Chapter 4—Profitability Analysis

MULTIPLE CHOICE

1. One important difference between return on assets (ROA) and return on common shareholder’s equity
(ROCE) is
a. ROA does not differentiate based on how a company finances its assets; ROCE does.
b. ROA does not distinguish between the different types of income items, such as income
from continuing operations, discontinued operations, extraordinary items and changes in
accounting principles; ROCE does.
c. ROCE does not distinguish between the different types of income items, such as income
from continuing operations, discontinued operations, extraordinary items and changes in
accounting principles; ROA does.
d. ROCE does not differentiate based on how a company finances its assets; ROA does.
ANS: A PTS: 1

2. Asset turnover represents

a. The ability of the firm to generate income from operations for a particular level of sales.
b. The ability to generate sales from a particular investment in assets.
c. The ability to manage the level of investment in assets for a particular level of assets.
d. The number of days, on average, it takes management to turnover assets.
ANS: B PTS: 1

3. Which factor does not explain differences or changes in ROA?

a. Operating leverage
b. Cyclicality of sales
c. Product life cycle
d. Financial leverage
ANS: D PTS: 1

4. Which of the following industries would you expect to have, on average, high asset turnover and low
profit margin?
a. Hotels
b. Grocery stores
c. Utilities
d. Oil and Gas extraction
ANS: B PTS: 1

5. Firms with high levels of operating leverage experience which of the following in comparison to firms
with low levels of operating leverage
a. Higher levels of risk in operations.
b. Lower expected rates of return.
c. Lower variability in returns on assets.
d. Higher sales.
ANS: A PTS: 1

6. Return on assets can be disaggregated into three components. Which of the following is not one of the
components?
a. Assets Turnover ratio

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 b. Profit Margin ratio
c. Debt to Equity ratio
d. Capital Structure Leverage ratio
ANS: D PTS: 1

Orca Industries
Below are the two most recent balance sheets and most recent income statement for Orca Industries.
The company has an effective tax rate of 35%.

Balance Sheet
2011 2010
Assets:
Cash $10,000 $ 6,000
Accounts Receivable (net) 6,000 1,500
Inventory 8,000 10,000
Long-lived assets 12,000 11,000
Less: Accumulated depreciation (4,000) (2,000)
Total assets $32,000 $26,500

Liabilities and Stockholders’ Equity:

Accounts payable $ 5,000 $ 6,000
Deferred revenues 1,000 2,000
Long-term note payable 10,000 10,000
Less: Discount on note payable (800) (1,000)
Common stock 12,000 6,000
Retained earnings 4,800 3,500
Total liabilities and stockholders’ equity $32,000 $26,500

Income Statement
For the year ended December 31, 2011
Revenues $42,000
Cost of goods sold (24,000)
Depreciation expense (2,000)
Interest expense (3,000)
Bad debt expense (2,000)
Other expense (including income taxes) (9,000)
Net income $ 2,000

7. Refer to the information for Orca Industries. The return on assets for Orca Industries is
a. 6.8%
b. 13.5%
c. 10%
d. 12.3%
ANS: B
[2,000 + (1 - .35)3,000] / [(32,000 + 26,500)/2] = 13.5%

PTS: 1

8. Refer to the information for Orca Industries. The return on common shareholders’ equity for Orca
Industries is
a. 15.2%
b. 13.5%

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 c. 10%
d. 11.9%
ANS: A
2,000 / [(16,800 + 9,500)/2] = 15.2%

PTS: 1

9. Refer to the information for Orca Industries. The profit margin for computing ROA for Orca
Industries is
a. 9.4%
b. 13.5%
c. 4.8%
d. 12.3%
ANS: A
[2,000 + (1 - .35) 3,000] / 42,000 = 9.4%

PTS: 1

10. Refer to the information for Orca Industries. Orca’s asset turnover is
a. 1.31
b. 1
c. 1.58
d. 1.44
ANS: D
42,000 / [(32,000 + 26,500)/2] = 1.44

