Chapter 17, Problem 5AP

Comparative ratio analysis

Summary information from the financial statements of two companies competing in the same industry follows.

Required

1. 1. For both companies compute the (a) current ratio, (b) acid-test ratio, (c) accounts (including notes) receivable turnover, (d) inventory turnover, (e) days’ sales in inventory, and (f) days’ sales uncollected. Identify the company you consider to be the better short-term credit risk and explain why. Round to one decimal place.

  Check (1) Kyan: Accounts receivable turnover, 14.8; Inventory turnover, 5.3

1. 2. For both companies compute the (a) profit margin ratio, (b) total asset turnover, (c) return on total assets, and (d) return on common stockholders’ equity. Assuming that each company’s stock can be purchased at $75 per share, compute their (e) price-earnings ratios and ( f) dividend yields. Round to one decimal place. Identify which company’s stock you would recommend as the better investment and explain why.

  (2) Barco: Profit margin, 21.1%; PE, 16.6

To determine

Compute the (a) current ratio, (b) acid-test ratio, (c) accounts (including notes) receivable turnover, (d) inventory turnover, (e) days’ sales in inventory, and (f) days’ sales uncollected of Company F and Company B and identify the company that would the better on terms of short-term credit risk and explain the reasons.

Explanation of Solution

1. a) 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. Current ratio is calculated by using the formula:

$\text{Current ratio}=\frac{\text{Current Assets}}{\text{Current Liabilities}}$

1. b) Acid-test 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.

$\text{Acid-test ratio}=\frac{\text{Quick Assets}}{\text{Current Liabilities}}$

1. c) Accounts 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 average net receivables.

$\text{Receivables turnover}=\frac{\text{}\text{Net credit sales}}{\text{Average accounts receivables}}$

1. d) 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. It is calculated by using the formula:

$\text{Inventory turnover}=\frac{\text{Cost of goods sold}}{\text{Average inventory}}$

1. e) Days’ sales in inventory: Days’ in inventory is determined as the number of days a particular company takes to make sales of the inventory available with them.

$\text{Days’ in inventory}\text{=}\frac{\text{Ending}\text{Inventory}}{\text{Cost of goods sold}}\times 365\text{days}$

1. f) Days’ sales uncollected: This ratio is used to determine the number of days a particular company takes to collect accounts receivables.

$\text{Days’ sales uncollected}\text{=}\frac{\text{Ending accounts receivable}}{\text{ Sales}}\times 365\text{days}$

Compute ratios of Company B and Company K:

