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ECON 3A–SP'01–EXAM # 1–ANSWER KEY Page 1 Econ 3A - Financial Accounting - Sp'01 Exam # 1 - 100 points ANSWER KEY ANSWER KEY PROBLEM 1 (25 points) a. What is meant by "profitability"? What kind of information would be useful in assessing profitability? Would creditors or equity investors be more likely to take greater interest in assessing a company's profitability? Why? Profitability is a measure of how well management is using a company's resources to earn a return on those resources. Measures such as the gross profit ratio and the profit margin would be useful in assessing profitability. Both groups would be interested in profitability, but especially equity investors, because profitability greatly influences stock prices. RETURN ON RESOURCES (ASSETS) EMPLOYED GP RATIO PROFIT MARGIN EQUITY INVESTORS STOCK PRICES b. How do the two basic forms of owners' equity items for a corporation–capital stock and retained earnings–differ? Both capital stock and retained earnings represent claims of the shareholders against the assets of the company. They differ in their source. Capital stock represents the amounts invested by the owners which was contributed or paid-in, while retained earnings arise from the earnings of the business which are not distributed in the form of dividends.
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