PTS: 1

11. Refer to the information for Orca Industries. Orca’s accounts receivable turnover is (assume that
Orca makes all sales on account)
a. 7.0
b. .53
c. 11.2
d. 10
ANS: C
42,000 / [(6,000 + 1,500) / 2] = 11.2

PTS: 1

12. Refer to the information for Orca Industries. Orca’s basic earnings per share is
a. .22
b. .13
c. .25
d. .30

ANS: A
2,000/(12,000+6,000)/2=.22

PTS: 1

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Net Devices Inc.
The following balance sheets and income statements are for Net Devices Inc., a manufacturer of small
electronic devices, including calculators, personal digital assistants and mp3 players. For purposes of
these questions assume that the company has an effective tax rate of 35%.

BALANCE SHEETS

ASSETS ($ in thousands)

Fiscal year end 2011 2010 2009

Cash $ 875,650 $ 571,250 $ 154,230
Marketable securities 6,560 0 0
Receivables 771,580 775,250 902,000
Inventories 1,320,150 1,254,600 1,418,500
Other current assets 249,000 231,200 229,900
Total current assets 3,222,940 2,832,300 2,704,630

Property, plant & equipment 1,118,750 1,100,300 1,122,400

Intangibles 263,050 241,000 215,600

Deposits & other assets 184,500 168,250 168,900
Total assets $4,789,240 $4,341,850 $4,211,530

LIABILITIES ($ in thousands)

Fiscal year end 2011 2010 2009

Accounts payable $1,178,540 $1,061,100 $1,138,250
Current long term debt 18,100 316,500 150,900
Accrued expenses 664,100 615,900 585,400
Income taxes payable 138,900 108,400 38,200
Other current liabilities 0 0 0
Total current liabilities 1,999,640 2,101,900 1,912,750

Long term debt 478,250 378,400 599,630

Other long term liabilities 13,350 0 0
Total liabilities 2,491,240 2,480,300 2,512,380

Preferred stock 850,000 850,000 550,000

Common stock net 4,000 3,950 3,800
Additional Paid-in Capital 869,000 758,000 689,500
Retained earnings 1,430,500 1,055,000 1,245,050
Treasury stock (855,500) (805,400) (789,200)
Shareholders' equity 2,298,000 1,861,550 1,699,150

Total Liab. & Equity $4,789,240 $4,341,850 $4,211,530

INCOME STATEMENTS ($ in thousands)

Fiscal year end 2011 2010

Net sales $11,455,500 $11,082,100
Cost of Goods Sold (8,026,450) (7,940,065)
Gross profit 3,429,050 3,142,035

Selling, general & admin. Exp. (1,836,400) (1,789,200)

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 Income before deprec. & amort. 1,592,650 1,352,835

Depreciation & amortization (785,250) (757,250)

Interest expense (46,195) (43,340)

Income before tax 761,205 552,245

Provision for income taxes (157,725) (112,290)
Minority interest -- --

Net income $ 603,480 $ 439,955

Outstanding shares (in thousands) 308,515 303,095

Preferred Dividends (in thousands) $85,000 $85,000

13. Refer to the information for Net Devices Inc. What is the rate of return on assets for Net Devices for
2011?
a. 11.64%
b. 14.50%
c. 12.60%
d. 13.88%
ANS: D
[603,480 + (1-.35)  46,195] / [(4,789,240 + 4,341,850)/2] = 13.88%

PTS: 1

14. Refer to the information for Net Devices Inc. What is the profit margin for ROA for Net Devices for
2010?
a. 7.26%
b. 4.22%
c. 5.00%
d. 3.97%
ANS: B
[439,955 + (1-.35)  43,340] / 11,082,100 = 4.22 %

PTS: 1

15. Refer to the information for Net Devices Inc. What is the accounts receivable turnover ratio for Net
Devices for 2011?
a. 24.65
b. 14.85
c. 14.81
d. 10.50
ANS: C
11,455,500 / [ (771,580 + 775,250) / 2 ] = 14.81

