Chapter 9, Problem 9.17E

Profitability metrics

The following selected data were taken from the financial statements of The O'Malley Group Inc. for December 31, 20Y5. 20Y4. and 20Y3:

No dividends on common stock were declared between 20Y3 and 20Y5.

a.Determine the return on total assets, the return on stockholders' equity, and the return on common stockholders' equity Tor the years 20Y4 and 20Y5. Round to one decimal place.
b. What conclusions can be drawn from these data as to the company's profitability?

To determine

(a)

Concept Introduction:

Profitability analysis:

Ithelps to evaluate the ability of a company to generate income relative to revenue, assets, operating cost and shareholders' equity during a specific period.

It measures how efficiently the resources have been utilised to generate profit.

To calculate:

Return on total assets, return on common stockholders' equity and return on stockholders' equity for the year 20Y4 and 20Y5

Explanation of Solution

  $\text{Return on total assets=}\frac{\text{net income+interest expenses }}{\text{Average total assets}}$

  ${\text{Return on shareholders}}^{\text{'}}\text{equity=}\frac{\text{net income-preferred dividends }}{\text{shareholders equity}}$

  $\text{Return on commonstock holders equity =}\frac{\text{net income }}{\text{common stock holders equity}}$

Particulars	20Y5	20Y4
Net income	$530,000	$430,000
Interest on Notes Payable	$\$800,000\times 5\%=\$40,000$	$\$800,000\times 5\%=\$40,000$
Preferred Dividends	$30,000	$30,000

Particulars	20Y5	20Y4
Common Stock (A)	$250,000	$250,000
Preferred Stock (B)	$400,000	$400,000
Retained Earnings (C)	$1,450,000	$950,000
Total Stockholders' Equity (A+B+C)	$2,100,000	$1,600,000
Total Common Stockholders' Equity (A+C)	$1,700,000	$1,200,000
Total Assets (Beginning)	$2,400,000	$2,000,000
Total Assets (Ending)	$2,900,000	$2,400,000
Total Assets (Average)	$\begin{array}{l}\frac{\$2,900,000+\$2,400,000}{2}\\ =\$2,650,000\end{array}$	$\begin{array}{l}\frac{\$2,000,000+\$2,400,000}{2}\\ =\$2,200,000\end{array}$
Return on Total Assets	$\begin{array}{l}\frac{\$530,000+\$40,000}{\$2,650,000}\times 100\\ =22.26\%\end{array}$	$\begin{array}{l}\frac{\$430,000+\$40,000}{\$2,200,000}\times 100\\ =21.36\%\end{array}$
Return on Shareholders' Equity	$\frac{\$530,000-\$30,000}{\$2,100,000}=23.81\%$	$\frac{\$430,000-\$30,000}{\$1,600,000}=25\%$
Return on Common Shareholders' Equity	$\begin{array}{l}\frac{\$530,000}{\$1,700,000}\times 100\\ =31.18\%\end{array}$	$\begin{array}{l}\frac{\$430,000}{\$1,200,000}\times 100\\ =35.83\%\end{array}$

Retained Earnings (ending) = Retained Earnings (beginning) + Net Income − Dividends

Retained Earnings (20Y5) = Retained Earnings (20Y4) + Net Income (20Y5) − Dividends (20Y5)

$1,450,000 = $950,000 + $530,000 − Dividends (20Y5)

$1,480,000 - $1,450,000 = Dividends (20Y5)

Dividends (20Y5) = $30,000

Retained Earnings (20Y4) = Retained Earnings (20Y3) + Net Income (20Y4) − Dividends (20Y4)

$950,000 = $550,000 + $430,000 − Dividends (20Y4)

$980,000 - $950,000 = Dividends (20Y4)

Dividends (20Y4) = $30,000

To determine

(b)

Concept Introduction:

Profitability analysis:

It is used to evaluate the ability of a company to generate income relative to revenue, assets, operating cost and shareholders' equity during a specific period.

It measures how efficiently the resources have been utilised to generate profit.

To analyze:

The calculated ratios to evaluate company's profitability.

Explanation of Solution

Over the past three years company's profitability has steady increase in terms of return on total assets but a steady decline has been noticed in return on equity and return on common stock.

This is due to the earnings retained each year by the company. Though, the company is unable to utilise it to increase its profitability. Thus, the retained earnings should be utilisedaccurately to generate revenue which will in return improve the profitability of the company.