Question

Question: P15-38 Using ratios to evaluate a stock investment

This problem continues the Canyon Canoe Company situation from Chapter 14. The company wants to invest some of its excess cash in trading securities and is considering two investments, The Paddle Company (PC) and Recreational Life Vests (RLV). The income statement, balance sheet, and other data for both companies follow for 2019 and 2018, as well as selected data for 2017:

	THE PADDLE COMPANY Comparative Financial Statements Years Ended December 31			RECREATIONAL LIFE VESTS Comparative Financial Statements Years Ended December 31
Income statement	2019	2018	2017	2019	2018	2017
Net sales revenue	\(430,489	\)425,410		\(410,570	\)383,870
Cost of goods sold	258,756	256,797		299,110	280,190
Gross profit	171,733	168,613		111,460	103,680
Operating expenses	153,880	151,922		78,290	70,830
Operating income	17,853	16,691		33,170	32,850
Interest expenses	865	788		2,780	2,980
Income before income tax	16,988	15,903		30,390	29,870
Income tax expenses	5,137	4,809		8,780	8,630
Net income	\(11,851	\)11,094		\(21,610	\)21,240
Balance sheet
Assets
Cash & Cash Equivalents	\(69,159	\)70,793		\(65,730	\)55,270
Accounts Receivable	44,798	44,452	\(44,104	39,810	38,650	\)36,460
Merchandise Inventory	79,919	66,341	76,363	68,500	65,230	59,930
Other Current Assets	15,494	16,264		24,450	37,630
Total Current Assets	209,370	197,850		198,490	196,780
Long-term Assets	89,834	90,776		116,760	116,270
Total Assets	\(299,204	\)288,626	\(276,482	\)315,250	$$313,050	\(310,640
Liabilities
Current Liabilities	\)69,554	\(60,232		\)90,810	\(90,010
Long-term Liabilities	31,682	29,936		96,310	105,890
Total Liabilities	101,236	90,168		187,120	195,900
Stockholders’ Equity
Common Stock	72,795	80,885		111,530	102,480
Retained Earnings	125,173	117,573		16,600	14,670
Total Stockholders’ Equity	197,968	198,458		128,130	117,150	103,840
Total Liabilities and Stockholder’s Equity	\)299,204	\(288,626		\)315,250	\(313,050
Other data
Market price per share	\)21.38	\(33.82		\)46.37	$51.64
Annual dividend per share	0.32	0.30		0.53	0.45
Weighted average number of shares outstanding	9,000	8,000		9,000	8,000

Requirements

1. Using the financial statements given, compute the following ratios for both companies for 2019 and 2018. Assume all sales are credit sales. Round all ratios to two decimal places.

2. a. Current ratio	h. Profit margin ratio
   b. Cash ratio	i. Asset turnover ratio
   c. Inventory turnover	j. Rate of return on common stockholders’ equity
   d. Accounts receivable turnover	k. Earnings per share
   e. Gross profit percentage	l. Price/earnings ratio
   f. Debt ratio	m. Dividend yield
   g. Debt to equity ratio	n. Dividend payout

1. Compare the companies’ performance for 2019 and 2018. Make a recommendation to Canyon Canoe Company about investing in these companies. Which company would be a better investment, The Paddle Company or Recreational Life Vests? Base your answer on the ability to pay current liabilities, ability to sell merchandise and collect receivables, ability to pay the long-term debt, profitability, and attractiveness as an investment.

Short answer

Answer

1. Financial ratios:

   Current ratio	3.01	3.28	2.18	2.19
   Cash ratio	0.99	1.17	0.72	0.61
   Inventory turnover ratio	3.54	3.60	4.47	4.48
   Accounts receivables turnover ratio	9.65	9.61	10.46	10.22
   Gross profit percentage	39.89%	39.64%	27.15%	27%
   Debt ratio	0.33	0.31	0.59	0.62
   Debt-to-equity ratio	0.51	0.45	1.46	1.67
   Profit margin ratio	2.75%	2.60%	5.26%	5.53%
   Asset turnover ratio	1.46	1.50	1.31	1.23
   Rate of return on common stockholder’s equity	0.059	0.056	0.17	0.19
   Earnings per share	$1.32	$1.39	$2.40	$2.65
   Price-earnings ratio	16.20	24.33	19.32	19.49
   Dividend yield ratio	1.50%	0.88%	1.14%	0.87%
   Dividend payout ratio	0.24	0.21	0.22	0.17

2. 1. The business entity must invest in the Recreational Life Vests Company.

