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Horngren'S Financial And Managerial Accounting
Found in: Page 850

Short Answer

Using ratios to evaluate a stock investment

Comparative financial statement data of Garfield, Inc. follow:

GARFIELD, INCComparative Income StatementYears 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, INCComparative Income StatementYears 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’s equity

Preferred stock, 3%

98,000

98,000

Common stockholder equity, no par

142,000

122,000

89,000

Total liabilities and stockholder’s equity

$584,000

$566,000

1. Market price of Garfield’s common stock: $69.36 at December 31, 2018, and $38.04 at December 31, 2017.

2. Common shares outstanding: 14,000 on December 31, 2018 and 12,000 on December 31, 2017 and 2016.

3. All sales are on credit.

Requirements

1. Compute the following ratios for 2018 and 2017:

a. Current ratio

b. Cash ratio

c. Times-interest-earned ratio

d. Inventory turnover

e. Gross profit percentage

f. Debt to equity ratio

g. Rate of return on common stockholders’ equity

h. Earnings per share of common stock

i. Price/earnings ratio

2. Decide (a) whether Garfield’s ability to pay debts and to sell inventory improved or deteriorated during 2018 and (b) whether the investment attractiveness of its common stock appears to have increased or decreased.

  1. Financial ratios:

Ratios

2018

2017

Current ratio

1.64

1.57

Cash ratio

0.44

0.40

Times-interest earned ratio

7.22

4

Inventory turnover

1.55

1.15

Gross profit percentage

47.83%

50.24%

Debt-to-equity ratio

1.43

1.57

Rate of return on common stockholder’s equity

42.42%

38.86%

Earnings per share of common stock

$4.31 per share

$3.42 per share

Price-earnings ratio

16.09

11.12

2. Ability to pay off has decreased, the ability to sell has increased, and the attractiveness of the common stock has increased.

See the step by step solution

Step by Step Solution

Step 1: Definition of Financial Ratios

The figures that are calculated by comparing various line items of the financial statement to arrive at a conclusive decision regarding liquidity, solvency, and profitability are known as financial ratios.

Step 2: Financial ratios Calculation

a. Current ratio:

2018:

2017:

b. Cash ratio:

2018:

2017:

c. Times interest earned:

2018:

2017:

d. Inventory turnover ratio:

2018:

2017:

e. Gross profit percentage:

2018:

2017:

f. Debt to equity ratio:

2018:

2017:

g. Rate of return on common stockholder’s equity

2018:

2017:

h. Earnings per share of common stock:

2018:

2017:

i. Price-earnings ratio:

2018:

2017:

Step 3: Analysis of the business entity

a) Debt to equity ratio reflects that the business entity is borrowing more money and that the ability to pay off debts is decreased.

The inventory turnover ratio improved in the year 2018, which means that the ability of the business entity to sell its inventory has improved.

b) Attractiveness of the common stock has increased because the return on common stockholders’ equity has increased.

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