the current ratio should be monitored.

• The acid-test (quick) ratio has improved over the last three years; however, it is still below the industry average. Furthermore, an acid-test ratio below 1 indicates that TRI may have difficulty meeting its short-term obligations.

• TRI's times interest earned ratio has been improving over the last three years and is above the industry average. This indicates that the relationship between profits and interest expense is favorable and is one indication that TRI might consider increasing its debt--particularly if there are attractive investment opportunities.

• TRI's debt to equity ratio has deteriorated slightly in Year 2 but has been below the industry average over the last three years. This indicates that TRI should be able to raise additional financing through debt and still remain below the industry average.

• TRI's inventory turnover ratio has been steadily declining and is below the industry average. This may indicate a decline in operating efficiency, problems with obsolete inventory, or overpriced stocks.