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Chapter 23 Analysis and Interpretation of Financial Statements The Need for Financial Statement Analysis Owners, managers, and others use the information on a firm’s financial statements to make judgments and decisions.

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Chapter 23 l.jpg

Chapter 23

Analysis and Interpretation of Financial Statements


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The Need for Financial Statement Analysis

  • Owners, managers, and others use the information on a firm’s financial statements to make judgments and decisions.

  • However, the raw figures on the financial statements do not provide a complete picture.

  • To gain a good understanding of the information on the financial statements, it is necessary to make certain comparisons and analyses.

Chapter 23


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Liquidity and Profitability

  • For the users of financial statements, two major areas of interest are:

    • Liquidity of a business

    • Profitability of a business

Chapter 23


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Liquidity

  • Definition: Ability of a business to pay its debts when they become due.

Chapter 23


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Profitability

  • Definition: Ability of a business to earn a reasonable return on the investment of the owners.

Chapter 23


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Comparative Financial Statements

  • Present a side-by-side comparison of a firm’s statements for two or more accounting periods.

  • Used to observe trends.

  • Help to answer the following types of questions: Is net income increasing or decreasing? Is the firm’s cash position improving or getting worse?

Chapter 23


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Approaches to Comparing Financial Statements

  • Two basic approaches are used to compare financial statements.

    • Horizontal Analysis

    • Vertical Analysis

Chapter 23


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Horizontal Analysis

  • Definition: The comparison of each item in a company’s financial statements in the current period with the same item from a previous accounting period or periods.

  • The changes found in horizontal analysis can be expressed as dollar changes or percent changes.

Chapter 23


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Horizontal AnalysisComparative Income Statement

  • In 20X2, the Clay Corporation had sales of $345,000. In 20X1, the amount of sales was $300,000.

  • Thus, sales increased by $45,000 from 20X1 to 20X2. This is the dollar change.

Chapter 23


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Horizontal AnalysisComparative Income Statement

  • To find the percent change, it is necessary to divide the dollar change by the dollar amount for the earlier year.

  • $45,000  $300,000 = 15.0% increase

Chapter 23


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Horizontal AnalysisComparative Income Statement

  • In 20X2, the Clay Corporation had interest expense of $3,500. In 20X1, the amount of interest expense was $4,100.

  • Thus, interest expense decreased by $600. This is the dollar change.

Chapter 23


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Horizontal AnalysisComparative Income Statement

  • To find the percent change, it is necessary to divide the dollar change by the dollar amount for the earlier year.

  • $600  $4,100 = 14.6% decrease

Chapter 23


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Interpreting Horizontal Analysis

  • The horizontal income statement makes it possible to spot strengths and weaknesses in a firm’s operating results.

Chapter 23


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Interpreting Horizontal Analysis

  • Example:

  • If sales increase by 15% but total selling expenses increase by 28%, management should be concerned.

  • The rate of increase for total selling expenses is almost twice the rate of increase for sales.

Chapter 23


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Horizontal AnalysisComparative Balance Sheet

  • In 20X2, the Clay Corporation had cash totaling $34,000. In 20X1, the amount of cash was $25,000.

  • Thus, cash increased by $9,000 from 20X1 to 20X2. This is the dollar change.

Chapter 23


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Horizontal AnalysisComparative Balance Sheet

  • To find the percent change, it is necessary to divide the dollar change by the dollar amount for the earlier year.

  • $9,000  $25,000 = 36.0%

Chapter 23


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Vertical Analysis

  • Definition: The expression of each item on a financial statement as a percent of a base figure in order to see the relative importance of each item.

Chapter 23


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Vertical Analysis

  • In 20X2, the income statement of the Clay Corporation shows net sales of $332,000.

  • The base figure for the income statement is net sales (sales minus sales returns and allowances and sales discounts).

Chapter 23


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Vertical AnalysisIncome Statement

  • The income statement of the Clay Corporation for 20X2 shows a gross profit of $150,000.

  • The dollar amount of each item on the income statement is divided by the dollar amount of net sales (the base figure).

  • $150,000  $332,000 = 45.2%

Chapter 23


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Interpreting Vertical Analysis

  • The vertical income statement makes it possible to compare items from year to year in terms of the base figure.

  • Example:

  • In 20X2, the gross profit of the Clay Corporation was 45.2% of net sales. In 20X1, it was 46.1%.

Chapter 23


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Interpreting Vertical Analysis

  • Gross profit has decreased slightly.

  • Management should look at the gross profit percent for prior years to see whether a negative trend is developing.

Chapter 23


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Vertical AnalysisBalance Sheet

  • The base figure for vertical analysis of the balance sheet is total assets.

