4-1
Chapter 4—Profitability Analysis
MULTIPLE CHOICE
1. One important difference between return on assets (ROA) and return on common shareholder’s equity
(ROCE) is
a.
ROA does not differentiate based on how a company finances its assets; ROCE does.
b.
ROA does not distinguish between the different types of income items, such as income
from continuing operations, discontinued operations, extraordinary items and changes in
accounting principles; ROCE does.
c.
ROCE does not distinguish between the different types of income items, such as income
from continuing operations, discontinued operations, extraordinary items and changes in
accounting principles; ROA does.
d.
ROCE does not differentiate based on how a company finances its assets; ROA does.
2. Asset turnover represents
a.
The ability of the firm to generate income from operations for a particular level of sales.
b.
The ability to generate sales from a particular investment in assets.
c.
The ability to manage the level of investment in assets for a particular level of assets.
d.
The number of days, on average, it takes management to turnover assets.
3. Which factor does not explain differences or changes in ROA?
a.
Operating leverage
b.
Cyclicality of sales
c.
Product life cycle
d.
Financial leverage
4. Which of the following industries would you expect to have, on average, high asset turnover and low
profit margin?
a.
Hotels
b.
Grocery stores
c.
Utilities
d.
Oil and Gas extraction
5. Firms with high levels of operating leverage experience which of the following in comparison to firms
with low levels of operating leverage
a.
Higher levels of risk in operations.
b.
Lower expected rates of return.
c.
Lower variability in returns on assets.
d.
Higher sales.
6. Return on assets can be disaggregated into three components. Which of the following is not one of the
components?
a.
Assets Turnover ratio
4-2
b.
Profit Margin ratio
c.
Debt to Equity ratio
d.
Capital Structure Leverage ratio
7. Refer to the information for Orca Industries. The return on assets for Orca Industries is
a.
6.8%
b.
13.5%
c.
10%
d.
12.3%
8. Refer to the information for Orca Industries. The return on common shareholders’ equity for Orca
Industries is
a.
15.2%
b.
13.5%
c.
10%
d.
11.9%
9. Refer to the information for Orca Industries. The profit margin for computing ROA for Orca
Industries is
a.
9.4%
b.
13.5%
c.
4.8%
d.
12.3%
10. Refer to the information for Orca Industries. Orca’s asset turnover is
a.
1.31
b.
1
c.
1.58
d.
1.44
11. Refer to the information for Orca Industries. Orca’s accounts receivable turnover is (assume that
Orca makes all sales on account)
a.
7.0
b.
.53
c.
11.2
d.
10
12. Refer to the information for Orca Industries. Orca’s basic earnings per share is
a.
.22
b.
.13
c.
.25
d.
.30
4-4
Net Devices Inc.
The following balance sheets and income statements are for Net Devices Inc., a manufacturer of small
electronic devices, including calculators, personal digital assistants and mp3 players. For purposes of
these questions assume that the company has an effective tax rate of 35%.
BALANCE SHEETS
2011
2010
2009
$ 875,650
$ 571,250
$ 154,230
6,560
0
0
771,580
775,250
902,000
1,320,150
1,254,600
1,418,500
249,000
231,200
229,900
3,222,940
2,832,300
2,704,630
1,118,750
1,100,300
1,122,400
263,050
241,000
215,600
184,500
168,250
168,900
$4,789,240
$4,341,850
$4,211,530
2011
2010
2009
$1,178,540
$1,061,100
$1,138,250
18,100
316,500
150,900
664,100
615,900
585,400
138,900
108,400
38,200
0
0
0
1,999,640
2,101,900
1,912,750
478,250
378,400
599,630
13,350
0
0
2,491,240
2,480,300
2,512,380
850,000
850,000
550,000
4,000
3,950
3,800
869,000
758,000
689,500
1,430,500
1,055,000
1,245,050
(855,500)
(805,400)
(789,200)
2,298,000
1,861,550
1,699,150
$4,789,240
$4,341,850
$4,211,530
INCOME STATEMENTS ($ in thousands)
Fiscal year end
2011
2010
Net sales
$11,455,500
$11,082,100
Cost of Goods Sold
(8,026,450)
(7,940,065)
Gross profit
3,429,050
3,142,035
4-5
Selling, general & admin. Exp.
(1,836,400)
(1,789,200)
Income before deprec. & amort.
