Chapter 14 Financial Statement Analysis 637
The rate earned on total assets of Pixar was 12.4%, which is good, while
DreamWorks was 35.4%. DreamWorks’ high rate earned on total assets is from the suc-
cessful DVD sales of Shrek 2during 2004. Pixar is earning good returns on its assets,
with earnings coming from the launch of The Incrediblesat the end of 2004. Much of
the difference between Pixar and DreamWorks can be explained by differences in the
relative timing of their film earning cycles. DreamWorks earned most of its revenues
forShrek 2in 2004, while Pixar still had much of the revenues for The Incrediblesto be
realized in 2005.
A company’s objective is to generate a return on total assets that exceeds the cost of
capital. The cost of capitalis the cost of financing its operations from both debt and com-
mon stock, expressed in percentage terms. For example, if a company borrows money at
an 8% interest rate, the invested funds must generate a rate of return in excess of 8% to
be successful.^3 The rate earned on total assets is widely acknowledged as a good sum-
mary measure of managerial performance, since it measures the return on total assets
under management care and control, regardless of the method of financing those assets.
Sometimes, it may be desirable to compute the rate of income from operations to
total assets. This is especially true if significant amounts of nonoperating income and
expense, such as interest income and expense, are reported on the income statement.
In this case, any assets related to the nonoperating income and expense items should
be excluded from total assets in computing the rate. In addition, using income from
operations (which is before tax) has the advantage of eliminating the effects of any
changes in the tax structure on the rate of earnings. When evaluating published data
on rates earned on assets, you should be careful to determine the exact nature of the
measure that is reported.
Pixar DreamWorks
(in millions) (in millions)
Year Ended Year Ended
Jan. 1, 2005 Dec. 31, 2004a. Net income $ 141.7 $ 333.0
Total assets:
Beginning of year $1,002.0 $ 681.4
End of year 1,275.0 1,200.0
Total $2,277.0 $1,881.4
b. Average (Total ÷ 2) $1,138.5 $ 940.7
Rate earned on total assets (a ÷ b) 12.4% 35.4%
2 Alternatively, the numerator could be net income plus interest expense in order to remove the impact of
the financing decision from the numerator. We select a simpler approach here to ease interpretation of the
comprehensive analysis.
3 The cost of capital calculation is illustrated in finance textbooks.
Rate Earned on Total Assets
Therate earned on total assetsis computed by dividing net income by the average to-
tal assets.^2 The rate earned on total assets measures the profitability of total assets,
without considering how the assets are financed. That is, the rate is not affected by
whether assets are financed primarily by creditors or stockholders.
The rate earned on total assets by PixarandDreamWorksfor a recent year is com-
puted as follows: