Chapter 11, Problem 11.3EYCT

(a)

To determine

Annual Report: It is a comprehensive financial report that shows all the business activities that takes place throughout the previous financial year. Its purpose is to provide the complete financial information of a company’s financial activities to its users in order to help them analyze and take well informed decisions.

Financial Ratios: Financial ratios are the metrics used to evaluate the overall financial performance of a company during a specific period of time.

To Compute: the return on common stockholders’ equity for Incorporation A and Incorporation W.

Answer to Problem 11.3EYCT

Compute the return on common stockholders’ equity:

For Incorporation A

  $\begin{array}{c}\begin{array}{l}\text{Return on common}\\ \text{stockholders' equity}\end{array}\}=\frac{\left(\begin{array}{l}\text{Net income–Preferred }\\ \text{dividends}\end{array}\right)}{\left(\begin{array}{l}\text{Average common }\\ \text{stockholders' }\\ \text{equity}\end{array}\right)}\times 100\\ =\frac{\left(\$241\right)–\$0}{\text{\$10,243}\text{.5}\left(1\right)}\times 100\\ =\left(2.4\%\right)\end{array}$

For Incorporation W

  $\begin{array}{c}\begin{array}{l}\text{Return on common}\\ \text{stockholders' equity}\end{array}\}=\frac{\left(\begin{array}{l}\text{Net income–Preferred }\\ \text{dividends}\end{array}\right)}{\left(\begin{array}{l}\text{Average common }\\ \text{stockholders' }\\ \text{equity}\end{array}\right)}\times 100\\ =\frac{\$16,363-\$0}{\$78,824.5\left(2\right)}\times 100\\ =20.8\%\end{array}$

Working notes:

Compute average stockholders’ equity for Incorporation A.

$\begin{array}{c}\begin{array}{l}\text{Average common}\\ \text{stockholders’ equity}\end{array}\}\text{=}\left(\frac{\begin{array}{l}\text{Beginning balance of stockholders’ equity }\\ \text{+}\text{Ending balance of stockholders’ equity }\end{array}}{\text{2}}\right)\\ \text{=}\frac{\text{\$10,741+\$9,746}}{\text{2}}\\ =\$10,243.5\end{array}$ (1)

Compute average stockholders’ equity for Incorporation W.

  $\begin{array}{c}\begin{array}{l}\text{Average common}\\ \text{stockholders’ equity}\end{array}\}\text{=}\left(\frac{\begin{array}{l}\text{Beginning balance of stockholders’ equity }\\ \text{+}\text{Ending balance of stockholders’ equity }\end{array}}{\text{2}}\right)\\ \text{=}\frac{\text{\$81,394+\$76,255}}{\text{2}}\\ =\$78,824.5\end{array}$ (2)

Explanation of Solution

Return on common stockholders’ equity ratio: 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 common stockholders’ equity is as follows:

  $\begin{array}{l}\text{Return on common}\\ \text{stockholders' equity}\end{array}\}=\frac{\text{Net income–Preferred dividends}}{\text{Average common stockholders' equity}}\times 100$

Conclusion

Therefore, for Incorporation A the Return on Common Stockholders’ equity is (2.4%) and, for Incorporation W the Return on Common Stockholders’ equity is 20.8%

To determine

To Compute: the debt to assets ratio for Incorporation A and Incorporation W.

Answer to Problem 11.3EYCT

Compute the debt to assets ratio:

For Incorporation A

  $\begin{array}{c}\text{Debt to assets ratio}]\text{ = }\frac{\text{Total liabilities}}{\text{Total assets}}\times 100\\ ==\frac{\$43,764\left(3\right)}{\$54,505}\times 100\\ =80.3\%\end{array}$

For Incorporation W

  $\begin{array}{c}\text{Debt to assets ratio}]\text{ = }\frac{\text{Total liabilities}}{\text{Total assets}}\times 100\\ =\frac{\$117,769\left(4\right)}{\$203,706}\times 100\\ =8.0\%\end{array}$

Working note:

Compute total liabilities value for Incorporation A.

  $\begin{array}{c}\text{Total liabilities value = }\left\{\begin{array}{l}\text{Current liabilities + }\\ \text{Long-term debt + }\\ \text{Other liabilities}\end{array}\right\}\\ \text{= \$28,089+\$8,265+\$7,410}\\ \text{= \$43,764}\end{array}$ (3)

Compute total liabilities value for Incorporation W.

$\begin{array}{c}\text{Total liabilities value = }\left\{\begin{array}{l}\text{Current liabilities + }\\ \text{Long-term debt + }\\ \text{Other liabilities}\end{array}\right\}\\ \text{= \$65,272+\$41,086+\$2,606+\$8,805}\\ \text{= \$117,769}\end{array}$ (4)

Explanation of Solution

Debt to assets ratio: It is the ratio that measures the ability of a company to meet its long-term obligations out of its total assets available. It shows the relationship of total liabilities and total assets.

