Question

Using ratios to decide between two stock investments

Assume that you are purchasing an investment and have decided to invest in a company in the digital phone business. You have narrowed the choice to Digitalized Corp. and Every Zone, Inc. and have assembled the following data.

Selected income statement data for the current year:

	Digitalized	Every Zone
Net sales revenue (all on credit)	\(423,035	\)493,845
Cost of goods sold	210,000	260,000
Interest expenses	0	19,000
Net income	51,000	72,000

Selected balance sheet and market price data at the end of the current year:

	Digitalized	Every Zone
Current assets:
Cash	\(24,000	\)17,000
Short-term investment	40,000	14,000
Accounts receivables, Net	40,000	48,000
Merchandise inventory	66,000	97,000
Prepaid expenses	23,000	12,000
Total current assets	\(193,000	\)188,000
Total assets	266,000	323,000
Total current liabilities	105,000	96,000
Total liabilities	105,000	128,000
Common stock
\(1 par (12,000 shares)	12,000
\)1 par (17,000 shares)		17,000
Total stockholders equity	161,000	195,000
Market price per share of common stock	76.50	114.48
Dividend paid per common stock	1.10	1.00

Selected balance sheet data at the beginning of the current year:

	Digitalized	Every Zone
Balance sheet:
Accounts Receivable, net	\(41,000	\)54,000
Merchandise Inventory	81,000	87,000
Total Assets	261,000	272,000
Common Stock:
\(1 par (12,000 shares)	12,000
\)1 par (17,000 shares)		17,000

Your strategy is to invest in companies that have low price/earnings ratios but appear to be in good shape financially. Assume that you have analyzed all other factors and that your decision depends on the results of ratio analysis.

Requirements

1. Compute the following ratios for both companies for the current year:

a. Acid-test ratio

b. Inventory turnover

c. Days’ sales in receivables

d. Debt ratio

e. Earnings per share of common stock

f. Price/earnings ratio

g. Dividend payout

2. Decide which company’s stock better fits your investment strategy.

Short answer

1. Financial ratios:
2. 
   

Ratio	Digitalized	Every Zone
Acid test ratio	0.99	0.82
Inventory turnover	2.85	2.82
Days sales in receivables	35	38
Debt ratio	0.39	0.40
Earnings per share	$4.25	$4.23
Price-earnings ratio	18	27.06
Dividend payout ratio	0.2588	0.2364

2. The investment must be made in the Digitalized corporation.

Step-by-step solution

Definition of Financial Ratios

The figures that are calculated by comparing various line items of the financial statement to arrive at a conclusive decision regarding liquidity, solvency, and profitability are known as financial ratios.

Calculation of financial ratios:

1. Acid test ratio:

Digitalized:

Every Zone:

b. Inventory turnover ratio:

Digitalized:

Every Zone:

c. Days’ sales in receivables:

Digitalized:

$\begin{array}{c}\mathrm{Days}\mathrm{sales}\mathrm{in}\mathrm{receivables}=\frac{365}{\mathrm{Accounts}\mathrm{receivables}\mathrm{turn}\mathrm{over}\mathrm{ratio}}\\ =\frac{365}{10.44}\\ =35\mathrm{days}\end{array}$

Working note:

Every Zone:

$\begin{array}{c}\mathrm{Days}\mathrm{sales}\mathrm{in}\mathrm{receivables}=\frac{365}{\mathrm{Accounts}\mathrm{receivables}\mathrm{turn}\mathrm{over}\mathrm{ratio}}\\ =\frac{365}{9.68}\\ =38\mathrm{days}\end{array}$

Working note:

d. Debt ratio:

Digitalized:

Every Zone:

e. Earnings per share of common stock:

Digitalized:

Every Zone:

$\begin{array}{c}\mathrm{Earnings}\mathrm{per}\mathrm{share}\mathrm{of}\mathrm{common}\mathrm{stock}=\frac{\mathrm{Net}\mathrm{income}-\mathrm{Preferred}\mathrm{dividend}}{\mathrm{Weighted}\mathrm{average}\mathrm{common}\mathrm{shares}\mathrm{outstanding}}\\ =\frac{\mathrm{\$}72,000-\mathrm{\$}0}{17,000}\\ =\mathrm{\$}4.23\mathrm{pershare}\end{array}$

f. Price/earnings ratio:

Digitalized:

Every Zone:

g. Dividend payout:

Digitalized:

Every Zone:

Investment Decision

The business entity must invest in the digitalized corporation because this corporation is having lower price earnings ratio and is financially strong as all other ratios are reflecting efficiency in the operation as compared to Every Zone corporation.