Question

Using ratios to evaluate a stock investment

Comparative financial statement data of Garfield, Inc. follow:

GARFIELD, INC Comparative Income Statement Years Ended December 31, 2018 and 2017
	2018	2017
Net sales revenue	\(461,000	\)424,000
Cost of goods sold	241,000	211,000
Gross profit	220,000	213,000
Operating expenses	137,000	135,000
Income from operations	83,000	78,000
Interest expenses	9,000	13,000
Income before taxes	74,000	65,000
Income tax expenses	18,000	24,000
Net income	\(56,000	\)41,000

GARFIELD, INC Comparative Income Statement Years Ended December 31, 2018 and 2017
	2018	2017	2016
Assets
Current assets
Cash	\(99,000	\)98,000
Accounts receivables, Net	108,000	114,000	107,000
Merchandise inventory	146,000	164,000	202,000
Prepaid expenses	20,000	9,000
Total current assets	373,000	385,000
Property, plant, and equipment	211,000	181,000
Total assets	\(584,000	\)566,000	\(602,000
Liabilities
Total current liabilities	\)227,000	\(246,000
Long-term liabilities	117,000	100,000
Total liabilities	344,000	346,000
Stockholder’s equity
Preferred stock, 3%	98,000	98,000
Common stockholder equity, no par	142,000	122,000	89,000
Total liabilities and stockholder’s equity	\)584,000	\(566,000

1. Market price of Garfield’s common stock: \)69.36 at December 31, 2018, and $38.04 at December 31, 2017.

2. Common shares outstanding: 14,000 on December 31, 2018 and 12,000 on December 31, 2017 and 2016.

3. All sales are on credit.

Requirements

1. Compute the following ratios for 2018 and 2017:

a. Current ratio

b. Cash ratio

c. Times-interest-earned ratio

d. Inventory turnover

e. Gross profit percentage

f. Debt to equity ratio

g. Rate of return on common stockholders’ equity

h. Earnings per share of common stock

i. Price/earnings ratio

2. Decide (a) whether Garfield’s ability to pay debts and to 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

1. Financial ratios:

Ratios	2018	2017
Current ratio	1.64	1.57
Cash ratio	0.44	0.40
Times-interest earned ratio	7.22	4
Inventory turnover	1.55	1.15
Gross profit percentage	47.83%	50.24%
Debt-to-equity ratio	1.43	1.57
Rate of return on common stockholder’s equity	42.42%	38.86%
Earnings per share of common stock	$4.31 per share	$3.42 per share
Price-earnings ratio	16.09	11.12

2. Ability to pay off has decreased, the ability to sell has increased, and the attractiveness of the common stock has increased.

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.

Financial ratios Calculation

$\begin{array}{c}\mathrm{Gross}\mathrm{profit}\mathrm{percentage}=\frac{\mathrm{Gross}\mathrm{profit}}{\mathrm{Net}\mathrm{sales}}\times 100\\ =\frac{\mathrm{\$}213,000}{\mathrm{\$}424,000}\times 100\\ =50.24\mathrm{\%}\end{array}$a. Current ratio:

2018:

$\begin{array}{c}\mathrm{Current}\mathrm{ratio}=\frac{\mathrm{Current}\mathrm{assets}}{\mathrm{Current}\mathrm{liabilities}}\\ =\frac{\mathrm{\$}373,000}{\mathrm{\$}227,000}\\ =1.64\end{array}$

2017:

$\begin{array}{c}\mathrm{Current}\mathrm{ratio}=\frac{\mathrm{Current}\mathrm{assets}}{\mathrm{Current}\mathrm{liabilities}}\\ =\frac{\mathrm{\$}385,000}{\mathrm{\$}246,000}\\ =1.57\end{array}$

b. Cash ratio:

2018:

$\begin{array}{c}\mathrm{Cash}\mathrm{ratio}=\frac{\mathrm{Cash}+\mathrm{Cash}\mathrm{equivalents}}{\mathrm{Total}\mathrm{current}\mathrm{liabilities}}\\ =\frac{\mathrm{\$}99,000+\mathrm{\$}0}{\mathrm{\$}227,000}\\ =0.44\mathrm{times}\end{array}$

2017:

