25 PGB - Horngren'S Financial And Managerial Accounting

Question

Using ROI and RI to evaluate investment centers

Consider the following condensed financial statements of Pure Life, Inc. The company’s target rate of return is 30%.

PURE LIFE, INC. Income Statement For the Year Ended December 31, 2018 Net Sales Revenue Cost of Goods Sold Gross Profit Operating Expenses 2,300,000 2,000,000 300,000 (34,000) 266,000 3,700,000 \( 6,000,000 Operating Income Interest Expense Other Income and (Expenses): Income Before Income Tax Expense Income Tax Expense Net Income 93,100 \) 172,900

PURE LIFE, INC. Comparative Balance Sheet As of December 31, 2018 and 2017 Assets 2018 2017 Cash Accounts Receivable Supplies Property, Plant, and Equipment, net Patents, net Total Assets Accounts Payable Short-term Notes Payable Long-term Notes Payable Common Stock, no Par Retained Earnings Total Liabilities and Stockholders’ Equity Liabilities and Stockholders’ Equity \( 62,000 200 204,000 101,000 \) 394,000 26,800 \( 76,000 600 305,000 163,000 \) 606,000 61,400 52,000 \( 31,000 126,500 169,000 15,500 \) 394,000 148,000 \( 29,000 196,000 205,500 27,500 \) 606,000

Requirements

1. Calculate the company’s ROI. Round all of your answers to four decimal places.

2. Calculate the company’s profit margin ratio. Interpret your results.

3. Calculate the company’s asset turnover ratio. Interpret your results.

4. Use the expanded ROI formula to confirm your results from Requirement 1. Interpret your results.

5. Calculate the company’s RI. Interpret your results.

Step-by-Step Solution

Answer

1. Company’s ROI is 34.58%
2. Company’s profit margin ratio is 0.0288 or 2.88%. It means of the sales revenue i.e., 100%, 2.88% is left as net income after meeting cost of goods sold and all operating expenses.
3. Company’s asset turnover ratio 12:1 it shows the efficiency of asset to generate sales revenue.
4. The expanded ROI shows the same result i.e., 34.58% as company’s ROI.

Company’s RI is $22,900.

computing average asset-

$\begin{array}{c}\text{Average total asset}=\frac{\text{Beginning asset}+\text{Ending asset}}{2}\\ =\frac{\$394,000+\$606,000}{2}\\ =\$500,000\end{array}$

Computing ROI-

$\begin{array}{c}\text{ROI}=\frac{\text{Net income}}{\text{Average asset}}\times 100\\ =\frac{\$172,900}{\$500,000}\times 100\\ =34.58\%\end{array}$

Computing profit margin ratio-

$\begin{array}{c}\text{Profit margin ratio}=\frac{\text{Net income}}{\text{Net sales revenue}}\\ =\frac{\$172,900}{\$6,000.000}\\ =0.0288\end{array}$

Computing asset turnover ratio-

$\begin{array}{c}\text{Asset Turnover Ratio }= \frac{\text{Net Sales }}{\text{Average Total Assets}}\\ =\frac{\$6,000,000}{\$500,000}\\ =12\end{array}$

Computing expanded ROI

$\begin{array}{c}\text{ROI}=\text{Profit margin ratio}\times \text{Asset turnover ratio}\times 100\\ \text{=0.0288}\times \text{12}\times \text{100}\\ \text{=34.56}\end{array}$

Computing expanded RI

$\begin{array}{c}\text{Residual Income}=\text{Operating income }-\left(\text{Minimum required rate of return}\times \text{Average operating assets}\right)\\ =\$172,900-\left(30\%\times \$500,000\right)\\ =\$172,900-\$150,000\\ =\$22,900\end{array}$