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Chapter 4
Profitability Analysis
4-11
in whole or in part.
b. The fixed asset turnovers of HP exceed those of TI for each year. One reason is
that HP outsources the manufacturing of components for some of its products.
The numerator of the fixed asset turnover for HP includes the sales of such
products, but the denominator does not include all of the fixed assets used in
equal).
c. The fixed asset turnover of TI remained relatively stable between Year 1 and
Year 3. This occurred during a period in which sales were declining. TI’s
average fixed assets also were declining over the three-year period. This
steadily as well. HPs sales growth was negative only in Year 3, and HP’s
average fixed assets balance was increasing across Years 1 through 3, consistent
with optimistic business levels expected in the future (or poor management). HP
also acquired Electronic Data Systems in Years 3, which would likely have
productive versus nonproductive assets required.
4.20 Calculating and Interpreting the Return on Common Shareholders’ Equity
and Its Components.
a. Return on Assets
Profit Margin for ROA
Total Assets Turnover
Chapter 4
Profitability Analysis
4-12
in whole or in part.
b. Return on Common Shareholders’ Equity
Profit Margin for ROCE
Total Assets Turnover
Capital Structure Leverage
c. JCPenney (Penney) operated at a net loss in Year 4. The problem does not
Year 5, the result of an improved profit margin for ROA and ROCE and
increased assets turnover. Again, one suspects that the sales of Eckerd Drugs
helped both of these financial ratios. Also, the capital structure leverage ratio
increased. The increase between Year 3 and Year 4 resulted from operating at a
sale.
d. Ratio of ROCE/ROA
Chapter 4
Profitability Analysis
4-13
in whole or in part.
e. Year 2 Year 3 Year 4
Average Assets ...................................... $17,917.5 $18,043.5 $16,213.5
Average Liabilities (plug) ...................... $11,668.0 $12,146.0 $11,073.0
Net Income Available to Common:
From Liabilities:
From Preferred Stock:
From Common Stock:
Total:
turn on liabilities than the cost of borrowing. Financial leverage worked to the
disadvantage of the common shareholders in Year 3. ROA is negative, and
ROCE is even more negative. The negative amount of net income available to
common shareholders comes in part from the sum of the negative return on lia-
Chapter 4
Profitability Analysis
4-14
in whole or in part.
4.21 Interpreting the Return on Common Shareholders’ Equity and Its Components.
a. Financial leverage works to the advantage of the common shareholders when-
ever ROCE exceeds ROA. In such cases, ROA exceeds the cost of debt financ-
ing. The excess return of ROA over the cost of financing belongs to the
ers during Year 1 and Year 2. ROA was barely positive in each of those years.
After subtracting interest on debt, however, the firm realized a net loss.
b. The capital structure leverage ratio increased in Year 1 and Year 2. The likely
well, but the data provided does not permit an informed analysis of this
possibility.
4.22 Calculating and Interpreting the Return on Common Shareholders’ Equity
and Earnings per Common Share.
a. Return on Common Shareholders’ Equity
b. Earnings per Common Share
equity. Net income was positive, which increased shareholders’ equity. Other
likely candidates are dividends (which General Mills did pay) and an increase in
accumulated other comprehensive loss (which did occur). Companies strive for
Chapter 4
Profitability Analysis
4-15
in whole or in part.
increasing both earnings per share and ROCE, so General Mills performed very
well during 2007–2008, which was not a strong economic environment.
4.23 Interpreting Several Measures of Profitability.
a. Profit Margin for ROA:
2010: Cannot be consistently computed without 2009 balance sheet data.
Assets Turnover:
Leverage:
Return on Assets:
b. Profit Margin for ROCE:
c. All profitability signals exhibit an increasing trend, but the growth in
profitability in 2011 is much larger than 2012. For example, net income
exercise activity in 2012. The exercise of stock options in 2012 is not surprising
given the strong financial performance and price appreciation that accompanied
it, and the inflow of equity from the stock option exercises led to an increase in
equity that outpaced the increase in net income.
Chapter 4
Profitability Analysis
4-16
in whole or in part.
4.24 Calculating and Interpreting Profitability Ratios.
a. Profit Margin for ROA:
Assets Turnover:
Return on Assets:
Profit Margin for ROCE:
Capital Structure Leverage:
Return on Common Shareholders’ Equity:
Cost of Goods Sold/Sales:
Advertising Expense/Sales:
Research and Development Expense/Sales:
Royalty Expense/Sales:
Other Selling and Administrative Expenses/Sales:
Income Tax Expense (excluding tax effects of interest expense)/Sales:
Accounts Receivable Turnover:
Inventory Turnover:
Fixed Asset Turnover:
b. Hasbro’s ROA increased significantly between Year 2 and Year 3 and increased
eral expense percentages.
