SM Financial Reporting and Analysis 13th Edition

SM Financial Reporting and Analysis 13th Edition

Chapter 8
Profitability

QUESTIONS

8- 1. Profits can be compared to the sales from which they are the residual. They can be compared to the assets that generate sales. Or, they can be viewed as return to the owner. Each measure looks at profits differently. The trends might move in different directions, depending on the base.

8- 2. Extraordinary items are by nature nonrecurring. They should be segregated in order to concentrate on profit that will be expected in the next period. Recurring earnings should be used in trend analysis of profitability.

8- 3. Expenses as a percent of sales must have increased if profits as a percent of sales declined.

8- 4. Profit margin in jewelry is usually much higher than in groceries. Groceries generate total profits based on volume of sales rather than high markup.

8- 5. A drop in profits or a rise in the asset base could cause a decline in the ratio. For example, higher cost of sales could cause a decline; or, a substantial investment in fixed assets that are not yet fully utilized could cause a decline.

8- 6. DuPont analysis relates return on assets to turnover and margin. It allows for further analysis of return on assets by this breakdown.

8- 7. Operating income is sales minus cost of sales and operating expenses. It does not include nonoperating items, such as other income, interest, and taxes. Operating assets are basically current assets plus plant, property, and equipment. They do not include investments, intangibles, and other assets.

Removing non-operating items from the DuPont analysis gives a clearer picture of productive operations and the efficient use of the company’s assets.

8- 8. Equity earnings are the owner’s proportionate share of the nonconsolidated subsidiary earnings. These earnings are usually greater than the cash from dividends from the nonconsolidated subsidiary.

8- 9. Return on assets is a function of net profit margin and total asset turnover. Return on assets could decline, given an increase in net profit margin, if the total asset turnover declined sufficiently.

8-10. Return on investment measures return to all long-term supplies of funds. It includes net income plus tax-adjusted interest in the numerator and all long-term funds in the denominator. Return on total equity is just return to shareholders.

Return on common equity is return only to common shareholders. Net income is reduced by preferred dividends in the numerator, and only common equity is in the denominator.

8-11. Return on investment is a profitability measure comparing income to capital utilized by the firm. Some measures are return on assts, return on equity, or income available to all capital sources, divided by capital. The given ratio is preferred, since it measures the profit available to all long-term sources of capital against that capital. The interest is multiplied by the tax adjustment factor to put interest on an after-tax basis.

8-12. This cannot be determined based only upon the absolute measures. It is necessary to compare these dollar figures to a base, such as investment or sales. Also, it is necessary to know if nonrecurring items are part of the firm’s income picture.

8-13. Interim reports are less reliable because they are not audited, but they can be very meaningful in indicating trends before the end of the year.

8-14. An objective considered here is timeliness rather than completeness. Full statements would take too long and involve too much cost to produce.

8-15. Comprehensive income includes net changes in (a) foreign currency translation adjustments, (b) unrealized holding gains and losses on available-for-sale marketable securities, and (c) changes to stockholders’ equity resulting from additional minimum pension liability adjustment. These items will tend to fluctuate more than other income items.

8-16. Pro forma financial information is hypothetical or a projected amount. For pro forma formation to be meaningful the company must use a reliable estimate to project future sales, expenses, etc. Used improperly pro forma financial information can be a negative contribution to financial reporting.

 

 

 

 

 

PROBLEMS

PROBLEM 8-1

Net Profit Margin = Net Income Before Minority Share of Earnings and Nonrecurring Items
Net Sales

2011 2010
$52,500 $40,000
$1,050,000 $1,000,000

= 5.00% = 4.00%

Return on Assets = Net Income Before Minority Share of Earnings and Nonrecurring Items
Average Total Assets

2011 2010
$52,500 $40,000
$230,000 $200,000

= 22.83% = 20.00%

Total Asset Turnover = Net Sales
Average Total Assets

2011 2010
$1,050,000 $1,000,000
$230,000 $200,000

=4.57 times
per year =5.00 times
per year

Return on Common Equity = Net Income Before Nonrecurring Items – Preferred Dividends
Average Common Equity

2011 2010
$52,500 $40,000
$170,000 $160,000

= 30.88% = 25.00%

Ahl Enterprise has had a substantial rise in profit to sales. This is somewhat tempered by a reduction in asset turnover. Given a slight rise in common equity, there is a substantial rise in return on common equity.

PROBLEM 8-2

a.
2011 2010
Sales 100.0% 100.0%
Cost of goods sold 60.7 60.8
Gross profit 39.3 39.2
Selling expense 14.6 20.0
General expense 10.0 8.3
Operating income 14.7 10.9
Income tax 5.9 4.2
Net income 8.8% 6.7%

b. Starr Canning has had a sharp decrease in selling expense coupled with only a modest rise in general expenses giving an overall rise in the net profit margin.

