Chapter 13, Problem 5P

1.

To determine

Compute the all possible ratios for Company E and Company Y

Answer to Problem 5P

Compute the all possible ratios for Company E

	Ratio	Formula	Calculation	Result
	Profitability ratios
1	Return on Equity (ROE)	$\frac{\text{Net}\text{Income}}{\text{Average}\text{Total}\text{Stockholder'}\text{Equity}}$	$\frac{\$45,000}{\left(\begin{array}{l}\$148,000+\$29,000+\\ \$61,000\end{array}\right)}$	18.91%
2	Return on Assets (ROA)	$\frac{\text{Net}\text{Income}}{\text{Average}\text{Total}\text{Assets}}$	$\frac{\$45,000+\left(\$65,000\times 10\%\times 0.70\right)}{\$402,000}$	12.3%
3	Financial leverage percentage	$\text{ROE}-\text{ROA}$	$18.91\%-12.3\%$	6.6%
4	Net profit margin	$\frac{\text{Net}\text{Income}}{\text{Net Sales Revenue}}$	$\frac{\$45,000}{\$447,000}$	10.07%
5	Earnings per share (EPS)	$\frac{\text{Net}\text{Income}}{\left(\begin{array}{l}\text{Weighted Average Number of }\\ \text{common Shares Outstanding}\end{array}\right)}$	$\frac{\$45,000}{\left(\$148,000÷\$10\text{per Share}\right)}$	$3.04
Turnover ratios
6	Total asset turnover	$\frac{\text{Net}\text{Sales}\text{Revenue}}{\text{Average}\text{Total}\text{Assets}}$	$\frac{\$447,000}{\$402,000}$	1.11
7	Fixed asset turnover	$\frac{\text{Net}\text{Sales}\text{Revenue}}{\text{Average}\text{Net}\text{Fixed}\text{Assets}}$	$\frac{\$447,000}{\$140,000}$	3.19
8	Receivables turnover	$\frac{\text{Net Credit}\text{Sales}}{\text{Average}\text{Net Receivables}}$	$\frac{\$149,000}{\left(\$38,000+\$18,000\right)÷2}$	5.3
9	Inventory turnover	$\frac{\text{Cost of Goods Sold}}{\text{Average Inventory}}$	$\frac{\$241,000}{\left(\$99,000+\$94,000\right)÷2}$	2.5
	Liquidity ratios
10	Current ratio	$\frac{\text{Current}\text{Assets}}{\text{Current}\text{Liabilities}}$	$\frac{\left(\$41,000+\$38,000+\$99,000\right)}{\$99,000}$	1.8
11	Quick ratio	$\frac{\text{Quick}\text{Assets}}{\text{Current}\text{Liabilities}}$	$\frac{\left(\$41,000+\$38,000\right)}{\$99,000}$	0.8
12	Cash ratio	$\frac{\text{Cash \& Cash Equivalents}}{\text{Current}\text{Liabilities}}$	$\frac{\$41,000}{\$99,000}$	0.41
	Solvency ratio
13	Debt-to-equity ratio	$\frac{\text{Total}\text{Liabilities}}{\text{Total}\text{Stockholder's}\text{Equity}}$	$\frac{\left(\$99,000+\$65,000\right)}{\left(\begin{array}{l}\$148,000+\$29,000+\\ \$61,000\end{array}\right)}$	0.69
	Market ratios
14	Price/Earnings (P/E) ratio	$\frac{\text{Market Price per Share}}{\text{Earnings}\text{per Share}}$	$\frac{\$22}{\$3.04}$	7.24
15	Dividend yield ratio	$\frac{\text{Dividend per Share}}{\text{ Market Price per Share}}$	$\frac{\left(\$33,000÷14,800\text{Shares}\right)}{\$22}$	10.14%

Table (1)

