Question

Return Ratios and Leverage

The following selected data are taken from the financial statements of Evergreen Company:

Sales revenue		$657,000
Cost of goods sold		387,000
Gross profit		$270,000
Selling and administrative expense		100,000
Operating income		$170,000
Interest expense		50,000
Income before tax		$120,000
Income tax expense (40%)		48,000
Net income		$72,000
Accounts payable		$45,000
Accrued liabilities		70,000
Income taxes payable		10,000
Interest payable		25,000
Short-term loans payable		150,000
Total current liabilities		$300,000
Long-term bonds payable		$500,000
Preferred stock, 10%, $100 par		$250,000
Common stock, no par		600,000
Retained earnings		350,000
Total stockholders' equity		$1,200,000
Total liabilities and stockholders' equity		$2,000,000

Required:

1. Compute the following ratios for Evergreen Company:

1. Return on sales
2. Asset turnover (Assume that total assets at the beginning of the year were $1,600,000.)
3. Return on assets
4. Return on common stockholders' equity (Assume that the only changes in stockholders' equity during the year were from the net income for the year and dividends on the preferred stock.)

When computing percentage amounts, carry out calculations to four decimal places, but enter your answers to two decimal places; for example, .17856 rounds to .1786 and would be entered as 17.86.

a. Return on sales	?	%
b. Asset turnover (round to 2 decimal places)	?	times
c. Return on assets	?	%
d. Return on common stockholders' equity	?	%

2. Comment on Evergreen’s use of leverage. Has it successfully employed leverage?

Answer 1

Answer:

1.   Ratios:

      a.   Return on Sales     = (Net Income + Interest Expense, Net of Tax)/Net Sales

                                          = [$72,000 + ($50,000 × 60%)]/$657,000

                                          = $102,000/$657,000 = 15.52%

      b.   Asset Turnover      = Net Sales/Average Total Assets

                                          = $657,000/[($1,600,000 + $2,000,000*)/2]

                                          = $657,000/$1,800,000 = 0.365 times

            *Total assets at year-end are the same as total liabilities and stockholders’
equity (given).

      c.   Return on Assets      = (Net Income + Interest Expense, Net of Tax)/Average Total

                                                 Assets

                                             = $102,000 [from part (a)]/$1,800,000 [from part (b)] = 5.67%

      d.   Return on Common Stockholders’ Equity

            = (Net Income – Preferred Dividends)/Average Common Stockholders’ Equity

            = ($72,000 – $25,000*)/[($950,000 # + $903,000**)/2] # (600,000+350,000)

            = $47,000/$926,500 = 5.07%

              *Preferred dividends: $250,000 par value × 10%

            **Stockholders’ equity at beginning of year:

                  Common stock                                                               $600,000

                  Retained earnings $350,000 at end of

                        year less $72,000 net income plus

                        $25,000 dividends                                                     303,000

                  Stockholders’ equity at beginning of year                     $903,000

2.   Evergreen has not been successful in using outside funds because the return on stockholders’ equity of 5.07% is less than the return to all providers of capital, as measured by the return on assets of 5.67%.

            Evidence that Evergreen has not successfully employed leverage is found by looking closer at the cost of outside funds. The average cost of borrowed funds is $50,000 in interest expense divided by $650,000 in short-term loans payable and long-term bonds. This cost of 7.7% times 1 minus the tax rate, or 60%, translates to an after-tax borrowing rate of 4.62%. The return paid to the preferred stockholders is 10%. cost of 7.7% times exceed the return to the common stockholder of 5.07% but borrowing rate of 4.62% is lessthan the return on common stock and indicate that Evergreen is successfully employing leverage.