-The following selected financial information was obtained from the 2010 financial reports of Roper Designs and Turner Industries:
Required:
a. Assume that you are considering purchasing the common stock of one of these companies. (Since you have limited data, assume that the beginning balance sheet amounts equal ending balance sheet amounts for total assets and stockholders' equity.) Based on this information, which company has a higher return on equity? Would your conclusion be different if the impact of the extraordinary item had not been included in net income? Should the extraordinary item be considered? Why or why not?
b. Which company uses leverage more effectively? Does your answer change if you do not consider the impact of the extraordinary item on net income?

Question

-The following selected financial information was obtained from the 2010 financial reports of Roper Designs and Turner Industries:
  Required: 
a. Assume that you are considering purchasing the common stock of one of these companies. (Since you have limited data, assume that the beginning balance sheet amounts equal ending balance sheet amounts for total assets and stockholders' equity.) Based on this information, which company has a higher return on equity? Would your conclusion be different if the impact of the extraordinary item had not been included in net income? Should the extraordinary item be considered? Why or why not?
b. Which company uses leverage more effectively? Does your answer change if you do not consider the impact of the extraordinary item on net income?

Quizplus · Accepted Answer

The Answer is a. Return on Equity = Net Income ÷ Average Stockholders' Equity

a. Return on Equity = Net Income ÷ Average Stockholders' Equity Based on return on equity, Turner is almost twice as efficient as Roper at managing the shareholders' capital. If unusual items were not considered, return on equity for each company would be: Turner now appears to be considerably worse than Roper at managing the stockholders' capital. Including unusual items in calculating return on equity does provide a more complete measure of how efficiently a company managed its stockholders' equity in the current year. However, since unusual items are, by definition, items that occur infrequently, these items do not indicate a company's continued ability to efficiently manage the stockholders' capital. Thus, unusual items probably should not be used to calculate return on equity. b. Financial leverage indicates how effectively a company uses debt for the benefit of stockholders. Financial leverage equals return on equity less return on assets. Thus, return on assets must be calculated before calculating financial leverage. Return on Assets = (Net Income + Interest Expense (net of tax)) ÷ Average Total Assets Roper: ($610,000 + $100,000) ÷ [($3,360,000 + $3,360,000) ÷ 2] = 0.211 or 21.1% Turner: ($1,675,000 + $175,000) ÷ [($1,870,000 + $1,870,000) ÷ 2] = 0.989 or 98.9% From this analysis, Roper is approximately twice as effective as Turner at using debt to generate returns for its stockholders. If unusual items are not considered, the return on assets for each company would be: Roper: ($610,000 + $100,000) ÷ [($3,360,000 + $3,360,000) ÷ 2] = 0.211 Turner: [($1,675,000 - $1,300,000) + $175,000] ÷ [($1,870,000 + $1,870,000)÷2]= 0.294 Therefore, the financial leverage of the two companies would be: If extraordinary items are not considered, Turner has negative financial leverage. That means that Turner is not generating a large enough return on its debt to even cover the interest expense. Thus, Turner is using debt to the detriment of its stockholders. It appears, therefore, that extraordinary items can affect the conclusions one draws when analyzing a company and its quality of earnings. BT: AN

Based on return on equity, Turner is almost twice as efficient as Roper at managing the shareholders' capital. If unusual items were not considered, return on equity for each company would be:

Turner now appears to be considerably worse than Roper at managing the stockholders' capital. Including unusual items in calculating return on equity does provide a more complete measure of how efficiently a company managed its stockholders' equity in the current year. However, since unusual items are, by definition, items that occur infrequently, these items do not indicate a company's continued ability to efficiently manage the stockholders' capital. Thus, unusual items probably should not be used to calculate return on equity.
b. Financial leverage indicates how effectively a company uses debt for the benefit of stockholders. Financial leverage equals return on equity less return on assets. Thus, return on assets must be calculated before calculating financial leverage.
Return on Assets = (Net Income + Interest Expense (net of tax)) ÷ Average Total Assets
Roper: ($610,000 + $100,000) ÷ [($3,360,000 + $3,360,000) ÷ 2] = 0.211 or 21.1%
Turner: ($1,675,000 + $175,000) ÷ [($1,870,000 + $1,870,000) ÷ 2] = 0.989 or 98.9%

From this analysis, Roper is approximately twice as effective as Turner at using debt to generate returns for its stockholders. If unusual items are not considered, the return on assets for each company would be:
Roper: ($610,000 + $100,000) ÷ [($3,360,000 + $3,360,000) ÷ 2] = 0.211
Turner: [($1,675,000 - $1,300,000) + $175,000] ÷ [($1,870,000 + $1,870,000)÷2]= 0.294
Therefore, the financial leverage of the two companies would be:

If extraordinary items are not considered, Turner has negative financial leverage. That means that Turner is not generating a large enough return on its debt to even cover the interest expense. Thus, Turner is using debt to the detriment of its stockholders. It appears, therefore, that extraordinary items can affect the conclusions one draws when analyzing a company and its quality of earnings.
BT: AN

-The Following Selected Financial Information Was Obtained from the 2010