Compute the all possible ratios for Company Y

	Ratio	Formula	Calculation	Result
	Profitability ratios
1	Return on Equity (ROE)	$\frac{\text{Net}\text{Income}}{\text{Average}\text{Total}\text{Stockholder'}\text{Equity}}$	$\frac{\$91,000}{\left(\$512,000+\$106,000+\$71,000\right)}$	13.21%
2	Return on Assets (ROA)	$\frac{\text{Net}\text{Income}}{\text{Average}\text{Total}\text{Assets}}$	$\frac{\$91,000+\left(\$60,000\times 10\%\times 70\%\right)}{\$798,000}$	11.9%
3	Financial leverage percentage	$\text{ROE}-\text{ROA}$	$13.21\%-11.9\%$	1.3%
4	Net profit margin	$\frac{\text{Net}\text{Income}}{\text{Net Sales Revenue}}$	$\frac{\$91,000}{\$802,000}$	11.35%
5	Earnings per share (EPS)	$\frac{\text{Net}\text{Income}}{\left(\begin{array}{l}\text{Weighted Average Number of }\\ \text{common Shares Outstanding}\end{array}\right)}$	$\frac{\$91,000}{\left(\$512,000÷\$10\text{per Share}\right)}$	$1.78
Turnover ratios
6	Total asset turnover	$\frac{\text{Net}\text{Sales}\text{Revenue}}{\text{Average}\text{Total}\text{Assets}}$	$\frac{\$802,000}{\$798,000}$	1.01
7	Fixed asset turnover	$\frac{\text{Net}\text{Sales}\text{Revenue}}{\text{Average}\text{Net}\text{Fixed}\text{Assets}}$	$\frac{\$802,000}{\$401,000}$	2.0
8	Receivables turnover	$\frac{\text{Net Credit}\text{Sales}}{\text{Average}\text{Net Receivables}}$	$\frac{\$267,333}{\left(\$31,000+\$38,000\right)÷2}$	7.8
9	Inventory turnover	$\frac{\text{Cost of Goods Sold}}{\text{Average Inventory}}$	$\frac{\$400,000}{\left(\$40,000+\$44,000\right)÷2}$	9.5
	Liquidity ratios
10	Current ratio	$\frac{\text{Current}\text{Assets}}{\text{Current}\text{Liabilities}}$	$\frac{\left(\$21,000+\$31,000+\$40,000\right)}{\$49,000}$	1.9
11	Quick ratio	$\frac{\text{Quick}\text{Assets}}{\text{Current}\text{Liabilities}}$	$\frac{\left(\$21,000+\$31,000\right)}{\$49,000}$	1.1
12	Cash ratio	$\frac{\text{Cash \& Cash Equivalents}}{\text{Current}\text{Liabilities}}$	$\frac{\$21,000}{\$49,000}$	0.43
	Solvency ratio
13	Debt-to-equity ratio	$\frac{\text{Total}\text{Liabilities}}{\text{Total}\text{Stockholder's}\text{Equity}}$	$\frac{\left(\$49,000+\$60,000\right)}{\left(\$512,000+\$106,000+\$71,000\right)}$	0.16
	Market ratios
14	Price/Earnings (P/E) ratio	$\frac{\text{Market Price per Share}}{\text{Earnings}\text{per Share}}$	$\frac{\$15}{\left(\$91,000÷51,200\text{ shares}\right)}$	8.43
15	Dividend yield ratio	$\frac{\text{Dividend per Share}}{\text{ Market Price per Share}}$	$\frac{\left(\$148,000÷51,200\text{ shares}\right)}{\$15}$	19.27%

Table (2)

Explanation of Solution

Profitability ratios:

Profitability ratios focus on net income. Profitability ratios explain that the net income compared to other amounts reported on the financial statements.

• Return on equity ratio: Rate of return on equity ratio is used to determine the relationship between the net income available for the common stockholders’ and the average common equity that is invested in the company. Return on equity of the Company E is 18.91% and Company Y is 13.21%.
• Return on assets: Return on assets is the financial ratio which determines the amount of net income earned by the business with the use of total assets owned by it. It indicates the magnitude of the company’s earnings with relative to its total assets. Return on assets of the Company E is 12.3% and Company Y is 11.9%.
• Financial leverage percentage: Financial Leverage Percentage is one of the profitability ratios. It measures that the assets held by a company proportionate to its common stock (Equity). Financial leverage percentage of the Company E is 6.6% and Company Y is 1.3%.
• Net profit margin: It is one of the profitability ratios. It explains the relationship between the net income and net sales as a percentage. Net profit margin of the Company E is 10.07% and 11.35% for Company Y.
• Earnings per Share: Earnings per share help to measure the profitability of a company. Earnings per share are the amount of profit that is allocated to each share of outstanding stock. EPS for Company E is $3.04 and Company Y is $1.78.

