Chapter 17, Problem 5BP

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 receivable turnover, (d) inventory turnover, (e) days’ sales in inventory, and (f) days’ sales uncollected. Round to one decimal place. Identify the company you consider to be the better short-term credit risk and explain why.
2. 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 paid cash dividends of $1.50 per share and each company’s stock can be purchased at $25 per share, compute their (e) price-earnings ratios and (f) dividend yields. Round to one decimal place; for part b, round to two decimals. Identify which company’s stock you would recommend as the better investment and explain why.

To determine

Compute the current ratio of Company F and Company B.

Explanation of Solution

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:

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

Compute the current ratio of Company F and Company B:

Ratios	Company F	Company B
Cash	$20,000	$36,500
Accounts receivables, net	$88,700	$79,500
Merchandise inventory	$86,800	$82,000
Prepaid expenses	$9,700	$10,100
Current assets (A)	$205,200	$208,100
Current liabilities (B)	$90,500	$97,000
Current ratio $\left(\text{A}\right)÷\left(\text{B}\right)$	2.3:1	2.1:1

Table (1)

Conclusion

Therefore, the current ratio of Company F and Company B is 2.3 to 1 and 2.1 to 1 respectively.

To determine

Compute the Acid-test ratio ratio of Company F and Company B.

Explanation of Solution

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.

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

Compute the Acid-test ratio of Company F and Company B:

Particulars	Company F	Company B
Cash	$20,000	$36,500
Accounts receivables, net	$77,100	$70,500
Current notes receivable (trade)	$11,600	$9,000
Quick assets (C)	$108,700	$116,000
Current liabilities (D)	$90,500	$97,000
Acid-test ratio $\left(\text{C}\right)÷\left(\text{D}\right)$	1.2:1	1.2:1

Table (2)

Conclusion

Therefore, the Acid-test ratio of Company F and Company B is 1.2 to 1 and 1.2 to 1 respectively.

To determine

Compute the accounts receivable turnover ratio of Company F and Company B.

Explanation of Solution

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.

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

Compute the accounts receivable turnover ratio of Company F and Company B:

Particulars	Company F	Company B
Beginning Accounts receivables, net (E)	$72,200	$73,300
Ending Accounts receivables, net (F)	$88,700	$79,500
Average accounts receivables $\left(\text{G}\right)=\left[\left(\text{E}\right)\text{+}\left(\text{F}\right)\text{÷}\text{2}\right]$	$80,450	$76,400
Net credit sales (H)	$393,600	$667,500
Accounts receivable turnover ratio $\left(\text{H}\right)÷\left(\text{G}\right)$	4.9 times	8.7 times

Table (3)

Conclusion

Therefore, the accounts receivable turnover ratio of Company F and Company B is 4.9 to 1 and 8.7 to 1 respectively.

To determine

Compute the Inventory turnover ratio of Company F and Company B.

Explanation of Solution

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:

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

Compute the Inventory turnover ratio of Company F and Company B:

Particulars	Company F	Company B
Ending inventory (I)	$86,800	$82,000
Beginning inventory (J)	$105,100	$80,500
Average inventory (K) $\left(\text{I}\right)+\left(\text{J}\right)÷2$	$95,950	$81,250
Cost of goods sold (L)	$290,600	$480,000
Inventory turnover ratio $\left(\text{L}\right)÷\left(\text{K}\right)$	3.0 times	5.9 times

Table (4)

Conclusion

Therefore, the Inventory turnover ratio of Company F and Company B is 3.0 to 1 and 5.9 to 1 respectively.

To determine

Compute the days’ sales in inventory of Company F and Company B.

Explanation of Solution

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.

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

Compute the days’ sales in inventory of Company F and Company B:

Particulars	Company F	Company B
Ending inventory (M)	$86,800	$82,000
Cost of goods sold (N)	$290,600	$480,000
Days’ sales in inventory  $\left[\left(\text{M}\right)\text{÷}\left(\text{N}\right)\right]\times 365\text{days}$	109.0 days	62.4 days

Table (5)

Conclusion

Therefore, the days’ sales in Inventory of Company F and Company B are 109 days and 62.4 days respectively.

