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Horngren'S Financial And Managerial Accounting
Found in: Page 851

Short Answer

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

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.

See the step by step solution

Step by Step Solution

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

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.

Most popular questions for Business-studies Textbooks

Completing a comprehensive financial statement analysis

In its annual report, ABC Athletic Supply, Inc. includes the following five-year financial summary:

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—Net

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’ 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’ Equity

35.5%

26.%

20.8%

13.5%

13.0%

Requirements

Analyze the company’s financial summary for the fiscal years 2014–2018 to decide whether to invest in the common stock of ABC. Include the following sections in your analysis.

  1. Trend analysis for net sales revenue and net income (use 2014 as the base year).
  2. Profitability analysis.
  3. Evaluation of the ability to sell merchandise inventory.
  4. Evaluation of the ability to pay debts.
  5. Evaluation of dividends.
  6. Should you invest in the common stock of ABC Athletic Supply, Inc.? Fully explain your final decision
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