Chapter 16, Problem 5PA

1(a)

To determine

Determine return on total assets for five years (20Y4 to 20Y8).

Explanation of Solution

Financial Ratios: Financial ratios are the metrics used to evaluate the liquidity, capabilities, profitability, and overall performance of a company.

Determine return on total assets for five years (20Y4 to 20Y8).

$\begin{array}{c}\text{Rate of return on assets}\left(\text{20Y8}\right)=\frac{\text{Net}\text{income + Interest expense}}{\text{Average total assets}}\\ =\frac{\$889,453}{\$4,270,764}\\ =20.8\%\end{array}$

$\begin{array}{c}\text{Rate of return on assets}\left(\text{20Y7}\right)=\frac{\text{Net}\text{income + Interest expense}}{\text{Average total assets}}\\ =\frac{\$939,979}{\$3,928,396}\\ =23.9\%\end{array}$

$\begin{array}{c}\text{Rate of return on assets}\left(\text{20Y6}\right)=\frac{\text{Net}\text{income + Interest expense}}{\text{Average total assets}}\\ =\frac{\$1,159,341}{\$3,535,472}\\ =32.8\%\end{array}$

$\begin{array}{c}\text{Rate of return on assets}\left(\text{20Y5}\right)=\frac{\text{Net}\text{income + Interest expense}}{\text{Average total assets}}\\ =\frac{\$1,379,000}{\$3,044,250}\\ =45.3\%\end{array}$

$\begin{array}{c}\text{Rate of return on assets}\left(\text{20Y5}\right)=\frac{\text{Net}\text{income + Interest expense}}{\text{Average total assets}}\\ =\frac{\$1,240,000}{\$2,475,000}\\ =50.1\%\end{array}$

Return on assets determines the particular company’s overall earning power. It is determined by dividing sum of net income and interest expense and average total assets.

Formula:

$\text{Rate of return on assets}=\frac{\text{Net}\text{income + Interest expense}}{\text{Average total assets}}$

1(b)

To determine

Determine return on stockholders’ equity for five years.

Explanation of Solution

$\begin{array}{c}\begin{array}{l}\text{Rate of return }\\ \text{on stockholders' equity}\left(\text{20Y8}\right)\end{array}\}=\frac{\text{Net income }}{\text{Average stockholder’s equity}}\\ =\frac{\$273,406}{\$3,569,855}\\ =7.7\%\end{array}$

$\begin{array}{c}\begin{array}{l}\text{Rate of return }\\ \text{on stockholders' equity}\left(\text{20Y7}\right)\end{array}\}=\frac{\text{Net income }}{\text{Average stockholder’s equity}}\\ =\frac{\$367,976}{\$3,249,164}\\ =11.3\%\end{array}$

$\begin{array}{c}\begin{array}{l}\text{Rate of return }\\ \text{on stockholders' equity}\left(\text{20Y6}\right)\end{array}\}=\frac{\text{Net income }}{\text{Average stockholder’s equity}}\\ =\frac{\$631,176}{\$2,749,588}\\ =23.0\%\end{array}$

$\begin{array}{c}\begin{array}{l}\text{Rate of return }\\ \text{on stockholders' equity}\left(\text{20Y5}\right)\end{array}\}=\frac{\text{Net income }}{\text{Average stockholder’s equity}}\\ =\frac{\$884,000}{\$1,992,000}\\ =44.4\%\end{array}$

$\begin{array}{c}\begin{array}{l}\text{Rate of return }\\ \text{on stockholders' equity}\left(\text{20Y4}\right)\end{array}\}=\frac{\text{Net income }}{\text{Average stockholder’s equity}}\\ =\frac{\$800,000}{\$1,150,000}\\ =69.6\%\end{array}$

Rate of return on stockholders’ equity is used to determine the relationship between the net income and the average common equity that are invested in the company.

Formula: $\text{Rate of return on stockholders' equtiy }=\frac{\text{Net income}}{\text{Average stockholder’s equity}}$ 

1(c)

To determine

Determine times interest earned ratio for five years.

