Chapter 9, Problem 23P

Problem 9-23 Ratio analysis

The following financial statements apply to Karl Company:

Required

Calculate the following ratios for 2018 and 2019. When data limitations prohibit computing averages, use year-end balances in your calculations. Round computations to two decimal points.

1. a. Net margin.
2. b. Return on investment.
3. c. Return on equity.
4. d. Earnings per share.
5. e. Price-earnings ratio (market prices at the end of 2018 and 2019 were $11.88 and $9.54, respectively).
6. f. Book value per share of common stock.
7. g. Times interest earned.
8. h. Working capital.
9. i. Current ratio.
10. j. Quick (acid-test) ratio.
11. k. Accounts receivable turnover.
12. l. Inventory turnover.
13. m. Debt to equity ratio.
14. n. Debt to assets ratio.

To determine

Compute net margin of Company K for 2019 and 2018.

Explanation of Solution

Net 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.

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

Compute net margin of Company K for 2019 and 2018:

Ratios and Formula	2019	2018
Net margin: $\frac{\text{Net income}}{\text{Net sales}}$	$\begin{array}{l}=\frac{\$72,000}{\$420,000}\\ =17.14\%\end{array}$	$\begin{array}{l}=\frac{\$54,000}{\$350,000}\\ =15.42\%\end{array}$

Table (1)

Conclusion

Thus, the net margin of Company K for 2019 and 2018 are 17.14% and 15.42% respectively.

To determine

Compute return on investment of Company K for 2019 and 2018.

Explanation of Solution

Return on investments (assets): Return on investments (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 investment is calculated as follows:

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

Compute return on investment of Company K for 2019 and 2018:

Ratios and Formula	2019	2018
Return on investment: $\frac{\text{Net income }}{\text{Average total assets}}$	$\begin{array}{l}=\frac{\$72,000}{\$512,000\left(1\right)}\\ =14.06\%\end{array}$	$\begin{array}{l}=\frac{\$54,000}{\$488,000}\\ =11.07\%\end{array}$

Table (2)

Note: Since, the beginning total assets for 2018 are not given. So, the total amount of total assets for 2018 is assumed as average total assets.

Working note:

(1) Determine the amount of average total assets for 2019.

$\begin{array}{c}\text{Average total assets =}\frac{\left(\begin{array}{l}\text{Ending }\\ \text{total assets}\end{array}\right)+\left(\begin{array}{l}\text{Beginning }\\ \text{total assets}\end{array}\right)}{2}\\ =\frac{\$536,000+\$488,000}{2}\\ =\frac{\$1,024,000}{2}\\ =\$512,000\end{array}$

Conclusion

Thus, the return on investment of Company K for 2019 and 2018 are 14.06% and 11.07% respectively.

To determine

Compute return on equity of Company K for 2019 and 2018.

Explanation of Solution

Return on equity: 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:

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

Compute return on equity of Company K for 2019 and 2018:

Ratios and Formula	2019	2018
Return on equity: $\frac{\text{Net income }}{\left[\begin{array}{l}\text{Average stockholders'}\\ \text{ equity}\end{array}\right]}$	$\begin{array}{l}=\frac{\$72,000}{\$253,000\left(2\right)}\\ =28.46\%\end{array}$	$\begin{array}{l}=\frac{\$54,000}{\$216,000}\\ =25\%\end{array}$

Table (3)

Note: Since, the beginning stockholders’ equity for 2018 is not given. So, the total amount of stockholders’ equity for 2018 is assumed as average total stockholders’ equity.

Working Note:

(2) Determine the amount of average total stockholders’ equity for 2019.

$\begin{array}{c}\begin{array}{l}\text{Average total }\\ \text{stockholders' equity }\end{array}\}\text{=}\frac{\left(\begin{array}{l}\text{Ending total }\\ \text{stockholders' equity}\end{array}\right)+\left(\begin{array}{l}\text{Beginning total }\\ \text{stockholders' equity}\end{array}\right)}{2}\\ =\frac{\$290,00+\$216,000}{2}\\ =\frac{\$506,000}{2}\\ =\$253,000\end{array}$

Conclusion

Thus, the return on equity of Company K for 2019 and 2018 are 28.46% and 25% respectively.

