5399289c9235cc589d5043b64db3bb92

CHAPTER 8PROFITABILITY
MULTIPLE CHOICE 1. Which of the following is not a base against which profits are measured? a owners' equity . b owners' and creditors' funds provided . c intangibles . d revenues . e productive assets .
ANS ! ". Net profit margin measures return on a sales . b owners' equity . c productive assets . d total assets . e inventory .
ANS A #. $otal asset turnover measures the ability of a firm to a generate profits on sales . b generate sales through the use of assets . c buy new assets . d move inventory . e cover long%term debt .
ANS & '. $he (u)ont method return on assets uses two component ratios. What are they? a inventory turnover gross profit margin
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+ ",11 !engage -earning. All .ights .eserved. $his edition is intended for use outside of the /.S. only0 with content that may be different from the /.S. 1dition. 2ay not be scanned0 copied0 duplicated0 or posted to a publicly accessible website0 in whole or in part.
. b . c . d . e .
times interest earned debt ratio return on equity dividend payout net profit margin total asset turnover return on investment total investment turnover
ANS ( 3. .eturn on assets cannot fall under which of the following circumstances? Net )rofit 2argin a . b . c . d . e . decline rise rise decline $otal Asset $urnover rise decline rise decline
$he ratio could fall under all of the answers.
ANS !
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4.
A reason that equity earnings create a problem in analy5ing profitability is that equity earnings are a usually greater than the related cash flow . b less than dividends declared . c more than dividends declared . d e6traordinary . e nonrecurring .
ANS A 7. 8n the analysis of profitability0 if equity earnings are substantial0 it is advisable to a consider them as e6traordinary . b consider them as nonrecurring . c investigate the earning power of the parent outside of the related investing activities . d recompute the debt ratio and times interest earned to remove the impact of equity . earnings e use the (u)ont method to lessen the impact of equity earnings .
ANS ! *. Which of the following is not a type of operating asset? a inventory . b cash . c land . d -ong%term investments . e equipment .
ANS ( 9. :perating income is a net sales less cost of goods sold . b earnings before interest and ta6 . c earnings before ta6 and nonrecurring items
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. d gross profit less operating e6penses . e net income plus interest .
ANS ( 1,. Which of the following circumstances will cause sales to fi6ed assets to be abnormally high? a A recent purchase of land. . b A labor%intensive industry. . c A highly mechani5ed facility. . d ;igh direct labor costs from a new union contract. . e $he use of units%of%production depreciation. .
ANS & 11. Which of the following ratios will usually have the lowest percent? a return on investment . b return on total equity . c return on common equity . d return on total assets . e there is not enough information to tell .
ANS (
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1". therefore earn the greatest return? a bondholders . b suppliers . c general creditors such as ban<s . d preferred shareholders . e common shareholders .
Which suppliers of funds bear the greatest ris< and should
ANS 1 1#. =ross profit margin is an important ratio of merchandising firms because a their investments in real property are high . b cost of goods sold is usually the largest e6pense . c selling e6penses0 li<e advertising0 are usually quite high . d it measures their ability to collect receivables . e it measures their ability to use total assets .
ANS & 1'. Which of the following is not a reporting requirement on interim reports? a seasonal information . b ma>or changes in income ta6 provision . c full0 although condensed0 balance sheet . d earnings per share . e significant changes in financial position .
ANS ! 13. 8ncome ta6 e6pense in interim reporting should a be based on the quarterly income only . b contain a >udgment estimation of the annual effective ta6 rate . c be based on the income year%to%date
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. d e6clude e6traordinary items in earlier quarters of the year . e disregard year%end ad>ustments .
ANS & 14. Noncontrolling interest share of earnings is a the total earnings of unconsolidated subsidiaries . b earnings based on the percent of holdings by parent company of unconsolidated . subsidiaries c the total earnings of consolidated subsidiaries . d earnings based on the percent of holdings by outside owners of consolidated subsidiaries . e none of the answers are correct .
ANS ( 17. Net earnings before deducting minority share of earnings is utili5ed in the following ratios0 since noncontrolling interests are included in the base. Which ratio is an e6ception to this statement? a net profit margin . b return on assets . c return on equity . d return on investment . e none of the answers are correct .
ANS ! 1*. Which of the following would most li<ely cause a rise in net profit margin? a increased sales . b decreased preferred dividends . c increased cost of sales . d decreased operating e6penses . e decreased earnings per share .
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ANS ( 19. Which of the following could cause return on assets to decline when net profit margin is increasing? a sale of investments at year%end . b increased turnover of operating assets . c decline in boo< value . d a stoc< split . e purchase of a new building at year%end .
ANS 1 ",. Which of the following e6presses (u)ont analysis? a net profit margin ? total asset turnover times return on assets . b total asset turnover ? operating asset turnover times financial leverage . c return on assets ? net profit margin times total asset turnover . d return on investment ? return on equity @1 % ta6 rateA . e dividend yield ? dividend payout times earnings per share .