$\begin{array}{c}\mathrm{Cash}\mathrm{ratio}=\frac{\mathrm{Cash}+\mathrm{Cash}\mathrm{equivalents}}{\mathrm{Total}\mathrm{current}\mathrm{liabilities}}\\ =\frac{\mathrm{\$}98,000+\mathrm{\$}0}{\mathrm{\$}246,000}\\ =0.40\mathrm{times}\end{array}$

c. Times interest earned:

2018:

$\begin{array}{c}\mathrm{Time}-\mathrm{interest}\mathrm{earned}\mathrm{ratio}=\frac{\mathrm{Net}\mathrm{income}+\mathrm{Income}\mathrm{tax}\mathrm{expenses}-\mathrm{Interest}\mathrm{expenses}}{\mathrm{Interest}\mathrm{expenses}}\\ =\frac{\mathrm{\$}56,000+\mathrm{\$}18,000-\mathrm{\$}9,000}{\mathrm{\$}9,000}\\ =7.22\mathrm{times}\end{array}$

2017:

$\begin{array}{c}\mathrm{Time}-\mathrm{interest}\mathrm{earned}\mathrm{ratio}=\frac{\mathrm{Net}\mathrm{income}+\mathrm{Income}\mathrm{tax}\mathrm{expenses}-\mathrm{Interest}\mathrm{expenses}}{\mathrm{Interest}\mathrm{expenses}}\\ =\frac{\mathrm{\$}41,000+\mathrm{\$}24,000-\mathrm{\$}13,000}{\mathrm{\$}13,000}\\ =4\mathrm{times}\end{array}$

d. Inventory turnover ratio:

2018:

$\begin{array}{c}\mathrm{Inventory}\mathrm{turn}\mathrm{over}\mathrm{ratio}=\frac{\mathrm{Cost}\mathrm{of}\mathrm{goods}\mathrm{sold}}{\mathrm{Average}\mathrm{merchandise}\mathrm{inventory}}\\ =\frac{\mathrm{\$}241,000}{\frac{\mathrm{\$}146,000+\mathrm{\$}164,000}{2}}\\ =\frac{\mathrm{\$}241,000}{\mathrm{\$}155,000}\\ =1.55\mathrm{times}\end{array}$

2017:

$\begin{array}{c}\mathrm{Inventory}\mathrm{turnover}\mathrm{ratio}=\frac{\mathrm{Cost}\mathrm{of}\mathrm{goods}\mathrm{sold}}{\mathrm{Average}\mathrm{merchandise}\mathrm{inventory}}\\ =\frac{\mathrm{\$}211,000}{\frac{\mathrm{\$}164,000+\mathrm{\$}202,000}{2}}\\ =\frac{\mathrm{\$}211,000}{\mathrm{\$}183,000}\\ =1.15\mathrm{times}\end{array}$

e. Gross profit percentage:

2018:

$\begin{array}{c}\mathrm{Gross}\mathrm{profit}\mathrm{percentage}=\frac{\mathrm{Gross}\mathrm{profit}}{\mathrm{Net}\mathrm{sales}}\times 100\\ =\frac{\mathrm{\$}220,000}{\mathrm{\$}461,000}\times 100\\ =47.83\mathrm{\%}\end{array}$

2017:

$\begin{array}{c}\mathrm{Gross}\mathrm{profit}\mathrm{percentage}=\frac{\mathrm{Gross}\mathrm{profit}}{\mathrm{Net}\mathrm{sales}}\times 100\\ =\frac{\mathrm{\$}213,000}{\mathrm{\$}424,000}\times 100\\ =50.24\mathrm{\%}\end{array}$

f. Debt to equity ratio:

2018:

$\begin{array}{c}\mathrm{Debt}-\mathrm{to}-\mathrm{equity}\mathrm{ratio}=\frac{\mathrm{Total}\mathrm{liabilities}}{\mathrm{Total}\mathrm{equity}}\\ =\frac{\mathrm{\$}344,000}{\mathrm{\$}240,000}\\ =1.43\end{array}$

2017:

$\begin{array}{c}\mathrm{Debt}-\mathrm{to}-\mathrm{equity}\mathrm{ratio}=\frac{\mathrm{Total}\mathrm{liabilities}}{\mathrm{Total}\mathrm{equity}}\\ =\frac{\mathrm{\$}346,000}{\mathrm{\$}220,000}\\ =1.57\end{array}$

g. Rate of return on common stockholder’s equity

2018:

