Page 45 - Accounting Principles (A Business Perspective)

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Capital stock (L)$30,000
Retained earnings (M)2,100
Total stockholders'
equity $32,100
Total liabilities and
Total assets $38,700 $38,700
stockholders' equity
C. Income Statement
METRO COURIER, INC.
Income Statement
For the Month Ended 2010 July 31
Revenues:
Service revenue (A+B)$ 5,700
Expenses:
Salaries expense (C)$ 2,600
Rent expense (D)400
Gas & oil expense (F)600
Total expenses 3,600
Net income $ 2,100
Exhibit 4:

Analyzing and using the financial results—the equity ratio
The two basic sources of equity in a company are stockholders and creditors; their combined interests are called
total equities. To find the equity ratio, divide stockholders’ equity by total equities or total assets, since total
equities equals total assets. In formula format:
Stockholders 'equity
Equity ratio=
Totalequities
The higher the proportion of equities (or assets) supplied by the owners, the more solvent the company.
However, a high portion of debt may indicate higher profitability because quite often the interest rate on debt is
lower than the rate of earnings realized from using the proceeds of the debt.
An example illustrates this concept: Suppose that a company with USD 100,000 in assets could have raised the

funds to acquire those assets in these two ways:
Case 1
Assets................$100,000 Liabilities.........................$20,000
Stockholders' equity............$80,000
Case 2
Assets................$100,000 Liabilities.........................$80,000
Stockholders' equity............$20,000
When a company suffers operating losses, its assets decrease. In Case 1, the assets would have to shrink by 80
per cent before the liabilities would equal the assets. In Case 2, the assets would have to shrink only 20 per cent

before the liabilities would equal the assets. When the liabilities exceed the assets, the company is said to be
insolvent. Therefore, creditors are safer in Case 1 and will more readily lend money to the company.
However, if funds borrowed at 10 per cent are used to produce earnings at a 20 per cent rate, Case 2 is
preferable in terms of profitability. Therefore, owners are better off in Case 2 if the borrowed funds can earn more
than they cost.
Next, we examine the recent equity ratios of some actual companies:

Stockholders'
Name of Company Total Equities ($ millions) Equity Ratio
Equity ($ millions)
Johnson & Johnson $ 23,734 $ 37,053 64.1%
3M Corporation 6,166 15,205 40.6
General Electric Company 53,597 460,097 11.6

Accounting Principles: A Business Perspective 46 A Global Text