1. Liabilities and Stockholders’ Equity
CHAPTER 8

2. Learning Objectives
After studying this chapter, you should be able to:
Describe how businesses finance their operations
Describe and illustrate current liabilities, notes payable, taxes, contingencies, and payroll
Describe and illustrate the financing of operations through issuance of bonds
Describe and illustrate the financing of operations through issuance of stock
Describe and illustrate the accounting for cash and stock dividends
(continued…)

3. Learning Objectives
After studying this chapter, you should be able to:
Describe the effects of stock splits on the financial statements
Describe financial statement reporting of liabilities and stockholders’ equity
Analyze the impact of debt or equity financing on earnings per share
Financial Analysis: Describe and illustrate the use of the ratio of liabilities to total assets and the price-earnings ratio in assessing a company’s financial condition and prospects for future performance

4. LEARNING OBJECTIVE 1
Describe how businesses finance their operations

5. Financing Operations
Businesses must finance operations through one of the two ways:
Debt Financing – includes all liabilities owed by a business
Equity Financing – includes investments from owners of the business
Proprietorship or partnership: obtains equity financing from investments by its owner(s)
Corporation: obtains equity financing by issuing stock
A company may finance its operations through debt, equity, or both.
Debt financing includes all liabilities of the company. For example, most companies have accounts payable due to vendors and other suppliers. In effect, these vendors and suppliers are helping finance the company. A company may also issue notes or bonds to finance its operations.
On the other hand, a proprietorship or partnership obtains equity financing from investments by its owner(s). A corporation obtains equity financing by issuing stock.

6. LEARNING OBJECTIVE 2
Describe and illustrate current liabilities, notes payable, taxes, contingencies, and payroll

7. Liabilities Debts owed to others
Current liabilities – due within a short time, usually 1 year
Long-term liabilities – due beyond 1 year
Contingent liability – in some cases a company incurs a liability if certain events occur in the future
Liabilities are nothing but debts owed to others. Liabilities to be paid out of current assets and are due within a short time are reported as current liabilities on the balance sheet. Long-term liabilities are debts due beyond one year, while contingent liabilities are liabilities that are dependent on certain events occurring in the future.

8. Notes Payable Notes payable are often issued to:
Satisfy an account payable
Purchase merchandise or other assets
Borrower: Issuer of the note
Lender: party receiving the note
Notes payable are often issued to satisfy an account payable or to purchase merchandise or other assets. The issuer of the note is the borrower and the party receiving the note is the lender. Notes are usually for a longer period of time and supported by a written document. This makes the obligation a more formal instrument than an account payable. Because of the longer time frame, interest is usually also due when the note is due.

9. Notes Payable
Assume that a business issues a 90-day, 6% note for $1,000, dated August 1 to satisfy an account payable
Assume that a business issues a 90-day, 6% note for $1,000, dated August 1 to satisfy an account payable. This transaction reduces accounts payable by the principal amount of $1,000 and is moved to Notes Payable.

10. Notes Payable
Assume that a business issues a 90-day, 6% note for $1,000, dated August 1 to satisfy an account payable
On October 30, $1,015 of cash must be disbursed to satisfy the note payable obligation and also record the $15 of interest expense on the Income Statement.

11. Income Taxes
Includes federal income taxes and possibly state and local income taxes
Most corporations are required to pay federal income taxes in four installments throughout the year
Taxable income of a corporation is determined according to the tax laws
Income before taxes reported on the income statement is usually different from taxable income
Under the US tax code, corporations are taxable entities and must complete a tax return and pay federal income taxes on corporate income. Most corporations pay estimated federal income taxes in four installments throughout the year.
The tax return is completed for the corporations using the rules set for in the Internal Revenue Code. These rules are different than the generally accepted accounting principles that govern corporate accounting and result in differences between taxable income and net income.

12. Income Taxes
Assume that a corporation, with a calendar-year accounting period, estimates its income tax expense for the year as $84,000
The effect on the accounts and the financial statements of the first of the four estimated tax payments of $21,000 (1/4 of $84,000) is as follows:
To illustrate, assume that a corporation, with a calendar-year accounting period, estimates its income tax expense for the year as $84,000. The effect on the accounts and the financial statements of the first of the four estimated tax
payments is a reduction in cash by $21,000, which is one-fourth of $84,000. And a corresponding reduction in retained earnings by $21,000.

