Chapter 12 (week 12 lecture)

Tutorial question (P12-4A, P12-5A)

P12–4A The following income statement and balance sheets for Virtual Gaming Systems are provided.

VIRTUAL GAMING SYSTEMS

Income Statement
For the year ended December 31, 2024
Net sales $3,086,000
Cost of goods sold 1,960,000
Gross profit 1,126,000
Expenses:
Operating expenses $868,000
Depreciation expense 32,000
Loss on sale of land 9,000
Interest expense 20,000
Income tax expense 58,000
Total expenses 987,000
Net income $ 139,000
VIRTUAL GAMING SYSTEMS
Balance Sheets
December 31
2024 2023
Assets
Current assets:
Cash $196,000 $154,000
Accounts receivable 91,000 70,000
Inventory 115,000 145,000
Prepaid rent 13,000 7,200
Long-term assets:
Investment in bonds 115,000 0
Land 220,000 250,000
Equipment 280,000 220,000
Less: Accumulated depreciation (84,000) (52,000)
Total assets $946,000 $794,200
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable $ 76,000 $ 91,000
Interest payable 8,000 4,000
Income tax payable 20,000 15,000
Long-term liabilities:
Notes payable 295,000 235,000
Stockholders' equity:
Common stock 310,000 310,000
Retained earnings 237,000 139,200
Total liabilities and stockholders' equity $946,000 $794,200
Required:

Assuming that all sales were on account, calculate the following risk ratios for 2024.

1. Receivables turnover ratio.

2. Average collection period.
3. Inventory turnover ratio.
4. Average days in inventory.
5. Current ratio.
6. Acid-test ratio.
7. Debt to equity ratio.
8. Times interest earned ratio.

P12–5A Data for Virtual Gaming Systems are provided in P12–4A. Earnings per share for the year ended
December 31, 2024, are $1.40. The closing stock price on December 31, 2024, is $28.30.
Required:

Calculate the following profitability ratios for 2024.

1. Gross profit ratio.
2. Return on assets.
3. Profit margin.
4. Asset turnover.
5. Return on equity.
6. Price-earnings ratio.
Take-home question (E12-5, E12-6, E12-7, E12-8, RWP12-6)
E12–5 The 2024 income statement of Adrian Express reports sales of $19,310,000, cost of goods sold of
$12,250,000, and net income of $1,700,000. Balance sheet information is provided in the following
table.

ADRIAN EXPRESS
Balance Sheets
December 31, 2024 and 2023
2024 2023
Assets
Current assets:
Cash $ 700,000 $ 860,000
Accounts receivable 1,600,000 1,100,000
Inventory 2,000,000 1,500,000
Long-term assets 4,900,000 4,340,000
Total assets $9,200,000 $7,800,000
Liabilities and Stockholders' Equity
Current liabilities $1,920,000 $1,760,000
Long-term liabilities 2,400,000 2,500,000
Common stock 1,900,000 1,900,000
Retained earnings 2,980,000 1,640,000
Total liabilities and stockholders' equity $9,200,000 $7,800,000

Industry averages for the following four risk ratios are as follows:

Average collection period 25 days

Average days in inventory 60 days
Current ratio 2 to 1
Debt to equity ratio 50%
Required:
1. Calculate the four risk ratios listed above for Adrian Express in 2024.
2. Do you think the company is more risky or less risky than the industry average? Explain your
answer.

E12–6 Refer to the information for Adrian Express in E12–5. Industry averages for the following
profitability ratios are as follows:

Gross profit ratio 45%

Return on assets 25%
Profit margin 15%
Asset turnover 2.5 times
Return on equity 35%
Required:
1. Calculate the five profitability ratios listed above for Adrian Express.
2. Do you think the company is more profitable or less profitable than the industry average? Explain
your answer.
E12–7 The balance sheets for Plasma Screens Corporation and additional information are provided
below.

PLASMA SCREENS CORPORATION

Balance Sheets
December 31, 2024 and 2023
2024 2023
Assets
Current assets:
Cash $ 242,000 $ 130,000
Accounts receivable 98,000 102,000
Inventory 105,000 90,000
Investments 5,000 3,000
Long-term assets:
Land 580,000 580,000
Equipment 890,000 770,000
Less: Accumulated depreciation (528,000) (368,000)
Total assets $1,392,000 $1,307,000
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable $ 109,000 $ 95,000
Interest payable 7,000 13,000
Income tax payable 9,000 6,000
Long-term liabilities:
Notes payable 110,000 220,000
Stockholders' equity:
Common stock 800,000 800,000
Retained earnings 357,000 173,000
Total liabilities and stockholders' equity $1,392,000 $1,307,000

Additional Information for 2024:

1. Net income is $184,000.
2. Sales on account are $1,890,000.
3. Cost of goods sold is $1,394,250.

Required:
1. Calculate the following risk ratios for 2024:
a. Receivables turnover ratio.
b. Inventory turnover ratio.
c. Current ratio.
d. Acid-test ratio.
e. Debt to equity ratio.
2. When we compare two companies, can one have a higher current ratio while the other has a
higher acid-test ratio? Explain your answer.
E12–8 Refer to the information provided for Plasma Screens Corporation in E12–7.
Required:

1. Calculate the following profitability ratios for 2024:

a. Gross profit ratio.

b. Return on assets.
c. Profit margin.
d. Asset turnover.
e. Return on equity.
2. When we compare two companies, can one have a higher return on assets while the other
has a higher return on equity? Explain your answer.
Ethics
RWP12–6 After years of steady growth in net income, Performance Drug Company reported a preliminary
net loss in 2024. The CEO, Joe Mammoth, notices the following estimates are included in reported
performance:

1. Warranty expense and liability for estimated future warranty costs associated with sales in the current
year.
2. Loss due to ending inventory's net realizable value (estimated selling price) falling below its cost.
This type of inventory write down occurs most years.
3. Depreciation of major equipment purchase dd this year, which is estimated to have a 10-year service life.

Joe is worried that the company's poor performance will have a negative impact on the company's risk and
profitability ratios. This will cause the stock price to decline and hurt the company's ability to obtain needed
loans in the following year. Before releasing the financial statements to the public, Joe asks his CFO to
reconsider these esimates. He argues that (1)warranty work won't happen until next year, so that estimate
can be eliminated, (2) there's always a chance we'll find the right customer and sell inventory above cost, so
the estimated loss on inventory write-down can be eliminated, and (3) we may use the equipment for 20
years (even though equipment of this type has little chance of being used for more than 10 years). Joe
explains that all of his suggestions make good business sense and reflect his optimism about the company's
future. Joe further notes that executive bonuses (including his and the CFO's) are tied to net income and if
we don't show a profit this year, there will be no bonuses.

Required:
1. Understand the reporting effect: How would excluding the warranty adjustment affect the debt to equity
ratio? How would excluding the inventory adjustment affect the gross profit ratio? How would extending
the depreciable life to 20 years affect the profit margin?
2. Specify the options: If the adjustments are kept, what will they indicate about the company's overall risk
and profitability?
3. Identify the ipact: Could these adjustments affect stockholders, lenders, and management?
4. Make a decision: Should the CFO follow Joe's suggestions of not including these adjustments?