ANS ! "1. :perating assets equals a cash0 accounts receivable0 and equipment . b current assets plus tangible assets . c total assets minus intangible assets . d only long%term assets . e only current assets .
ANS & "". .eturn on investment measures a return to all suppliers of funds .
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return to all long%term creditors b . c return to all long%term suppliers of funds . d return to stoc<holders . e return to all short%term suppliers of funds .
ANS ! "#. 8n the formula for return on investment0 interest e6pense is multiplied by @1 % ta6 rateA. Why is this ad>ustment made? a 8nterest is not ta6 deductible. . b (ebt is e6cluded from the denominator. . c Net income in the formula is after ta6. . d (ividends are not deductible for ta6 purposes. . e None of the answers are correct. .
ANS !
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TRUE/FALSE 1. )rofitability is the ability of the firm to generate earnings. ANS $ ". 8n profitability analysis0 absolute numbers are more meaningful than relative numbers because the analyst needs to <now if one firm earned more dollars than the other. ANS B #. Net profit margin is net profit before noncontrolling share of earnings and nonrecurring items to total assets. ANS B '. $he use of debt with high interest charges may cause the net profit margin to be low. ANS $ 3. ;igh fi6ed costs in a period of low activity can cause a low net profit margin. ANS $ 4. (u)ont analysis brea<s return on assets into net profit margin and borrowing capacity. ANS B 7. 1ither a drop in net profit margin or a drop in total asset turnover0 or both0 can cause return on assets to fall. ANS $ *. 1quity earnings are usually lower than the cash generated from the investment as dividends. ANS B 9. :perating assets e6clude investments0 land0 and intangibles from the asset base. ANS B 1,. $he operating ratios may give significantly different results from net earnings ratios if a firm has large amounts of nonoperating assets generating income. ANS $ 11. (u)ont analysis can be done with net income or operating income figures as long as the related asset base is consistent. ANS $
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1". relatively new. ANS B
Sales to fi6ed assets will have the least meaning if assets are
1#. .eturn on investment measures the return on long%term suppliers of funds. ANS $ 1'. .eturn on investment will typically be lower than return on equity. ANS $ 13. .edeemable preferred stoc< is best considered as equity for ratio analysis. ANS B 14. !hanges in the cost of goods sold can have a substantial impact on gross profit margin. ANS $ 17. 8n order to compute gross profit margin0 the income statement must be in single%step format. ANS B 1*. .atios of profits to sales and to identifiable assets can help to analy5e profitability by segment. ANS $ 19. Segment data contain information about geographic mar<ets0 including foreign countries. ANS $ ",. An interim period is a fiscal period less than one year. ANS $ "1. 8nterim reporting recogni5es that timeliness of data offsets lac< of detail and requires only minimum data. ANS $ "". 8nterim reports are usually audited. ANS B "#. 8nterim reports are useful in analy5ing the impact of seasonality. ANS $
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"'. ANS $
8nterim reports cover fiscal periods of less than one year.
"3. $he S1! requires interim financial data on Borm 1,%C. ANS $ "4. When used properly0 pro forma financial information ma<es a positive contribution to financial reporting. ANS $ PROBLEMS 1. .equired 8ndicate the effect of the transactions listed below on each of the following wor<ing capital0 current ratio0 debt ratio0 net income0 and stoc<holders' equity. /se D to indicate an increase0 % to indicate a decrease0 and , to indicate no effect. Assume an initial current ratio of more than 1 to 1. Wor<in g !apital !urre nt .atio (ebt .atio Net 8nco me Stoc<holdersE 1quity
$ransaction a . b . c . d . e . f. g . h . i. >. A cash dividend is declared and paid. !ash is obtained through long%term ban< loans. @(o not consider interest.A 1quipment is purchased with short% term notes. @(o not consider interest.A 2erchandise is purchased on credit. A fi6ed asset is sold for more than boo< value. A stoc< split ta<es effect. !urrent operating e6penses not previously recogni5ed are paid. A firm ma<es a long%term cash investment in the stoc< of a consolidated subsidiary. A firm recogni5es depreciation e6pense. A firm refinances short%term notes with long%term notes. @8gnore interest.A
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ANS Wor<in g !apital % D % , D , % % , D !urre nt .atio % D % % D , % % , D (ebt .atio D D D D % , D , D , Net 8nco me , , , , D , % , % , Stoc<holder's 1quity % , , , D , % , % ,
$ransaction a . b . c . d . e . f. g . h . i. >. A cash dividend is declared and paid. !ash is obtained through long%term ban< loans. @(o not consider interest.A 1quipment is purchased with short% term notes. @(o not consider interest.A 2erchandise is purchased on credit. A fi6ed asset is sold for more than boo< value. A stoc< split ta<es effect. !urrent operating e6penses not previously recogni5ed are paid. A firm ma<es a long%term cash investment in the stoc< of a consolidated subsidiary. A firm recogni5es depreciation e6pense. A firm refinances short%term notes with long%term notes. @8gnore interest.A
". (u&ois0 8nc.0 e6perienced the following trend in operating profit ratios for the five years ended in ",1,. :perating 8ncome 2argin ",1, ",,9 ",,* ",,7 ",,4 9.7F 9.#F 9.1F *.*F *.4F .eturn on :perating Assets 1"."F 11.3F 11."F 1,.4F 1,.1F
.equired /sing the (u)ont analysis0 determine whether the trend in turnover increased the return on operating assets or lowered it.
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ANS .eturn on :perating Assets ",1 , ",, 9 ",, * ",, 7 ",, 4

