Question

Profitability Ratios

The following selected data were taken from the financial statements of Vidahill Inc. for December 31, 20Y7, 20Y6, and 20Y5:

		December 31
		20Y7		20Y6		20Y5
Total assets		$320,000		$288,000		$256,000
Notes payable (8% interest)		110,000		110,000		110,000
Common stock		44,000		44,000		44,000
Preferred 6% stock, $100 par		22,000		22,000		22,000
	(no change during year)
Retained earnings		117,200		80,880		66,000

The 20Y7 net income was $37,640, and the 20Y6 net income was $16,200. No dividends on common stock were declared between 20Y5 and 20Y7. Preferred dividends were declared and paid in full in 20Y6 and 20Y7.

a. Determine the return on total assets, the rate earned on stockholders' equity, and the return on common stockholders’ equity for the years 20Y6 and 20Y7. When required, round to one decimal place.

	20Y7		20Y6
Return on total assets		%		%
Return on stockholders’ equity		%		%
Return on common stockholders’ equity		%		%

b. The profitability ratios indicate that Vidahill Inc.'s profitability has improved . Since the rate of return on assets is less than the return on stockholders' equity in both years, there must be positive leverage from the use of debt.

Answer 1

a.

Return on total assets = (Net Income + Interest) / Average Total Assets
20Y7 = {$37,640 + ($110,000 X 8%)} / {($320,000 + $288,000) / 2}
= 15.3%

20Y6 = {$16,200 + ($110,000 X 8%)} / {($288,000 + $256,000) / 2}
= 9.2%

Return on stockholders’ equity = Net Income / Average Stockholders equity
20Y7 =  $37,640 / [{(44,000 + 22,000 + 117,200) + (44,000 + 22,000 + 80,880)} / 2]
= 22.8%

20Y6 =  $16,200 / [{(44,000 + 22,000 + 80,880) + (44,000 + 22,000 + 66,000)} / 2] = 11.6%

Return on common stockholders’ equity = (Net Income - Preferred Dividend) / Avg. Common Stockholders equity

20Y7 = {$37,640 - (22,000 x 6%)} / [{(44,000 + 117,200) + (44,000 + 80,880)} / 2]
= 25.4%

20Y6 = {$16,200 - (22,000 x 6%)} / [{(44,000 + 80,880) + (44,000 + 66,000)} / 2] = 12.7%

b. The profitability ratios indicate that Vidahill Inc.'s profitability has improved . Since the rate of return on assets is less than the return on stockholders' equity in both years, there must be positive leverage from the use of debt.