General Hospital has a current ratio of 0.5. Which of the following actions would improve (increase) this ratio? (Hint: Create a simple balance sheet that has a current ratio of 0.5. Then, judge how the transactions below would affect the balance sheet.)
1. Use cash to pay off current liabilities.
2. Collect some of the current accounts receivable.
3. Use cash to pay off some long-term debt.
4. Purchase additional inventory on credit (i.e., accounts payable).
5. Sell some of the existing inventory at cost (book value).
b. Now assume that General Hospital has a current ratio of 1.2. In this situation, which of the above actions would improve this ratio?
13.2 Southwest Physicians, a medical group practice in Oklahoma City, is just being formed. It will need $2 million of total assets to generate $3 million in revenues. Furthermore, the group expects to have a total margin of 5 percent. The group is considering two financing alternatives. First, it can use all-equity financing by requiring each physician to contribute his or her pro rata share. Second, the practice can finance up to 50 percent of its assets with a bank loan. Assuming that the debt alternative has no impact on the expected total margin, what is the difference between the expected return on equity (ROE) if the group finances with 50 percent debt versus the expected ROE if it finances entirely with equity capital?
1. Using cash to pay off current liabilities would improve the current ratio because it would decrease current liabilities while not affecting current assets.
2. Collecting some of the current accounts receivable would also improve the current ratio because it would increase current assets.
3. Using cash to pay off some long-term debt would not affect the current ratio as it focuses on short-term assets and liabilities.
4. Purchasing additional inventory on credit (accounts payable) would not improve the current ratio, as it would increase both current assets and current liabilities.
5. Selling existing inventory at cost would not impact the current ratio, as it would simply convert one current asset (inventory) into another (cash).
If General Hospital has a current ratio of 1.2, the actions that would improve this ratio are:
1. Using cash to pay off current liabilities.
2. Collecting some of the current accounts receivable.
In this case, reducing current liabilities or increasing current assets would help improve the current ratio.
To improve (increase) the current ratio of General Hospital, we need to consider the impact of each action on the balance sheet:
1. Using cash to pay off current liabilities: This action decreases both current assets (cash) and current liabilities, which would increase the current ratio.
2. Collecting some of the current accounts receivable: This action increases current assets (cash) without affecting current liabilities, which would increase the current ratio.
3. Using cash to pay off some long-term debt: This action decreases long-term debt and cash without affecting current liabilities, so it would not have a significant impact on the current ratio.
4. Purchasing additional inventory on credit (accounts payable): This action increases both current assets (inventory) and current liabilities (accounts payable), so it does not significantly change the current ratio.
5. Selling some of the existing inventory at cost (book value): This action decreases current assets (inventory) without affecting current liabilities, which would decrease the current ratio.
Therefore, actions 1 and 2 would improve (increase) the current ratio of General Hospital.
b. If General Hospital already has a current ratio of 1.2, it means the current assets are already relatively higher compared to current liabilities. In this situation, action 2 (collecting some of the current accounts receivable) would further increase the current ratio, as it increases current assets without affecting current liabilities. However, action 1 (using cash to pay off current liabilities) would not have a significant impact on the current ratio since it may already be relatively high.
For the second part of the question:
To calculate the difference between the expected return on equity (ROE) if the group finances with 50 percent debt versus the expected ROE if it finances entirely with equity capital, we need to compare the return on equity under the two different financing scenarios.
1. All-equity financing: With all-equity financing, the ROE can be calculated as the total margin multiplied by the asset turnover ratio (revenue/total assets). In this case, the expected ROE would be 5% (total margin) multiplied by the asset turnover ratio (3 million/2 million = 1.5), which equals 7.5%.
2. Debt financing: With 50% debt financing, the ROE needs to be adjusted to reflect the interest expense from the bank loan. Assuming an interest expense of 5%, the total margin would remain the same at 5%. However, since debt financing is used, the equity invested is only 50% of the total assets. Therefore, the expected ROE would be 5% (total margin) multiplied by the asset turnover ratio (3 million/2 million = 1.5), divided by the equity investment ratio (50% = 0.5), which equals 10%.
The difference between the expected ROE with 50% debt financing and all-equity financing would be 10% (debt financing) minus 7.5% (all-equity financing) = 2.5%.
To determine how each action would affect the current ratio, let's understand what the current ratio represents. The current ratio is a financial metric used to assess a company's ability to pay off its short-term obligations using its current assets. It is calculated by dividing current assets by current liabilities.
1. Using cash to pay off current liabilities: This action would decrease both current assets and current liabilities. Since the current ratio is calculated by dividing current assets by current liabilities, decreasing both would result in a smaller ratio. Therefore, this action would not improve the current ratio.
2. Collecting some of the current accounts receivable: This action would increase current assets since accounts receivable are part of current assets. However, it would not impact current liabilities. Increasing current assets without increasing current liabilities would result in a higher current ratio. Therefore, this action would improve the current ratio.
3. Using cash to pay off some long-term debt: This action would decrease both current assets and long-term debt, but it would not directly impact current liabilities. Therefore, it would not improve the current ratio.
4. Purchasing additional inventory on credit (accounts payable): This action would increase both current assets (inventory is part of current assets) and current liabilities (accounts payable). Since both increase proportionally, there would be no impact on the current ratio. Therefore, this action would not improve the current ratio.
5. Selling some of the existing inventory at cost (book value): This action would not directly impact current assets or current liabilities since it involves a sale of existing inventory. Therefore, it would not improve the current ratio.
b. If the current ratio is already 1.2, it indicates that the company has a stronger ability to pay off its short-term obligations. In this situation, actions that reduce current assets or increase current liabilities would likely improve the current ratio. Based on the previous analysis:
- Using cash to pay off current liabilities: This action would decrease both current assets and current liabilities, which would improve the current ratio.
- Collecting some of the current accounts receivable: This action would increase current assets, but it would not impact current liabilities. Therefore, it would further improve the current ratio.
- Using cash to pay off some long-term debt: This action would decrease both current assets and long-term debt, but it would not directly impact current liabilities. Therefore, it would have no impact on the current ratio.
- Purchasing additional inventory on credit (accounts payable): This action would increase both current assets and current liabilities, which would not improve the current ratio.
- Selling some of the existing inventory at cost (book value): This action would not directly impact current assets or current liabilities. Therefore, it would not improve the current ratio.
13.2. To calculate the difference in expected return on equity (ROE) between financing with 50 percent debt and financing entirely with equity capital, we need to determine the ROE for each financing alternative.
When financed entirely with equity capital:
- Total assets = $2 million
- Total margin = 5% of $3 million = $150,000
- Equity capital = Total assets = $2 million
ROE = Total margin / Equity capital = $150,000 / $2 million = 0.075 or 7.5%
When financed with 50% debt:
- Total assets = $2 million
- Total margin = $150,000 (no impact on total margin stated)
- Equity capital = 50% of $2 million = $1 million
- Debt capital = 50% of $2 million = $1 million
ROE = Total margin / Equity capital = $150,000 / $1 million = 0.15 or 15%
The difference in expected ROE between financing with 50% debt and financing entirely with equity capital is 15% - 7.5% = 7.5%. Therefore, financing with 50% debt would result in a higher expected return on equity compared to financing entirely with equity capital by 7.5%.