PTS: 1

16. Refer to the information for Net Devices Inc. What is the inventory turnover for Net Devices for
2011?
a. 10.32
b. 8.90

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 c. 2.51
d. 6.23
ANS: D
8,026,450 / [ (1,320,150 + 1,254,600) / 2] = 6.23

PTS: 1

17. Refer to the information for Net Devices Inc. What is Net Devices’ return on common shareholders’
equity for 2011?
a. 26.54%
b. 30.89%
c. 35.81%
d. 42.16%
ANS: D
[603,480 - 85,000] / [(1,448,000 + 1,011,550)/2] = 42.16%

PTS: 1

18. Refer to the information for Net Devices Inc. What is Net Devices’ capital structure leverage ratio for
2011?
a. 3.89
b. 1.68
c. 3.71
d. 10.32
ANS: C
[(4,789,240 + 4,341,850) / 2 ] / [(1,448,000 + 1,011,550) / 2] = 3.71

PTS: 1

19. Refer to the information for Net Devices Inc. What is Net Devices’ earnings per share for 2011?
a. $1.00
b. $1.70
c. $1.96
d. $0
ANS: B
(603,480,000 - 85,000,000) / (308,515,000 + 303,095,000)/2 = $1.70

PTS: 1

20. Which of the following might an analyst not want to eliminate from past earnings when using past
earnings to forecast future earnings?
a. nonrecurring gains from the sale of assets.
b. unusual asset impairment charges.
c. nonrecurring restructuring charges.
d. revenue from the sale of inventory.
ANS: D PTS: 1

21. Sustainable earnings represent

a. the level of earnings expected to persist in the future.
b. the level of earnings and the growth in the levels of earnings expected to persist in the

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 future.
c. the growth rate of future earnings.
d. retained earnings.
ANS: B PTS: 1

22. The statutory tax rate differs from a firm’s average tax rate due to which of the following reasons
a. the statutory tax rate is a marginal tax rate.
b. some expenses are included in book income but do not enter into taxable income.
c. the average tax rate is for a period of three years.
d. the statutory tax rate does not effect GAAP measures of revenues and expenses.
ANS: B PTS: 1

23. The profit margin for ROA indicates the ability of a firm to generate earnings for a particular level of
a. sales
b. assets
c. working capital
d. shareholders’ equity
ANS: A PTS: 1

24. Which of the following would be considered a committed fixed cost ( a cost that is incurred regardless
of the level of activity during the period)?
a. depreciation expense
b. bad debt expense
c. advertising expense
d. cost of goods sold
ANS: C PTS: 1

25. Hall and Porter argue that firms have two generic alternative strategies for any particular product.
These strategies are
a. low risk focus, low risk focus
b. retail customer focus, wholesale customer focus
c. product differentiation, low-cost leadership
d. low operating leverage, high operating leverage
ANS: C PTS: 1

26. Which of the following is not a way a company can achieve a low-cost position
a. economies of scale
b. production efficiency
c. customer service
d. outsourcing
ANS: C PTS: 1

27. Which of the following scenarios is consistent with an increasing cost of goods sold to sales
percentage and increasing inventory turnover?
a. Firm raises prices to increase its gross margin but inventory sells more slowly.
b. Weak economic conditions lead to reduced demand for a firm’s products, necessitating
price reductions to move goods.
c. Strong economic conditions lead to increased demand for a firm’s products, allowing price
increases.
d. Firm shifts its product mix toward lower margin, faster moving products.

4-7
 ANS: D PTS: 1

Extreme Sports Company and All Sports Corporation

Below is financial information for two sporting goods retailers. Extreme Sports Company operates a
retail business and franchising business. At the end 2011, Extreme Sports had 263 Company-owned
and 120 franchise-operated retail stores. Extreme’s stores are located in suburban, strip mall and
regional mall locations, the company operates in 32 states. All Sports Corporation sells sporting goods
and related products at over 2,500 Company-operated retail stores.

