2014 Midterm SAQs

Question 1

Part I – Questions About Leverage and the Financing of the Business
Joe decided he wanted to go into business as a car mechanic. He did his research and asked a number of friends and acquaintances who had been in the auto mechanic business for years. They advised him that he would need $200,000 to fully equip and outfit a garage (i.e. purchase the fixed assets like tools and equipment, as well as the opening inventory of parts for sale).
Joe’s life savings were $40,000. That could be his initial equity. In order to come up with the rest of the necessary capital, Joe thought he would take out a bank loan.

Question a)
Calculate the debt to equity ratio that Joe would have if he borrowed 1 mark
the balance of the money necessary to outfit “Joe’s Garage”.

Joe went to see his bank manager. His bank manager was friendly and sympathetic, but he advised Joe that it was the bank’s policy not to allow small business customers to have a debt to equity ratio of more than 3:1

Question b)
Why would the bank want to limit on a borrower’s debt to equity ratio? 3 marks

Question c)
What would be the maximum amount of money that the bank would lend 1 mark
to Joe, to outfit a $200,000 garage, and not violate its lending policies?

Answer 1

Question a)
Joe needs $200,000
He has equity of only $40,000
Therefore he will need to borrow $160,000
He would have a debt to equity ratio of $160,000 / $40,000 or 4: 1

Question b)
A bank will limit a borrower’s debt to equity ratio for at least two reasons.
Interest payments are an expense. So the more money a business borrows the more interest it will have to pay, lowering its profit. A bank wants prevent a customer from borrowing more than it can afford to pay back.
Also, a bank wants to know that the owner of the business is committing a reasonable amount of his/her own money. This will ensure that the owner of the business maximizes the care and attention that he/she will put into the running of the business

Question c)
The bank will allow a maximum debt to equity ratio of 3 : 1, i.e. it will lend up to $3 for every $1 that Joe invests.
To raise a total of $200,000 therefore, the bank will lend a maximum of $150,000 – but only if Joe invests $50,000.

Question 2

Part II – Questions About Liquidity and the Balance Sheet
On the first day of trading (i.e. the day that Joe’s Garage opened its doors for business), the balance sheet looked like this:

Joe’s Garage Inc.
Balance Sheet on 1 April, 2011

Assets - Current Liabilities - Current
Cash 4,000 Accounts Payable 00
Accts. Receivable 00
Parts 26,000

                                             Liabilities - Term
                                             5 year term loan 150,000 Assets - Fixed Tools & Equipment 170,000 

                                            Equity
                                            Share capital 50,000

Question d) Calculate Joe’s Garage’s working capital 1 mark

Question e) What is the purpose of calculating a business’ working capital? 1 mark

Answer 2

Question d)
Working capital is defined as Current Assets – Current Liabilities.
Current Assets are $26,000 + $4,000
Current Liabilities qare $0
Current Assets – Current Liabilities = $30,000 - $00 = $30,000

Question e)
“Working Capital” is one of several measures of liquidity. Liquidity refers to the ease and speed with which assets can be turned into cash, in order for a business to pay its bills.
In this case, with NO current liabilities, the business currently has NO bills to pay in the short term (coming due within the next year.)
The business has $30,000 in cash, or soon-to-be cash. It has more than enough money with which to pay its current obligations.

Question 3

Part III – Questions About Profitability and The Income Statement

Question f) Calculate Joe’s Garage’s gross profit 1 mark

Question g) Calculate Joe’s Garage’s profit before interest and taxes 1 mark

Question h ) Explain why interest expense is considered to be a cost of running a business 2 marks

Question i ) Calculate Joe’s Garage’s interest expense 1 mark

Question j) Calculate Joe’s Garage’s profit before taxes 1 mark

Answer 3

Question f)
Gross Profit = Sales – Cost of Goods Sold (identified above as direct expenses)
Gross profit = $240,000 - $120,000
Gross Profit = $120,000

Question g)
Profit before interest and taxes = Gross Profit – Admin. (or Operating) Expenses
Profit before interest and taxes = $120,000
less
Joe’s Salary 30,000
Depreciation of the equipment 20,000
Electricity and other utilities 8,000
Insurance 4.000
Newspaper advertising 3,000
Stationery and office supplies 2,000
Cleaning supplies 1,000
($68,000)
= $52,000

Question h )
Money (or capital) is a necessary resource to create and run a business.
But, money is neither plentiful nor – if you borrow it – is money free.
A business must pay interest on the money that it borrows. The interest is - in effect - the cost of renting someone else’s money. That is a cost of doing business.
The business owner must reach into his wallet (or his bank account) and hand over the interest payment to the lender. Thus, interest is a cost of running a business.

Question i)
The interest on the bank loan was 8% on the original full principal of $150,000.
$150,000 x .08 = $12,000

Question j)
Profit before taxes = Operating Profit – Interest
Profit before taxes = $52,000 - $12,000
Profit before taxes = $40,000

Question 4

Part IV– Questions About Return on Equity and the Profitability of Investments

Question k) If the profit after tax for Joes’s Garage was $20,000, what was (i.e. calculate) the return on equity to the shareholders of Joe’s Garage, for the year ended March 31, 2012? 1 mark

Question l) If the profit after tax for Joe’s Garage was $20,000 calculate the earnings per share generated by Joe’s Garage for the year ended March 31, 2012 1 mark

Answer 4

Question k)
Return on Equity = Net Profit (after all expenses and taxes) / Owner’s Equity
Return on Equity = $20,000 (given) / $50,000 (invested by Joe and Rick)
Return on Equity = 40%

Question l)
Earnings per Share = Net Profit (after all expenses and taxes) / Number of shares
Earnings per Share = $20,000 / Number of shares (owned by Joe and Rick)
Earnings per Share = $20,000 / 50,000
Earnings per Share = 40 cents per share