Q35PGB - Horngren'S Financial And Managerial Accounting

Question

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’s 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’ sales in receivables 

d. Debt ratio 

e. Earnings per share of common stock 

f. Price/earnings ratio 

g. Dividend payout 

2. Decide which company’s stock better fits your investment strategy

Step-by-Step Solution

Answer

Answer

1. Financial ratios:

   Financial ratio	All digital	Green Zone
   Acid test ratio	0.94	0.85
   Inventory turnover ratio	2.88	2.70
   Days’ 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%

   
   

2. The appropriate investment will be All digital.

Step 1: 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.

Step 2: Calculation of financial ratios

$$\begin{gathered} \text{a.Acid test ratio:} \\ \text{ All digital: } \\ Acid-testratio=\frac{Cashandcashequivalents+Shortterminvestments+Netreceivables}{Totalcurrentliabilities} \\ =\frac{\$23,000+\$37,000+\$39,000}{\$105,000} \\ =\frac{\$99,000}{\$105,000} \\ =0.94 \\ \text{ Green zone:} \\ Acid-testratio=\frac{Cashandcashequivalents+Shortterminvestments+Netreceivables}{Totalcurrentliabilities} \\ =\frac{\$18,000+\$17,000+\$49,000}{\$99,000} \\ =\frac{\$84,000}{\$99,000} \\ =0.85 \end{gathered}$$

$$\begin{gathered} \text{ b.Inventory turnover ratio: } \\ \text{All digital: } \\ Inventoryturnoverratio=\frac{Costofgoodssold}{Averagemerchandiseinventory} \\ =\frac{\$209,000}{\frac{\$64,000+\$81,000}{2}} \\ =\frac{\$209,000}{\$72,500} \\ =2.88 \\ \text{Green zone:} \\ Inventoryturnoverratio=\frac{Costofgoodssold}{Averagemerchandiseinventory} \\ =\frac{\$258,000}{\frac{\$102,000+\$89,000}{2}} \\ =\frac{\$258,000}{\$95,500} \\ =2.70 \\ \text{c..Days’ sales in receivables: } \\ \text{All digital: } \\ Dayssalesinreceivables=\frac{365}{Accountsreceivablesturnoverratio} \\ =\frac{365}{10.45} \\ =35days \\ \text{ Working note: } \\ \text{Green zone:} \\ Accountsreceivablesturnoverratio=\frac{Netcreditsales}{Averageaccountsreceivables} \\ =\frac{\$417,925}{\frac{\$39,000+\$41,000}{2}} \\ =\frac{\$417,925}{\$40,000} \\ =10.45 \end{gathered}$$

$$\begin{gathered} \text{d.Debt ratio:} \\ \text{ All digital: } \\ \text{ Green zone: } \\ Dayssalesinreceivables=\frac{365}{Accountsreceivablesturnoverratio} \\ =\frac{365}{9.57} \\ =38 days \\ Working note: \\ Accountsreceivablesturnoverratio=\frac{Netcreditsales}{Averageaccountsreceivables} \\ =\frac{\$493,115}{\frac{\$49,000+\$54,000}{2}} \\ =\frac{\$493,115}{\$51,500} \\ =9.57 \\ \text{ e.Earnings per share of common stock } \\ \text{All digital: } \\ Debtratio=\frac{Totalliabilities}{Totalassets} \\ =\frac{\$105,000}{\$263,000} \\ =0.40 \\ \text{Green Zone}\text{: } \\ Debtratio=\frac{Totalliabilities}{Totalassets} \\ =\frac{\$134,000}{\$326,000} \\ =0.41 \end{gathered}$$

$$\begin{gathered} \text{ f.Price/earnings ratio:} \\ \text{ All digital:} \\ Earningspershare=\frac{Netincome-Preferreddividend}{Weightedaveragesharesouts\tan ding} \\ =\frac{\$58,000-\$0}{10,000} \\ =\$5.8 pershare \\ \text{Green Zone: } \\ Earningspershare=\frac{Netincome-Preferreddividend}{Weightedaveragesharesouts\tan ding} \\ =\frac{\$72,000-\$0}{14,000} \\ =\$5.14pershare \\ g.Dividend payout: \\ All digital: \\ Price/earningsratio=\frac{Marketpricepershare}{Earningspershare} \\ =\frac{\$92.80}{\$5.8} \\ =16 \\ Green Zone: \\ Dividendpayoutratio=\frac{Annualdividendpershare}{Earningspershare}\times 100 \\ =\frac{\$0.90}{\$5.14}\times 100 \\ =17.51\% \end{gathered}$$

Step 3: 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.