13. Taxable Income vs. Income Before Taxes
Taxable Income – determined according to federal tax laws (IRS Code)
Income Before Taxes – determined according to generally accepted accounting principles (GAAP)
Differences between the two may need to be allocated between various financial statement periods
The tax implications that arise from differences between a company’s taxable income and the income before taxes reported on the Income Statement may need to be allocated between financial statement periods. The difference may be the result of certain items being recognized in one period for tax purposes and in another period for income statement purposes. These differences are called temporary differences because they will reverse or turn around in later years. Temporary differences do not change the total amount of taxes paid, they only change the timing of when the taxes are to be paid.
Some differences arise because some revenue is exempted from tax or some expenses are not deductible. These differences are called permanent differences. Permanent differences do not create any special financial reporting issues.

14. Accounting for Temporary Differences
Since temporary differences affect only the timing of the payment of taxes and not the total taxes to be paid, most corporations will have two tax liabilities:
• Current income tax liability which is due on the current year’s taxable income.
• Postponed or deferred tax liability, which is due in the future when the temporary differences reverse.
On the income statement, income tax expense of $120,000 is calculated as 40% of $300,000. This is done so that the current year’s expenses, including income tax, are properly matched against the current year’s revenue. Of this amount,
$40,000, that is 40% tax rate applied against the taxable income of $100,000, is currently due and $80,000 will be due in future years.

15. Contingent Liabilities
Accounting Treatment of Contingent Liabilities
Some liabilities may arise from past transactions if certain events occur in the future. These potential liabilities are called contingent liabilities.
As shown in the Exhibit, the accounting for contingent liabilities depends on two factors:
First, the likelihood of occurring, which are — Probable, reasonably possible, or remote
Second, the measurement, which are — Estimable or not estimable
The first step in evaluating contingent liabilities involves determining the likelihood of the future event occurring. If the likelihood is probable and the amount can be estimated, the liability must be recorded. An example of this would be the liability for warranty repairs.
If an event is probably but not estimable, the accounting treatment is to simply disclose the liability in the notes to the financial statements. An example of this would be if an oil company was responsible for an oil spill. The same is true if the likelihood of the future event is only reasonably possible.
If the likelihood is remote, no recording or disclosure is necessary.

16. Payroll
Amount paid to employees for services they provide during a period
Salary – payment for managerial, administrative, or similar services - yearly
Wages – payment for manual labor, both skilled and unskilled - hourly
Payroll and related taxes significantly impact the net income of most businesses
The term payroll refers to the amount paid to employees for services they provide during a period. Payroll can include either salaries or wages or both. Salary refers to payment for managerial, administrative, or similar services, while wages
refers to payment for manual labor, both skilled and unskilled.
Expenses for payroll and the related payroll taxes account for a significant expense for most businesses.

17. Payroll Taxes Employer Taxes Employee Taxes FICA
Federal and State Unemployment Taxes
FICA
Federal and State Income Taxes
Most employers are subject to federal and state payroll taxes. Such taxes are an operating expense of the business. For example, employers are required to match the employees’ contributions to FICA. In addition, most companies are liable for federal and state unemployment taxes. The payroll taxes due from employers become liabilities when the related payroll is paid to the employees. However, the liabilities may not be paid to the appropriate taxing authorities until a later time.
Payroll taxes become a liability when the related payroll is paid to employees
The liability is relieved when the taxes are paid to the appropriate agencies

18. Recording Payroll
Assume that McDermott Co. had a gross payroll of $13,800 for the week ending April 11. Assume that the FICA tax was 7.5% of the gross payroll and that federal and state withholding were $1,655 and $280, respectively
The FICA, federal, and state taxes withheld from the employees’ earnings are not expenses of the employer. Rather, these amounts are withheld on behalf of the employee and must be remitted periodically to the state and federal agencies. Other deductions may also be made on behalf of the employee for medical insurance, union dues, 401K contributions, etc.
To illustrate recording payroll, assume that McDermott Co. had a gross payroll of $13,800 for the week ending April 11. Assume that the FICA tax was 7.5% of the gross payroll and that federal and state withholding were $1,655 and $280, respectively.
The total earnings for an employee for a payroll period, including bonuses and overtime pay, is called gross pay. That is the amount recorded to wages and salary expense for the pay period. In this illustration, gross pay is $13,800. From gross pay, one or more deductions are subtracted to arrive at an employee’s net pay. Net pay is what is deducted from cash and paid to employees, in this transaction, $10,830. The deductions made include FICA taxes payable, Employee Federal Income Tax Payable, and Employee State Tax Payable.