12.2% 11.5% 11.2% 10.6% 10.1%
?
= = = = =
:perating 8ncome 2argin

9.7% 9.3% 9.1% 8.8% 8.6%
:perating Asset $urnover

1.26 1.24 1.23 1.20 1.17
:perating asset turnover has risen. $his helped increase the rate of growth of return on operating assets.
#. Bluctuation0 8nc.0 recorded the following profit figures in ",,*G",1,. ",1, Net sales !osts and e6penses !ost of products sold Selling =eneral .esearch and development :perating income :ther income @e6penseA 1arnings before ta6 8ncome ta6 Net income
$30,500 $12,600 7,875 2,950 4,100 $27,525 $ 2,975 525 $ 3,500 1,480 $ 2,020
",,9
$25,600 $10,300 5,025 2,325 3,190 $20,840 $ 4,760 (300) $ 4,460 1,990 $ 2,470
",,*
$22,900 $ 8,350 4,580 2,150 2,840 $17,920 $ 4,980 (400) $ 4,580 2,100 $ 2,480
.equired a !ompute the net profit margin for ",,*G",1,. . b !ompute the gross profit margin for ",,*G",1,. . c (escribe the trend in profitability and pinpoint its causes. .
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ANS a . Net )rofit 2argin ? Net 8ncome &efore 2inority Share of 1arnings and Nonrecurring 8tems Net Sales ",1, ",,9 ",,*
$2,02 0 $30,50 0 6.62%
$2,4 70 $25,6 00 9.65%
$2,48 0 $22,90 0 10.83%
b .
=ross )rofit 2argin ?
=ross )rofit Sales
$30,500 (12,600 ) $17,900 $30,500 58.69%
$25,600 (10,300) $15,300 $25,600 59.77%
$22,900 (8,350) $14,550 $22,900 63.54%
c .
&oth net profit margin and gross profit margin have declined in the three years. A ma>or factor has been the rising cost of goods which causes gross profit to fall. Selling e6penses0 general e6penses0 and research and development e6penses have all increased in relation to net sales. ",1, "3.*"F 9.47 1#.'' ",,9 19.4#F 9.,* 1".'4 ",,* ",.,,F 9.#9 1".',
Selling =eneral .H(
Selling e6penses0 in particular0 impaired ",,4 profit.
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'. $he following are e6tracted from the financial statements of Brem0 8nc.0 for ",1,0 ",,90 and ",,*.
",1, Net sales !ost of sales Selling and administrative e6penses :ther income 8nterest :ther 1arnings before ta6 and e6traordinary credit )rovision for income ta6 1arnings before e6traordinary credit 16traordinary credit
$ 5,600 $233,000 (124,000) (95,000)
",,9
$204,000 (110,000) (81,500)
",,*
(3,700) 100 $ 10,400 (4,800) 5,600
(3,050) 1,175 $ 10,625 (4,740) 5,885 1,510 $ 7,395 $173,000 17,400 116,800 4,000 280 $161,000 15,200 112,800 4,000 280
$otal assets -ong%term debt !ommon equity )referred stoc< )referred dividends .equired a .
$202,000 24,600 123,000 4,000 280
!ompute the following ratios for ",1, and ",,9. 1 . " . # . ' . 3 . 4 . 7 . Net profit margin $otal asset turnover .eturn on assets .eturn on investment .eturn on total equity .eturn on common equity =ross profit margin
b .
(iscuss the trend in profitability and identify specific causes for the trend.
ANS a . 1 ",1, Net )rofit 2argin ? ",,9
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. Net 8ncome &efore Noncontrolling 8nterest and Nonrecurring 8tems Net Sales
I304,, I"##0,,, ? ".',F
I30**3 I",'0,,, ".**F
" .
$otal Asset $urnover ? Net Sales Average $otal Assets I"##0,,, @I","0,,, D I17#0,,,AJ" 1."' times I",'0,,, @I17#0,,, D I1410,,,AJ" 1."" times
# .eturn :n Assets ? . Net 8ncome &efore Noncontrolling 8nterest and Nonrecurring 8tems Average $otal Assets
I304,, I1*703,, ".99F
I30**3 I1470,,, #.3"F
' .
.eturn :n 8nvestment ? Net 8ncome &efore Noncontrolling 8nterest and Nonrecurring 8tems D @8nterest 16penseA @1 % $a6 .ateA Average @-ong%$erm -iabilities D 1quityA
Net income before e6traordinary item 8nterest e6pense $a6 rate