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 various financial ratios

$$\begin{gathered} \text{a.Currentassetratio} \\ \text{:PaddleCompany} \\ \text{2018:} \\ Currentratio=\frac{Currentassets}{Currentliabilities} \\ =\frac{\$197,850}{\$60,232} \\ =3.28 \\ \text{2019:} \\ Currentratio=\frac{Currentassets}{Currentliabilities} \\ =\frac{\$209,370}{\$69,554} \\ =3.01 \\ \text{Recreationallifevests} \\ \text{2018:} \\ Currentratio=\frac{Currentassets}{Currentliabilities} \\ =\frac{\$196,780}{\$90,010} \\ =2.19 \\ \text{2019:} \\ Currentratio=\frac{Currentassets}{Currentliabilities} \\ =\frac{\$198,490}{\$90,810} \\ =2.18 \end{gathered}$$

$$\begin{gathered} \text{b.CashratioPaddleCompany} \\ \text{2018:} \\ Cashratio=\frac{Cash+Cashequivalents}{Currentliabilities} \\ =\frac{\$70,793}{\$60,232} \\ =1.17 \\ 2019: \\ Cashratio=\frac{Cash+Cashequivalents}{Currentliabilities} \\ =\frac{\$69,159}{\$69,554} \\ =0.99 \end{gathered}$$

$$\begin{gathered} Recreationallifevests \\ 2018: \\ Cashratio=\frac{Cash+Cashequivalents}{Currentliabilities} \\ =\frac{\$55,270}{\$90,010} \\ =0.61 \\ 2019: \\ Cashratio=\frac{Cash+Cashequivalents}{Currentliabilities} \\ =\frac{\$65,730}{\$90,810} \\ =0.72 \\ c.InventoryturnoverratioPaddleCompany \\ 2018: \\ Inventoryturnoverratio=\frac{Costofgoodssold}{Averagemerchandiseinventory} \\ =\frac{\$256,797}{\frac{\$76,363+\$66,341}{2}} \\ =\frac{\$256,797}{\$71,352} \\ =3.60 \\ 2019: \\ Inventoryturnoverratio=\frac{Costofgoodssold}{Averagemerchandiseinventory} \\ =\frac{\$258,756}{\frac{\$79,919+\$66,341}{2}} \\ =\frac{\$258,756}{\$73,130} \\ =3.54 \end{gathered}$$

$$\begin{gathered} e.GrossprofitpercentagePaddleCompany \\ 2018: \\ Grossprofitpercentage=\frac{Grossprofit}{Netsales}\times 100 \\ =\frac{\$168,613}{\$425,410}\times 100 \\ =39.64\% \\ 2019: \\ Grossprofitpercentage=\frac{Grossprofit}{Netsales}\times 100 \\ =\frac{\$171,733}{\$430,489}\times 100 \\ =39.89\% \\ Recreationallifevests \\ 2018: \\ Grossprofitpercentage=\frac{Grossprofit}{Netsales}\times 100 \\ =\frac{\$103,680}{\$383,870}\times 100 \\ =27\% \\ 2019: \\ Grossprofitpercentage=\frac{Grossprofit}{Netsales}\times 100 \\ =\frac{\$111,460}{\$410,570}\times 100 \\ =27.15\% \\ f.DebtratioPaddleCompany \\ 2018: \\ Debtratio=\frac{Totalliabilities}{Totalassets} \\ =\frac{\$90,168}{\$288,626} \\ =0.31 \\ 2019: \\ Debtratio=\frac{Totalliabilities}{Totalassets} \\ =\frac{\$101,236}{\$299,204} \\ =0.33 \end{gathered}$$

Investment Decision

The business entity must invest in the Recreational life Vests Company because the company is performing well in profitability, return on common stockholder’s equity and earnings per share. But this company is not performing well compared to Paddle Company in terms of repayment of the long-term liabilities.