19. Recording Payroll Taxes
The effect on the accounts and financial statements of McDermott Co. of recording the payroll tax liabilities for the week follows:
The prior payroll information of McDermott Co. indicates that the amount of FICA tax withheld is $1,035 on April 11. Since the employer must match the employees’ FICA contributions, the employer’s social security payroll tax will also be $1,035. Furthermore, assume that the FUTA and SUTA taxes are $145 and $25, respectively.
Payroll tax liabilities are paid to appropriate taxing authorities on a quarterly basis by decreasing Cash and the related taxes payable.

20. LEARNING OBJECTIVE 3
Describe and illustrate the financing of operations through issuance of bonds

21. Bonds A form of interest-bearing note
Bonds include interest that must be paid on a regular basis
Bonds face value must be repaid at maturity
Bond indenture: Contract between the company issuing the bonds and the bondholders
A bond issue is normally divided into several individual bonds
The most common face value is $1,000 per bond
Many large corporations finance their operations through the issuance of bonds. A bond is simply a form of an interest-bearing note. Like a note, bonds require periodic interest payments to be made and, at maturity, the face value of the bond must be repaid to the bondholders.
A corporation that issues bonds enters into a contract, called a bond indenture, with the bondholders. Each individual bond bears a face value, usually $1,000 per bond. Interest on the bond may be payable annually, semi-annually, or quarterly.

22. Calculating the Bond Issue Price
The price that buyers are willing to pay for the bonds depends on three factors:
Face amount of the bonds due at the maturity date
Periodic interest to be paid on the bonds – stated in the bond indenture
This is called the contract or coupon rate
Market/Effective rate of interest
Bond prices are determined by the amount investors are willing to pay. Prices of bonds are quoted on bond exchanges as a percentage of the bonds’ face value.
When a corporation issues a bond, the issue price of the bond is dependent on:
The face amount of bonds due at the maturity date
The periodic interest to be paid on the bonds, also called the contract rate
The market rate of interest on the date the bonds are issued, also called the effective rate.

23. Recording Bond Issuance
Assume that a business issues $100,000 of 6%, 5-year bonds, with interest of $3,000 payable semiannually. The market rate of interest at the time the bonds are issued is 6%
Issuance of bonds payable at face amount on January 1.
To illustrate, assume that on January 1 a corporation issues for cash $100,000 of 6%, 5-year bonds, with interest of $3,000 payable semiannually. The market rate of interest at the time the bonds are issued is 6%.
Since the contract rate and the market rate of interest are the same, the bonds will sell at their face amount.
When the bonds are issued, cash increases by $100,000 and the Bond Payable is established on the Balance Sheet as a liability.

24. Recording Bond Issuance
Assume that a business issues $100,000 of 6%, 5-year bonds, with interest of $3,000 payable semiannually. The market rate of interest at the time the bonds are issued is 6%
The interest on the bond being $3,000 reduces cash and the retained earnings.

25. Recording Bond Issuance
Assume that a business issues $100,000 of 6%, 5-year bonds, with interest of $3,000 payable semiannually. The market rate of interest at the time the bonds are issued is 6%
During the payment of face value of bond at maturity of $100,000, cash is reduced by that amount and hence reducing the bond liability.

26. Bonds Not Issued at Face Value
Market Rate = Contract Rate
Selling Price = Face Amount of Bonds
Discount on Bonds Payable
Market rate of interest > contract rate
Buyers are only willing to pay less than the face value for the bonds
Premium on Bonds Payable
Market rate of interest < contract rate
Buyers are willing to pay more than the face value for the bonds
The market and contract rates of interest determine whether the selling price of a bond will be equal to, less than, or greater than the face amount.
When the market rate equals contract rate, selling price is equal to the face amount of bonds.
A bond sells at a discount because buyers are only willing to pay less than the full face value for a bond where the contract rate is lower than the market rate.
A bond sells at a premium when the contract rate exceeds the market rate. Investors are willing to pay more than the face value when the contract rate is higher than market rate.

