CHAPTER 8—PROFITABILITY
MULTIPLE CHOICE
1.Which of the following is nota base against
which profits are measured?
a.owners' equity
b.owners' and creditors' funds provided
c.intangibles
d.revenues
e.productive
assetsANS:C2.Net profit margin measures
return on:a.salesb.owners' equityc.productive
assetsd.total assetse.inventoryANS:A3.Total
asset turnover measures the ability of a firm
to:a.generate profits on salesb.generate sales
through the use of assetsc.buy new
assetsd.move inventorye.cover long-term
debtANS:B4.The DuPont method return on
assets uses two component ratios. What are
they?a.inventory turnover gross profit
marginb.times interest earned debt
ratioc.return on equity dividend payoutd.net
profit margin total asset turnovere.return on
investment total investment
turnoverANS:D5.Return on assets cannotfall
under which of the following
circumstances?Net Profit MarginTotal Asset
Turnovera.decline
riseb.rise
declinec.rise
rised.decline
declinee.The ratio could fall under all of the
answers.ANS:C
Assets:Current assets$1,700$1,120$1,544Plant
and equipment (net)8,1107,8305,404Total
assets1,004695772$10,814$9,645$7,720Liabilit
ies and Stockholders' Equity:Current
liabilities$950$880$769Long-term
liabilities2,0231,5911,544Capital stock ($10
par)4,6004,6003,000Paid-in capital in excess of
par770770389Retained
earnings2,4711,8042,018Total liabilities and
stockholders' equity$10,814$
9645$7,720Income StatementFor the Year
Ended April 30(in thousands of
dollars)201020092008Net
sales$38,610$32,175$25,740Cost of
sales25,10019,95015,400Gross
profit$13,510$12,225$10,340Selling
expenses7,7006,5655,148Administrative
expenses4,2704,1753,861Total operating
expenses$11,970$10,740$9,009Operating
income$ 1,540$ 1,485$1,331Interest
expense11595100Net income before tax$
1,425$ 1,390$1,231Income taxes655645541Net
income$ 770$ 745$ 690Required:Perform a
vertical, common size analysis of the income
statement. Comment on significant
trends.ANS:201020092008Net
sales100.0%100.0%100.0%Cost of
sales65.062.059.8Gross
profit35.038.040.2Selling
expenses19.920.420.0Administrative
expenses11.113.015.0Total operating
expenses31.033.435.0Operating income4.04.6
5.2Interest expense.3.3.4Net income before
tax3.74.34.8Income taxes1.72.02.1Net
income2.0%2.3%2.7%Although absolute profits
have risen, the profit margin on sales has
declined steadily. The principal cause ofthe
decline is increased cost of sales. Cost of sales
have risen from 59.8% to 65.0%. This increase is
offset by declining selling and administrative
costs in relation to sales. Taxes as a percent of
sales also have declined.
11.On the left is a list of terms related to trend
analysis and other types of financial
information and services. On the right are
descriptions and definitions of these
terms.Required:Match each term to its best
description by placing the correct number
before the term._____a.Vertical, common-size
statement1.Full or partial statements expressed
in percentages of a given base._____
b.Segment reporting2.Requires full financial
statements on a quarterly basis._____ c.Interim
reporting3.All statement figures are expressed
as a percentage of a base figure from that
year's statement._____ d.Trend analysis4.A
breakdown by major lines of business, only
required in SEC reporting._____ e.Common
size5.A breakdown by major lines of
business._____ f.Horizontal6.All statement
figures are expressed as a percentage of baseyear figures.7.Requires estimation of some
expense items.8.A comparison of financial data
over time.9.Visual aids to understanding
financial
data.ANS:a.3b.5c.7d.8e.1f.6Descriptions/definit
ions not used are 2, 4, and 9.
