Profitability Ratios The following selected data were taken from the financial s

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 20YS Total assets Notes payable (8% interest) Common stock Preferred 4% stock, $100 par $219,000 70,000 28,000 14,000 $197,000 70,000 28,000 14,000 $175,000 70,000 28,000 14,000 (no change during year) Retained earnings The 20Y7 net income was $30,440, and the 20Y6 net income was $13,460. No dividends on common stock were declared between 20YS and 20Y7 Preferred dividends were declared and paid in full in 20Y6 and 20Y7 a. Determine the return on total assets, the return on stockholders' equity, and the return on common stockholders' equity for the years 20Y6 and 20Y Round percentages to one decimal place 84,780 54,900 42,000 20Y7 20Y6 Return on total assets Return on stockholders' equity Return on common stockholders' equity b. The profitability ratios indicate that the company's profitability has the return on stockholders' equity in both years, there must be Since the rate of return on assets is leverage from the use of debt.

Explanation / Answer

Answer a.

Interest Expense = 8% * $70,000
Interest Expense = $5,600

Preferred Stock Dividend = 4% * $14,000
Preferred Stock Dividend = $560

20Y7:

Average Total Assets = ($219,000 + $197,000) / 2
Average Total Assets = $208,000

Average Stockholders’ Equity = ($28,000 + $14,000 + $84,780 + $28,000 + $14,000 + $54,900) / 2
Average Stockholders’ Equity = $111,840

Average Common Stockholders’ Equity = ($28,000 + $84,780 + $28,000 + $54,900) / 2
Average Common Stockholders’ Equity = $97,840

Return on Total Assets = (Net Income + Interest Expense) / Average Total Assets
Return on Total Assets = ($30,440 + $5,600) / $208,000
Return on Total Assets = 17.3%

Return on Stockholders’ Equity = Net Income / Average Stockholders’ Equity
Return on Stockholders’ Equity = $30,440 / $111,840
Return on Stockholders’ Equity = 27.2%

Return on Common Stockholders’ Equity = (Net Income - Preferred Stock Dividend) / Average Common Stockholders’ Equity
Return on Common Stockholders’ Equity = ($30,440 - $560) / $97,840
Return on Common Stockholders’ Equity = 30.5%

20Y6:

Average Total Assets = ($197,000 + $175,000) / 2
Average Total Assets = $186,000

Average Stockholders’ Equity = ($28,000 + $14,000 + $54,900 + $28,000 + $14,000 + $42,000) / 2
Average Stockholders’ Equity = $90,450

Average Common Stockholders’ Equity = ($28,000 + $54,900 + $28,000 + $42,000) / 2
Average Common Stockholders’ Equity = $76,450

Return on Total Assets = (Net Income + Interest Expense) / Average Total Assets
Return on Total Assets = ($13,460 + $5,600) / $186,000
Return on Total Assets = 10.2%

Return on Stockholders’ Equity = Net Income / Average Stockholders’ Equity
Return on Stockholders’ Equity = $13,460 / $90,450
Return on Stockholders’ Equity = 14.9%

Return on Common Stockholders’ Equity = (Net Income - Preferred Stock Dividend) / Average Common Stockholders’ Equity
Return on Common Stockholders’ Equity = ($13,460 - $560) / $76,450
Return on Common Stockholders’ Equity = 16.9%

Answer b.

The profitability ratios indicate that the company’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.

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