27. LEARNING OBJECTIVE 4
Describe and illustrate the financing of operations through issuance of stock

28. Stock Authorized – total number allowed to issue
Issued – shares issued to shareholders
Outstanding – shares currently in the hands of stockholders
For companies a major means of equity financing for a corporation is issuing stock. The equity in the assets that results from issuing stock is called paid-in-capital or contributed capital. Another major means of equity financing for operations is through retained earnings. Retained earnings represents earnings retained in the business and not distributed to stockholders as dividends.
The number of authorized shares for a corporation is determined in the company charter, filed in the state of incorporation. The term issued relates to the number of shares issued to stockholders. Since corporations may reacquire some of the stock that it has issued, the stock remaining in the shareholders’ hands is called outstanding stock.

29. Shares of Stock
Can be issued with or without assigning a monetary amount:
Par: monetary value stated on stock certificate
No-par: some states might require a stated value
Legal Capital
Minimum stockholder contribution required by some states
Shares of stock are often assigned a monetary value, called par. Upon request, companies may issue stock certificates to stockholders to document their ownership interest in the company.
Because corporations have limited liability, creditors have no claim against the personal assets of the stockholders. However, some state laws require that corporations maintain a minimum stockholder contribution to protect creditors. This is called legal capital and the amount varies from state to state, but it usually includes the amount of par or stated value of the stock issued.

30. Stock Rights Right to vote in matters concerning the corporation
Right to share in distributions of earnings
Right to share in assets on liquidation
The major rights that accompany ownership of a share of stock are:
Right to vote in matters concerning the corporation- this is usually voting for board of director members and any other major corporate issues the bylaws may require to be voted on by the entire stockholder group.
Right to share in distributions of earnings- if earnings are distributed, shareholders have the right to participate in the distribution of earnings. Some shareholders may have certain preferences in the distribution based on the type of stock they own. This will be discussed in a later slide.
Right to share in assets on liquidation – creditors of a company have first claim on any liquidation of assets. After that, shareholders maintain a right to share in any remaining assets upon liquidation of the corporation.

31. Common and Preferred Stock
Each share has equal rights
Each share has voting rights
Has preference rights over common stock
Dividend rights stated in monetary terms or as % of par
If only one class of stock is issued, it is called common stock. Each share of common stock has equal rights, and these rights include voting rights. Corporations can offer one or more classes of stock with various preference rights – usually called preferred stock. Preferred shareholders have first rights (preference) to any dividends and any asset distribution as a result of liquidation. Preferred dividend rights are usually stated in monetary terms or as a percentage of par. However, since dividends are normally based on earnings, dividends are not guaranteed even to preferred shareholders.

32. Issuance of Stock
The price at which stock sells depends on a variety of factors:
The financial condition, earnings record, and dividend record of the corporation
Investor expectations of the corporation’s potential earning power
General business and economic conditions and prospects
Because different classes of stock have different rights, when stock is issued to investors, separate accounts are used to record each issuance. Stock is often issued by a corporation at a price that is different from the par value of a share of stock. The issue price will depend on several factors:
The financial condition, earnings record, and dividend record of the corporation
Investor expectations of the corporation’s potential earning power
General business and economic conditions and prospects
Normally, a stock is issued at a price greater than its par value.

33. Issuance of Stock
Assume that a corporation issues 2,000 shares of $1 par value common stock for $55 per share
When stock is issued at a price above par value which is at premium, cash will be increased for the total amount received from the issuance of the shares. In the illustration, 2,000 shares at $55 per share will results in an increase to cash of $110,000. Common stock is increased for $2,000, which is 2,000 shares at the par value per share of $1. Premium is the difference between the issue price and the par value and is recorded in the account Paid-In Capital in Excess of Par. In this illustration the amount of $108,000 is calculated by multiplying the 2,000 shares by $54, the difference between the issue price of $55 per share and the $1 par value per share.
Stock can also be issued in exchange for assets other than cash. If stock is exchanged for assets such as land, buildings, or equipment, the fair market value of the non-cash assets is used to value the exchange. If that value cannot be objectively determined, the fair market price of the shares of stock issued may be used.