2008 $4,800 $10,400 2007 $4,740 $10,625
$5,600 3,700
$5,885 3,050
= 46.15%
= 44.61% 1,992 1,689
8nterest e6penseK @1 % tA
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Net income before e6traordinary item D interest e6pense @1 % tA @304,, D 1099"ALAM @30**3 D 104*9ALAM
7,592 7,574
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-ong%term liabilities and stoc<holders' equity &eginning of year -ong%term debt !ommon equity )referred stoc< 1nd of year -ong%term debt !ommon equity )referred stoc<
$ 17,400 116,800 4,000
$ 15,200 112,800 4,000
24,600 123,000 4,00 0
17,400 116,800 4,000
$otal Average L&M
$289,80 0 144,900
$270,200 135,100
.eturn on investment LAMJL&M
5.24%
5.61%
3. .eturn on 1quity ? Net income before nonrecurring 8tems % (ividends on .edeemable )referred Stoc< Average $otal 1quity
Net income before nonrecurring items %% (ividends on redeemable preferred stoc< LAM $otal equity &eginning of year !ommon equity )referred stoc< 1nd of year !ommon stoc< )referred stoc< $otal Average L&M
5,600
5,885
$116,800 4,000 123,000 4,000 $247,800 123,900
$112,800 4,000 116,800 4,000 $237,600 118,800
.eturn on total equity LAMJL&M
4.52%
4.95%
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4. .eturn on !ommon 1quity ? Net 8ncome &efore Nonrecurring 8tems % )referred (ividends Average !ommon 1quity
Net income before nonrecurring items -ess )referred dividends Numerator LAM $otal common equity &eginning of year 1nd of year $otal Average L&M .eturn on common equity LAMJL&M
5,600 280 5,320
5,885 280 5,605
116,800 123,000 $239,800 119,900 4.44%
112,800 116,800 $229,600 114,800 4.88%
7. a. =ross )rofit 2argin ? Net Sales L&M !ost of Sales =ross )rofit LAM LAMJL&M
$233,000 -124,000 $109,000 46.78% $204,000 -110,000 $ 94,000 46.08%
b .
Net profit margin0 return on total assets0 return on investment0 return on total equity0 and return on common equity have declined. $otal asset turnover and gross profit margin rose slightly. $he problem appears to be in selling and administrative e6penses0 other income0 and ta6es0 since gross profit margin rose. :f particular concern is the very low return to common shareholders. 8t is lower than return on total equity and investment0 which indicates that preferred owners and creditors0 who bear less ris<0 are getting a higher return.
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3. 2otorise0 8nc.0 for ",1, and ",,9.
$he following data are ta<en from the financial statements of ",1, Net sales 1quity income @dividends I430I4"A $otal $otal e6penses0 including ta6es Net income $otal assets 8nvestment @using equity methodA
$65,000 320 $65,320 63,800 $ 1,520 $32,200 3,800
",,9
$61,000 365 $61,365 59,700 $ 1,665 $30,600 2,800
.equired a !ompute the following ratios for both years0 using total net income and assets. /se ending . balance sheet figures. 1 net profit margin . " return on total assets @use year%end total assetsA . b .ecompute the ratios0 removing the effect of equity income on investments. @Bor return on . total assets0 use year%end total assets.A c (iscuss the change. Why is it advisable to remove equity earnings in this case? .
ANS a. 1. Net )rofit 2argin ? Net 8ncome Net Sales ". .eturn on $otal Assets ? Net 8ncome $otal Assets
$1,520 $32,200 4.72% $1,665 $30,600 5.44%
",1,
$1,520 $65,000 2.34%
",,9
$1,665 $61,000 2.73%
b. .emove equity earnings and investments 1. Net )rofit 2argin ? Net 8ncome less 1quity 8ncome Net Sales ". .eturn on $otal Assets ?
$1,520 - $320 $65,000 1.85% $1,665 - $365 $61,000 2.13%
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Net 8ncome less 1quity 8ncome $otal Assets less 8nvestments
$1,200 $32,200 $3,800 4.23%
$1,300 $30,600 $2,800 4.68%
c .
Net profit margin declined when equity income was removed. .eturn on total assets also declined when equity income and investments were removed. $he trend stays the same0 however. $he main reason for removing equity earnings is that they are not derived from the primary business and do not represent cash flow0 since dividends are much lower.
)$S
4. $he following is the summary quarterly financial data for !ommunico0 8nc. @unauditedA. !ommunico ends its year on 2arch #1. ",1, Sales =ross profit Net income 1arnings per share ",,9 Sales =ross profit Net income 1arnings per share Nune #,
$2,100,000 905,000 90,000 0.78
September #,
$2,350,000 930,000 220,000 0.88
(ecember #1
$2,350,000 1,090,000 290,000 1.10
2arch #1
$3,700,000 1,600,000 550,000 1.55
$1,280,000 440,000 88,000 0.44
$1,700,000 650,000 185,000 0.93
$1,700,000 880,000 240,000 1.20
$3,000,000 1,500,000 500,000 2.50
.equired a (iscuss the concept of seasonality raised by this data. . b (oes it appear that this firm uses a natural business year? .
ANS a $his firm clearly operates with a seasonal pattern. 8ts busiest time0 represented both by sales . and profits0 is NanuaryG2arch. 1ach quarter of the year builds up to this. b $his firm clearly uses a natural business year0 counting inventory after pea< sales when . inventory is at its lowest.
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7. @in thousandsA .evenues &roadcasting (ivision .ecords (ivision &oo< (ivision $otal )rofits &roadcasting (ivision .ecords (ivision &oo< (ivision $otal 8dentifiable Assets &roadcasting (ivision .ecords (ivision &oo< (ivision $otal !apital :utlays &roadcasting (ivision .ecords (ivision &oo< (ivision $otal
$he following is segment data for Audio%Oisual !orporation. ",1,

