Ch 15.4 (Presentation and Analysis of Stockholders' Equity)

Question 1

What should companies disclose regarding stockholders’ equity in the Balance Sheet?

Answer 1

Companies must disclose all of the following: dividend and liquidation preferences, participation rights, call prices and dates, conversion or exercise prices and pertinent dates, sinking fund requirements, unusual voting rights, and significant terms of contracts to issue additional shares.

Question 2

Disclosure of restrictions on Retained Earnings

Answer 2

Many corporations restrict retained earnings or dividends, without any formal journal entries. Such restrictions are best disclosed by note.

Question 3

Statement of Stockholders’ Equity

Answer 3

The statement of stockholders’ equity is frequently presented in the following basic format.

1. Balance at the beginning of the period.
2. Additions.
3. Deductions.
4. Balance at the end of the period.

A columnar format for the presentation of changes in stockholders’ equity items in published annual reports is gaining in popularity.

Question 4

Stockholders’ Equity Ratios

Answer 4

Analysts use stockholders’ equity ratios to evaluate a company’s profitability and long-term solvency.

1. Return on common stockholders’ equity.
2. Payout ratio.
3. Book value per share.

Question 5

Return on Common Stockholders’ Equity (Return on Equity - ROE)

Answer 5

Measures profitability from the common stockholders’ viewpoint. This ratio shows how many dollars of net income the company earned for each dollar invested by the owners.

Return on equity also helps investors judge the worthiness of a stock when the overall market is not doing well.

Return on equity equals net income less preferred dividends, divided by average common stockholders’ equity.

Question 6

Trading on the Equity

Answer 6

The practice of using borrowed money or issuing preferred stock in hopes of obtaining a higher rate of return on the money used.

A company can improve its return on common stockholders’ equity through the prudent use of debt or preferred stock financing.

Shareholders win if return on the assets is higher than the cost of financing these assets.

In this situation, the money obtained from bondholders or preferred stockholders earns enough to pay the interest or preferred dividends and leaves a profit for the common stockholders.

Question 7

Payout Ratio

Answer 7

Ratio of cash dividends to net income.

If preferred stock is outstanding, this ratio equals cash dividends paid to common stockholders, divided by net income available to common stockholders.

Question 8

Book Value Per Share (of stock)

Answer 8

The amount each share would receive if the company were liquidated on the basis of amounts reported on the balance sheet.

Book value per share equals common stockholders’ equity divided by outstanding common shares.