  • In 20X2, the Clay Corporation had total assets of $270,000. The amount of cash was $34,000.

Chapter 23


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Vertical AnalysisBalance Sheet

  • The dollar amount of each item on the balance sheet is divided by the dollar amount of total assets (the base figure).

  • $34,000  $270,000 = 12.6%

Chapter 23


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Trend Percentages

  • Used to compare financial data for a period of several years.

  • The base year is usually the earliest year.

  • Each item in the base year is assigned a value of 100%.

  • The dollar amount of an item for any year is expressed as a percent of the same item for the base year.

Chapter 23


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Trend Percentages

  • The Cox Corporation had the following net sales from 20X1 to 20X5.

  • 20X1 $350,000 20X3 $330,000 20X5 $410,000

  • 20X2 $360,000 20X4 $380,000

Chapter 23


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Trend Percentages

  • Using 20X1 as the base year, we calculate the percentages for 20X2 and 20X3 as shown below.

  • $360,000  $350,000 = 103% for 20X2

  • $330,000  $350,000 = 94% for 20X3

Chapter 23


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Trend PercentagesExample

  • At the Cox Corporation, the trend percentages for net sales from 20X1 to 20X5 are as follows.

  • 20X1 20X2 20X3 20X4 20X5

  • 100% 103% 94% 109% 117%

Chapter 23


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Trend PercentagesExample

  • The figures show a positive trend except for 20X3.

  • However, the gain between 20X1 and 20X5 has been very small—only 17%.

Chapter 23


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Short-term Liquidity Measures

  • There are certain measures used to evaluate short-term liquidity—the ability to pay debts that will mature within one year.

  • These measures are often used by creditors and potential creditors such as banks and suppliers of goods.

Chapter 23


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Working Capital

  • Definition: The difference between current assets and current liabilities.

  • Working capital provides the funds needed for the day-to-day operations of a business.

Chapter 23


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Working Capital

  • In 20X1, the Drake Corporation had current assets of $135,000 and current liabilities of $40,000. Its working capital was $95,000.

  • $135,000  $40,000 = $95,000

Chapter 23


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Current Ratio

  • A ratio is a fractional relationship of one number to another.

  • The current ratio is the ratio of current assets to current liabilities.

Chapter 23


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Current Ratio

  • At the end of 20X1, the Drake Corporation had a current ratio of 3.4 to 1. A current ratio of 2 to 1 is usually considered safe.

  • Current Assets  Current Liabilities = Current Ratio

  • $135,000  $40,000 = 3.4 to 1

Chapter 23


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Acid-test Ratio

  • Certain current assets can be converted to cash more quickly than others.

  • Cash, accounts receivable, short-term notes receivable, and marketable securities are called quick assets.

  • They provide cash more quickly than merchandise inventory and supplies.

Chapter 23


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Acid-test Ratio

  • The acid-test or quick ratio is the ratio of quick assets to current liabilities.

  • At the end of 20X1, the Drake Corporation had quick assets of $84,000 (cash of $21,000 and net receivables of $63,000).

Chapter 23


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Acid-test Ratio

  • Drake’s acid-test ratio is 2.1 to 1. An acid-test ratio of 1 to 1 is usually considered safe.

  • Quick Assets  Current Liabilities = Acid-test Ratio

  • $84,000  $40,000 = 2.1 to 1

Chapter 23


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Accounts Receivable Turnover

  • Shows how quickly a firm is collecting its accounts receivable.

  • Specifically, this measure indicates how many times per year the average amount of accounts receivable is collected.

  • Found by dividing the net credit sales by the average net accounts receivable.

Chapter 23


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Accounts Receivable Turnover

  • In 20X1, the Drake Corporation had net credit sales of $250,000 (credit sales minus sales returns and allowances and sales discounts).

  • The average of the net accounts receivable for 20X1 is calculated as follows. (Net accounts receivable is accounts receivable minus estimated uncollectible accounts.)

Chapter 23


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Accounts Receivable Turnover

  • Net accounts receivable at beginning of year $35,000

  • Net accounts receivable at end of year 63,000

  • Total $98,000

  • Average of net accounts receivable: $98,000  2 = $49,000

Chapter 23


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Accounts Receivable Turnover

  • In 20X1, the Drake Corporation had an accounts receivable turnover of 5.1 times.

  • Net Credit Sales  Average Net Accts. Rec. = Accts. Rec. Turnover

  • $250,000  $49,000 = 5.1 times

  • Drake converted its accounts receivable to cash 5.1 times during 20X1.

Chapter 23


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Average Collection Period for Accounts Receivable

  • Definition: A rough measure of the length of time it takes the firm to collect its outstanding accounts receivable.

