Chapter 17, Problem 17E

### Financial Accounting

15th Edition
Carl Warren + 2 others
ISBN: 9781337272124

Chapter
Section

### Financial Accounting

15th Edition
Carl Warren + 2 others
ISBN: 9781337272124
Textbook Problem
4 views

# Profitability ratiosThe following selected data were taken from the financial statements of Vidahill Inc. for December 31, 20Y7, 20Y6, and 20Y5:The 20Y7 net income was $411,000, and the 20Y6 net income was$462,500. 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 return on stockholdersâ€™ equity, and the return on common stockholdersâ€™ equity for the years 20Y6 and 20Y7. Round percentages to one decimal place. b. What conclusions can be drawn from these data as to the companyâ€™s profitability?

a)

To determine

Determine Return on total assets, return on stockholders’ equity and the return on common stockholders’ equity for the years 20Y6 and 20Y7.

Explanation

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

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

Formula:

RateÂ ofÂ returnÂ onÂ assets=Netâ€‰â€‰incomeÂ +Â InterestÂ expenseAverageÂ totalÂ assets

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

Formula: RateÂ ofÂ returnÂ onÂ stockholders'Â equtiyÂ =Â NetÂ incomeAverageÂ Â stockholderâ€™sÂ equity

Rate of return on common stockholdersâ€™ equity is used to determine the relationship between the difference of net income and preference dividends and the average common equity that are invested in the company.

Formula:

RateÂ ofÂ returnÂ onÂ commonÂ stockholders'Â equity}=Â NetÂ incomeÂ â€“Â PreferredÂ dividendsÂ AverageÂ commonÂ stockholderâ€™sÂ equity

Determine return on total assets.

For 20Y7:

RateÂ ofÂ returnÂ onÂ assets=Netâ€‰â€‰incomeÂ +Â InterestÂ expenseAverageÂ totalÂ assets=$411,000+$150,000$5,100,000=11.0% For 20Y6: RateÂ ofÂ returnÂ onÂ assets=Netâ€‰â€‰incomeÂ +Â InterestÂ expenseAverageÂ totalÂ assets=$462,500+$150,000$4,900,000=12.5%

Hence, return on assets for 20Y7 and 20Y6 is 11.0% and 12.5%.

Working notes:

Determine interest expense and average total assets as follows:

Interest expense for 20Y7

InterestÂ expenseÂ forÂ 20Y7Â =Â NotesÂ payableÂ Ã—Â InterestÂ percentageÂ =Â $2,500,000Â Ã—Â 6%=Â$150,000

Interest expense for 20Y6

InterestÂ expenseÂ forÂ 20Y6Â =Â NotesÂ payableÂ Ã—Â InterestÂ percentageÂ =Â $2,500,000Â Ã—Â 6%=Â$150,000

Average total assets for 20Y7

AverageÂ totalÂ assetsÂ forÂ 20Y7=OpeningÂ assetsÂ +Â ClosingÂ assetsÂ 2=$5,200,000+$5,000,0002=$5,100,000 Average total assets for 20Y6 AverageÂ totalÂ assetsÂ forÂ 20Y6=OpeningÂ assetsÂ +Â ClosingÂ assetsÂ 2=$5,000,000+$4,800,0002=$4,900,000

Determine return on stockholdersâ€™ equity.

For 20Y7:

Â RateÂ ofÂ returnÂ onÂ stockholders'Â equity}=Â NetÂ incomeÂ AverageÂ stockholderâ€™sÂ equity=â€‰$411,000$2,148,000=19.1%

For 20Y6:

Â RateÂ ofÂ returnÂ onÂ stockholders'Â equity}=Â NetÂ incomeÂ AverageÂ stockholderâ€™sÂ equity=â€‰$462,500$1,736,000=26

b)

To determine

Draw the conclusion about Company’s profitability

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