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Unformatted text preview: 216 Chapter 8 Profitability QUESTIONS 8 1. Profits can be compared to the sales from which they are the residual. They can be compared to the assets that generate sales. Or, they can be viewed as return to the owner. Each measure looks at profits differently. The trends might move in different directions, depending on the base. 8 2. Extraordinary items are by nature nonrecurring. They should be segregated in order to concentrate on profit that will be expected in the next period. Recurring earnings should be used in trend analysis of profitability. 8 3. Expenses as a percent of sales must have increased if profits as a percent of sales declined. 8 4. Profit margin in jewelry is usually much higher than in groceries. Groceries generate total profits based on volume of sales rather than high markup. 8 5. A drop in profits or a rise in the asset base could cause a decline in the ratio. For example, higher cost of sales could cause a decline; or, a substantial investment in fixed assets that are not yet fully utilized could cause a decline. 8 6. DuPont analysis relates return on assets to turnover and margin. It allows for further analysis of return on assets by this breakdown. 8 7. Operating income is sales minus cost of sales and operating expenses. It does not include nonoperating items, such as other income, interest, and taxes. Operating assets are basically current assets plus plant, property, and equipment. They do not include investments, intangibles, and other assets. Removing nonoperating items from the DuPont analysis gives a clearer picture of productive operations. 8 8. Equity earnings are the owners proportionate share of the nonconsolidated subsidiary earnings. These earnings are usually greater than the cash from dividends from the nonconsolidated subsidiary. 8 9. Return on assets is a function of net profit margin and total asset turnover. Return on assets could decline, given an increase in net profit margin, if the total asset turnover declined sufficiently. 217 810. Return on investment measures return to all longterm suppliers of funds. It includes net income plus taxadjusted interest in the numerator and all longterm funds in the denominator. Return on total equity is just return to shareholders. Return on common equity is return only to common shareholders. Net income is reduced by preferred dividends in the numerator, and only common equity is in the denominator. 811. Return on investment is a profitability measure comparing income to capital utilized by the firm. Some measures are return on assts, return on equity, or income available to all capital sources, divided by capital. The given ratio is preferred, since it measures the profit available to all longterm sources of capital against that capital. The interest is multiplied by the tax adjustment factor to put interest on an aftertax basis....
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 Fall '10
 MOYSIDIS
 Valuation

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