Earth’s Best Company has sales of $200,000, a net income of $15,000, and the following balance sheet:

a. The company’s new owner thinks that inventories are excessive and can be lowered to the point where the current ratio is equal to the industry average, 2.5, without affecting either sales or net income. If inventories are sold off and not replaced so as to reduce the current ratio to 2.5, if the funds generated are used to reduce common equity (stock can be repurchased at book value), and if no other changes occur, by how much will the ROE change?

b. Now suppose we wanted to take this problem and modify it for use on an exam—that is, to create a new problem that you have not seen to test your knowledge of this type of problem. How would your answer change if we made the following changes? 

(1) We doubled all of the dollar amounts? 

(2) We stated that the target current ratio was 3.0? 

(3) We said that the company had 10,000 shares of stock outstanding, and we asked how much the change in part (a) would increase EPS? 

(4) What would your answer to (3) be if we changed the original problem to state that the stock was selling for twice the book value, so common equity would not be reduced on a dollar-for-dollar basis?

c. Explain how we could have set the problem up to have you focus on changing accounts receivable, or fixed assets, or using the funds generated to retire debt (we would give you the interest rate on outstanding debt), or how the original problem could have stated that the company needed more inventories and it would finance them with new common equity or with new debt.

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Cash Receivables Inventories Net fixed assets Total assets 10,000 50,000 150,000 90,000 $300,000 Accounts payable Other current liabilities Long-term debt Common equity Total liabilities and equity S 30,000 20,000 50,000 200,000 $300,000