The formula to calculate the debt to assets ratio is as follows:

  $\text{Debt to assets ratio}]\text{ = }\frac{\text{Total liabilities}}{\text{Total assets}}\times 100$

Conclusion

Therefore, for Incorporation A the Debt to assets ratio is 80.3% and, for Incorporation W the Debt to assets ratio is 57.8%.

To determine

To Compute: the return on assets ratio for Incorporation A and Incorporation W.

Answer to Problem 11.3EYCT

Compute the return on assets ratio:

For Incorporation A

  $\begin{array}{c}\text{Return on assets}]=\frac{\text{Net}\text{income}}{\text{Average total assets}}\times 100\\ =\frac{\left(\$241\right)}{\$47,332\left(5\right)}\times 100\\ =\left(0.5\%\right)\end{array}$

For Incorporation W

  $\begin{array}{c}\text{Return on assets}]=\frac{\text{Net}\text{income}}{\text{Average total assets}}\times 100\\ =\frac{\$16,363}{\$204,228.5\left(6\right)}\times 100\\ =8.0\%\end{array}$

Working notes:

Compute average total assets for Incorporation A.

  $\begin{array}{c}\text{Average total assets}=\frac{\left(\begin{array}{l}\text{Beginning balance of total assets+}\\ \text{Ending balance of total assets}\end{array}\right)}{2}\\ =\frac{\$54,505+\$40,159}{2}\\ =\$47,332\end{array}$ (5)

Compute average total assets for Incorporation W.

  $\begin{array}{c}\text{Average total assets}=\frac{\left(\begin{array}{l}\text{Beginning balance of total assets+}\\ \text{Ending balance of total assets}\end{array}\right)}{2}\\ =\frac{\$203,706+\$204,751}{2}\\ =\$204,228.5\end{array}$ (6)

Explanation of Solution

Return on assets is used to measure the overall earning ability of the company. Thus, it shows the relationship between the net income and the average total assets.

The formula to calculate the return on assets ratio is as follows:

  $\text{Return on assets}]=\frac{\text{Net}\text{income}}{\text{Average total assets}}\times 100$

Conclusion

Therefore, for Incorporation A the Return on assets is (0.5%) and, for Incorporation W the Return on assets is 8.0%.

(b)

To determine

To explain: the conclusions concerning the companies’ profitability ratios can be drawn on these ratios.

Explanation of Solution

From the above calculated ratios in part a, the following conclusions can be drawn concerning both companies’ profitability:

• Return on assets for Incorporation A is negative, that is, (0.5%) and that of Incorporation W is 8.0%. Thus, the positive ratio percentage of Incorporation W indicates that it is more profitable by generating more net income through effective utilization of total assets.
• Return on stockholders’ equity for Incorporation A is negative, that is, (2.4%) and that of Incorporation W is 20.8%. Thus, the positive ratio percentage of Incorporation W indicates that it is more profitable as its shareholders could earn good income from each equity share available to common stockholders.

To determine

To find: the company that relies more on debt to boost its return to common shareholders.

Answer to Problem 11.3EYCT

Incorporation A is the company that relies more on debt to boost its return to common shareholders.

Explanation of Solution

Debt to assets for Incorporation A is 80.3%. Thus, the higher ratio percentage of Incorporation A indicates that it relies more on the borrowed funds than its own available assets. Since its interest rate on borrowed funds is more than its return on assets, it provides could not provide good return on common stockholders’ equity.

However, more reliance on debts than assets for Incorporation A has lead to negative return on assets and return on common stockholders’ equity. This would again, increase the risk of non-repayment of debts in future and would adversely affect its liquidity position.

(c)

To determine

To Compute: the payout ratio for Incorporation A and Incorporation W.

Answer to Problem 11.3EYCT

Compute the payout ratio:

For Incorporation A

  $\begin{array}{c}\text{Payout ratio = }\frac{\text{Cash dividend declared on common stock}}{\text{Net income}}\times 100\\ \text{=}\frac{\text{\$0}}{\left(\text{\$241}\right)}\text{×100}\\ \text{=0\%}\end{array}$

For Incorporation W

  $\begin{array}{c}\text{Payout ratio = }\frac{\text{Cash dividend declared on common stock}}{\text{Net income}}\times 100\\ \text{=}\frac{\text{\$6,185}}{\text{\$16,363}}\text{×100}\\ \text{=37}\text{.8\%}\end{array}$

Explanation of Solution

Payout Ratio: It refers to a measure that evaluates the amount of dividends paid to the shareholders out of the net income earned by a corporation. It is generally expressed as a percentage. The formula to calculate the payout ratio is as follows:

  $\text{Payout ratio = }\frac{\text{Cash dividend declared on common stock}}{\text{Net income}}\times 100$

Conclusion

Therefore, for Incorporation A the Payout ratio is 0% and, for Incorporation W the Payout ratio is 37.8%.

To determine

To find: which company pays out a higher percentage of its earnings.

Explanation of Solution

Incorporation W has a higher percentage of payout ratio of 37.8%. However, Incorporation A with negative net income could not declare any dividends to be paid to its shareholders in the year 2014