more profitable than the median firm in our economy, whether one mea-
sures profitability on the basis of sales, assets, or equity (see Table 2.4).
The company’s use of leverage has enhanced its return on equity (ROE) rel-
ative to its return on assets (ROA), such that it has generated returns on its
equity more than three times the corresponding ratio for the median firm
in the economy.
Dividends are a charge on earnings. In most jurisdictions, however,
legally they constitute a charge against surplus, not current earnings, and
may be declared as long as there is a sufficient credit balance in the surplus
account, even if there are no current profits. Firms may elect to do this. As
a practical matter, though, the dividend policies of most firms are condi-
tioned by their current earnings positions and not by their retained surplus
accounts, and so from the point of view of functional relationships the or-
der of accounting presented seems quite correct. Common stock dividends
are a voluntary distribution of the profits of the firm and not a legal oblig-
ation. Their declaration does not reduce the profits of the firm. Thus they
are deducted after the earnings on the common stock are calculated. More-
over, the profits tax liability of the firm is not affected by the payment of ei-
ther preferred dividends or common dividends.
What is left after all dividends are subtracted from the reported profits
is the retained earnings, reinvested earnings, or net addition to surplus for
the year. If expenses exceed revenues, there would be instead an operating
loss or deficit for the year. The retained earnings for the period depend on
the level of profit and the dividend policy of the company. These in turn are
influenced by factors such as the stability and amount of the company’s
cash flow, the firm’s growth prospects, and its need for equity funds either
The Operating Statements: The Income Statement and Sources and Uses of Funds 23
TABLE 2.4 Johnson & Johnson Relative Returns on Sales, Assets, and Equity
Ratio 1970 1975 1980 1985 1990 1995 2000 2001 2002 2003
Johnson & Johnson
ROS 0.083 0.083 0.083 0.096 0.102 0.128 0.165 0.172 0.182 0.172
ROA 0.118 0.118 0.120 0.120 0.120 0.134 0.153 0.147 0.163 0.149
ROE 0.157 0.160 0.177 0.183 0.233 0.266 0.255 0.234 0.291 0.268
Firm: Median—WRDS Ratio
ROS 0.038 0.035 0.043 0.027 0.021 0.037 0.019 0.006 0.018 0.031
ROA 0.041 0.039 0.044 0.026 0.018 0.022 0.009 0.004 0.009 0.012
ROE 0.100 0.104 0.128 0.096 0.090 0.098 0.075 0.068 0.073 0.082
N 3,711 6,169 6,185 7,134 7,241 10,112 9,861 9,224 8,519 7,085