Selected Data for All Sports and Extreme Sports

(amounts in millions)
All Sports Extreme Sports
Sales $5,320 $1,344
Cost of Goods Sold 3,897 887
Interest Expense 138 43
Net Income 212 33
Average Inventory 998 286
Average Fixed Assets 1,163 130
Average Total Assets 2,472 662
Average Tax Rate 40% 40%

28. Refer to the information for Extreme Sports Company and All Sports Corporation.
Compute the Asset Turnover for All Sports
a. 3.2%
b. 2.15
c. 8.9%
d. 1.1%
ANS: B
[$5320/2472=2.15
PTS: 1

29. Refer to the information for Extreme Sports Company and All Sports Corporation.
What is the return on assets for All Sports?
a. 11.9%
b. 10.8%
c. 9.2%
d. 8.6%
ANS: A
[212 + (1-.4)  138 ] / 2,472 = 11.9%

PTS: 1

30. Refer to the information for Extreme Sports Company and All Sports Corporation.
Calculate All Sports’ inventory turnover ratio
a. 5.3
b. 1.2
c. 3.9
d. .256
ANS: C
3,897/998=3.9

4-8
 PTS: 1

31. Multiples of EPS to value firms are referred to as.

a. ROA
b. price-earnings ratios
c. ROCE
d. Weighted average number of common shares outstanding
ANS: B PTS: 1

32. Adjustments for dilutive securities and the adjustment to weighted average number of
shares outstanding presumes that the dilutive securities are converted to common shares

a. as of the beginning of the year.

b. as of the end of the year.
c. as of the middle of the year.
d. as of the point in time where the maximum number of shares are outstanding.
ANS: A PTS: 1

33. To calculate diluted EPS, the accountant does all of the following except:
a. adds back to net income any compensation expense recognized on the employee stock
options
b. adds back any interest expense (net of taxes) on convertible bonds
c. adds back any dividends on convertible preferred stock the firm subtracted in computing
net income to common shareholders.
d. enters only the net incremental shares issued (shares issued under options minus assumed
shares repurchased) in the computation of diluted EPS.
ANS: A PTS: 1

34. Which of the following is the primary objective in most financial statement analysis?
a. to value a firm’s equity securities.
b. to look for unrecorded liabilities.
c. to establish a firm’s strategy within the industry.
d. to define markets for the firm.
ANS: A PTS: 1

35. Time-series analysis helps answer all of the following questions except:
a. Is the firm becoming more or less profitable over time?
b. Is the firm becoming more or less risky?
c. How is management of the firm responding to external economic forces?
d. What is the amount of assets or capital required to generate a particular level of earnings?
ANS: D PTS: 1

36. Critics of EPS as a measure of profitability point out that it does not consider:
a. simple capital structures.
b. the amount of assets or capital required to generate a particular level of earnings.
c. the deduction of preferred stock dividends from net income.
d. Adjustments for dilutive securities and the adjustment to weighted average number of
shares outstanding for complex capital structures.
ANS: B PTS: 1

4-9
 Ramos Company
Ramos Company included the following information in its annual report:
2011 2010 2009
Sales $178,400 $162,500 $155,500
Cost of goods sold 115,000 102,500 100,000
Operating expenses 50,000 50,000 45,000
Net income 13,400 10,000 10,500

37. Refer to the information for Ramos Company. In a common size income statement for 2011, the
operating expenses are expressed as:
a. 30.3%
b. 28.0%
c. 43.8%
d. 100%
ANS: B
$50,000 / $178,400 = 28%

PTS: 1

38. Refer to the information for Ramos Company. In a common size income statement for 2009, the cost
of goods sold are expressed as:
a. 64.3%
b. 40.0%
c. 87 %
d. 103%
ANS: A
$100,000 / $155,500 = 64.3%

PTS: 1

39. Refer to the information for Ramos Company. In a common size income statement for 2011, the cost
of goods sold are expressed as:
a. 130%
b. 115%
c. 64.5%
d. 63.1%
ANS: C
$115,000 / $178,400 = 64.5%

