Q35PGB Question: Using ratios to decide... [FREE SOLUTION]

Chapter 15: Q35PGB (page 851)

Question: Using ratios to decide between two stock investments
Assume that you are purchasing an investment and have decided to invest in a company in the digital phone business. You have narrowed the choice to All Digital Corp. and Green Zone, Inc. and have assembled the following data.
Selected income statement data for the current year:
All digital
Green Zone
Net sales revenue (all on credit)
$417,925
$493,115
Cost of goods sold
209,000
258,000
Interest expenses
0
14,000
Net income
58,000
72,000
Selected balance sheet and market price data at the end of the current year:
All digital
Green Zone
Current assets:
Cash
$23,000
$18,000
Short-term investment
37,000
17,000
Accounts receivables, Net
39,000
49,000
Merchandise inventory
64,000
102,000
Prepaid expenses
21,000
17,000
Total current assets
$184,000
$203,000
Total assets
$263,000
$326,000
Total current liabilities
105,000
99,000
Total liabilities
105,000
134,000
Common stock:
$1 par (10,000 shares)
10,000
$2 par (14,000 shares)
28,000
Total stockholder鈥檚 equity
158,000
192,000
Market price per share of common stock
92.80
128.50
Dividend paid per common share
1.20
0.90
Selected balance sheet data at the beginning of the current year:
All digital
Green Zone
Balance sheet:
Accounts receivables, Net
$41,000
$54,000
Merchandise inventory
81,000
89,000
Total assets
258,000
277,000
Common stock:
$1 par (10,000 shares)
10,000
$2 par (14,000 shares)
28,000
Your strategy is to invest in companies with low price/earnings ratios but in good financial shape. Assume that you have analyzed all other factors and that your decision depends on the results of ratio analysis.
Requirements
1. Compute the following ratios for both companies for the current year:
a. Acid-test ratio
b. Inventory turnover
c. Days鈥� sales in receivables
d. Debt ratio
e. Earnings per share of common stock
f. Price/earnings ratio
g. Dividend payout
2. Decide which company鈥檚 stock better fits your investment strategy

Short Answer

Expert verified

Answer

Financial ratios:

Financial ratio	All digital	Green Zone
Acid test ratio	0.94	0.85
Inventory turnover ratio	2.88	2.70
Days鈥� sales in receivables	35	38
Debt ratio	0.40	0.41
Earnings per share	$5.8	$5.14
Price/earnings ratio	16	25
Dividend payout ratio	20.69$	17.51%

The appropriate investment will be All digital.

Step by step solution

Definition of Financial Ratios

Financial ratios refer to the calculations between the various line items of the financial statement to arrive at a conclusive decision regarding liquidity, solvency, and profitability.

Calculation of financial ratios

$a.Acidtestratio: Alldigital: A c i d - t e s t r a t i o = \frac{C a s h a n d c a s h e q u i v a l e n t s + S h o r t t e r m i n v e s t m e n t s + N e t r e c e i v a b l e s}{T o t a l c u r r e n t l i a b i l i t i e s} = \frac{$ 23, 000 + $ 37, 000 + $ 39, 000}{$ 105, 000} = \frac{$ 99, 000}{$ 105, 000} = 0.94 Greenzone: A c i d - t e s t r a t i o = \frac{C a s h a n d c a s h e q u i v a l e n t s + S h o r t t e r m i n v e s t m e n t s + N e t r e c e i v a b l e s}{T o t a l c u r r e n t l i a b i l i t i e s} = \frac{$ 18, 000 + $ 17, 000 + $ 49, 000}{$ 99, 000} = \frac{$ 84, 000}{$ 99, 000} = 0.85$

