Question

Using ratios to evaluate a stock investment

Comparative financial statement data of Sanfield, Inc. follow:

SANFIELD, INC. Comparative Income Statement Years Ended December 31, 2018, and 2017
	2018	2017
Net Sales Revenue	\( 462,000	\) 430,000
Cost of Goods Sold	236,000	213,000
Gross Profit	226,000	217,000
Operating Expense	135,000	133,000
Income from Operations	91,000	84,000
Interest Expense	8,000	12,000
Income Before Income Tax	83,000	72,000
Income Tax Expense	18,000	22,000
Net Income	\( 65,000	\) 50,000

SANFIELD, INC. Comparative Balance Sheet December 31, 2018, and 2017
	2018	2017	2016
Asset
Current Assets:
Cash	\( 99,000	\) 97,000
Accounts Receivable, Net	109,000	117,000	\( 100,000
Merchandise Inventory	142,000	164,000	207,000
Prepaid Expenses	15,000	5,000
Total Current Assets	365,000	383,000
Property, Plant, and Equipment, Net	215,000	177,000
Total Assets	\) 580,000	\( 560,000	\) 599,000
Liabilities
Total Current Liabilities	\( 222,000	\) 244,000
Long-term Liabilities	113,000	92,000
Total Liabilities	335,000	336,000
Stockholders’ Equity
Preferred Stock, 4%	92,000	92,000
Common Stockholders’ Equity, no par	153,000	132,000	85,000
Total Liabilities and Stockholders’ Equity	\( 580,000	\) 560,000

1. Market price of Sanfield’s common stock: \(51.48 at December 31, 2018, and \)37.08 at December 31, 2017.

2. Common shares outstanding: 16,000 on December 31, 2018 and 15,000 on December 31, 2017 and 2016.

3. All sales are on credit.

Requirements

1. Compute the following ratios for 2018 and 2017:

1. Current ratio
2. Cash ratio
3. Times-interest-earned ratio
4. Inventory turnover
5. Gross profit percentage
6. Debt to equity ratio
7. Rate of return on common stockholders’ equity
8. Earnings per share of common stock
9. Price/earnings ratio

2. Decide (a) whether Sanfield’s ability to pay debts and sell inventory improved or deteriorated during 2018 and (b) whether the investment attractiveness of its common stock appears to have increased or decreased.

Short answer

S. no.	2018	2017
1
a.	1.64	1.57
b.	0.45	0.39
c.	11.38	7.00
d.	1.54	1.15
e.	48.9%	50.5%
f.	1.37	1.50
g.	43.0%	42.7%
h.	$3.96	$3.09
i.	13.0	12.0
2
a.	The company's capacity to sell inventory increased as the inventory turnover improved.
b.	The desirability of Sanfield's stock increased in 2018.

Step-by-step solution

Meaning of Ratio Analysis

Ratio analysis is a fundamental approach to assessing a company's health by examining the relationships between key financial indicators. According to many analysts, ratio analysis is the most critical aspect of the analytical process.

(1) Computing ratios

a).Current ratio

2018

$\begin{array}{c}\mathrm{Current}\mathrm{ratio}=\frac{\mathrm{Total}\mathrm{current}\mathrm{asset}}{\mathrm{Total}\mathrm{current}\mathrm{liabilities}}\\ =\frac{\mathrm{\$}365,000}{\mathrm{\$}222,000}\\ =1.64\end{array}$

2017

$\begin{array}{c}\mathrm{Current}\mathrm{ratio}=\frac{\mathrm{Total}\mathrm{current}\mathrm{asset}}{\mathrm{Total}\mathrm{current}\mathrm{liabilities}}\\ =\frac{\mathrm{\$}383,000}{\mathrm{\$}244,000}\\ =1.57\end{array}$

b) Cash ratio

2018

$\begin{array}{c}\mathrm{Cash}\mathrm{ratio}=\frac{\mathrm{Cash}+\mathrm{Cash}\mathrm{equivalent}}{\mathrm{Total}\mathrm{current}\mathrm{liabilities}}\\ =\frac{\mathrm{\$}99,000+\mathrm{\$}0}{\mathrm{\$}222,000}\\ =0.45\end{array}$
2017