$1,500 1,050 450 $3,000
",,9
$1,100 780 380 $2,260 $
",,*
880 510 210 $1,600
270 72 41 383
226 95 28 349
175 68 18 261
600 560 300 $1,460
380 450 240 $1,070
280 300 160 740
40 28 12 80
25 20 10 55
20 11 5 36
.equired a !ompute profitJrevenues and profitJassets for the three divisions and in total for all three . years. b (iscuss your findings. . c 1valuate this firm's capital e6penditure policy0 given the results in parts @aA and @bA. .
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ANS ",1, a . )rofit .evenues &roadcasting

$ 270 $1,500 18.00% $ 226 $1,100 20.55% $ $ 95 780 12.18% $ $ 28 380 7.37% $ 349 $2,260 15.44% $ $ 226 380 59.47% $ $ 95 450 21.11% $ $ 28 240 11.67% $ 349 $1,070 32.62% $ $ $ $ $ $ $ $ $ $ $ $ $ $ 175 880 19.89% 68 510 13.33% 18 210 8.57% $ 261 $1,600 16.31% 175 280 62.50% 68 300 22.67% 18 160 11.25% 261 740 35.27%
",,9
",,*
.ecords
$ 72 $1,050 6.86%
&oo<
$ $
41 450 9.11%
$otal
$ 383 $3,000 12.77%
)rofit Assets
&roadcasting
$ $
270 600 45.00%
.ecords
$ $
72 560 12.86%
&oo<
$ $
41 300 13.67%
$otal
$ 383 $1,460 26.23%
b .
$he overall trend in profitJrevenue and profitJassets for this firm is downward0 with the biggest drop in ",1,. $he ma>or cause of this is the declining profitability in the .ecord (ivision. -ower profit margins in the &roadcasting (ivision also have an impact0 especially since this is the biggest division.
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c .
:ne way to answer this is to loo< at capital outlaysJidentifiable assets. ",1, &roadcasting
$40 $600 6.67%
",,9
$25 $380 6.58% $20 $450 4.44% $10 $240 4.17%
",,*
$20 $280 7.14% $11 $300 3.67% $5 $160 3.13%
.ecords
$28 $560 5.00%
&oo<
$12 $300 4.00%
$he high profit ratio would support e6pansion in &roadcasting where capital outlays as a percent of assets are highest. ;owever0 the drop in profitability in .ecords does not support a rising rate of e6penditures to assets. $he increasing e6penditure in the boo< segment can li<ely be >ustified by the improved profitability of this segment.
*. Briendly &oo<store has e6perienced rapid growth since its formation in ",,'. Bollowing is selected data from its annual report. ",1, Sales !ost of Sales Net )rofit $otal Assets Number of &oo<s Sold .equired a . b . )erform a hori5ontal0 common%si5e analysis of the data given0 using ",,4 as the base year. !omment on the results.
$1,500,00 0 1,008,000 60,000 1,489,000 97,500
",,9
$1,260,0 00 971,000 53,000 1,100,00 0 85,703
",,*
$970,00 0 598,000 46,000 897,000 73,192
",,7
$840,00 0 515,000 39,000 768,000 63,200
",,4
$600,00 0 360,000 30,000 545,000 45,187
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ANS a. ",1, Sales !ost of Sales Net )rofit $otal Assets Number of &oo<s Sold
250.0% 280.0% 200.0% 273.2% 215.8%
",,9
210.0% 269.7% 176.7% 201.8% 189.7%
",,*
161.7% 166.1% 153.3% 164.6% 162.0%
",,7
140.0% 143.1% 130.0% 140.9% 139.9%
",,4
100.0% 100.0% 100.0% 100.0% 100.0%
b .
Sales have grown rapidly but at a slower rate than costs of sales. $his has caused a lower rate of profit growth. Assets have grown faster than sales0 indicating that the firm is generating less sales per dollar of assets. 8t is also generating less profit on assets0 since profits grew much more slowly than assets. $he number of boo<s sold has grown less rapidly than total sales. $his indicates a rise in selling price per boo< sold.
9. !ondensed comparative financial statements for Woodstoc< 2anufacturing !ompany appear below. &alance Sheet April #, @in thousands of dollarsA ",1, Assets !urrent assets )lant and equipment @netA :ther assets $otal assets -iabilities and Stoc<holders' 1quity !urrent liabilities -ong%term liabilities !apital stoc< @I1, parA )aid%in capital in e6cess of par .etained earnings $otal liabilities and stoc<holders' equity
$ 1,700 8,110 1,004 $10,814
",,9
$1,120 7,830 695 $9,645
",,*
$1,544 5,404 772 $7,720
950 2,023 4,600 770 2,471 $10,814
880 1,591 4,600 770 1,804 $9,645
772 1,544 3,000 386 2,018 $7,720
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8ncome Statement Bor the Pear 1nded April #, @in thousands of dollarsA ",1, Net sales !ost of sales =ross profit Selling e6penses Administrative e6penses $otal operating e6penses :perating income 8nterest e6pense Net income before ta6 8ncome ta6es Net income
$38,610 25,100 $13,510 7,700 4,270 $11,970 $ 1,540 115 $ 1,425 655 $ 770
",,9
$32,175 19,950 $12,225 6,565 4,175 $10,740 $ 1,485 95 $ 1,390 645 $ 745
",,*
$25,740 15,400 $10,340 5,148 3,861 $9,009 $1,331 100 $1,231 541 $ 690