  • This measure is calculated by dividing 365 days by the accounts receivable turnover.

Chapter 23


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Average Collection Period for Accounts Receivable

  • At the Drake Corporation, the average collection period for 20X1 was 71.6 days.

  • 365 days  Accts. Rec. Turnover = Average Collection Period

  • 365 days  5.1 times = 71.6 days

Chapter 23


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Average Collection Period for Accounts Receivable

  • If Drake provides credit terms of n/30 to its customers, an average collection period of 71.6 days is very poor.

Chapter 23


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Merchandise Inventory Turnover

  • Definition: A measure of how many times a firm sells its average inventory during a year.

  • This measure is calculated by dividing the cost of goods sold by the average inventory.

Chapter 23


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Merchandise Inventory Turnover

  • In 20X1, the Drake Corporation had cost of goods sold of $168,000.

  • The average inventory is calculated as follows.

  • Merchandise inventory at beginning of year $40,000

  • Merchandise inventory at end of year 44,000

  • Total $84,000

  • Average inventory: $84,000  2 = $42,000

Chapter 23


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Merchandise Inventory Turnover

  • In 20X1, the Drake Corporation turned over (sold and replaced) its merchandise inventory 4.0 times.

  • Cost of Goods Sold  Average Inventory = Inventory

  • Turnover

  • $168,000  $42,000 = 4.0 times

Chapter 23


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Merchandise Inventory Turnover

  • To judge the meaning of this figure, it is necessary to know the firm’s inventory turnover in previous years and the inventory turnover of similar types of businesses.

Chapter 23


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Number of Days in Merchandise Inventory

  • This measure indicates the number of days it takes a firm to sell its merchandise inventory.

  • In 20X1, the Drake Corporation had 91.3 days in merchandise inventory.

  • 365 days  Inventory Turnover = Number of Days in Inventory

  • 365 days  4.0 times = 91.3 days

Chapter 23


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Long-term Liquidity Measures

  • There are certain measures used to evaluate a firm’s ability to pay its long-term liabilities.

  • Long-term liquidity measures are of particular interest to holders of mortgages and bonds.

Chapter 23


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Ratio of Plant Assets to Long-term Liabilities

  • Plant assets are sometimes pledged as security for long-term notes payable.

  • The ratio of plant assets to long-term liabilities indicates the margin of safety for the holders of notes backed by plant assets.

  • This ratio is calculated by dividing a firm’s plant assets by its long-term liabilities.

Chapter 23


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Ratio of Plant Assets to Long-term Liabilities

  • At the end of 20X1, the Drake Corporation had plant assets of $110,000 and long-term liabilities of $30,000.

  • Pl. Assets  Long-term Liab. = Ratio of Pl. Assets to Long-term Liab.

  • $110,000  $30,000 = 3.7 to 1

Chapter 23


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Ratio of Plant Assets to Long-term Liabilities

  • A ratio of 2 to 1 for this measure is considered safe. Thus, Drake’s ratio of 3.7 to 1 is good.

Chapter 23


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Ratio of Owner’s Equity to Total Liabilities

  • Creditors and potential creditors will want to know how a firm’s liabilities and owner’s equity relate to each other.

  • This measure is known as the ratio of owner’s equity to total liabilities or the debt-equity ratio.

  • It is found by dividing owner’s equity by total liabilities.

Chapter 23


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Ratio of Owner’s Equity to Total Liabilities

  • At the end of 20X1, the Drake Corporation had owner’s equity of $175,000 and total liabilities of $70,000.

  • Owner’s Equity  Total Liab. = Ratio of OE to Total Liab.

  • $175,000  $70,000 = 2.5 to 1

Chapter 23


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Ratio of Owner’s Equity to Total Liabilities

  • Drake has $2.50 of owner’s equity for each $1 of debt.

  • The higher this ratio is, the better the firm’s credit position will be.

Chapter 23


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Times Interest Earned

  • To evaluate a firm’s ability to meet its interest payments, analysts use a ratio called times interest earned.

  • This ratio shows the number of times a firm has earned its interest expense.

  • This ratio is calculated by adding net income, interest expense, and income taxes and dividing the result by interest expense.

Chapter 23


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Times Interest Earned

  • In 20X1, the Drake Corporation had net income of $56,000, interest expense of $11,000, and income taxes of $9,000. The total is $76,000.

  • To find the times interest earned ratio, it is necessary to divide the total of the net income, interest expense, and income taxes by the interest expense.

  • $76,000  $11,000 = 6.91 to 1

Chapter 23


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Times Interest Earned

  • Most U.S. firms are in the range of 2.0 to 3.0 for this ratio. Thus, Drake has good coverage of its interest.

