Financial Statement Analysis: Measuring Profitability, cont'd - Accounting video

Summary

In this continuation of the financial statement analysis series, the video explores two key profitability ratios: the Rate of Return on Common Stockholders' Equity (ROE) and Earnings Per Share (EPS). ROE measures how much profit a company generates for each dollar invested by a common stockholder, while EPS calculates the income generated by each share of common stock. Through an example, the video demonstrates the calculation of both ratios and emphasizes the importance of comparing them with industry standards to assess a company's financial performance effectively.

Takeaways

• 😀 The rate of return on common stockholders' equity measures how much income a company generates for each dollar invested by common stockholders.
• 😀 To calculate the rate of return on common stockholders' equity, subtract preferred dividends from net income and divide by the average common stockholders' equity.
• 😀 The formula for calculating average common stockholders' equity is (beginning equity + ending equity) ÷ 2.
• 😀 Earnings per share (EPS) measures the amount of net income generated by each share of common stock.
• 😀 To calculate earnings per share, subtract preferred dividends from net income and divide by the number of outstanding shares of common stock.
• 😀 A higher rate of return on common stockholders' equity indicates better profitability for common stockholders.
• 😀 EPS provides insight into the company's profitability on a per-share basis, which is useful for investors.
• 😀 Both the rate of return on common stockholders' equity and EPS help assess a company's financial health and its ability to generate returns for stockholders.
• 😀 For accurate comparisons, it’s crucial to compare these ratios to other companies within the same industry.
• 😀 The rate of return on common stockholders' equity for the given example is 14.1%, meaning the company earns 14.1 cents for every dollar invested by common stockholders.
• 😀 The earnings per share for the example is 65 cents, indicating that each outstanding share generates 65 cents of net income.

Q & A

What is the purpose of calculating profitability ratios in financial statement analysis?

Profitability ratios help determine the financial health and performance of a company by assessing its ability to generate income relative to its revenue, assets, and equity.

What is the formula for calculating the rate of return on common stockholders' equity?

The formula is: (Net Income - Preferred Dividends) / Average Common Stockholders' Equity. Average Common Stockholders' Equity is calculated by adding the beginning and ending equity and dividing by 2.

Why do we subtract preferred dividends when calculating the rate of return on common stockholders' equity?

Preferred dividends are subtracted because the calculation is focused on the income available to common stockholders, not preferred stockholders.

How do you calculate average common stockholders' equity?

To calculate average common stockholders' equity, you add the beginning common stockholders' equity to the ending common stockholders' equity and then divide the sum by two.

What does a rate of return of 14.1% on common stockholders' equity mean?

It means that for every dollar invested by a common stockholder, the company earns 14.1 cents of net income.

What is the significance of calculating earnings per share (EPS)?

Earnings per share (EPS) measures the profitability of a company by showing how much income is generated for each outstanding share of common stock.

What is the formula for calculating earnings per share (EPS)?

The formula is: (Net Income - Preferred Dividends) / Number of Shares of Common Stock Outstanding.

How does the number of shares affect the earnings per share (EPS)?

The number of shares affects EPS because a higher number of shares results in a lower EPS, assuming net income remains constant, while fewer shares would result in a higher EPS.

Why is it important to compare the calculated ratios to industry standards?

Comparing the calculated ratios to industry standards helps assess whether the company's profitability is strong or weak relative to its competitors, providing context for the figures.

In the example, what does an EPS of 65 cents indicate?

An EPS of 65 cents means that each share of common stock generates 65 cents of net income for the company.