.equired )erform a hori5ontal0 common%si5e analysis of the balance sheet items0 using ",,* as the base year. Also include a hori5ontal analysis of sales and net income. !omment on significant trends and relationships revealed by the computations. ANS ",1, Assets !urrent assets )lant and equipment @netA :ther assets $otal assets -iabilities and Stoc<holders' 1quity !urrent liabilities -ong%term liabilities !apital stoc< @I1, parA )aid%in capital in e6cess of par .etained earnings $otal liabilities and stoc<holders' equity Sales Net 8ncome
110.1 150.1 130.1 140.1
",,9
72.5 144.9 90.0 124.9
",,*
100.0% 100.0% 100.0% 100.0%
123.1 131.0 153.3 199.5 122.4 140.1 150.0 111.6
114.0 103.0 153.3 199.5 89.4 124.9 125.0 108.0
100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
8n ",,90 the firm had a significant increase in plant and equipment. $here was also a substantial rise in common stoc< and paid%in capital. Apparently0 the e6pansion was primarily financed by a stoc< sale. Brom ",,9 to ",1,0 there is a substantial rise in current assets0 from a drop in ",,9. $here also is a large rise in long%term liabilities. Sales have risen faster than assets0 indicating increased turnover. ;owever0 profits have risen much more slowly than sales. 8n ",,90 the firm must have paid substantial dividends0 since retained earnings declined0 despite the net income. 1,. !ondensed comparative financial statements for Woodstoc< 2anufacturing !ompany appear below.
*%"7
",1, Assets !urrent assets )lant and equipment @netA $otal assets -iabilities and Stoc<holders' 1quity !urrent liabilities -ong%term liabilities !apital stoc< @I1, parA )aid%in capital in e6cess of par .etained earnings $otal liabilities and stoc<holders' equity
$ 1,700 8,110 1,004 $10,814 $ 950 2,023 4,600 770 2,471 $10,814
",,9
$1,120 7,830 695 $9,645 880 1,591 4,600 770 1,804 $ 9645 $
",,*
$1,544 5,404 772 $7,720 $ 769 1,544 3,000 389 2,018 $7,720
8ncome Statement Bor the Pear 1nded April #, @in thousands of dollarsA ",1, Net sales !ost of sales =ross profit Selling e6penses Administrative e6penses $otal operating e6penses :perating income 8nterest e6pense Net income before ta6 8ncome ta6es Net income
$38,610 25,100 $13,510 7,700 4,270 $11,970 $ 1,540 115 $ 1,425 655 $ 770
",,9
$32,175 19,950 $12,225 6,565 4,175 $10,740 $ 1,485 95 $ 1,390 645 $ 745
",,*
$25,740 15,400 $10,340 5,148 3,861 $9,009 $1,331 100 $1,231 541 $ 690
.equired )erform a vertical0 common si5e analysis of the income statement. !omment on significant trends. ANS ",1, Net sales !ost of sales =ross profit Selling e6penses Administrative e6penses $otal operating e6penses :perating income 8nterest e6pense Net income before ta6 8ncome ta6es Net income
100.0% 65.0 35.0 19.9 11.1 31.0 4.0 .3 3.7 1.7 2.0% 4.6 .3 4.3 2.0 2.3%
",,9
100.0% 62.0 38.0 20.4 13.0 33.4
",,*
100.0% 59.8 40.2 20.0 15.0 35.0 5.2 .4 4.8 2.1 2.7%
*%"*
Although absolute profits have risen0 the profit margin on sales has declined steadily. $he principal cause of the decline is increased cost of sales. !ost of sales have risen from 39.*F to 43.,F. $his increase is offset by declining selling and administrative costs in relation to sales. $a6es as a percent of sales also have declined.
11. :n the left is a list of terms related to trend analysis and other types of financial information and services. :n the right are descriptions and definitions of these terms. .equired 2atch each term to its best description by placing the correct number before the term. QQQQQ a. QQQQQ b. QQQQQ c. QQQQQ d. QQQQQ e. QQQQQ f. Oertical0 common%si5e statement Segment reporting 8nterim reporting $rend analysis !ommon si5e ;ori5ontal 1. ". #. '. 3. 4. 7. *. 9. Bull or partial statements e6pressed in percentages of a given base. .equires full financial statements on a quarterly basis. All statement figures are e6pressed as a percentage of a base figure from that year's statement. A brea<down by ma>or lines of business0 only required in S1! reporting. A brea<down by ma>or lines of business. All statement figures are e6pressed as a percentage of base%year figures. .equires estimation of some e6pense items. A comparison of financial data over time. Oisual aids to understanding financial data.
ANS a # . b 3 . c 7 . d * . e 1 . f. 4 (escriptionsJdefinitions not used are "0 '0 and 9.
*%"9
1".
$he !lothes !lutch0 a retail clothier0 has had average sales of I',,0,,, for the last five years0 ",,4G",1,. $he firm's total assets at the end of ",1, were I',,0,,,. An internal staff cost analyst has prepared the following financial data from the annual reports. Pou have been hired as a consultant to help analy5e the financial position. ",1, !urrent .atio Acid $est .atio (ays' Sales in .eceivables 2erchandise 8nventory $urnover (ebt .atio $imes 8nterest 1arned Sales as a )ercent of 1994 Sales Net 8ncome as a )ercent of 1994 8ncome =ross )rofit 2argin :perating 16penses to Net Sales Net )rofit 2argin .eturn on $otal Assets
