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Question 1

A company has a return on equity of 18%, a return on assets of 10%, and a dividend payout ratio of 60%. The company’s sustainable equity growth rate is:

10.8%.

7.2%.

6.0%.

4.0%.

Answer 1

The company’s sustainable equity growth rate is 7.2%. The sustainable equity growth rate (SEGR) is calculated as follows:

SEGR = Return on equity × (1 – Dividend payout ratio)
18% × (1 – 60%) = 7.2%

Question 2

Dividend Payout Ratio

Answer 2

The dividend payout ratio is the percentage of earnings paid out to shareholders in cash, calculated as:

Dividend per share ÷ Earnings per share or
Dividends ÷ Net income.

Question 3

Return on Net Worth

Answer 3

Return on net worth is a profitability ratio which measures the return on owners’ (common) equity. It measures the return that accrues to the owners (stockholders) after interest is paid to creditors. It measures the residual return to owners on their investment in the enterprise.

The computation is:

Net income available to common ÷ Average common equity, or
(Net income − Preferred dividends) ÷ Average common equity
Transformation of other ratios will also give the return on common:

Return on common = Return on total assets ÷ (1 − Debt ratio)
There are limitations on use of this ratio.

Examples: Accrual income involves estimates and does not reflect actual cash returns. Book value of common stock reflects historical, not current, value.

Question 4

2160.01

Answer 4

Sample data

Many different ratios are computed and used to analyze the operating characteristics of enterprises by investors and creditors, both present and potential, as well as management. Some of the frequently used ratios are described in following sections using hypothetical information for the Sample Company for the years 20X1 and 20X2.

Question 5

2160.01

Answer 5

Question 6

2160.01

2160.01

Answer 6

Question 7

2163.04

Answer 7

Payout ratio to common shareholders

• The payout ratio to common shareholders measures the portion of net income to common shareholders that is paid out in dividends.Payout ratio to common shareholders = Common dividends / (Net income – Preferred dividends)
• Income does not necessarily measure cash available for dividend payment. Payments are heavily influenced by management policy, the nature of the industry, and the stage of development of the particular firm. All of these items diminish comparability between companies.
• Organizations that have high growth rates generally have low payout ratios since most earnings are kept as retained earnings with the funds being reinvested in the company instead of providing cash dividends. A firm that has consistently paid a dividend and suddenly lowers its dividend payout often is signaling a lack of available cash and the existence of liquidity or solvency problems.
• Calculation using data from the Sample Company for 20X2 (section 2160.01):

Payout ratio to common = Common dividends
shareholders Net income – Preferred dividends

=      $10,000 /($75,000 – $15,000)

                     = 16.67%