Ratios	Company B		Company K
(a) Current ratio
Cash		$19,500	$34,000
Accounts receivables, net		$37,400	$57,400
Current notes receivable (trade)		$9,100	$7,200
Merchandise inventory		$84,440	$132,500
Prepaid expenses		$5,000	$6,950
Current assets (A)		$155,440	$238,050
Current liabilities (B)		$61,340	$93,300
Current ratio $\left(\text{A}\right)÷\left(\text{B}\right)$		2.5:1	2.6:1
(b) Acid-test ratio
Cash	$19,500		$34,000
Accounts receivables, net	$37,400		$57,400
Current notes receivable (trade)	$9,100		$7,200
Quick assets (C)	$66,000		$98,600
Current liabilities (D)	$61,340		$93,300
Acid-test ratio $\left(\text{C}\right)÷\left(\text{D}\right)$	1.1:1		1.1:1
(c) Accounts (including notes) receivables turnover ratio
Accounts receivables, net (E)	$29,800		$54,200
Current notes receivable (trade) (F)	$0		$0
Total beginning net accounts (including notes) receivables (G) $\left(\text{E}\right)+\left(\text{F}\right)$	$29,800		$54,200
Accounts receivables, net (H)	$37,400		$57,400
Current notes receivable (trade) (I)	$9,100		$7,200
Total ending  net accounts (including notes) receivables (J) $\left(\text{E}\right)+\left(\text{F}\right)$	$46,500		$64,600
Average net accounts (including notes) receivables (K) $\left(\text{J}\right)+\left(\text{G}\right)÷2$	$38,150		$59,400
Net credit sales (L)	$770,000		$880,200
Accounts (including notes) receivables turnover ratio $\left(\text{L}\right)÷\left(\text{K}\right)$	20.2 times		14.8 times
(d) Inventory turnover ratio
Ending inventory (M)	$84,440		$132,500
Beginning inventory (N)	$55,600		$107,400
Average inventory (O) $\left(\text{M}\right)+\left(\text{N}\right)÷2$	$70,020		$119,950
Cost of goods sold (P)	$585,100		$632,500
Inventory turnover ratio $\left(\text{P}\right)÷\left(\text{O}\right)$	8.4 times		5.3 times
(e) Days’ sales in inventory
Ending inventory (Q)	$84,440		$132,500
Cost of goods sold (R)	$585,100		$632,500
Days’ sales in inventory  $\left(\text{O}\right)÷\left(\text{R}\right)\times 365$	52.7 days		76.5 days
(f) Days’ sales uncollected
Ending Accounts receivables, net (S)	$37,400		$57,400
Ending Current notes receivable (trade) (T)	$9,100		$7,200
Total ending  net accounts (including notes) receivables (U) $\left(\text{S}\right)+\left(\text{T}\right)$	$46,500		$64,600
Net credit sales (V)	$770,000		$880,200
Days’ sales uncollected $\left(\text{U}\right)÷\left(\text{V}\right)\times 365$	22.0 days		26.8 days

Table (1)

Short term credit risk analysis: As per Table (1) the current ratio of Company K is slightly better than the current ratio of Company B. The acid-test ratios of both the companies are same. The accounts turnover and the inventory turnover of Company B are better than the ratios of Company F. However, the day’s sales in inventory and the day’s sales uncollected of Company F are 76.5 days and 26.8 days respectively, that are higher than the ratios of Company B. Hence, Company B is better in managing the short term credit risk.

To determine

Compute the (a) profit margin  ratio, (b) total asset turnover, (c) return on total assets, (d) return on common stockholders’ equity, (e) price earnings ratio, and (f) dividend yields of Company F and Company B and identify the company that could be recommended as better investment and explain the reasons.

Explanation of Solution

1. a) Profit margin: It is one of the profitability ratios. Profit margin ratio is used to measure the percentage of net income that is being generated per dollar of revenue or sales.

$\text{Profit margin}=\frac{\text{Net income}}{\text{Net sales}}$

1. b) 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. Turnover of assets is calculated as follows:

$\text{Turnover of assets}=\frac{\text{Net sales }}{\text{Average total assets}}$

1. c) Return on total assets: Return on total assets is the financial ratio that 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 investment is calculated as follows:

$\text{Return on total assets}=\frac{\text{Net income }}{\text{Average total assets}}$

1. d) Return on common stockholders’ equity ratio: It is a profitability ratio that measures the profit generating ability of the company from the invested money of the shareholders. The formula to calculate the return on equity is as follows:

$\text{Return on equity}=\frac{\text{Net income}}{\text{Average stockholders' equity}}\times 100$

1. e) Price/Earnings Ratio: The price/earnings ratio shows the market value of the amount invested to earn $1 by a company. It is major tool used by investors for making decisions related to the investment in a company.