2.80 2.03 61 4.20 0.48 4.60 1.46 1.31 38.5% 11.4% 7.6% 9.4%
",,9
2.43 1.93 58 4.10 0.50 4.80 1.23 1.20 38.8% 11.3% 8.6% 9.6%
",,*
2.36 1.82 54 4.10 0.49 5.90 1.12 1.10 38.9% 11.5% 8.9% 9.6%
",,7
2.10 1.61 42 3.90 0.47 5.70 1.06 1.06 40.0% 11.4% 9.4% 10.0%
",,4
2.00 1.47 35 3.70 0.47 6.00 1.00 1.00 39.7% 11.7% 9.3% 10.7%
.equired a 16plain the trend in liquidity. 2a<e specific reference to the effect of receivables and . inventory on this trend. b &riefly describe the trend in the long%term0 debt%paying ability of $he !lothes !lutch. . 16plain the cause@sA of this trend. c $he net profit margin has declined substantially. !ite and discuss specific causes of this. . d ;as the firm utili5ed its total assets effectively? (iscuss the ability of the firm to generate . sales based on total assets. @/se (u)ont analysis.A e Specifically cite and briefly describe two additional types of information that would aid in . your analysis.
ANS a . &oth the current ratio and acid%test ratio have risen. 8nitially0 this might appear to be a good sign. ;owever0 days' sales in receivables have nearly doubled0 indicating a worsening problem in the collection of receivables. $his problem could cause the rise in the current ratio and acid%test ratio. 2erchandise inventory turnover has increased0 although not substantially. $his indicates better movement of inventory. :verall0 liquidity appears to be good0 but not as good as it appears based on the current ratio and acid%test ratio because receivables appear to create a liquidity problem. $wo measures of long%term0 debt%paying ability are given. $he debt ratio appears to be relatively stable. ;owever0 the times interest earned ratio has declined. $his indicates that the firm is not covering its debt as well as it did previously. $his decrease could restrict its future borrowing power. =ross profit margin has declined slightly0 indicating a slight rise in the cost of goods sold. :perating e6penses to net sales has remained relatively stable. :ther causes of the decline could be other income and e6pense items0 such as interest e6pense. )roblems with interest were already indicated in times interest earned.
b . c .
*%#,
d .
$his question calls for the use of (u)ont analysis0 specifically0 asset turnover.
*%#1
.eturn on $otal Assets ",1, ",,9 ",,* ",,7 ",,4 9.' 9.4 9.4 1,., 1,.7
? ? ? ? ? ?
Net )rofit 2argin 7.4 *.4 *.9 9.' 9.#
$otal Asset $urnover
1."' 1.1" 1.,* 1.,4 1.13
$his computation shows that part of the decline in net profit margin between ",,4 and ",1, has been offset by increased turnover. 8ncreased turnover indicates more efficient use of assets to generate sales dollars. e Almost any type of additional data would be of help. Some of the better suggestions are !ommon%si5e analysis 8ndustry statistics $he cash flow statement :ther specific ratios Segment data (ata for competition
1#. -isted below are several ratios. a. b. c. d. e. f. g. h. i. >. <. l. m. net profit margin total asset turnover return on assets (u)ont return on assets operating income margin operating asset turnover return on operating assets (u)ont return on operating assets sales to fi6ed assets return on investment return on total equity return on common equity gross profit margin
*%#"
.equired 2atch the letter that goes with each formula. Net 8ncome &efore Nonrecurring 8tems % )referred (ividends Average !ommon 1quity Net 8ncome &efore Noncontrolling 8nterest and Nonrecurring 8tems D L@8nterest 16penseA @1 % 1 $a6 .ateAM Average @-ong % $erm -iabilities D 1quityA Net 8ncome &efore Noncontrolling 8nterest and Nonrecurring 8tems Net Sales Net 8ncome &efore Noncontrolling 8nterest and Nonrecurring 8tems Average $otal Assets QQQQQ 3. QQQQQ 4. :perating 8ncome Net Sales :perating 8ncome Average :perating Assets QQQQQ 7. Net Sales Average net Bi6ed Assets Net 8ncome &efore Nonrecurring 8tems % (ividends on .edeemable preferred Stoc< Average $otal 1quity =ross )rofit
QQQQ Q 1.
QQQ QQ ".
QQQ QQ #.
QQQ QQ '.
QQQQ Q *.
QQQQQ 9.
*%##
Net Sales QQ QQ Q 1,. :perating 8ncome 2argin :perating Asset $urnover
QQQQQ 11.
Net Sales Average :perating Assets
QQ QQ Q 1".
Net )rofit 2argin $otal Asset $urnover
QQQQQ 1#.
Net Sales Average $otal Assets
*%#'
ANS 1. ". #. '. 3. 4. 7. *. 9. 1, . 11 . 1" . 1# . l > a c e g i < m h f d b
*%#3