$\begin{array}{c}\mathrm{Cash}\mathrm{ratio}=\frac{\mathrm{Cash}+\mathrm{Cash}\mathrm{equivalent}}{\mathrm{Total}\mathrm{current}\mathrm{liabilities}}\\ =\frac{\mathrm{\$}97,000+\mathrm{\$}0}{\mathrm{\$}244,000}\\ =0.39\end{array}$

c)Times interest earned ratio

2018

$\begin{array}{c}\mathrm{Times}\mathrm{interest}\mathrm{earned}\mathrm{ratio}=\frac{\mathrm{Net}\mathrm{Income}+\mathrm{Income}\mathrm{tax}\mathrm{expense}+\mathrm{Interest}\text{\hspace{0.33em}}\mathrm{expense}}{\mathrm{Interest}\mathrm{expense}}\\ =\frac{\mathrm{\$}65,000+\mathrm{\$}18,000+\mathrm{\$}8,000}{\mathrm{\$}8,000}\\ =11.38\end{array}$

2017

$\begin{array}{c}\mathrm{Times}\mathrm{interest}\mathrm{earned}\mathrm{ratio}=\frac{\mathrm{Net}\mathrm{Income}+\mathrm{Income}\mathrm{tax}\mathrm{expense}+\mathrm{Interest}\text{\hspace{0.33em}}\mathrm{expense}}{\mathrm{Interest}\mathrm{expense}}\\ =\frac{\mathrm{\$}50,000+\mathrm{\$}22,000+\mathrm{\$}12,000}{\mathrm{\$}12,000}\\ =7.00\end{array}$

d) Inventory turnover ratio

2018

$\begin{array}{c}\mathrm{Inventory}\mathrm{turnover}\mathrm{ratio}=\frac{\mathrm{Cost}\mathrm{of}\mathrm{goods}\mathrm{sold}}{\mathrm{Average}\mathrm{merchandise}\mathrm{Inventory}}\\ =\frac{\mathrm{\$}236,000}{\left(\frac{\mathrm{\$}142,000+\mathrm{\$}164,000}{2}\right)}\\ =1.54\end{array}$

2017

$\begin{array}{c}\mathrm{Inventory}\mathrm{turnover}\mathrm{ratio}=\frac{\mathrm{Cost}\mathrm{of}\mathrm{goods}\mathrm{sold}}{\mathrm{Average}\mathrm{merchandise}\mathrm{Inventory}}\\ =\frac{\mathrm{\$}213,000}{\left(\frac{\mathrm{\$}164,000+\mathrm{\$}207,000}{2}\right)}\\ =1.15\end{array}$

e) Gross profit percentage

2018

$\begin{array}{c}\mathrm{Gross}\mathrm{profit}\mathrm{percentage}=\frac{\mathrm{Gross}\mathrm{profit}}{\mathrm{Net}\mathrm{sales}\mathrm{revenue}}\\ =\frac{\mathrm{\$}226,000}{\mathrm{\$}462,000}\\ =48.9\mathrm{\%}\end{array}$

2017

$\begin{array}{c}\mathrm{Gross}\mathrm{profit}\mathrm{percentage}=\frac{\mathrm{Gross}\mathrm{profit}}{\mathrm{Net}\mathrm{sales}\mathrm{revenue}}\\ =\frac{\mathrm{\$}217,000}{\mathrm{\$}430,000}\\ =50.5\mathrm{\%}\end{array}$

f) Debt to equity ratio

2018

$\begin{array}{c}\mathrm{Debt}\mathrm{to}\mathrm{equity}\mathrm{ratio}=\frac{\mathrm{Total}\mathrm{liabilities}}{\mathrm{Total}\mathrm{equity}}\\ =\frac{\mathrm{\$}335,000}{\mathrm{\$}245,000}\\ =1.37\end{array}$