12.The Clothes Clutch, a retail clothier, has had
average sales of $400,000 for the last five
years, 2006–2010. The firm's total assets at the
end of 2010 were $400,000.An internal staff
cost analyst has prepared the following
financial data from the annual reports. You
have been hired as a consultant to help analyze
the financial
position.20102009200820072006Current
Ratio2.802.432.362.102.00Acid Test
Ratio2.031.931.821.611.47Days' Sales in
Receivables6158544235Merchandise Inventory
Turnover4.204.104.103.903.70Debt
Ratio0.480.500.490.470.47Times Interest
Earned4.604.805.905.706.00Sales as a Percent
of 1996 Sales1.461.231.121.061.00Net Income
as a Percent of 1996
Income1.311.201.101.061.00Gross Profit
Margin38.5%38.8%38.9%40.0%39.7%Operating
Expenses to Net
Sales11.4%11.3%11.5%11.4%11.7%Net Profit
Margin7.6%8.6%8.9%9.4%9.3%Return on Total
Assets9.4%9.6%9.6%10.0%10.7%Required:a.Ex
plain the trend in liquidity. Make specific
reference to the effect of receivables and
inventory on this trend.b.Briefly describe the
trend in the long-term, debt-paying ability of
The Clothes Clutch. Explain the cause(s) of this
trend.c.The net profit margin has declined
substantially. Cite and discuss specific causes of
this.d.Has the firm utilized its total assets
effectively? Discuss the ability of the firm to
generate sales based on total assets. (Use
DuPont analysis.)e.Specifically cite and briefly
describe two additional types of information
that would aid in your analysis.ANS:a.Both the
current ratio and acid-test ratio have risen.
Initially, this might appear to be a good sign.
However, days' sales in receivables have nearly
doubled, indicating a worsening problem in the
collection of receivables. This problem could
cause the rise in the current ratio and acid-test
ratio.Merchandiseinventory turnover has
increased, although not substantially. This
indicates better movement of inventory.
Overall, liquidity appears to be good, but not as
good as it appears based on the current ratio
and acid-test ratio because receivables appear
to create a liquidity problem.b.Two measures
of long-term, debt-paying ability are given. The
debt ratio appears to be relatively stable.
However, the times interest earned ratio has
declined. This indicates that the firm is not
covering its debt as well as it did previously.
This decrease could restrict its future borrowing
power.c.Gross profit margin has declined
slightly, indicating a slight rise in the cost of
goods sold. Operating expenses to net sales has
remained relatively stable. Other causes of the
decline could be other income and expense
items, such as interest expense. Problems with
interest were already indicated in times
interest earned.d.This question calls for the use
of DuPont analysis, specifically, asset turnover.
Return on=Net Profit Total AssetTotal
AssetsMarginTurnover20109.4=7.6 1.2420099.
6=8.6 1.1220089.6=8.9 1.08200710.0=9.4 1.0
6200610.7=9.3 1.15This computation shows
that part of the decline in net profit margin
between 2006 and 2010 has been offset by
increased turnover. Increased 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:Common-size
analysisIndustry statisticsThe cash flow
statementOther specific ratiosSegment
dataData for competition13.Listed below are
several ratios.a.net profit marginb.total asset
turnoverc.return on assetsd.DuPont return on
assetse.operating income marginf.operating
asset turnoverg.return on operating
assetsh.DuPont return on operating
assetsi.sales to fixed assetsj.return on
investmentk.return on total equityl.return on
common equitym.gross profit margin
Required:Match the letter that goes with each
formula.Net Income Before Nonrecurring Items
-_____ 1.Preferred DividendsAverage Common
EquityNet Income Before Noncontrolling
Interestand Nonrecurring_____ 2.Items +
[(Interest Expense) (1 -1 Tax Rate)]Average
(Long -Term Liabilities + Equity)Net Income
Before Noncontrolling Interest_____ 3.and
Nonrecurring ItemsNet SalesNet Income Before
Noncontrolling Interest_____ 4.and
Nonrecurring ItemsAverage Total Assets_____
5.Operating IncomeNet Sales_____ 6.Operating
IncomeAverage Operating Assets_____ 7.Net
SalesAverage net Fixed AssetsNetIncome
Before Nonrecurring Items -_____ 8.Dividends
on Redeemable preferred StockAverage Total
Equity_____ 9.Gross ProfitNet Sales_____
10.Operating Income Margin Operating Asset
Turnover_____ 11.Net SalesAverage Operating
Assets_____ 12.Net Profit Margin Total Asset
Turnover_____ 13.Net SalesAverage Total
Assets
ANS:1.l2.j3.a4.c5.e6.g7.i8.k9.m10.h11.f12.d13.
ba