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CHAPTER 8PROFITABILITY

$he ratio could fall under all of the answers.

. d gross profit less operating e6penses . e net income plus interest .

Which suppliers of funds bear the greatest ris< and should

1". relatively new. ANS B

8nterim reports cover fiscal periods of less than one year.

ANS .eturn on :perating Assets ",1 , ",, 9 ",, * ",, 7 ",, 4

:perating 8ncome 2argin

:perating Asset $urnover

$2,02 0 $30,50 0 6.62%

$2,4 70 $25,6 00 9.65%

$2,48 0 $22,90 0 10.83%

=ross )rofit 2argin ?

=ross )rofit Sales

$30,500 (12,600 ) $17,900 $30,500 58.69%

$25,600 (10,300) $15,300 $25,600 59.77%

$22,900 (8,350) $14,550 $22,900 63.54%

Selling =eneral .H(

Selling e6penses0 in particular0 impaired ",,4 profit.

(3,700) 100 $ 10,400 (4,800) 5,600

$202,000 24,600 123,000 4,000 280

ANS a . 1 ",1, Net )rofit 2argin ? ",,9

I304,, I"##0,,, ? ".',F

I30**3 I",'0,,, ".**F

I304,, I1*703,, ".99F

I30**3 I1470,,, #.3"F

Net income before e6traordinary item 8nterest e6pense $a6 rate

= 44.61% 1,992 1,689

$ 15,200 112,800 4,000

24,600 123,000 4,00 0

17,400 116,800 4,000

$otal Average L&M

.eturn on investment LAMJL&M

$116,800 4,000 123,000 4,000 $247,800 123,900

$112,800 4,000 116,800 4,000 $237,600 118,800

.eturn on total equity LAMJL&M

5,600 280 5,320

5,885 280 5,605

116,800 123,000 $239,800 119,900 4.44%

112,800 116,800 $229,600 114,800 4.88%

3. 2otorise0 8nc.0 for ",1, and ",,9.

Net 8ncome less 1quity 8ncome $otal Assets less 8nvestments

$1,200 $32,200 $3,800 4.23%

$1,300 $30,600 $2,800 4.68%

$1,280,000 440,000 88,000 0.44

$1,700,000 650,000 185,000 0.93

$1,700,000 880,000 240,000 1.20

$3,000,000 1,500,000 500,000 2.50

$he following is segment data for Audio%Oisual !orporation. ",1,

600 560 300 $1,460

380 450 240 $1,070

280 300 160 740

ANS ",1, a . )rofit .evenues &roadcasting

$ 383 $3,000 12.77%

270 600 45.00%

$ 383 $1,460 26.23%

$28 $560 5.00%

$12 $300 4.00%

950 2,023 4,600 770 2,471 $10,814

880 1,591 4,600 770 1,804 $9,645

772 1,544 3,000 386 2,018 $7,720

123.1 131.0 153.3 199.5 122.4 140.1 150.0 111.6

114.0 103.0 153.3 199.5 89.4 124.9 125.0 108.0

100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

I303 I",'0,,, ".F

Net )rofit 2argin 7.4 .4 .9 9.' 9.#