1,592,650
1,352,835
Depreciation & amortization
(785,250)
(757,250)
Interest expense
(46,195)
(43,340)
Income before tax
761,205
552,245
Provision for income taxes
(157,725)
(112,290)
Minority interest
—
—
Net income
$ 603,480
$ 439,955
Outstanding shares (in thousands)
308,515
303,095
Preferred Dividends (in thousands)
$85,000
$85,000
13. Refer to the information for Net Devices Inc. What is the rate of return on assets for Net Devices for
2011?
a.
11.64%
b.
14.50%
c.
12.60%
d.
13.88%
14. Refer to the information for Net Devices Inc. What is the profit margin for ROA for Net Devices for
2010?
a.
7.26%
b.
4.22%
c.
5.00%
d.
3.97%
15. Refer to the information for Net Devices Inc. What is the accounts receivable turnover ratio for Net
Devices for 2011?
a.
24.65
b.
14.85
c.
14.81
d.
10.50
16. Refer to the information for Net Devices Inc. What is the inventory turnover for Net Devices for
2011?
4-6
a.
10.32
b.
8.90
c.
2.51
d.
6.23
17. Refer to the information for Net Devices Inc. What is Net Devices’ return on common shareholders’
equity for 2011?
a.
26.54%
b.
30.89%
c.
35.81%
d.
42.16%
18. Refer to the information for Net Devices Inc. What is Net Devices’ capital structure leverage ratio for
2011?
a.
3.89
b.
1.68
c.
3.71
d.
10.32
19. Refer to the information for Net Devices Inc. What is Net Devices’ earnings per share for 2011?
a.
$1.00
b.
$1.70
c.
$1.96
d.
$0
20. Which of the following might an analyst not want to eliminate from past earnings when using past
earnings to forecast future earnings?
a.
nonrecurring gains from the sale of assets.
b.
unusual asset impairment charges.
c.
nonrecurring restructuring charges.
d.
revenue from the sale of inventory.
21. Sustainable earnings represent
4-7
a.
the level of earnings expected to persist in the future.
b.
the level of earnings and the growth in the levels of earnings expected to persist in the
future.
c.
the growth rate of future earnings.
d.
retained earnings.
22. The statutory tax rate differs from a firm’s average tax rate due to which of the following reasons
a.
the statutory tax rate is a marginal tax rate.
b.
some expenses are included in book income but do not enter into taxable income.
c.
the average tax rate is for a period of three years.
d.
the statutory tax rate does not effect GAAP measures of revenues and expenses.
23. The profit margin for ROA indicates the ability of a firm to generate earnings for a particular level of
a.
sales
b.
assets
c.
working capital
d.
shareholders’ equity
24. Which of the following would be considered a committed fixed cost ( a cost that is incurred regardless
of the level of activity during the period)?
a.
depreciation expense
b.
bad debt expense
c.
advertising expense
d.
cost of goods sold
25. Hall and Porter argue that firms have two generic alternative strategies for any particular product.
These strategies are
a.
low risk focus, low risk focus
b.
retail customer focus, wholesale customer focus
c.
product differentiation, low-cost leadership
d.
low operating leverage, high operating leverage
26. Which of the following is not a way a company can achieve a low-cost position
a.
economies of scale
b.
production efficiency
c.
customer service
d.
outsourcing
27. Which of the following scenarios is consistent with an increasing cost of goods sold to sales
percentage and increasing inventory turnover?
a.
Firm raises prices to increase its gross margin but inventory sells more slowly.
b.
Weak economic conditions lead to reduced demand for a firm’s products, necessitating
price reductions to move goods.
c.
Strong economic conditions lead to increased demand for a firm’s products, allowing price
increases.
d.
Firm shifts its product mix toward lower margin, faster moving products.
Extreme Sports Company and All Sports Corporation
Below is financial information for two sporting goods retailers. Extreme Sports Company operates a
retail business and franchising business. At the end 2011, Extreme Sports had 263 Company-owned
and 120 franchise-operated retail stores. Extreme’s stores are located in suburban, strip mall and
regional mall locations, the company operates in 32 states. All Sports Corporation sells sporting goods
and related products at over 2,500 Company-operated retail stores.