To determine

Compute earnings per share of Company K for 2019 and 2018.

Explanation of Solution

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.

      $\text{Earnings per share}=\frac{\text{Net earnings available for common stock}}{\text{Average number of outstanding common shares}}$

Compute earnings per share of Company K for 2019 and 2018:

Ratios and Formula	2019	2018
Earnings per share: $\frac{\text{Net income}}{\left[\begin{array}{l}\text{Average common }\\ \text{shares outstanding}\end{array}\right]}$	$\begin{array}{l}=\frac{\$72,000}{100,000\text{ shares}}\\ =\$0.72\text{ per share}\end{array}$	$\begin{array}{l}=\frac{\$54,000}{100,000\text{ shares}}\\ =\$0.54\text{ per share}\end{array}$

Table (4)

Conclusion

Thus, the earnings per share of Company K for 2019 and 2018 are $0.72 per share and $0.54 per share respectively.

To determine

Compute price-earnings ratio of Company K for 2019 and 2018.

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.

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

Compute price-earnings ratio of Company K for 2019 and 2018:

Ratios and Formula	2019	2018
Price-earnings ratio: $\frac{\text{Market price per share}}{\text{ Earnings per share}}$	$\begin{array}{l}=\frac{\$9.54\left(\text{Given}\right)}{\$0.72}\\ =13.25\text{ times}\end{array}$	$\begin{array}{l}=\frac{\$11.88\left(\text{Given}\right)}{\$0.54}\\ =22\text{ times}\end{array}$

Table (5)

Note: The earnings per share for both years are computed in requirement d.

Conclusion

Thus, the price-earnings ratio of Company K for 2019 and 2018 are 13.25 times and 22 times respectively.

To determine

Compute book value per share of common stock of Company K for 2019 and 2018.

Explanation of Solution

Book value per share of common stock: This ratio is a measure of a share of common stock that is used to determine the value of per share based on the equity available to the common stockholders. This ratio is calculated by using the formula:

  $\begin{array}{l}\text{Book value per share }\\ \text{of common stock}\end{array}\}\text{=}\frac{\text{Stockholders' equity}-\text{Preferred stock }}{\text{Outstanding common shares}}$

Compute book value per share of common stock of Company K for 2019 and 2018:

Ratios and Formula	2019	2018
Book value per share of common stock: $\frac{\left[\begin{array}{l}\text{Stockholders' }\\ \text{equity}\end{array}\right]-\left[\begin{array}{l}\text{Preferred }\\ \text{stock}\end{array}\right]}{\text{Outstanding common shares}}$	$\begin{array}{l}=\frac{\$290,000-\$0}{100,000\text{ shares}}\\ =\$2.90\text{ per share}\end{array}$	$\begin{array}{l}=\frac{\$216,000-\$0}{100,000\text{ shares}}\\ =\$2.16\text{ per share}\end{array}$

Table (6)

Conclusion

Thus, the book value per share of common stock of Company K for 2019 and 2018 are $2.90 per share and $2.16 per share respectively.

To determine

Compute times interest earned of Company K for 2019 and 2018.

Explanation of Solution

Time’s interest earned: Number of times interest is earned quantifies the number of times the earnings before interest and taxes can pay the interest expense. First, determine the sum of income before income tax and interest expense. Then, divide the sum by interest expense.

$\text{Times interest earned}=\frac{\text{Earnings before interest and taxes expense}}{\text{ Interest expense }}$

Compute times interest earned of Company K for 2019 and 2018:

Ratios and Formula	2019	2018
Times interest earned: $\frac{\left[\begin{array}{l}\text{Earnings before interest}\\ \text{ and tax expense}\end{array}\right]}{\text{Interest expense}}$	$\begin{array}{l}=\frac{\$120,000\left(3\right)}{\$6,000}\\ =20.00\text{ times}\end{array}$	$\begin{array}{l}=\frac{\$96,000\left(4\right)}{\$6,000}\\ =16.00\text{ times}\end{array}$

Table (7)

Working Note:

(3) Determine the amount of earnings before interest and expenses for 2019.