Assets turnover ratios:

It is the extended form of rate of return on total assets. Rate of return on total assets measures the profit generated but asset turnover measures the sales generated whereas from the use of total assets.

• Total Asset turnover: Total asset turnover is a ratio that measures the productive capacity of the total assets to generate the sales revenue for the company. Thus, it shows the relationship between the net sales and the average total assets. Company E is having Total Assets turnover ratio of 1.11 and for the Company Y is having Total Assets turnover ratio of 1.01.
• Fixed Asset turnover: Fixed asset turnover is a ratio that measures the productive capacity of the fixed assets to generate the sales revenue for the company. Thus, it shows the relationship between the net sales and the average total fixed assets. Company E is having fixed Assets turnover ratio of 3.19 and for the Company Y is having Total Assets turnover ratio of 2.00.
• Receivables turnover ratio: Receivables turnover ratio is mainly used to evaluate the collection process efficiency. It helps the company to know the number of times the accounts receivable is collected in a particular time period. This ratio is determined by dividing credit sales and sales return. Company E is having receivables turnover ratio of 5.3 and for the Company Y is having receivables turnover ratio of 7.8.
• Inventory Turnover Ratio: This ratio is a financial metric used by a company to quantify the number of times inventory is used or sold during the accounting period. Company E is having inventory turnover ratio of 2.5 and for the Company Y is having inventory turnover ratio of 9.5.

Liquidity Ratios: Liquidity explains the extent of cash’s nearness to assets and liabilities. It explains how easily assets can be converted into cash. Following are the types of ratios that help to find liquidity position of a company.

• Current ratio: Current ratio is one of the liquidity ratios, which measures the capacity of the company to meet its short-term obligations using its current assets. Company E is having current ratio of 1.8 and for the Company Y is having current ratio of 1.9.
• Quick ratio: It is a ratio used to determine a company’s ability to pay back its current liabilities by liquid assets that are current assets except inventory and prepaid expenses. Company E is having Quick ratio of 0.8 and for the Company Y is having Quick of 1.1.
• Cash ratio: This ratio is used to measure the adequacy of the cash in the business. Company E is having cash ratio of 0.41 and for the Company Y is having cash of 0.43.

Solvency ratio:

Solvency ratio measures the capacity of a company to sustain over a long period of time. Solvency ratios are debt to assets ratio, time interest earned ratio, and debt to equity ratio, and more.

• Debt-equity ratio: The debt-to-equity ratio indicates that the company’s debt as a proportion of its stockholders’ equity. Company E is having Debt to equity ratio of 0.69 and for the Company Y is having debt to equity ratio of 0.16.

Market ratios:

Market ratios are used to relate the present market price of the common stock of the company to the earnings available to the stockholders.

• Price/Earnings Ratio: It depicts the relation of market price of a share to earnings per share of that company. The price/earnings ratio presents the market value of the amount invested to earn $1 by a company. It is major tool to be used by investors before the decisions related to investments in a company. Company E is having P/E ratio of 7.24 and for the Company Y is having P/E ratio of 8.43.
• Dividend yield: This is the ratio which measures the amount of dividends paid relative to the market price. Company E is having Dividend yield ratio of 10.14% and for the Company Y is having Dividend yield ratio of 19.27%.

To determine

Evaluate the above ratios and recommend the client to choose the company to invest with explanation.

Explanation of Solution

The above ratio analysis (requirement 1) indicates that Company E is the better Company to invest. The following are the reasons that support the above recommendation:

• The financial statements of the Company E are audited. Audited financial statements will have more credibility.
• Profitability ratios indicate that Company E is better because it is having high return on equity, high earnings per share and high financial leverage.
• Turnover ratios indicate that the Company E using its assets efficiently to revenues.
• Liquidity ratios indicate that the Company Y is having more capacity to pay its short term obligations.
• Solvency ratios indicates that the Company E is having better ratios that assures the investor that the Company E will have a capacity to sustain in long run.
• Company Y is having better Market ratios than Company E, but the difference is very marginal.

Overall analysis shows that the Company E is the better option to invest.