Selected Data for All Sports and Extreme Sports
(amounts in millions)
All Sports
Extreme Sports
$5,320
$1,344
3,897
887
138
43
212
33
998
286
1,163
130
2,472
662
40%
40%
28. Refer to the information for Extreme Sports Company and All Sports Corporation.
Compute the Asset Turnover for All Sports
a.
3.2%
b.
2.15
c.
8.9%
d.
1.1%
29. Refer to the information for Extreme Sports Company and All Sports Corporation.
What is the return on assets for All Sports?
a.
11.9%
b.
10.8%
c.
9.2%
d.
8.6%
30. Refer to the information for Extreme Sports Company and All Sports Corporation.
Calculate All Sports’ inventory turnover ratio
a.
5.3
b.
1.2
c.
3.9
d.
.256
4-9
31. Multiples of EPS to value firms are referred to as.
a.
ROA
b.
price-earnings ratios
c.
ROCE
d.
Weighted average number of common shares outstanding
32. Adjustments for dilutive securities and the adjustment to weighted average number of
shares outstanding presumes that the dilutive securities are converted to common shares
a.
as of the beginning of the year.
b.
as of the end of the year.
c.
as of the middle of the year.
d.
as of the point in time where the maximum number of shares are outstanding.
33. To calculate diluted EPS, the accountant does all of the following except:
a.
adds back to net income any compensation expense recognized on the employee stock
options
b.
adds back any interest expense (net of taxes) on convertible bonds
c.
adds back any dividends on convertible preferred stock the firm subtracted in computing
net income to common shareholders.
d.
enters only the net incremental shares issued (shares issued under options minus assumed
shares repurchased) in the computation of diluted EPS.
34. Which of the following is the primary objective in most financial statement analysis?
a.
to value a firm’s equity securities.
b.
to look for unrecorded liabilities.
c.
to establish a firm’s strategy within the industry.
d.
to define markets for the firm.
35. Time-series analysis helps answer all of the following questions except:
a.
Is the firm becoming more or less profitable over time?
b.
Is the firm becoming more or less risky?
c.
How is management of the firm responding to external economic forces?
d.
What is the amount of assets or capital required to generate a particular level of earnings?
36. Critics of EPS as a measure of profitability point out that it does not consider:
a.
simple capital structures.
b.
the amount of assets or capital required to generate a particular level of earnings.
c.
the deduction of preferred stock dividends from net income.
d.
Adjustments for dilutive securities and the adjustment to weighted average number of
shares outstanding for complex capital structures.
Ramos Company
Ramos Company included the following information in its annual report:
2011
2010
2009
Sales
$178,400
$162,500
$155,500
Cost of goods sold
115,000
102,500
100,000
Operating expenses
50,000
50,000
45,000
Net income
13,400
10,000
10,500
37. Refer to the information for Ramos Company. In a common size income statement for 2011, the
operating expenses are expressed as:
a.
30.3%
b.
28.0%
c.
43.8%
d.
100%
38. Refer to the information for Ramos Company. In a common size income statement for 2009, the cost
of goods sold are expressed as:
a.
64.3%
b.
40.0%
c.
87 %
d.
103%
39. Refer to the information for Ramos Company. In a common size income statement for 2011, the cost
of goods sold are expressed as:
a.
130%
b.
115%
c.
64.5%
d.
63.1%
40. Refer to the information for Ramos Company. In a percentage change income statement over the
period of 2009 to 2011, what is the change in sales?
a.
100%
b.
87.2%
c.
12.8%
d.
14.7%
4-11
41. Refer to the information for Ramos Company. In a percentage change income statement over the
period of 2009 to 2011, what is the change in net income?
a.
100%
b.
21.6%
c.
72.4%
d.
27.6%
42. Which of the following are better indicated by percentage change statements than common-size
statements?
a.
monetary changes
b.
profitability
c.
stability
d.
growth and decline
43. Common-size analysis requires the analyst to be aware that percentages can change because of all of
the following except:
a.
changes in expenses in the numerator independent of changes in sales
b.
changes in sales independent of changes in expenses
c.
interaction effects between the numerator and denominator
d.
All of these are possible explanations.
44. Firms with complex capital structures can use which of the following in calculating EPS
a.
outstanding convertible bonds.
b.
stock options exercised
c.
stock warrants issued
d.
all of the above
45. The computation of the additional shares to be issued on the exercise of stock options
assumes that the firm would repurchase common shares on the open market using an
amount equal to the sum of all the following except:
a.
any cash proceeds from such exercise
b.
net incremental shares issued
c.
any unamortized compensation expense on those options
d.
any tax benefits that would be credited to additional paid-in capital
46. Another term for earnings power is
a.
nonrecurrent revenue.
b.
nonrecurrent gains.
