PROFITABILITY ANALYSIS
The relative profitability of a firm can be analyzed by combining both profitability and
balance sheet information into a single ratio. Two relative profitability ratios con-
structed in this way are the rate earned on stockholders’ equity and the rate earned on
total assets.Rate Earned on Stockholders’ Equity
The stockholder desires a return on his or her investment. One measure of this return
is the rate earned on stockholders’ equity. The rate earned on stockholders’ equityis
calculated as the net income divided by the average stockholders’ equity. The average
stockholders’ equity is often calculated as the sum of the beginning and ending bal-
ances of stockholders’ equity, divided by two. Note that the average stockholders’ eq-
uity is determined from the balance sheet and not by the market value of the common
stock. To illustrate, the following information was provided in recent financial state-
ments of PixarandDreamWorks Animation SKG, Inc., a major competitor to Pixar
in the filmed animation entertainment market.^1Pixar earned a 13.1% return on stockholders’ equity, while DreamWorks earned 81.8%.
DreamWorks’ high return on stockholders’ equity relative to Pixar is partially ex-
plained by strong earnings combined with a negative beginning stockholders’ equity
balance, caused by DreamWorks Animation’s spinoff from DreamWorks.636 Chapter 14 Financial Statement Analysis
Calculate and interpret the
rate earned on stockhold-
ers’ equity and the rate
earned on total assets.2
Pixar DreamWorks
(in millions) (in millions)
Year Ended Year Ended
Jan. 1, 2005 Dec. 31, 2004
a. Net income $ 141.7 $ 333.0
Stockholders’ equity:
Beginning of year $ 940.5 $ (12.4)
End of year 1,220.1 826.9
Total $2,160.6 $814.5
b. Average (Total ÷ 2) $1,080.3 $407.3
Rate earned on stockholders’ equity (a ÷ b) 13.1% 81.8%1 We will shorten DreamWorks Animation SKG to DreamWorks in this chapter. However, this should not
be confused with movie production company by the same name.