$\begin{array}{c}\begin{array}{l}\text{Earnings before income }\\ \text{tax and interest}\end{array}\}=\left(\begin{array}{l}\text{Net }\\ \text{Income}\end{array}\right)+\left(\begin{array}{l}\text{Interest}\\ \text{ expense}\end{array}\right)+\left(\begin{array}{l}\text{Tax}\\ \text{ expense}\end{array}\right)\\ =\$72,000+\$6,000+\$42,000\\ =\$120,000\end{array}$

(4) Determine the amount of earnings before interest and expenses for 2018.

$\begin{array}{c}\begin{array}{l}\text{Earnings before income }\\ \text{tax and interest}\end{array}\}=\left(\begin{array}{l}\text{Net }\\ \text{Income}\end{array}\right)+\left(\begin{array}{l}\text{Interest}\\ \text{ expense}\end{array}\right)+\left(\begin{array}{l}\text{Tax}\\ \text{ expense}\end{array}\right)\\ =\$54,000+\$6,000+\$36,000\\ =\$96,000\end{array}$

Conclusion

Thus, the times interest earned ratio of Company K for 2019 and 2018 is 20.00 times and 16.00 times respectively.

To determine

Compute working capital of Company K for 2019 and 2018.

Explanation of Solution

Working capital: Working capital refers to the excess amount of current assets over its current liabilities of a business. It measures the excess funds that are required for the companies to carry out their day to day operations, excluding any new funds that have been invested during the year. Working capital is calculated by using the formula:

$\text{Working capital}=\text{ Current assets}-\text{Current liabilities }$

Compute working capital of Company K for 2019 and 2018:

Ratios and Formula	2019	2018
Working Capital: $\left(\begin{array}{l}\text{Current }\\ \text{Assets}\end{array}\right)-\left(\begin{array}{l}\text{Current }\\ \text{Liabilities}\end{array}\right)$	$\begin{array}{l}=\$286,000-\$114,000\\ =\$172,000\end{array}$	$\begin{array}{l}=\$278,000-\$138,000\\ =\$140,000\end{array}$

Table (8)

Conclusion

Thus, the working capital of Company K for 2019 and 2018 is $172,000 and $140,000 respectively.

To determine

Compute current ratio of Company K for 2019 and 2018.

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 current ratio of Company K for 2019 and 2018:

Ratios and Formula	2019	2018
Current ratio: $\frac{\text{Current Assets}}{\text{Current Liabilities}}$	$\begin{array}{l}=\frac{\$286,000}{\$114,000}\\ =2.50:1\end{array}$	$\begin{array}{l}=\frac{\$278,000}{\$138,000}\\ =2.01:1\end{array}$

Table (9)

Conclusion

Thus, the current ratio of Company K for 2019 and 2018 is 2.50:1 and 2.01:1 respectively.

To determine

Compute quick ratio of Company K for 2019 and 2018.

Explanation of Solution

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.

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

Compute quick ratio of Company K for 2019 and 2018:

Ratios and Formula	2019	2018
Quick ratio: $\frac{\text{Quick Assets}}{\text{Current Liabilities}}$	$\begin{array}{l}=\frac{\$80,000}{\$114,000}\\ =0.70:1\end{array}$	$\begin{array}{l}=\frac{\$82,000}{\$138,000}\\ =0.59:1\end{array}$

Table (10)

Note: Quick assets include cash, marketable securities and accounts receivable.

Conclusion

Thus, the quick ratio of Company K for 2019 and 2018 is 0.70:1 and 0.59:1 respectively.

To determine

Compute receivables turnover of Company K for 2019 and 2018.

Explanation of Solution

Account Receivables turnover ratio: Account 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 account receivables.

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

Compute receivables turnover of Company K for 2019 and 2018:

Ratios and Formula	2019	2018
Receivables turnover: $\frac{\text{}\text{Net credit sales}}{\left(\begin{array}{l}\text{Average accounts }\\ \text{receivables}\end{array}\right)}$	$\begin{array}{l}=\frac{\$420,000}{\$67,000\left(5\right)}\\ =6.27\text{ times}\end{array}$	$\begin{array}{l}=\frac{\$350,000}{\$64,000}\\ =5.47\text{ times}\end{array}$

Table (11)

Note: Since, the beginning value of receivable for 2018 is not given. So, the total amount of receivable for 2018 is assumed as average receivables.