2017

$\begin{array}{c}\mathrm{Debt}\mathrm{to}\mathrm{equity}\mathrm{ratio}=\frac{\mathrm{Total}\mathrm{liabilities}}{\mathrm{Total}\mathrm{equity}}\\ =\frac{\mathrm{\$}336,000}{\mathrm{\$}224,000}\\ =1.50\end{array}$

g) Rate of return on common stockholder’s equity

2018

$\begin{array}{c}\mathrm{Return}\mathrm{on}\mathrm{common}\mathrm{stockholder}\text{'}\mathrm{s}\mathrm{equity}=\frac{\mathrm{Net}\mathrm{income}-\mathrm{Preferred}\mathrm{dividends}}{\mathrm{Average}\mathrm{common}\mathrm{stockholder}\text{'}\mathrm{s}\mathrm{equity}}\\ =\frac{\mathrm{\$}65,000-\left(4\mathrm{\%}\times \mathrm{\$}92,000\right)}{\left(\frac{\mathrm{\$}153,000+\mathrm{\$}132,000}{2}\right)}\\ =\frac{\mathrm{\$}65,000-\mathrm{\$}3,680}{142,500}\\ =43\mathrm{\%}\end{array}$

2017

$\begin{array}{c}\mathrm{Return}\mathrm{on}\mathrm{common}\mathrm{stockholder}\text{'}\mathrm{s}\mathrm{equity}=\frac{\mathrm{Net}\mathrm{income}-\mathrm{Preferred}\mathrm{dividends}}{\mathrm{Average}\mathrm{common}\mathrm{stockholder}\text{'}\mathrm{s}\mathrm{equity}}\\ =\frac{\mathrm{\$}50,000-\left(4\mathrm{\%}\times \mathrm{\$}92,000\right)}{\left(\frac{\mathrm{\$}132,000+\mathrm{\$}85,000}{2}\right)}\\ =\frac{\mathrm{\$}50,000-\mathrm{\$}3,680}{\mathrm{\$}108,500}\\ =42.7\mathrm{\%}\end{array}$

h) Earnings per share of common stock

2018

$\begin{array}{c}\mathrm{Earning}\mathrm{per}\mathrm{share}\mathrm{of}\mathrm{common}\mathrm{stock}=\frac{\mathrm{Net}\mathrm{income}-\mathrm{Preferred}\mathrm{dividend}}{\mathrm{Weighted}\mathrm{average}\mathrm{number}\mathrm{of}\mathrm{common}\mathrm{share}\mathrm{of}\mathrm{common}\mathrm{stock}}\\ =\frac{\mathrm{\$}65,000-\mathrm{\$}3,860}{\left(\frac{16,000+15,000}{2}\right)}\\ =\mathrm{\$}3.96\end{array}$

2017

$\begin{array}{c}\mathrm{Earning}\mathrm{per}\mathrm{share}\mathrm{of}\mathrm{common}\mathrm{stock}=\frac{\mathrm{Net}\mathrm{income}-\mathrm{Preferred}\mathrm{dividend}}{\mathrm{Weighted}\mathrm{average}\mathrm{number}\mathrm{of}\mathrm{common}\mathrm{share}\mathrm{of}\mathrm{common}\mathrm{stock}}\\ =\frac{\mathrm{\$}50,000-\mathrm{\$}3,860}{15,000}\\ =\mathrm{\$}3.09\end{array}$

i) Price/earnings ratio

2018

$\begin{array}{c}\mathrm{Price}/\mathrm{Earning}\mathrm{ratio}=\frac{\mathrm{Market}\mathrm{price}\mathrm{per}\mathrm{share}\mathrm{of}\mathrm{common}\mathrm{stock}}{\mathrm{Earnings}\mathrm{per}\mathrm{share}}\\ =\frac{\mathrm{\$}51.48}{\mathrm{\$}3.96}\\ =13.0\end{array}$

2017

$\begin{array}{c}\mathrm{Price}/\mathrm{Earning}\mathrm{ratio}=\frac{\mathrm{Market}\mathrm{price}\mathrm{per}\mathrm{share}\mathrm{of}\mathrm{common}\mathrm{stock}}{\mathrm{Earnings}\mathrm{per}\mathrm{share}}\\ =\frac{\mathrm{\$}37.08}{\mathrm{\$}3.09}\\ =12.0\end{array}$

(2) Explaining the situation of Sanfield’s

1. Compared to 2017, Sanfield is better positioned to pay off the debt in 2018. The times-interest-earned ratio, cash ratio, and current ratio all increased. The company's capacity to sell inventory increased as the inventory turnover improved.
2. 2018 has seen an improvement in Sanfield's stock's appeal. The earnings per share and price/earnings ratio increased with the rate of return on common stockholders' equity.