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.

Short 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.

Step-by-step solution

computing average asset-

$\begin{array}{c}\text{Averagetotalasset}=\frac{\text{Beginningasset}+\text{Endingasset}}{2}\\ =\frac{\$394,000+\$606,000}{2}\\ =\$500,000\end{array}$

Computing ROI-

$\begin{array}{c}\text{ROI}=\frac{\text{Netincome}}{\text{Averageasset}}\times 100\\ =\frac{\$172,900}{\$500,000}\times 100\\ =34.58\%\end{array}$

Computing profit margin ratio-

$\begin{array}{c}\text{Profitmarginratio}=\frac{\text{Netincome}}{\text{Netsalesrevenue}}\\ =\frac{\$172,900}{\$6,000.000}\\ =0.0288\end{array}$

Computing asset turnover ratio-

$\begin{array}{c}\text{AssetTurnoverRatio}=\frac{\text{NetSales}}{\text{AverageTotalAssets}}\\ =\frac{\$6,000,000}{\$500,000}\\ =12\end{array}$

Computing expanded ROI

$\begin{array}{c}\text{ROI}=\text{Profitmarginratio}\times \text{Assetturnoverratio}\times 100\\ \text{=0.0288}\times \text{12}\times \text{100}\\ \text{=34.56}\end{array}$

Computing expanded RI

$\begin{array}{c}\text{ResidualIncome}=\text{Operatingincome}-\left(\text{Minimumrequiredrateofreturn}\times \text{Averageoperatingassets}\right)\\ =\$172,900-\left(30\%\times \$500,000\right)\\ =\$172,900-\$150,000\\ =\$22,900\end{array}$