Working Note:

(5) Determine the amount of average accounts receivable for 2019.

$\begin{array}{c}\begin{array}{l}\text{Average accounts}\\ \text{ receivable}\end{array}\}=\frac{\left(\begin{array}{l}\text{Ending Net }\\ \text{Receivables}\end{array}\right)+\left(\begin{array}{l}\text{Beginning Net }\\ \text{Receivables}\end{array}\right)}{2}\\ =\frac{\$70,000+\$64,000}{2}\\ =\frac{\$134,000}{2}\\ =\$67,000\end{array}$

Conclusion

Thus, the accounts receivable turnover of Company K for 2019 and 2018 is 6.27 times and 5.47 times respectively.

To determine

Compute inventory turnover of Company K for 2019 and 2018.

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 inventory turnover of Company K for 2019 and 2018:

Ratios and Formula	2019	2018
Inventory turnover: $\frac{\text{Cost of goods sold}}{\text{Average inventory}}$	$\begin{array}{l}=\frac{\$252,000}{\$196,000\left(6\right)}\\ =1.28\text{ times}\end{array}$	$\begin{array}{l}=\frac{\$206,000}{\$192,000}\\ =1.07\text{ times}\end{array}$

Table (12)

Note: Since, the beginning value of inventory for 2018 is not given. So, the total amount of inventory for 2018 is assumed as average inventory.

Working Note:

(6) Determine the amount of average inventory for 2019.

$\begin{array}{c}\text{Average inventory}=\frac{\left(\begin{array}{l}\text{Ending }\\ \text{Inventory}\end{array}\right)+\left(\begin{array}{l}\text{Beginning}\\ \text{ Inventory}\end{array}\right)}{2}\\ =\frac{\$200,000+\$192,000}{2}\\ =\frac{\$392,000}{2}\\ =\$196,000\end{array}$

Conclusion

Thus, the inventory turnover of Company K for 2019 and 2018 is 1.28 times and 1.07 times respectively.

To determine

Compute debt to equity ratio of Company K for 2019 and 2018.

Explanation of Solution

Debt–to-equity ratio: The debt-to-equity ratio indicates that the company’s debt as a proportion of its stockholders’ equity. The debt-to-equity ratio is calculated using the formula:

  $\text{Debt-to-equity ratio}=\frac{\text{Total liabilities}}{\text{Total stockholders' equity}}$

Compute debt to equity ratio of Company K for 2019 and 2018:

Ratios and Formula	2019	2018
Debt to equity ratio: $\frac{\text{Total liabilities }}{\left(\begin{array}{l}\text{Total stockholders' }\\ \text{equity}\end{array}\right)}$	$\begin{array}{l}=\frac{\$246,000}{\$290,000}\\ =0.85:1\end{array}$	$\begin{array}{l}=\frac{\$272,000}{\$216,000}\\ =1.26:1\end{array}$

Table (13)

Conclusion

Thus, the debt to equity ratio of Company K for 2019 and 2018 is 0.85:1 and 1.26:1 respectively.

To determine

Compute debt to assets ratio of Company K for 2019 and 2018.

Explanation of Solution

Debt to assets ratio: The debt to asset ratio shows the relationship between total asset and the total liability of the company. Debt ratio reflects the financial strategy of the company. It is used to measure the percentage of company’s assets that are financed by long term debts.  Debt to assets ratio is calculated by using the formula:

  $\text{Debt-to-assets ratio}=\frac{\text{Total Liabilities}}{\text{Total Assets }}$

Compute debt to assets ratio of Company K for 2019 and 2018:

Ratios and Formula	2019	2018
Debt to assets ratio: $\frac{\text{Total liabilities }}{\text{Total assets}}$	$\begin{array}{l}=\frac{\$246,000}{\$536,000}\\ =45.89\%\end{array}$	$\begin{array}{l}=\frac{\$272,000}{\$488,000}\\ =55.73\%\end{array}$

Table (14)

Conclusion

Thus, the debt to assets ratio of Company K for 2019 and 2018 is 45.89% and 55.73% respectively.