$\begin{array}{c}\mathrm{Return}\mathrm{on}\mathrm{common}\mathrm{stock}\mathrm{holder}\mathrm{equity}=\frac{\mathrm{Net}\mathrm{income}-\mathrm{Preferred}\mathrm{dividend}}{\mathrm{Average}\mathrm{common}\mathrm{stock}\mathrm{holder}\mathrm{equity}}\times 100\\ =\frac{\mathrm{\$}56,000-\mathrm{\$}0}{\frac{\mathrm{\$}142,000+\mathrm{\$}122,000}{2}}\times 100\\ =\frac{\mathrm{\$}56,000}{\mathrm{\$}132,000}\times 100\\ =42.42\mathrm{\%}\end{array}$

2017:

$\begin{array}{c}\mathrm{Return}\mathrm{on}\mathrm{common}\mathrm{stock}\mathrm{holder}\mathrm{equity}=\frac{\mathrm{Net}\mathrm{income}-\mathrm{Preferred}\mathrm{dividend}}{\mathrm{Average}\mathrm{common}\mathrm{stock}\mathrm{holder}\mathrm{equity}}\times 100\\ =\frac{\mathrm{\$}41,000-\mathrm{\$}0}{\frac{\mathrm{\$}122,000+\mathrm{\$}89,000}{2}}\times 100\\ =\frac{\mathrm{\$}41,000}{\mathrm{\$}105,500}\times 100\\ =38.86\mathrm{\%}\end{array}$

h. Earnings per share of common stock:

2018:

$\begin{array}{c}\mathrm{Earnings}\mathrm{per}\mathrm{share}\mathrm{of}\mathrm{common}\mathrm{stock}=\frac{\mathrm{Netincome}-\mathrm{Preferreddividend}}{\mathrm{Weightedaveragecommonsharesoutstanding}}\\ =\frac{\mathrm{\$}56,000-\mathrm{\$}0}{\frac{14,000+12,000}{2}}\\ =\frac{\mathrm{\$}56,000}{13,000}\\ =\mathrm{\$}4.31\text{\hspace{0.33em}}\mathrm{pershare}\end{array}$

2017:

$\begin{array}{c}\mathrm{Earnings}\mathrm{per}\mathrm{share}\mathrm{of}\mathrm{common}\mathrm{stock}=\frac{\mathrm{Net}\mathrm{income}-\mathrm{Preferred}\mathrm{dividend}}{\mathrm{Weighted}\mathrm{average}\mathrm{common}\mathrm{shares}\mathrm{outstanding}}\\ =\frac{\mathrm{\$}41,000-\mathrm{\$}0}{\frac{12,000+12,000}{2}}\\ =\frac{\mathrm{\$}41,000}{12,000}\\ =\mathrm{\$}3.42\mathrm{per}\mathrm{share}\end{array}$

i. Price-earnings ratio:

2018:

$\begin{array}{c}\mathrm{Price}\mathrm{earnings}\mathrm{ratio}=\frac{\mathrm{Market}\mathrm{price}\mathrm{per}\mathrm{share}\mathrm{of}\mathrm{common}\mathrm{stock}}{\mathrm{Earnings}\mathrm{per}\mathrm{share}}\\ =\frac{\mathrm{\$}69.36}{\mathrm{\$}4.31}\\ =16.09\mathrm{times}\end{array}$

2017:

$\begin{array}{c}\mathrm{Price}\mathrm{earnings}\mathrm{ratio}=\frac{\mathrm{Market}\mathrm{price}\mathrm{per}\mathrm{share}\mathrm{of}\mathrm{common}\mathrm{stock}}{\mathrm{Earnings}\mathrm{per}\mathrm{share}}\\ =\frac{\mathrm{\$}38.04}{\mathrm{\$}3.42}\\ =11.12\mathrm{times}\end{array}$

Analysis of the business entity

a) Debt to equity ratio reflects that the business entity is borrowing more money and that the ability to pay off debts is decreased.

The inventory turnover ratio improved in the year 2018, which means that the ability of the business entity to sell its inventory has improved.

b) Attractiveness of the common stock has increased because the return on common stockholders’ equity has increased.