4-12
c.
sustainable earnings.
d.
net change in equity.
47. The three elements of risk that help in understanding differences across firms and changes over time in
ROAs are:
a.
product life cycles, cyclicality of sales, competitive constraint.
b.
operating leverage, cyclicality of sales, product life cycles.
c.
cyclicality of sales, competitive constraint, operating leverage.
d.
operating leverage, competitive constraint, product life cycles.
Carl Industries
Carl Industries has condensed balance sheets as shown:
2011
2010
2009
Assets:
Current assets
65,000
$46,500
$80,000
Plant & equipment, net
600,000
420,000
410,000
Intangible assets, net
15,000
36,500
50,000
Total assets
680,000
$503,000
540,000
Liabilities & Stockholders’ Equity:
Current liabilities
$70,000
$25,000
$33,500
Long-term liabilities
420,000
290,000
400,000
Stockholders’ equity
190,000
188,000
106,500
Total liabilities & equity
$680,000
$503,000
540,000
48. Refer to the information for Carl Industries. In a common size balance sheet for 2010, plant and
equipment (net) is expressed as
a.
74.5%
b.
93.2%
c.
83.5 %
d.
30.5%
49. Refer to the information for Carl Industries. In a common size balance sheet for 2009, total liabilities
and equity are expressed as
a.
25.9%
b.
100%
c.
74.1%
d.
103.6%
50. Refer to the information for Carl Industries. In a percentage change balance sheet over the period of
2009 to 2011, what is the change in long-term liabilities?
a.
94.7%
b.
15.4%
c.
5.3%
d.
5%
51. Refer to the information for Carl Industries. In a percentage change balance sheet over the period of
2009 to 2011, what is the change in current assets?
a.
78.6%
b.
(27.3%)
c.
(21.4%)
d.
(18.75%)
COMPLETION
1. In order to measure how profitable a firm is in generating a return for its common shareholders, a
financial analyst would examine the return on
_____________________________________________.
2. When the financial analysts multiplies the profit margin for ROA with the assets turnover ratio the
result is called______________
3. The ____________________ effect of interest expense on net income equals one minus the marginal
tax rate times the interest expense.
4. Return on common equity can be disaggregated into profit margin for ROCE, capital structure
leverage and _________________________________________________.
5. Return on assets can be disaggregated into asset turnover and
____________________________________________________________.
4-14
6. Return on assets will likely differ across firms and across time. Three elements of risk that will help
explain these differences are ________________________________________, cyclicality of sales and
stage and length of product life cycle.
7. Return on assets will likely differ across firms and across time. Three elements of risk that will help
explain these differences are operating leverage, ___________________________________, and
stage and length of product life cycle.
8. Firms with high operating leverage have a higher proportion of _________________________ in their
cost structure.
9. Firms with ____________________ levels of operating leverage experience greater variability in their
return on assets.
10. The ability of a firm to generate income from operations given a particular level of sales is measured
by the ______________________________.
11. The ability of a firm to manage the level of investment in assets for a particular level of sales is
measured by the ______________________________.
12. Accounts receivable turnover is calculated by dividing
________________________________________ by average net accounts receivable.
13. Inventory turnover is calculated by dividing ________________________________________ by
average inventories.
4-15
14. Return on assets can be a misleading ratio when analyzing technology firms because two important
assets, ______________________________ and ______________________________ do not appear
on their balance sheets
15. When calculating Basic earnings per share net income is adjusted by____________
16. When calculating the return on fixed assets sales is divided by _________________
17. One problem with using EPS as a measure of profitability is that it does not consider the amount of
____________________ or ____________________ required to generate a particular level of
earnings.
18. When an analyst uses measures of past profitability to forecast the firm’s future profitability the
expectation is that those revenues, gains, expenses and losses will ____________________.
19. ________________________________________ is the level of earnings and the growth in the levels
of earnings expected to persist in the future.
20. The ___________________________________ of interest expense on net income equals one minus
the marginal tax rate times interest expense.
21. The rationale for adding back the _______________________________________________________
relates to attaining consistency in the numerator and denominator of ROA.