Chapter 23


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Profitability Analysis

  • Profitability measures are mostly of interest to owners, managers, potential investors, and financial analysts.

Chapter 23


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Return on Assets

  • Indicates the profitability of a firm’s assets.

  • This measure is calculated by adding net income and interest expense and dividing the result by the average of the total assets for the year.

  • In 20X1, the Drake Corporation had a net income of $56,000 and interest expense of $11,000. The total is $67,000.

Chapter 23


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Return on Assets

  • The next step in finding the return on assets is to calculate the average total assets for the year.

  • Beginning total assets for year $213,000

  • Ending total assets for year 245,000

  • Total $458,000

  • Average total assets: $458,000  2 = $229,000

Chapter 23


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Return on Assets

  • The final step in finding the return on assets is to divide the sum of the net income and the interest expense by the average total assets.

  • $67,000  $229,000 = 29.3%

Chapter 23


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Asset Turnover

  • Definition: A measure of how effectively the assets of a firm are being used to produce sales.

  • This measure is calculated by dividing the net sales for the year by the total assets (excluding investments) at the end of the year.

Chapter 23


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Asset Turnover

  • In 20X1, the Drake Corporation had net sales of $370,000. At the end of the year, its assets totaled $245,000. (There are no investments.)

  • Net Sales  Total Assets = Asset Turnover

  • $370,000  $245,000 = 1.5 times

Chapter 23


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Asset Turnover

  • Usually, the higher the asset turnover rate, the better the firm is using its assets to produce sales.

Chapter 23


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Return on Stockholders’ Equity

  • Stockholders and potential stockholders want to know what return a business is earning on its stockholders’ equity.

  • This measure is calculated by dividing the net income for a year by the average stockholders’ equity.

Chapter 23


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Return on Stockholders’ Equity

  • In 20X1, the Drake Corporation had net income of $56,000.

  • The average stockholders’ equity is found as follows.

Chapter 23


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Return on Stockholders’ Equity

  • Stockholders’ equity at beginning of year $143,000

  • Stockholders’ equity at end of year 175,000

  • Total $318,000

  • Average stockholders’ equity:

  • $318,000  2 = $159,000

Chapter 23


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Return on Stockholders’ Equity

  • In 20X1, the Drake Corporation had a return of 35.2% on stockholders’ equity.

  • Net income  Average Stockholders’ Equity = Return on S.E.

  • $56,000  $159,000 = 35.2%

  • Investors are attracted to a firm that has a high rate of return on stockholders’ equity.

Chapter 23


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Earnings Per Share of Common Stock

  • Definition: Amount of a corporation’s net income available for each share of common stock.

  • To calculate this amount:

  • Step 1. Subtract the dividends owed on the preferred stock from the net income.

  • Step 2. Divide the remaining net income by the average number of shares of common stock outstanding during the year.

Chapter 23


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Earnings Per Share of Common Stock

  • In 20X1, the Drake Corporation had net income of $56,000. There is no preferred stock.

  • The firm had 12,500 shares of common stock outstanding throughout the year. The common stock is not actively traded.

Chapter 23


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Earnings Per Share of Common Stock

  • The amount of earnings per share of common stock at Drake in 20X1 is $4.48.

  • Net Income  Shares Outstanding = Earnings per Share

  • $56,000  12,500 shares = $4.48

Chapter 23


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Price/earnings Ratio

  • Definition: A measure of the relationship between the market price of common stock and the earnings per share.

    • This measure is widely used by financial analysts as an indication of the future earnings prospects of a corporation.

    • The P/E ratio is calculated by dividing the market price of each share of common stock by the earnings per share.

Chapter 23


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Price/earnings Ratio

  • Assume the common stock of the Drake Corporation has a market price of $32 on December 31, 20X1.

  • The amount of earnings per share of common stock for 20X1 is $4.48.

Chapter 23


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Price/earnings Ratio

  • The price/earnings ratio is 7.1. This means the common stock is selling for 7.1 times the amount of earnings per share.

  • Price per Share  Earnings per Share = P/E Ratio

  • $32.00  $4.48 = 7.1

Chapter 23


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Dividend Yield

  • Shows the rate an investor has earned on the stock.

  • This measure is calculated by dividing the dividend per share by the market price per share.

Chapter 23


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Dividend Yield

  • During 20X1, the Drake Corporation paid a dividend of $1.50 per share of common stock.

  • The market price of each share of common stock is $32 on December 31, 20X1.

  • The dividend yield is 4.7%.

  • Dividend per Share  Price per Share = Dividend Yield

  • $1.50  $32.00 = 4.7%

Chapter 23


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