$\text{Price/Earnings Ratio}\text{=}\frac{\text{Market Price per Share }}{\text{Earnings per Share}}$

1. f) Dividend yields: Dividend yield ratio indicates how much percentage of share prices a company pays out in the form of dividends price. The formula to calculate the dividend yield percentage is as follows:

$\text{Dividend yield=}\frac{\text{Annual dividends per Share }}{\text{Market Price per Share}}$

Compute ratios of Company B and Company K:

Ratios and Formula	Company B	Company K
a. Profit margin: $\frac{\text{Net income}}{\text{Net sales}}$	$\begin{array}{l}=\frac{\$162,200}{\$770,000}\\ =21.1\%\end{array}$	$\begin{array}{l}=\frac{\$210,400}{\$880,200}\\ =23.9\%\end{array}$
b. Total asset turnover: $\frac{\text{Net sales }}{\begin{array}{l}\text{Average total assets}\\ \left(\text{Refer Table (3)}\right)\end{array}}$	$\begin{array}{l}=\frac{\$770,000}{\$421,720}\\ =1.8\text{ times}\end{array}$	$\begin{array}{l}=\frac{\$880,200}{\$462,475}\\ =1.9\text{ times}\end{array}$
c. Return on total assets: $\frac{\text{Net income }}{\begin{array}{l}\text{Average total assets}\\ \left(\text{Refer Table (3)}\right)\end{array}}$	$\begin{array}{l}=\frac{\$162,200}{\$421,720}\\ =38.5\%\end{array}$	$\begin{array}{l}=\frac{\$210,400}{\$462,475}\\ =45.5\%\end{array}$
d. Return on  common stockholders’ equity: $\frac{\text{Net income }}{\left[\begin{array}{l}\text{Average common}\\ \text{ stockholders' equity}\\ \left(\text{Refer Table (3)}\right)\end{array}\right]}$	$\begin{array}{l}=\frac{\$162,200}{\$290,800}\\ =55.8\%\end{array}$	$\begin{array}{l}=\frac{\$210,400}{\$323,875}\\ =65.0\%\end{array}$
e. Price-earnings ratio: $\frac{\text{Market price per share}}{\text{ Earnings per share}}$	$\begin{array}{l}=\frac{\$75\left(\text{Given}\right)}{\$4.51}\\ =16.6\end{array}$	$\begin{array}{l}=\frac{\$75\left(\text{Given}\right)}{\$5.11}\\ =14.7\end{array}$
f. Dividend yield: $\frac{\text{Annual cash dividend per share}}{\text{Market price per share}}$	$\begin{array}{l}=\frac{\$3.81}{\$75}\\ =5.1\%\end{array}$	$\begin{array}{l}=\frac{\$3.93}{\$75}\\ =5.1\%\end{array}$

Table (2)

Investment analysis: As per Table (2) the profitability ratios of Company K is higher than the ratios of Company B. However, the price earnings ratio of Company B is higher than Company K, but the dividend yield of Company K is higher than Company B. Hence, Company K is a better investment option.

Working Note:

Determine the average total assets and average common stockholders’ equity.

Ratios and Formula	Company B	Company K
a. Average total assets: $\frac{\left(\begin{array}{l}\text{Ending }\\ \text{total assets}\end{array}\right)+\left(\begin{array}{l}\text{Beginning }\\ \text{total assets}\end{array}\right)}{2}$	$\begin{array}{l}=\frac{\$445,440+\$398,000}{2}\\ =\frac{\$843,440}{2}\\ =\$421,720\end{array}$	$\begin{array}{l}=\frac{\$542,450+\$382,500}{2}\\ =\frac{\$924,950}{2}\\ =\$462,475\end{array}$
b. Average common stockholders’ equity: $\frac{\left(\begin{array}{l}\text{Ending total }\\ \text{stockholders' }\\ \text{equity}\end{array}\right)+\left(\begin{array}{l}\text{Beginning total }\\ \text{stockholders' }\\ \text{equity}\end{array}\right)}{2}$	$\begin{array}{l}=\frac{\$303,300+\$278,300}{2}\\ =\frac{\$581,600}{2}\\ =\$290,800\end{array}$	$\begin{array}{l}=\frac{\$348,150+\$299,600}{2}\\ =\frac{\$647,750}{2}\\ =\$323,875\end{array}$

Table (3)