34. Reacquired Stock Treasury Stock
Stock that a corporation has issued and then reacquired
Balance at year-end is reported as a reduction of stockholders’ equity
A corporation may reacquire (purchase) its own stock for a variety of reasons
To provide shares for resale to employees
To reissue as bonuses to employees
To support the market price of the stock
Treasury stock is stock that a corporation has issued and then reacquired. The purchase of treasury stock increases Treasury Stock and decreases Cash by the cost of the repurchased shares. At the end of the year, the balance of the treasury stock account is reported as a reduction of stockholders’ equity.
A corporation may reacquire its stock for a variety of reasons:
To provide shares for resale to employees
To reissue as bonuses or stock options to employees
To support the market price of the stock

35. LEARNING OBJECTIVE 5
Describe and illustrate the accounting for cash and stock dividends

36. Dividends
Cash dividend: When a board of directors authorize the distribution of cash to stockholders
Stock dividend: When a board of directors authorize the distribution of its stock to the stockholders
When a board of directors declares a cash dividend, it authorizes the distribution of cash to stockholders. When a board of directors declares a stock dividend, it authorizes the distribution of its stock.

37. Cash Dividends
Cash distribution of earnings by a corporation to its shareholders
Most common form of dividend
Usually three conditions:
Sufficient retained earnings
Sufficient cash
Formal action by the board of directors
When a company’s board of directors declares a dividend, it authorizes the distribution of retained earnings to the stockholders. Distributions in the form of cash are the most common form of distribution. Three conditions must be met in order for a cash dividend to be declared:
Sufficient retained earnings
Sufficient cash
Formal action by the board of directors
Even if there are sufficient retained earnings and cash, a company’s board of directors is not required to pay dividends. Nevertheless, many corporations pay quarterly cash dividends to make their stock more attractive to future investors.

38. Dates in Dividend Announcement
Since a dividend declaration requires formal action by the board of directors of a corporation, there is often delay between when the dividend is declared and when it is actually paid out in cash.
The date of declaration is the date the board of directors takes the formal action to authorize the payment of the dividend. On this date, the company records the liability to the stockholders to pay the amount of the dividend.
The date of record is the date the corporation uses to determine which stockholders will receive the dividend. During the period between the date of declaration and the date of record, the stock price is quoted as selling with-dividends. This means any investor purchasing the stock during this period will be stockholders on the date of record and will ultimately received the declared dividend. This usually impacts the selling price of the share of stock.
The date of payment is the date the corporation pays the dividend to the stockholders who owned the stock on the date of record. Any stock sold during the period between the date of record and the date of payment is quoted as selling ex-dividends. This means since the date of record has passed, any new investors will not receive the dividend. This also usually impacts the selling price of the share of stock.

39. Cash Dividends
Assume a company declares the following cash dividend on December 1 for payment on February 2:
On the declaration date of December 1, the company records the liability for the dividends declared. Since dividends are distributions of Retained Earnings, Retained Earnings are decreased for the amount of the dividend as the liability Dividends Payable is established.
On February 2, when the dividend is actually paid in cash, Cash would be decreased and the liability Dividends Payable would be eliminated.
The date of record would not result in any transactions on the books of the corporation.

40. Stock Dividends
Distribution of stock to stockholders (usually common shares)
No distribution of cash or other assets
Requirements:
Sufficient retained earnings
Formal action by board of directors
Amount transferred for small stock dividends (<25% of outstanding shares) is market value per share
When a company’s board of directors declares a dividend, it authorizes the distribution of retained earnings to the stockholders. While distributions in the form of cash are the most common form of distribution, a corporation may also elect to distribute a dividend in a distribution of shares of stock. This is called a stock dividend.
Stock dividends are normally declared only on common stock and issued to common shareholders. There is still the requirement of sufficient Retained Earnings and a formal action of declaration by the board of directors.
A stock dividend does not change the assets, liabilities or total stockholders’ equity of a corporation. There is not a distribution of cash or other assets, nor is there a liability to distribute a payment at a future date. The effect of a stock dividend is to transfer retained earnings to paid-in capital, so overall total stockholders’ equity does not change. The amount transferred from Retained Earnings to paid-in capital accounts is normally the market value of the shares issued as a result of the stock dividend.