PROBLEM 8-3

Earnings before interest and tax $ 245,000
Interest (750,000 x 6%) 45,000
Earnings before tax $ 200,000
Tax 80,000
Net income $ 120,000
Preferred dividends 15,000
Income available to common $ 105,000

a. Return on Assets = Net Income Before Minority Share of Earnings Equity Income and Nonrecurring Items = $120,000 = 4.00%
Average Total Assets $3,000,000

b. Return on Total Equity = Net Income Before Nonrecurring Items – Dividends on
Redeemable Preferred Stock = $120,000 = 6.67%
Average Total Equity $1,800,000

 

c.
Return on Common Equity = Net Income Before Nonrecurring Items – Preferred Dividends
Average Common Equity

$120,000 – $15,000 = 7.00%
$1,500,000

d. Times Interest Earned = Recurring Earnings, Excluding Interest Expense, Tax Expense Equity Earnings, and Noncontrolling Interest = $245,000 = 5.44 times
Interest Expense, Including
Capitalized Interest $45,000 per year

PROBLEM 8-4

Vent Molded
Plastics Plastics Industry
Sales 101.0 % 100.3 %
Sales returns 1.0 0.3
Cost of goods sold 72.1 67.1
Selling expense 9.4 10.1
General expense 7.0 7.9
Other income 0.4 0.4
Other expense 1.5 1.3
Income tax 4.8 5.5
Net income 5.5 % 8.5 %

Sales returns are higher than the industry. Cost of sales is much higher, offset some by lower operating expenses. Other expense (perhaps interest) is somewhat higher. Lower taxes are perhaps caused by lower income. Overall profit is less, primarily due to cost of sales.

PROBLEM 8-5

a. $1,589,150 = 122.72%
$1,294,966

2011 sales were 122.72% of those in 2010.

b. $138,204 = 100.80%
$137,110

2011 net earnings were 100.80% of those in 2010.

c. 1. Net Profit Margin = Net Income Before Minority Share of Earnings, Equity Income and Nonrecurring Items
Net Sales

2011 2010
$149,260 = 9.39% $149,760 = 11.56%
$1,589,150 $1,294,966

2. Return on Assets = Net Income Before Minority Share of Earnings and Nonrecurring Items
Average Total Assets

2011 2010
$149,260 = 10.38% $149,760 = 12.67%
$1,437,636* $1,182,110*

*Used year end because average could not be computed for 2010.

3. Total Asset Turnover = Net Sales
Average Total Assets

2011 2010
$1,589,150 = 1.11 times $1,294,966 = 1.10 times
$1,437,636* $1,182,110*

*Used year end because average could not be computed for 2010.

 

4. DuPont Analysis: Return on Assets = Net Profit Margin x Total Asset Turnover

2011 10.42* = 9.39% x 1.11
2010 10.72* = 11.56% x 1.10

*Rounding causes the difference from the 10.38% and 12.67% computed in (2).

5.
2011 2010
Operating income
Net sales $ 1,589,150 $ 1,294,966
Less: Cost of product sold $ 651,390 $ 466,250
Research and development expenses 135,314 113,100
General and selling 526,680 446,110
Operating income $ 275,766 $ 269,506

Operating Income Margin = Operating Income
Net Sales

2011 2010
$275,766 $269,506
$1,589,150 $1,294,966

= 17.35% = 20.81%

6. Return on Operating Assets = Operating Income
Average Operating Assets

2011 2010
$275,766 $269,506
$1,411,686* $1,159,666*

= 19.53% = 23.24%

*Used year end because average could not be computed for 2010.

 

 

 

7. Operating Asset Turnover = Net Sales
Average Operating Assets

2011 2010
$1,589,150 $1,294,966
$1,411,686* $1,159,666*

= 1.13 times per year = 1.12 times per year

*Used year end because average could not be computed for 2010.

8. DuPont Analysis: Return on Operating Assets = Operating Income Margin x Operating Asset Turnover

2011: 19.61%* = 17.35% x 1.13
2010: 23.31%* = 20.81 x 1.12

*Rounding causes the difference from the 19.53% and 23.24% computed in (6).

9.
Return on Investment = Net Income Before Minority Share of Earnings and Nonrecurring Items + [(Interest Expense) x (1 – Tax Rate)]
Average (Long-Term Liabilities) + Equity

2011 2010
Net earnings before minority share $ 149,260 $ 149,760
Interest expense 18,768 11,522
Earnings before tax 263,762 271,500
Provision for income tax 114,502 121,740
Tax rate 43.4 % 44.8 %
1 – tax rate 56.6 % 55.2 %
Interest expense x (1 – tax rate) 10,623 6,360
Net earnings before minority share + interest expense x 1(1 – tax rate)] 159,883 156,120
Long-term debt and equity 1,019,420 933,232
Return on investment 15.7 % 16.7 %

 

 

10. Return on Common Equity = Net Income Before Nonrecurring Items – Preferred Dividends
Ending Common Equity

2011 2010
$138,204 $137,110
$810,292 $720,530

= 17.06% = 19.03%

d. Profits in relation to sales, assets, and equity have all declined. Turnover has remained stable. Overall, although absolute profits have increased in 2011, compared with 2010, the profitability ratios show a decline.