To determine

Compute the days’ sales uncollected of Company F and Company B.

Explanation of Solution

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 the days’ sales uncollected of Company F and Company B:

Particulars	Company F	Company B
Ending Accounts receivables, net (F)	$88,700	$79,500
Net credit sales (O)	$393,600	$667,500
Days’ sales uncollected $\left[\left(\text{F}\right)÷\left(\text{O}\right)\right]\times 365\text{days}$	82.3 days	43.5 days

Table (6)

Conclusion

Therefore, the days’ sales uncollected of Company F and Company B are 82.3 days and 43.5 days respectively.

To determine

Identify the company with better short-term credit risk and explain the same.

Explanation of Solution

The current ratio of Company F 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. Hence, Company B is better in managing the short term credit risk.

To determine

Compute the profit margin ratio of Company F and Company B.

Explanation of Solution

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.

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

Given, net income and net sales of Company F are $33,850 and $393,600.

Compute the profit margin ratio of Company F:

$\begin{array}{c}\text{Profit margin}=\frac{\text{Net income}}{\text{Net sales}}\\ =\frac{\$33,850}{\$393,600}\\ =8.6\%\end{array}$

Given, net income and net sales of Company B are $61,700 and $667,500.

Compute the profit margin ratio of Company B:

$\begin{array}{c}\text{Profit margin}=\frac{\text{Net income}}{\text{Net sales}}\\ =\frac{\$61,700}{\$667,500}\\ =9.2\%\end{array}$

Conclusion

Therefore, the profit margin of Company F and Company B is 8.6% and 9.2% respectively.

To determine

Compute the total asset turnover of Company F and Company B.

Explanation of Solution

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:

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

Given, average total assets and net sales of Company F are $382,750 (1) and $393,600.

Compute the total assets turnover ratio of Company F:

$\begin{array}{c}\text{Total}\text{assets}\text{Turnover}=\frac{\text{Net sales }}{\text{Average total assets}}\\ =\frac{\$393,600}{\$382,750}\\ =1.03\text{ times}\end{array}$

Given, average total assets and net sales of Company B are $451,700 (1) and $667,500.

Compute the total assets turnover ratio of Company B:

$\begin{array}{c}\text{Total}\text{assets}\text{Turnover}=\frac{\text{Net sales }}{\text{Average total assets}}\\ =\frac{\$667,500}{\$451,700}\\ =1.48\text{ times}\end{array}$

Working note:

Compute the average total assets of Company F and Company B:

Ratios and Formula	Company F	Company B
Average total assets: $\frac{\left(\begin{array}{l}\text{Ending }\\ \text{total assets}\end{array}\right)+\left(\begin{array}{l}\text{Beginning }\\ \text{total assets}\end{array}\right)}{2}$	$\begin{array}{l}=\frac{\$382,100+\$383,400}{2}\\ =\frac{\$765,500}{2}\\ =\$382,750\end{array}$	$\begin{array}{l}=\frac{\$460,400+\$443,000}{2}\\ =\frac{\$903,400}{2}\\ =\$451,700\end{array}$

…… (1)

Table (7)

Conclusion

Therefore, the total assets turnover of Company F and Company B is 1.03 times and 1.48 times respectively.

To determine

Compute the return on total assets of Company F and Company B.

Explanation of Solution

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:

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

Given, average total assets and net income of Company F are $382,750 (1) and $33,850.

Compute the return on total assets ratio of Company F:

$\begin{array}{c}\text{Return on total assets}=\frac{\text{Net income }}{\text{Average total assets}}\\ =\frac{\$33,850}{\$382,750}\\ =8.8\%\end{array}$

Given, average total assets and net income of Company B are $451,700 (1) and $61,700.

Compute the return on total assets ratio of Company B:

$\begin{array}{c}\text{Return on total assets}=\frac{\text{Net income }}{\text{Average total assets}}\\ =\frac{\$61,700}{\$451,700}\\ =13.7\%\end{array}$

Conclusion

Therefore, the total assets turnover of Company F and Company B is 8.8% and 13.7% respectively.

