Question

Consider the following condensed financial statements of Forever Free, Inc. The company’s target rate of return is 40%.

Forever Free, Inc
Income Statement
For the year ended December 31, 2018
Net Sales revenue	\( 3,500,000
Cost of Goods Sold	2,200,000
Gross Profit	1,300,000
Operating Expenses	950,000
Operating Income	350,000
Other income and (expenses)
Interest Expense	(27,000)
Income before income tax expense	323,000
Income tax expense	113,050
Net Income	\) 209,950

Forever Free, Inc
Income Statement
For the year ended December 31, 2018
	2018	2017
Assets
Cash	\( 64,000	\) 52,000
Accounts Receivable	49,200	17,800
Supplies	1,000	400
Property, Plant, and Equipment, net	331,800	229,800
Patents, net	135,000	119,000
Total Assets	\( 581,000	\) 419,000
Liabilities and Stockholders’ Equity
Accounts Payable	\( 17,000	\) 19,000
Short-term Notes Payable	136,000	42,000
Long-term Notes Payable	184,000	114,500
Common Stock, no Par	232,000	242,000
Retained Earnings	12,000	1,500
Total Liabilities and Stockholders’ Equity	\( 581,000	\) 419,000

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.

Short answer

1. 70%

2. 10%

3. 7 times

4. 70%

5. $150,000

Step-by-step solution

Computation of ROI

$\begin{array}{c}\mathbf{A}\mathbf{v}\mathbf{r}\mathbf{e}\mathbf{g}\mathbf{a}\mathbf{e}\mathbf{}\mathbf{T}\mathbf{o}\mathbf{t}\mathbf{a}\mathbf{l}\mathbf{}\mathbf{A}\mathbf{s}\mathbf{s}\mathbf{e}\mathbf{t}\mathbf{s}\mathbf{\left(}\mathbf{2018}\mathbf{\right)}\mathbf{=}\frac{\mathbf{T}\mathbf{o}\mathbf{t}\mathbf{a}\mathbf{l}\mathbf{}\mathbf{A}\mathbf{s}\mathbf{s}\mathbf{e}\mathbf{t}\mathbf{s}\mathbf{}\mathbf{i}\mathbf{n}\mathbf{}\mathbf{2018}\mathbf{+}\mathbf{T}\mathbf{o}\mathbf{t}\mathbf{a}\mathbf{l}\mathbf{}\mathbf{A}\mathbf{s}\mathbf{s}\mathbf{e}\mathbf{t}\mathbf{s}\mathbf{}\mathbf{i}\mathbf{n}\mathbf{}\mathbf{2017}}{\mathbf{2}}\\ \mathbf{=}\frac{\mathbf{\$}\mathbf{581}\mathbf{,}\mathbf{000}\mathbf{+}\mathbf{\$}\mathbf{419}\mathbf{,}\mathbf{000}}{\mathbf{2}}\\ \mathbf{=}\frac{\mathbf{\$}\mathbf{1}\mathbf{,}\mathbf{000}\mathbf{,}\mathbf{000}}{\mathbf{2}}\\ \mathbf{=}\mathbf{\$}\mathbf{500}\mathbf{,}\mathbf{000}\end{array}$

$\begin{array}{c}\mathbf{R}\mathbf{O}\mathbf{I}\mathbf{}\mathbf{i}\mathbf{n}\mathbf{}\mathbf{2018}\mathbf{=}\frac{\mathbf{O}\mathbf{p}\mathbf{e}\mathbf{r}\mathbf{a}\mathbf{t}\mathbf{i}\mathbf{n}\mathbf{g}\mathbf{}\mathbf{I}\mathbf{n}\mathbf{c}\mathbf{o}\mathbf{m}\mathbf{e}\mathbf{\left(}\mathbf{2018}\mathbf{\right)}}{\mathbf{A}\mathbf{v}\mathbf{e}\mathbf{r}\mathbf{a}\mathbf{g}\mathbf{e}\mathbf{}\mathbf{T}\mathbf{o}\mathbf{t}\mathbf{a}\mathbf{l}\mathbf{}\mathbf{A}\mathbf{s}\mathbf{s}\mathbf{e}\mathbf{t}\mathbf{s}\mathbf{\left(}\mathbf{2018}\mathbf{\right)}}\\ \mathbf{=}\frac{\mathbf{\$}\mathbf{350}\mathbf{,}\mathbf{000}}{\mathbf{\$}\mathbf{500}\mathbf{,}\mathbf{000}}\\ \mathbf{=}\mathbf{0}\mathbf{.}\mathbf{7}\mathbf{o}\mathbf{r}\mathbf{70}\mathbf{\%}\end{array}$

Computation of profit margin ratio

$\begin{array}{c}\mathbf{P}\mathbf{r}\mathbf{o}\mathbf{f}\mathbf{i}\mathbf{t}\mathbf{}\mathbf{M}\mathbf{a}\mathbf{r}\mathbf{g}\mathbf{i}\mathbf{n}\mathbf{}\mathbf{R}\mathbf{a}\mathbf{t}\mathbf{i}\mathbf{o}\mathbf{\left(}\mathbf{2018}\mathbf{\right)}\mathbf{=}\frac{\mathbf{O}\mathbf{p}\mathbf{e}\mathbf{r}\mathbf{a}\mathbf{t}\mathbf{i}\mathbf{n}\mathbf{g}\mathbf{}\mathbf{I}\mathbf{n}\mathbf{c}\mathbf{o}\mathbf{m}\mathbf{e}}{\mathbf{N}\mathbf{e}\mathbf{t}\mathbf{}\mathbf{S}\mathbf{a}\mathbf{l}\mathbf{e}\mathbf{s}\mathbf{}\mathbf{R}\mathbf{e}\mathbf{v}\mathbf{e}\mathbf{n}\mathbf{u}\mathbf{e}}\\ \mathbf{=}\frac{\mathbf{\$}\mathbf{350}\mathbf{,}\mathbf{000}}{\mathbf{\$}\mathbf{3}\mathbf{,}\mathbf{500}\mathbf{,}\mathbf{000}}\\ \mathbf{=}\mathbf{0}\mathbf{.}\mathbf{10}\mathbf{o}\mathbf{r}\mathbf{10}\mathbf{\%}\end{array}$

Interpretation:-

The profit margin ratio is an indicator of income generation against every single amount of sales. The computed profit margin of 10% shows that the company is able to generate $0.1 of operating income from $1 of sales.