Explanation of Solution

Times interest earned ratio for five years

$\begin{array}{c}\begin{array}{l}\text{Times-interest-}\\ \text{earned ratio }\left(\text{20Y8}\right)\end{array}\}=\frac{\text{Net Income}+\text{Income}\text{tax}\text{expense}+\text{Interest expense}}{\text{Interest expense}}\\ =\frac{\$921,202}{\$616,047}\\ =1.5\text{times}\end{array}$

$\begin{array}{c}\begin{array}{l}\text{Times-interest-}\\ \text{earned ratio }\left(\text{20Y7}\right)\end{array}\}=\frac{\text{Net Income}+\text{Income}\text{tax}\text{expense}+\text{Interest expense}}{\text{Interest expense}}\\ =\frac{\$993,539}{\$572,003}\\ =1.7\text{times}\end{array}$

$\begin{array}{c}\begin{array}{l}\text{Times-interest-}\\ \text{earned ratio }\left(\text{20Y6}\right)\end{array}\}=\frac{\text{Net Income}+\text{Income}\text{tax}\text{expense}+\text{Interest expense}}{\text{Interest expense}}\\ =\frac{\$1,266,061}{\text{\$528,165}}\\ =2.4\text{times}\end{array}$

$\begin{array}{c}\begin{array}{l}\text{Times-interest-}\\ \text{earned ratio }\left(\text{20Y5}\right)\end{array}\}=\frac{\text{Net Income}+\text{Income}\text{tax}\text{expense}+\text{Interest expense}}{\text{Interest expense}}\\ =\frac{\$1,539,000}{\text{\$495,000}}\\ =3.1\text{times}\end{array}$

$\begin{array}{c}\begin{array}{l}\text{Times-interest-}\\ \text{earned ratio }\left(\text{20Y4}\right)\end{array}\}=\frac{\text{Net Income}+\text{Income}\text{tax}\text{expense}+\text{Interest expense}}{\text{Interest expense}}\\ =\frac{\$1,440,000}{\text{\$440,000}}\\ =3.3\text{times}\end{array}$

Times interest earned ratio quantifies the number of times the earnings before interest and taxes can pay the interest expense. First, determine the sum of income before income tax and interest expense. Then, divide the sum by interest expense.

Formula:

$\begin{array}{l}\text{Times-interest-}\\ \text{earned ratio }\end{array}\}=\frac{\text{Income before income tax}+\text{Interest expense}}{\text{Interest expense}}$

1(d)

To determine

Determine ratio of liabilities to stockholders’ equity for five years (20Y4 to 20Y8).

Explanation of Solution

$\begin{array}{c}\begin{array}{l}\text{Ratio of liabilities to}\\ \text{ stockholders' equity}\left(\text{20Y8}\right)\end{array}\}=\frac{\text{Total liabilities}}{\text{Stockholders' equity}}\\ =\frac{\$710,621}{\$3,706,557}\\ =0.2\end{array}$\

$\begin{array}{c}\begin{array}{l}\text{Ratio of liabilities to}\\ \text{ stockholders' equity}\left(\text{20Y7}\right)\end{array}\}=\frac{\text{Total liabilities}}{\text{Stockholders' equity}}\\ =\frac{\$691,198}{\$3,433,152}\\ =0.2\end{array}$

$\begin{array}{c}\begin{array}{l}\text{Ratio of liabilities to}\\ \text{ stockholders' equity}\left(\text{20Y6}\right)\end{array}\}=\frac{\text{Total liabilities}}{\text{Stockholders' equity}}\\ =\frac{\$667,267}{\$3,065,176}\\ =0.2\end{array}$

$\begin{array}{c}\begin{array}{l}\text{Ratio of liabilities to}\\ \text{ stockholders' equity}\left(\text{20Y5}\right)\end{array}\}=\frac{\text{Total liabilities}}{\text{Stockholders' equity}}\\ =\frac{\$904,500}{\$234,000}\\ =0.4\end{array}$

$\begin{array}{c}\begin{array}{l}\text{Ratio of liabilities to}\\ \text{ stockholders' equity}\left(\text{20Y4}\right)\end{array}\}=\frac{\text{Total liabilities}}{\text{Stockholders' equity}}\\ =\frac{\$1,200,000}{\$1,550,000}\\ =0.8\end{array}$

Ratio of liabilities to stockholders’ equity is determined by dividing liabilities and stockholders’ equity. Liabilities are determined as the difference between ending balance of assets and stockholders’ equity. 

Formula:

$\text{ Ratio of liabilities to stockholders' equity}=\frac{\text{Total liabilities}}{\text{Stockholders' equity}}$

To determine

Display the determined ratios in a graph.

Explanation of Solution

Return on total assets

Figure (1)

Return on stockholders’ equity

Figure (2)

Times interest earned ratio

Figure (3)

Ratio of liabilities to stockholders’ equity

Figure (4)

2.

To determine

Prepare analysis of graphs.

Explanation of Solution

Analysis:

• • The return on total assets and return on stockholders’ equity is negative trend for the last five years. These measures have moved below the industry average. The reason behind this might be due to decline in the amount of earnings earned.
• • The use of debt is very evident from the ratio of liabilities to stockholders’ equity and it is in the declining pace.
• • The level of debt has been relative to the equity and has improved in the five years.
• • The times interest earned ratio is below the industry average.