$b.Inventoryturnoverratio: Alldigital: I n v e n t o r y t u r n o v e r r a t i o = \frac{C o s t o f g o o d s s o l d}{A v e r a g e m e r c h a n d i s e i n v e n t o r y} = \frac{$ 209, 000}{\frac{$ 64, 000 + $ 81, 000}{2}} = \frac{$ 209, 000}{$ 72, 500} = 2.88 Greenzone: I n v e n t o r y t u r n o v e r r a t i o = \frac{C o s t o f g o o d s s o l d}{A v e r a g e m e r c h a n d i s e i n v e n t o r y} = \frac{$ 258, 000}{\frac{$ 102, 000 + $ 89, 000}{2}} = \frac{$ 258, 000}{$ 95, 500} = 2.70 肠..顿补测蝉鈥檚补濒别蝉颈苍谤别肠别颈惫补产濒别蝉: Alldigital: D a y s s a l e s i n r e c e i v a b l e s = \frac{365}{A c c o u n t s r e c e i v a b l e s t u r n o v e r r a t i o} = \frac{365}{10.45} = 35 d a y s Workingnote: Greenzone: A c c o u n t s r e c e i v a b l e s t u r n o v e r r a t i o = \frac{N e t c r e d i t s a l e s}{A v e r a g e a c c o u n t s r e c e i v a b l e s} = \frac{$ 417, 925}{\frac{$ 39, 000 + $ 41, 000}{2}} = \frac{$ 417, 925}{$ 40, 000} = 10.45$

$d.Debtratio: Alldigital: Greenzone: D a y s s a l e s i n r e c e i v a b l e s = \frac{365}{A c c o u n t s r e c e i v a b l e s t u r n o v e r r a t i o} = \frac{365}{9.57} = 38 d a y s W o r k i n g n o t e : A c c o u n t s r e c e i v a b l e s t u r n o v e r r a t i o = \frac{N e t c r e d i t s a l e s}{A v e r a g e a c c o u n t s r e c e i v a b l e s} = \frac{$ 493, 115}{\frac{$ 49, 000 + $ 54, 000}{2}} = \frac{$ 493, 115}{$ 51, 500} = 9.57 e.Earningspershareofcommonstock Alldigital: D e b t r a t i o = \frac{T o t a l l i a b i l i t i e s}{T o t a l a s s e t s} = \frac{$ 105, 000}{$ 263, 000} = 0.40 GreenZone : D e b t r a t i o = \frac{T o t a l l i a b i l i t i e s}{T o t a l a s s e t s} = \frac{$ 134, 000}{$ 326, 000} = 0.41$

$f.Price/earningsratio: Alldigital: E a r n i n g s p e r s h a r e = \frac{N e t i n c o m e - P r e f e r r e d d i v i d e n d}{W e i g h t e d a v e r a g e s h a r e s o u t s \tan d i n g} = \frac{$ 58, 000 - $ 0}{10, 000} = $ 5.8 p e r s h a r e GreenZone: E a r n i n g s p e r s h a r e = \frac{N e t i n c o m e - P r e f e r r e d d i v i d e n d}{W e i g h t e d a v e r a g e s h a r e s o u t s \tan d i n g} = \frac{$ 72, 000 - $ 0}{14, 000} = $ 5.14 p e r s h a r e g . D i v i d e n d p a y o u t : A l l d i g i t a l : P r i c e / e a r n i n g s r a t i o = \frac{M a r k e t p r i c e p e r s h a r e}{E a r n i n g s p e r s h a r e} = \frac{$ 92.80}{$ 5.8} = 16 G r e e n Z o n e : D i v i d e n d p a y o u t r a t i o = \frac{A n n u a l d i v i d e n d p e r s h a r e}{E a r n i n g s p e r s h a r e} 脳 100 = \frac{$ 0.90}{$ 5.14} 脳 100 = 17.51 %$

Appropriate investment according to financial ratios

The investor must invest in All digital investments because it generates a higher pay-pay-out ratio and earnings per share. Also, this company can recover the cash receivable earlier than Green Zone.