PTS: 1

40. Refer to the information for Ramos Company. In a percentage change income statement over the
period of 2009 to 2011, what is the change in sales?
a. 100%
b. 87.2%
c. 12.8%
d. 14.7%
ANS: D
($178,400 - $155,500)/ $155,500 = 14.7%

PTS: 1

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41. Refer to the information for Ramos Company. In a percentage change income statement over the
period of 2009 to 2011, what is the change in net income?
a. 100%
b. 21.6%
c. 72.4%
d. 27.6%
ANS: D
($13,400 - 10,500) / $10,500 = 27.6%

PTS: 1

42. Which of the following are better indicated by percentage change statements than common-size
statements?
a. monetary changes
b. profitability
c. stability
d. growth and decline
ANS: D PTS: 1

43. Common-size analysis requires the analyst to be aware that percentages can change because of all of
the following except:
a. changes in expenses in the numerator independent of changes in sales
b. changes in sales independent of changes in expenses
c. interaction effects between the numerator and denominator
d. All of these are possible explanations.
ANS: D PTS: 1

44. Firms with complex capital structures can use which of the following in calculating EPS
a. outstanding convertible bonds.
b. stock options exercised
c. stock warrants issued
d. all of the above
ANS: D PTS: 1

45. The computation of the additional shares to be issued on the exercise of stock options
assumes that the firm would repurchase common shares on the open market using an
amount equal to the sum of all the following except:
a. any cash proceeds from such exercise
b. net incremental shares issued
c. any unamortized compensation expense on those options
d. any tax benefits that would be credited to additional paid-in capital
ANS: B PTS: 1

46. Another term for earnings power is

a. nonrecurrent revenue.
b. nonrecurrent gains.
c. sustainable earnings.
d. net change in equity.
ANS: C PTS: 1

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47. The three elements of risk that help in understanding differences across firms and changes over time in
ROAs are:
a. product life cycles, cyclicality of sales, competitive constraint.
b. operating leverage, cyclicality of sales, product life cycles.
c. cyclicality of sales, competitive constraint, operating leverage.
d. operating leverage, competitive constraint, product life cycles.
ANS: B PTS: 1

Carl Industries
Carl Industries has condensed balance sheets as shown:
2011 2010 2009
Assets:
Current assets 65,000 $46,500 $80,000
Plant & equipment, net 600,000 420,000 410,000
Intangible assets, net 15,000 36,500 50,000
Total assets 680,000 $503,000 540,000

Liabilities & Stockholders’ Equity:

Current liabilities $70,000 $25,000 $33,500
Long-term liabilities 420,000 290,000 400,000
Stockholders’ equity 190,000 188,000 106,500
Total liabilities & equity $680,000 $503,000 540,000

48. Refer to the information for Carl Industries. In a common size balance sheet for 2010, plant and
equipment (net) is expressed as
a. 74.5%
b. 93.2%
c. 83.5 %
d. 30.5%
ANS: C
$420,000/503,000 83.50%
PTS: 1

49. Refer to the information for Carl Industries. In a common size balance sheet for 2009, total liabilities
and equity are expressed as
a. 25.9%
b. 100%
c. 74.1%
d. 103.6%
ANS: B PTS: 1

50. Refer to the information for Carl Industries. In a percentage change balance sheet over the period of
2009 to 2011, what is the change in long-term liabilities?
a. 94.7%
b. 15.4%
c. 5.3%
d. 5%
ANS: D
($ ($420,000-400000)/$400,000=5%

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 PTS: 1

51. Refer to the information for Carl Industries. In a percentage change balance sheet over the period of
2009 to 2011, what is the change in current assets?
a. 78.6%
b. (27.3%)
c. (21.4%)
d. (18.75%)
ANS: D
($65,000-80,000)/80,000=(18.75%)
PTS: 1

COMPLETION

1. In order to measure how profitable a firm is in generating a return for its common shareholders, a
financial analyst would examine the return on
_____________________________________________.