41. Stock Dividends
To illustrate, assume a stockholder owns 1,000 of a corporation’s 10,000 shares outstanding. If the corporation declares a 6% stock dividend, the stockholder’s proportionate interest will not change, as shown below:
To illustrate, assume a stockholder owns 1,000 of a corporation’s 10,000 shares outstanding. If the corporation declares a 6% stock dividend, the stockholder’s proportionate interest will not change, as shown.

42. LEARNING OBJECTIVE 6
Describe the effects of stock splits on the financial statements

43. Stock Splits
Process by which a corporation reduces the par or stated value of its common stock and issues a proportionate number of additional shares
Major objective is to reduce the stock’s market price per share in order to attract more investors
A stock split is the process by which a corporation reduces the par or stated value of its common stock. A stock split will also increase the number of shares outstanding and the split will apply to all shares of common stock: issued, unissued, and shares of treasury stock. The objective of a stock split is to reduce the market price per share of the stock. This, in turn, attracts more investors to the stock and broadens the types and numbers of stockholders.

44. Stock Splits
In this illustration, a 5 for 1 stock split is declared by the board of directors of a corporation. A stockholder who held four shares of stock with a par value of $100 per share before the split holds a total par value of $400. After the split, that same shareholder will now hold 20 shares of common stock. Each share will now carry a par value of $20 per share. The total par value of the 20 shares will be the same as the original par value of the 4 shares.
Since there are more shares outstanding after a stock split, the market price of the stock should decrease in proportion to the split.

45. LEARNING OBJECTIVE 7
Describe financial statement reporting of liabilities and stockholders’ equity

46. Reporting Liabilities and Stockholders’ Equity
Current liabilities are due within 1 year
Long-term liabilities are due beyond 1 year
Stockholders’ Equity
Part of the balance sheet
Details of the changes in stockholders’ equity are disclosed in a separate statement
Liabilities and stockholders’ equity on the balance sheet represent how the assets of a company are financed. Detailed information on these items can be found in the notes to the financial statements.
On the balance sheet, liabilities are classified into current and non-current, depending upon when they are due. Current liabilities can be compared to current assets of a company to begin to determine short-term bill paying ability of a company.
Stockholders’ Equity is reported on the balance sheet, but detailed information is also usually included on the statement of stockholders’ equity that analyzes changes to the stockholder equity accounts.

47. Balance Sheet
The balance sheet illustrated here shows the liabilities of Bergstom Corporation split between current and long-term liabilities. Within current liabilities, there is a further break-out of the main types of current liabilities, including accounts payable and notes payable. Within the long-term liability classification, the debenture reporting includes the contract rate, the due date, and the market value of the debenture. Further information on all the liabilities would be included in the footnotes to the financial statements.
The stockholders’ equity section of the balance sheet displays the ending balances in the stockholders’ equity accounts. For stock, this includes shares authorized and issued, par values, and, in the case of preferred stock, the stated dividend rate. As you can see, Bergstom is reporting $75,000 of Treasury Stock as a deduction to stockholders’ equity. Although stockholders’ equity is reported on the balance sheet, significant changes in stockholders’ equity during the year should also be disclosed. Changes in retained earnings are often reported in a separate Retained Earnings Statement. Footnotes to the financial statements are also used to disclose information regarding stockholder equity activity. Additional details of the stockholder equity accounts may also be presented in statement of stockholders’ equity.

48. Statement of Stockholders’ Equity
While the balance sheet only reports the ending balances in the stockholder equity accounts, the statement of stockholders’ equity reports the activity in the stockholder equity accounts during the year. On this statement, significant changes or activity in the equity accounts are reported. Changes in retained earnings may be presented in a separate retained earnings statement. Changes in paid-in capital during the year may be reported on the face of the balance sheet or in the notes.

49. LEARNING OBJECTIVE 8
Analyze the impact of debt or equity financing on earnings per share

50. Net Income – Preferred Dividends Number of Common Shares
Earnings Per Share
Measures the income earned by each share of common stock
Major profitability measure reported in the financial statements
Net Income – Preferred Dividends
Number of Common Shares
One of the many factors that influence a company’s decision of whether to finance operations using debt or equity is the impact of the decision on earnings per share. It measures the income earned by each share of common stock.
Earnings per share is a major profitability measure reported on the financial statements. Corporations often make earnings projections for both the quarter and on an annual basis. Since these projections are so closely followed, managers must monitor the potential impact of decisions on earning per share.
In its most basic form, earnings per share (EPS) is calculated by dividing net income remaining after preferred dividends divided by the number of common shares of stock outstanding. EPS measures the income earned by each share of common stock.
Earning per Share =