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ABC ATHLETIC SUPPLY, INC. Five-Year Financial Summary (Partial; adapted)
(Dollar amounts in thousands except per share data)	2018	2017	2016	2015	2014	2013
Net Sales Revenue	\(250,000	\)216,000	\(191,000	\)161,000	\(134,000
Net Sales Revenue Increase	16%	13%	19%	20%	17%
Domestic Comparative Store Sales Increase	5%	6%	4%	7%	9%
Other Income鈥擭et	2,110	1,840	1,760	1,690	1,330
Cost of Goods Sold	189,250	164,592	148,216	126,385	106,396
Selling and Administrative Expenses	41,210	36,330	31,620	27,440	22,540
Interest:
Interest Expense	(1,080)	(1,380)	(1,400)	(1,020)	(830)
Interest Income	125	165	155	235	190
Income Tax Expense	4,470	3,900	3,700	3,320	2,700
Net Income	16,225	11,803	7,979	4,760	3,054
Per Share of Common Stock:
Net Income	1.60	1.30	1.20	1.00	0.78
Dividends	0.40	0.38	0.34	0.30	0.26
Financial Position
Current Assets, Excluding Merchandise Inventory	\)30,700	\(27,200	\)26,700	\(24,400	\)21,500
Merchandise Inventory	24,500	22,600	21,700	19,000	17,500	$16,700
Property, Plant, and Equipment, Net	51,400	45,200	40,000	35,100	25,600
Total Assets	106,600	95,000	88,400	78,500	64,600
Current Liabilities	32,300	28,000	28,300	25,000	16,500
Long-term Debt	23,000	21,500	17,600	19,100	12,000
Stockholders鈥� Equity	51,300	45,500	42,500	34,400	36,100
Financial Ratios
Acid-Test Ratio	1.0	1.0	0.9	1.0	1.3
Rate of Return on Total Assets	17.2%	14.4%	11.2%	8.1%	7.1%
Rate of Return on Common Stockholders鈥� Equity	35.5%	26.%	20.8%	13.5%	13.0%

1..Includes the income statement, balance sheet, statement of stockholders鈥� equity, and statement of cash flows	a. Notes to financial statements
2. Attests to the fairness of the presentation of the financial statements.	b. Report of independent registered public accounting firm
3. Includes a summary of significant accounting policies and explanations of specific items on the financial statements.	c. Management鈥檚 discussion and analysis of financial condition and results of operations (MD&A)
4. Is written by the company to help investors understand the results of operations and the financial condition of the company.	d. Financial statements

GARFIELD, INC Comparative Income Statement Years Ended December 31, 2018 and 2017
	2018	2017
Net sales revenue	\(461,000	\)424,000
Cost of goods sold	241,000	211,000
Gross profit	220,000	213,000
Operating expenses	137,000	135,000
Income from operations	83,000	78,000
Interest expenses	9,000	13,000
Income before taxes	74,000	65,000
Income tax expenses	18,000	24,000
Net income	\(56,000	\)41,000

GARFIELD, INC Comparative Income Statement Years Ended December 31, 2018 and 2017
	2018	2017	2016
Assets
Current assets
Cash	\(99,000	\)98,000
Accounts receivables, Net	108,000	114,000	107,000
Merchandise inventory	146,000	164,000	202,000
Prepaid expenses	20,000	9,000
Total current assets	373,000	385,000
Property, plant, and equipment	211,000	181,000
Total assets	\(584,000	\)566,000	\(602,000

Liabilities
Total current liabilities	\)227,000	\(246,000
Long-term liabilities	117,000	100,000
Total liabilities	344,000	346,000

Stockholder鈥檚 equity
Preferred stock, 3%	98,000	98,000
Common stockholder equity, no par	142,000	122,000	89,000
Total liabilities and stockholder鈥檚 equity	\)584,000	\(566,000

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Definition of Financial Ratios

Calculation of financial ratios

Appropriate investment according to financial ratios

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	All digital	Green Zone
Net sales revenue (all on credit)	\(417,925	\)493,115
Cost of goods sold	209,000	258,000
Interest expenses	0	14,000
Net income	58,000	72,000

	All digital	Green Zone
Current assets:
Cash	\(23,000	\)18,000
Short-term investment	37,000	17,000
Accounts receivables, Net	39,000	49,000
Merchandise inventory	64,000	102,000
Prepaid expenses	21,000	17,000
Total current assets	\(184,000	\)203,000
Total assets	\(263,000	\)326,000
Total current liabilities	105,000	99,000
Total liabilities	105,000	134,000
Common stock:
\(1 par (10,000 shares)	10,000
\)2 par (14,000 shares)		28,000
Total stockholder鈥檚 equity	158,000	192,000
Market price per share of common stock	92.80	128.50
Dividend paid per common share	1.20	0.90

	All digital	Green Zone
Balance sheet:
Accounts receivables, Net	\(41,000	\)54,000
Merchandise inventory	81,000	89,000
Total assets	258,000	277,000
Common stock:
\(1 par (10,000 shares)	10,000
\)2 par (14,000 shares)		28,000