ANS: common shareholders’ equity

PTS: 1

2. When the financial analysts multiplies the profit margin for ROA with the assets turnover ratio the
result is called______________
ANS: return on assets

PTS: 1

3. The ____________________ effect of interest expense on net income equals one minus the marginal
tax rate times the interest expense.

ANS: incremental

PTS: 1

4. Return on common equity can be disaggregated into profit margin for ROCE, capital structure
leverage and _________________________________________________.

ANS: asset turnover

PTS: 1

5. Return on assets can be disaggregated into asset turnover and

____________________________________________________________.

ANS: profit margin for return on assets

PTS: 1

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 6. Return on assets will likely differ across firms and across time. Three elements of risk that will help
explain these differences are ________________________________________, cyclicality of sales and
stage and length of product life cycle.

ANS: operating leverage

PTS: 1

7. Return on assets will likely differ across firms and across time. Three elements of risk that will help
explain these differences are operating leverage, ___________________________________, and stage
and length of product life cycle.

ANS: cyclicality of sales

PTS: 1

8. Firms with high operating leverage have a higher proportion of _________________________ in their
cost structure.

ANS: fixed costs

PTS: 1

9. Firms with ____________________ levels of operating leverage experience greater variability in their
return on assets.

ANS: high

PTS: 1

10. The ability of a firm to generate income from operations given a particular level of sales is measured
by the ______________________________.

ANS: profit margin

PTS: 1

11. The ability of a firm to manage the level of investment in assets for a particular level of sales is
measured by the ______________________________.

ANS: asset turnover

PTS: 1

12. Accounts receivable turnover is calculated by dividing

________________________________________ by average net accounts receivable.

ANS: net sales on account

PTS: 1

13. Inventory turnover is calculated by dividing ________________________________________ by

average inventories.

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 ANS: cost of goods sold

PTS: 1

14. Return on assets can be a misleading ratio when analyzing technology firms because two important
assets, ______________________________ and ______________________________ do not appear
on their balance sheets

ANS: their employees; their technologies

PTS: 1

15. When calculating Basic earnings per share net income is adjusted by____________
ANS: preferred dividends

PTS: 1

16. When calculating the return on fixed assets sales is divided by _________________

ANS: Average fixed assets

PTS: 1

17. One problem with using EPS as a measure of profitability is that it does not consider the amount of
____________________ or ____________________ required to generate a particular level of
earnings.

ANS: assets, capital

PTS: 1

18. When an analyst uses measures of past profitability to forecast the firm’s future profitability the
expectation is that those revenues, gains, expenses and losses will ____________________.

ANS: persist

PTS: 1

19. ________________________________________ is the level of earnings and the growth in the levels
of earnings expected to persist in the future.

ANS: Sustainable earnings

PTS: 1

20. The ___________________________________ of interest expense on net income equals one minus
the marginal tax rate times interest expense.

ANS: incremental effect

PTS: 1

21. The rationale for adding back the _______________________________________________________

relates to attaining consistency in the numerator and denominator of ROA.

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 ANS: minority interest in earnings

PTS: 1

22. Economic theory suggests that higher levels of ____________________ in any activity should lead to
higher levels of ___________________________________.

ANS: risk, expected return

PTS: 1

23. All else being equal, firms with high levels of ________________________________________ incur
more risk in their operations and should earn higher rates of return.

ANS: operating leverage

PTS: 1

24. To reduce the risk inherent in ______________________________ a company should strive for a high
proportion of variable costs in its cost structure.

ANS: cyclical sales

PTS: 1

25. Firms that have either convertible securities or stock options or warrants outstanding have
__________________________________________________.

ANS: complex capital structures

PTS: 1

26. EPS is an ambiguous measure of profitability because it reflects operating performance in the
numerator and ________________________________________ in the denominator.

ANS: capital structure

PTS: 1

27. Operating income is negative in an amount equal to _________________________ when revenues are
zero.

ANS: fixed costs

PTS: 1

28. Firms and industries characterized by heavy fixed capacity costs and lengthy periods required to add
new capacity operate under a ___________________________________.