51. LEARNING OBJECTIVE 9
Financial Analysis: Describe and illustrate the use of the ratio of liabilities to total assets and the price-earnings ratio in assessing a company’s financial condition and prospects for future performance

52. Ratio of Liabilities to Total Assets
Useful in assessing a company’s financial condition and risk
Indicates the percent of a company’s total assets that are financed with debt
A high ratio indicates the company is financing its operations with a high percent of debt
Also, a high ratio indicates that the company may not be able to easily borrow additional funds
The ratio of liabilities to total assets is useful in assessing a company’s financial condition and risk to its creditors. The ratio of liabilities to total assets, also called as the debt ratio, indicates the percent of a company’s total assets that are financed with debt. A high ratio of liabilities to total assets indicates the company is financing its operations with a high percent of debt. This, in turn, increases the risk that if operating performance declines the company may not be able to pay its liabilities. In addition, a high ratio indicates that the company may not be able to easily borrow additional funds, which could prevent such opportunities as expanding into new product lines. The ratio of liabilities to total assets is computed as total liabilities divided by total assets.
Total Liabilities
Total Assets =
Ratio of Liabilities to Total Assets

53. Ratio of Liabilities to Total Assets
The following data (in millions) were taken from two of Lowe’s recent financial statements
Year 1 ($15,587 ÷ $33,699)
Year 2 ($17,026 ÷ $33,559)
Ratio of Liabilities to Total Assets
46.3
50.7%
Let us now look at an illustration. Data taken from two of its recent financial statements of Lowe’s have been provided. All amounts are in millions.
By dividing total liabilities by total assets, the ratio of liabilities to total assets is calculated as 46.3 percent in Year 1 and 50.7 percent in Year 2.
Note the ratio has increased from 46.3% to 50.7% during Year 2. This indicates Lowe’s finances slightly more than half of its operations through debt.

54. Ratio of Liabilities to Stockholders’ Equity
Total Liabilities
Ratio of Liabilities to Stockholders’ Equity =
Total Stockholders’ Equity
The relationship between liabilities and equity financing for a company can also be expressed as the ratio of liabilities to stockholders’ equity. It is computed as total liabilities divided by total stockholders’ equity.

55. Ratio of Liabilities to Stockholders’ Equity
The following data (in millions) were taken from two of Lowe’s recent financial statements
Year 1 ($15,587 ÷ $18,112)
Year 2 ($17,026 ÷ $16,533)
Ratio of Liabilities to Stockholders’ Equity
0.86
1.03
For Lowe’s, by dividing total liabilities by total stockholders’ liability, the ratio of liabilities to stockholders’ equity is 1.03 in Year 2and 0.86 in Year 1.
This implies that, the company financed its operations almost equally with debt and equity financing in Year 2 and with more equity than debt financing in Year 1.

56. Price-Earnings Ratio Market Price per Share of Common Stock
Indicates the market’s assessment of the future earnings potential of a company
Market Price per Share of Common Stock
Price-Earnings Ratio =
Earnings per Share of Common Stock
The price-earnings ratio indicates the market’s assessment of the future earnings potential of a company. It is computed as market price per share of common stock by earnings per share of common stock.

57. Price-Earnings Ratio
Year 2
Year 1
$1.43
$38.44
$1.42
$26.35
Market Price per Share of Common Stock
Earnings per Share of Common Stock
The higher a company’s price-earnings ratio, the more favorable the market’s assessment of the future earnings potential and growth of the company
Year 1 ($26.35 ÷ $1.42)
Year 2 ($38.44 ÷ $1.43)
Price-Earnings Ratio
18.6
26.9
For Lowe’s, by dividing market price per share of common stock by earnings per share of common stock, the price-earnings ratio is 26.9 in Year 2. This means that investors are willing to pay 26.9 times current earnings per share. Lowe’s price-earnings ratio was 18.6 in Year 1. Thus, the market’s assessment of Lowe’s future earnings potential has increased since Year 1.
The higher a company’s price-earnings ratio, the more favorable the market’s assessment of the future earnings potential and growth of the company.