978-1337614689 Chapter 4 Part 1

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CHAPTER 4

PROFITABILITY ANALYSIS

Solutions to Questions, Exercises, Problems, and Teaching Notes to Cases

4.1 Common-Size Analysis. Restating income statement line items as a percentage of

sales and balance sheets as a percentage of total assets enables the analyst to com-

4.2 Earnings per Share. Firms can be identical in all respects but report different earn-

ings per share due simply to different decisions regarding the number of shares out-

4.3 Pro Forma Earnings. Twitter redefined earnings to exclude stock-based compensa-

tion expense ($25.7 million), depreciation and amortization expense ($72.5 million),

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4.4 Profit Margin for ROA versus ROCE. The profit margin for ROA excludes

subtractions for the cost of debt and equity financing, whereas the profit margin for

4.5 Concept and Measurement of Financial Leverage. Financial leverage involves

using assets financed with debt and preferred equity and earning a higher return on

those assets (that is, ROA) than the cost of these sources of capital. The excess of

4.6 Advantages of Financial Leverage. For financial leverage to work effectively,

ROA must exceed the after-tax cost of debt and preferred stock financing. One in-

4.7 Disadvantages of Financial Leverage. The cost of borrowing increases as a firm

becomes more levered. Thus, although a firm’s ROA may exceed its cost of

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with current levels. First, there are typically lags between securing financing,

deploying assets, getting operations up and running, and realizing returns from

investments. In the meantime, firms are saddled with costs of borrowing. Second,

there are diminishing returns to scale. Many growth firms that generate high ROA

tend to overinvest, only to realize that there are limits to their ability to scale up

operations. For example, a restaurant may find that additional restaurants merely

cannibalize sales from nearby restaurants rather than satisfy unlimited demand.

4.8 Concept of Residual Income. Residual income can be viewed as income after

inserting an additional line item on the income statement for the cost of equity capi-

4.9 Return on Common Shareholders’ Equity versus Basic Earnings per Common

Share. The statement is correct that both ROCE and basic earnings per share use

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4.10 Calculating ROA and Its Components (amounts in millions).

4.11 Calculating ROCE and Its Components (amounts in thousands).

Return on Common Shareholders’ Equity:

4.12 Calculating Basic and Diluted EPS (amounts in thousands).

4.13 Relating ROA and ROCE (amounts in millions).

a. Return on Assets: [$1,062 + (1 – 0.35)($64)]/$6,934.5 = 15.9%

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4.14 Relating ROA and ROCE (amounts in millions).

a. Return on Assets: [$1,803.8 + (1 – 0.35)($359.7)]/$17,527.9 = 11.6%

cess return generated for the common shareholders on assets financed with lia-

$12.5). The assets financed by common shareholders’ capital generated a return

for the common shareholders of $762.9 (0.116 × $6,562.3) (calculations taken

4.15 Analyzing Operating Profitability (amounts in millions).

a. Return on Assets = Profit Margin × Assets

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Supervalu:

Cost of Goods Sold Inventory Fixed Asset

÷ Sales Turnover Turnover

Supervalu 92.5

$7,531

56.12

$2,743

%3.77

564,44$

b. Macy’s performed poorly, reporting a large net loss. It also has the slowest

assets turnover of the three companies. Its product line is less commodity-like

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Home Depot was the only profitable company, so it is the only company

showing a positive profit margin for ROA. Combined with total assets turnover

valu. Home Depot’s overall asset turnover also lies between Macy’s and

Supervalu, but individual asset turnover ratios lie closer to Macy’s than to

Supervalu, which is not surprising given Home Depot’s inventory of non-

perishable products. Overall, Home Depot’s profitability likely resulted from

lower selling and administrative expenses as a percentage of sales. Home Depot

many companies reported losses, and the grocery industry was no different. The

10-K reports, “The unprecedented decline in the economy and credit market

turmoil during fiscal 2009 combined with high food inflation and energy costs

negatively impacted consumer confidence and spending.” [Supervalu’s fiscal

year ended February 28, 2009, which management refers to as their 2009 year,

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4.16 Calculating and Interpreting Accounts Receivable Turnover Ratios (amounts

in millions).

