Comprehensive Profitability Analysis
Exhibit 5 diagrams the comprehensive ratio relationships that can be used to analyze
the rate earned on stockholders’ equity. Reading left to right, the rate earned on stock-
holders’ equity and rate earned on total assets as computed previously can be related
to each other. Specifically, the rate earned on stockholders’ equity is the product of the
rate earned on total assets and the amount of debt, or leverage, held by the firm. The
rate earned on stockholders’ equity is normally higher than the rate earned on total as-
sets when a company uses debt, or leverage, in its capital structure.
The relationship between the rate earned on stockholders’ equity and the rate
earned on total assets can be computed using the following leverage formula:Rate Earned on Rate Earned on
Stockholders’ Equity
Total Assets LeverageNet Income
Net Income
Average Total Assets
Average Stockholders’ Equity Average Total Assets Average Stockholders’ EquityThe leverage formula for Pixar and DreamWorks Animation is as follows for fiscal
year 2004:Pixar’s leverage is 1.05 ($1,138.5 ÷ $1,080.3), while DreamWorks’ is 2.31 ($940.7 ÷
$407.3). Thus, the rate earned on stockholders’ equity using the leverage formula for
Pixar is 13.1% (12.4% 1.05), and for DreamWorks it is 81.8% (35.4% 2.31). The
leverage term (average total assets divided by average stockholders’ equity) measures
the number of asset dollars supported by each dollar of stockholders’ equity. The
larger the value of this measure, the greater the leverage. For example, if a firm had
no debt, then this ratio would be 1.0, thus causing the rate earned on stockholders’ eq-
uity to equal the rate earned on total assets. If the firm had average debt equal to 50%
of average total assets, then this leverage ratio would be 2.0. It is clear that DreamWorks
uses more leverage than does Pixar. We will discuss leverage in greater detail in a later
section of this chapter.638 Chapter 14 Financial Statement Analysis
Rate Earned on Rate Earned on
Stockholders’ Equity Total Assets Leverage
Pixar 13.1%a 12.4% (p. 637) 1.05b
DreamWorks 81.8% 35.4% (p. 637) 2.31c
aSmall differences in multiplication may occur due to rounding.
b$1,138.5 ÷ $1,080.3 = 1.05, from average total assets and stockholders’ equity on pp. 636 and 637.
c$940.7 ÷ $407.3 = 2.31, from average total assets and stockholders’ equity on pp. 636 and 637.International Perspective
International Accounting
Standards provide a consis-
tent financial reporting
framework that allows users
of financial statements to
compare companies from
different countries.