Chapter 4
Profitability Analysis
4-17
in whole or in part.
Cost of Goods Sold/Sales: The cost of goods sold to sales percentage increased
continually over the three-year period. Increased competition from electronic
and online games might have required Hasbro to lower selling prices or not pass
along entire manufacturing costs increases. The shift to core products away
Advertising Expense/Sales: This expense also increased continually during the
three-year period. Increased advertising to combat increased competition and to
promote core products likely explains the increasing percentage.
Royalty Expense/Sales: This expense declined during the three years, particu-
larly between Year 2 and Year 3. The shift to core brands away from license ar-
rangements likely explains this declining percentage.
percentage.
The slightly increased assets turnover between Year 2 and Year 3 results in
part from similar increases in the receivables, inventory, and fixed asset turnovers.
c. ROCE follows the same path as ROA, increasing significantly in Year 3 and in-
creasing slightly more in Year 4. Thus, the explanations in Solution b. for
changes in ROA help explain changes in ROCE as well. In addition, Hasbro re-
duced its capital structure leverage ratio each year. The statement of cash flows
structure leverage ratio.
Chapter 4
Profitability Analysis
4-18
in whole or in part.
4.25 Calculating and Interpreting Profitability Ratios.
a. Profit Margin for ROA:
Assets Turnover:
Return on Assets:
Profit Margin for ROCE:
Capital Structure Leverage:
Return on Common Shareholders’ Equity:
Cost of Goods Sold/Sales:
Selling and Administrative Expense/Sales:
Interest Revenue/Sales:
Income Tax Expense (excluding tax effects of interest expense)/Sales:
Accounts Receivable Turnover:
Inventory Turnover:
Fixed Asset Turnover:
Sales per Stores:
Sales per Square Foot:
Sales per Employee:
sold to sales percentage. One possibility is that an increasingly attractive
retailing environment was present in fiscal Year 4 and fiscal Year 5, permitting
the firm to institute higher markups of selling prices over cost. The data on sales
growth, comparable store sales, sales per store, and sales per square foot,
Chapter 4
Profitability Analysis
4-19
in whole or in part.
Fitch. The decreasing cost of goods sold to sales percentage coupled with the
decreasing inventory turnover ratio is consistent with a move toward slower-
moving but higher-margin products. Again, there is no evidence that this is the
case. The MD&A in Abercrombie & Fitch’s annual report merely suggests
have not yet fully materialized. The troublesome aspect of this interpretation is
that the number of employees grew much faster than the number of stores. The
that Abercrombie & Fitch collects its receivables in two to three days. The de-
cline in the inventory and fixed asset turnovers in fiscal Year 4 is likely due to
the decline in comparable store sales in that year as well as the rapid growth in
new stores.
instituted a dividend in fiscal Year 4. These actions reduce common sharehold-
ers’ equity and increase the capital structure leverage ratio.
4.26 Analyzing the Profitability of a Service Firm. The ROA of Kelly Services
revenues in Year 3, Kelly might have offered more attractive pricing terms to cus-
tomers purchasing its services. Another explanation for the increased compensation
of temporary employees expense percentage in Year 3 is that the revenue mix
shifted toward Kelly’s international segment, which is its least profitable segment.
Chapter 4
Profitability Analysis
4-20
in whole or in part.
The fixed asset turnover increased slightly between Year 2 and Year 3, consistent
with the larger revenues per office.
ROA increased between Year 3 and Year 4, the result of an increase in both the
profit margin for ROA and the assets turnover. The improvement in the profit mar-
to the increased fixed asset turnover.
ROCE follows the same path as ROA. The capital structure leverage ratio in-
creased during the three years, but the problem does not provide sufficient informa-
tion to understand the reason. Kelly increased the number of offices and likely
increased long-term debt for its lease commitments.
ROA fell from 10.9% to 4.8% and ROCE fell from 25.4% to 17.8%. Choice Hotels
also reports declining ROA, but the level is extremely high (32.6%–42.9%); ROCE
is not meaningful because the company has negative common shareholders’ equity
(for “good” rather than “bad” reasons, as discussed in the instructions to the
problem).
pancy between the two companies is that Choice’s assets turnover is approximately
three times that of Starwood’s. The nonfinancial metrics provide some insight into
these differences in margins and turnovers.
Consistent with expectations, the average daily rates for Starwood are
Alternatively, the more likely (and true) explanation for Choice’s higher assets
turnover is because Choice is primarily a hotel franchisor and almost all hotel