a. Year 3 Year 2 Year 1

$51,122

$60,420

437,58$ ===

Oracle: 9.3

$4,589

9.3

$5,799

2.5

430,4$

b. The accounts receivable turnover of Microsoft is steady, ranging between 4.8

c. The accounts receivable turnover of Microsoft was relatively steady during the

three years. Microsoft appears to manage its accounts receivable well, with col-

4.17 Calculating and Interpreting Inventory Turnover Ratios (amounts in millions).

a. Year 3 Year 2 Year 1

$47,433

$48,855

375,49$ ===

$623

$602

$532

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b. The faster inventory turnover ratio for Dell reflects its made-to-order business

c. In contrast to rapid growth experienced in the past, sales growth at Dell has

been in the low single digits over the last three years and has been slowing. Sun

provider).

4.18 Calculating and Interpreting Accounts Receivable and Inventory Turnover

Ratios (amounts in millions).

a. Year 2 Year 1

$16,593

$23,663 ==

AK Steel: 10.2

$686

13.4

$572

b. The faster accounts receivable turnover for Nucor reflects its sales to steel ser-

c. The accounts receivable turnover of both Nucor and AK Steel increased across

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d. Year 1 Year 2

$13,035

$19,612 ==

e. Nucor had higher inventory turnover than AK Steel in Year 1, but lower inven-

tive inventory turnovers.

f. The inventory turnover of AK Steel increased significantly between Year 1 and

Year 2 as a result of a moderate increase in sales coupled with a decline in in-

4.19 Calculating and Interpreting Fixed Assets Turnover Ratios (amounts in millions).

a. Year 3 Year 2 Year 1

$14,255

$13,835

501,12$ ===

Hewlett-Packard: 2.14

$7,331

7.12

$9,318

4.10

050,11$

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b. The fixed asset turnovers of HP exceed those of TI for each year. One reason is

c. The fixed asset turnover of TI remained relatively stable between Year 1 and

4.20 Calculating and Interpreting the Return on Common Shareholders’ Equity

and Its Components.

a. Return on Assets

Year 3: [$405 + (0.65)($245)]/[0.5($18,048 + $17,787)] = 3.1%

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b. Return on Common Shareholders’ Equity

Year 3: ($405 – $27)/[0.5($5,766 + $6,037)] = 6.4%

Capital Structure Leverage

c. JCPenney (Penney) operated at a net loss in Year 4. The problem does not

net loss, which reduces retained earnings and shareholders’ equity. The increase

between Year 4 and Year 5 likely resulted from the net effect of a reduction in

debt from selling Eckerd Drugs and the stock buyback with the proceeds of the

sale.

d. Ratio of ROCE/ROA

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e. Year 2 Year 3 Year 4

Average Assets ……………………………….. $17,917.5 $18,043.5 $16,213.5

Net Income Available to Common:

From Liabilities:

f. Considering all sources of financing, financial leverage worked to the advantage

of the common shareholders in Year 2 and Year 4 because ROCE exceeds

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4.21 Interpreting the Return on Common Shareholders’ Equity and Its Components.

a. Financial leverage works to the advantage of the common shareholders when-

b. The capital structure leverage ratio increased in Year 1 and Year 2. The likely

4.22 Calculating and Interpreting the Return on Common Shareholders’ Equity

and Earnings per Common Share (amounts in millions).

a. Return on Common Shareholders’ Equity

b. Earnings per Common Share

c. Both ROCE and EPS increased during the three-year period. General Mills was a

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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 (amounts in millions).

a. Profit Margin for ROA:

Year 1: Cannot be consistently computed without 2009 balance sheet data.

b. Profit Margin for ROCE:

c. All profitability signals exhibit an increasing trend, but the growth in