Computation of Asset Turnover Ratio

$\begin{array}{c}\mathbf{Asset}\mathbf{}\mathbf{Turnover}\mathbf{}\mathbf{Ratio}\mathbf{\left(}\mathbf{2018}\mathbf{\right)}\mathbf{=}\frac{\mathbf{Net}\mathbf{}\mathbf{Sales}\mathbf{}\mathbf{revenue}\mathbf{\left(}\mathbf{2018}\mathbf{\right)}}{\mathbf{Average}\mathbf{}\mathbf{Total}\mathbf{}\mathbf{Assets}\mathbf{\left(}\mathbf{2018}\mathbf{\right)}}\\ \mathbf{=}\frac{\mathbf{\$}\mathbf{3}\mathbf{,}\mathbf{500}\mathbf{,}\mathbf{000}}{\mathbf{\$}\mathbf{500}\mathbf{,}\mathbf{000}}\\ \mathbf{=}\mathbf{7}\mathbf{times}\end{array}$

Interpretation:-

The asset turnover ratio is the benchmark of the efficiency of the company’s assets in generating sales. In the given case, 7 times of asset turnover ratio indicates the company is able to generate $7 of sales for every $1 of average asset value.

Interpretation of ROI using expanded formula

The expanded ROI formula uses the profit margin ratio and asset turnover ratio to compute the ROI. Thus ROI is evaluated against the profit margin earned and sales generation capacity from average assets.

In the given case,

$\begin{array}{c}\mathbf{R}\mathbf{e}\mathbf{t}\mathbf{u}\mathbf{r}\mathbf{n}\mathbf{}\mathbf{o}\mathbf{n}\mathbf{}\mathbf{I}\mathbf{n}\mathbf{v}\mathbf{e}\mathbf{s}\mathbf{t}\mathbf{m}\mathbf{e}\mathbf{n}\mathbf{t}\mathbf{=}\mathbf{P}\mathbf{r}\mathbf{o}\mathbf{f}\mathbf{i}\mathbf{t}\mathbf{}\mathbf{M}\mathbf{a}\mathbf{r}\mathbf{g}\mathbf{i}\mathbf{n}\mathbf{}\mathbf{R}\mathbf{a}\mathbf{t}\mathbf{i}\mathbf{o}\mathbf{\times }\mathbf{A}\mathbf{s}\mathbf{s}\mathbf{e}\mathbf{t}\mathbf{}\mathbf{T}\mathbf{u}\mathbf{r}\mathbf{n}\mathbf{o}\mathbf{v}\mathbf{e}\mathbf{r}\mathbf{}\mathbf{R}\mathbf{a}\mathbf{t}\mathbf{i}\mathbf{o}\\ \mathbf{=}\mathbf{10}\mathbf{\%}\mathbf{\times }\mathbf{7}\\ \mathbf{=}\mathbf{0}\mathbf{.}\mathbf{7}\mathbf{o}\mathbf{r}\mathbf{70}\mathbf{\%}\end{array}$

Interpretation:-

From the above results, it can be seen that profit generation capacity is only 10% but the company has been able to generate 7 times of sales from the average asset value. Because of this, the return of assets of the company turns out to be 70% indicating the company is able to utilize its assets efficiently to generate $0.7 of income from $1 of average asset value.

Computation of residual income

$\begin{array}{c}\mathbf{R}\mathbf{e}\mathbf{s}\mathbf{i}\mathbf{d}\mathbf{u}\mathbf{a}\mathbf{l}\mathbf{}\mathbf{I}\mathbf{n}\mathbf{c}\mathbf{o}\mathbf{m}\mathbf{e}\mathbf{=}\mathbf{O}\mathbf{p}\mathbf{e}\mathbf{r}\mathbf{a}\mathbf{t}\mathbf{i}\mathbf{n}\mathbf{g}\mathbf{}\mathbf{i}\mathbf{n}\mathbf{c}\mathbf{o}\mathbf{m}\mathbf{e}\mathbf{-}\left(Targetrateofretrun\times Averagetotalassets\right)\\ \mathbf{=}\mathbf{\$}\mathbf{350}\mathbf{,}\mathbf{000}\mathbf{-}\left(40\%\times \$500,000\right)\\ \mathbf{=}\mathbf{\$}\mathbf{350}\mathbf{,}\mathbf{000}\mathbf{-}\mathbf{\$}\mathbf{200}\mathbf{,}\mathbf{000}\\ \mathbf{=}\mathbf{\$}\mathbf{150}\mathbf{,}\mathbf{000}\end{array}$

Interpretation:-

The residual income is the measure of profitability that shows how efficiently the company has earned actual operating income against the minimum acceptable operating income.

In the given case, the residual income is positive and $150,000 in figures which indicates that the company has been able to earn around 50% more than the minimum acceptable criteria.

Furthermore, the ROI of the company is 70% which confirms the difference between the required rate of return and residual income.