To determine

Compute the return on common stockholders’ equity of Company F and Company B.

Explanation of Solution

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:

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

Given, average Common stockholders’ equity and net income of Company F are $190,350 (2) and $33,850.

Compute the return on common stockholders’ equity of Company F:

$\begin{array}{c}\text{Return on equity}=\frac{\text{Net income}}{\text{Average stockholders' equity}}\times 100\\ =\frac{\$33,850}{\$190,350}\\ =17.8\%\end{array}$

Given, average Common stockholders’ equity and net income of Company B are $260,400 (2) and $61,700.

Compute the return on common stockholders’ equity of Company B:

$\begin{array}{c}\text{Return on equity}=\frac{\text{Net income}}{\text{Average stockholders' equity}}\times 100\\ =\frac{\$61,700}{\$260,400}\\ =23.7\%\end{array}$

Working note:

Compute the average Common stockholders’ equity of Company F and Company B:

Ratios and Formula	Company F	Company B
Average common stockholders’ equity: $\frac{\left(\begin{array}{l}\text{Ending total }\\ \text{stockholders' }\\ \text{equity}\end{array}\right)+\left(\begin{array}{l}\text{Beginning total }\\ \text{stockholders' }\\ \text{equity}\end{array}\right)}{2}$	$\begin{array}{l}=\frac{\$198,600+\$182,100}{2}\\ =\frac{\$380,700}{2}\\ =\$190,350\end{array}$	$\begin{array}{l}=\frac{\$270,100+\$250,700}{2}\\ =\frac{\$520,800}{2}\\ =\$260,400\end{array}$

…… (2)

Table (8)

Conclusion

Therefore, the common stockholders’ equity of Company F and Company B is 17.8% and 23.7% respectively.

To determine

Compute the price/earnings ratio of Company F and Company B.

Explanation of Solution

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.

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

Given, market price per share of company F is $25 and earnings per share is $1.27.

Compute the price/earnings ratio of Company F:

$\begin{array}{c}\text{Price/Earnings Ratio}\text{=}\frac{\text{Market Price per Share }}{\text{Earnings per Share}}\\ =\frac{\$25}{\$1.27}\\ =19.7\end{array}$

Given, market price per share of company B is $25 and earnings per share is $2.19.

Compute the price/earnings ratio of Company B:

$\begin{array}{c}\text{Price/Earnings Ratio}\text{=}\frac{\text{Market Price per Share }}{\text{Earnings per Share}}\\ =\frac{\$25}{\$2.19}\\ =11.4\end{array}$

Conclusion

Therefore, the price/earnings ratio of Company F and Company B is 19.7 and 11.4 respectively.

To determine

Compute the dividend yield ratio of Company F and Company B.

Explanation of Solution

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:

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

Given, market price per share of company B is $25 and annual dividend per share is $1.50.

Compute the dividend yield ratio of Company F:

$\begin{array}{c}\text{Dividend yield=}\frac{\text{Annual dividends per Share }}{\text{Market Price per Share}}\\ =\frac{\$1.50}{\$25}\\ =6.0\%\end{array}$

Given, market price per share of company B is $25 and annual dividend per share is $1.50.

Compute the dividend yield ratio of Company B:

$\begin{array}{c}\text{Dividend yield=}\frac{\text{Annual dividends per Share }}{\text{Market Price per Share}}\\ =\frac{\$1.50}{\$25}\\ =6.0\%\end{array}$

Conclusion

Therefore, the dividend yield ratio of Company F and Company B is 6.0% and 6.0% respectively.

To determine

Identify the company, that its stock would be recommended as the better investment and explain the same.

Explanation of Solution

The price earnings ratio of Company F is slightly better than the price earnings ratio of Company B. The dividend yield ratios of both the companies are same. The profitability ratios of Company B are better than the ratios of Company F. Hence, Hence, Company B is a better investment option.