ANS: capacity constraint

PTS: 1

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SHORT ANSWER

1. Below is financial information for two restaurant retailers. Popper’s Company operates an innovative
retail bakery-cafe business and franchising business. At the end 2010, Popper’s had 132 company-
owned and 346 franchise-operated bakery-cafes. Popper’s located most of their unique bakery-cafe
concept stores in suburban, strip mall, and regional mall locations. As a first mover in this concept, the
company operates in 32 states. Simmer Corporation began operations five years earlier than Popper’s
and purchases and roasts whole bean coffees and sells them, along with numerous coffee drinks and
related products at over 2,900 Company-operated retail stores.

Selected Data for Popper’s Company and Simmer Corporation

(amounts in millions)
Simmer Popper’s
Net Sales $4,076 $278
Sales Simmer $5,000 Popper’s
300
Cost of Goods Sold 1,686 97
Interest Expense 0 0
Net Income 268 22
Average Inventory 303 4
Average Fixed Assets 2,163 130
Required:
a. Compute the Inventory turnover, fixed asset turnover, and accounts receivable turnover.
b. Describe the likely reasons for the difference in the accounts receivable turnover and the
inventory turnover

ANS:
a. Simmer Popper’s
Inventory turnover $$1686/$303=5.56 $97/$22=4.41

Fixed assets turnover $5,000/$2,163= 2.31 = $300/130=2.31=

Accounts receivable turnover $4,076/$2,598=1.57 $278/120 = 2.32 1

The differences between the two companies accounts receivable turnover can be explained
by looking at the individual company’s credit policies and the general economic conditions.
As the economy weakens companies may take longer to pay off their accounts receivable.
Companies that have looser credit policies are assuming more default risk than their
counterparts with stricter credit policies. Simmer may be having some collection issues and
need to re-evaluate their credit policies. Popper’s has the lower inventory turnover ratio and
this could be accounted for because Popper’s sells higher priced bakery goods and as a
result has less sales. Additionally bakery goods have a shorter life span than does coffee
beans and drinks made to order.

PTS: 1

2. Sensitron and Douglas Tools manufacture and market power tools and accessories. Sensitron targets
customers in the professional contractor market, while Douglas Tools focuses on home users and
professionals. Selected financial data for the companies appears below.

Sensitron 2010 2009 2008

Sales $2,109,100 $2,095,700 $2,175,700

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 Average Accounts Receivable 564,500 608,650 631,072
Change in Sales from previous year 0.64% -3.68% 11.83%

Douglas Tools 2010 2009 2008

Sales $4,394,000 $4,245,600 $4,474,900
Average Accounts Receivable 718,800 745,850 803,150
Change in Sales from previous year 3.50% -5.12% 0.59%

Required:
1. Calculate the accounts receivable turnover ratio for each firm for year 2010, 2009, 2008.
2. Suggest reasons for the differences in the accounts receivable turnover ratios for these two
firms.

ANS:
1.
2010 2009 2008
A/R Turnover-- $2,109,100 / 564,500 $2,095,700 / 608, 650 $2,175,700 / 631,072
Sensitron =3.74 =3.44 =3.45
A/R Turnover-- $4,394,000 / 718,800 $4,245,600 / 745,850 $4,474,900 / 803,150
Douglas Tools =6.11 =5.69 =5.57

2.
The main reason for the difference is that Sensitron are sold at more specialty retail stores. Sensitron
probably allows these customers to have more lenient credit terms.

PTS: 1

3. Sensitron and Douglas Tools manufacture and market power tools and accessories. Sensitron targets
customers in the professional contractor market, while Douglas Tools focuses on home users and
professionals. Both firms use the same cost flow assumption for valuing inventories and cost of goods
sold. Selected financial data for the companies appears below.

Sensitron 2010 2009 2008

Cost of Goods Sold $1,144,200 $1,134,100 $1,169,400
Average Inventory 372,550 397,050 436,870
Change in Sales from previous year 0.64% -3.68% 11.83%

Douglas Tools 2010 2009 2008

Cost of Goods Sold $2,876,100 $2,846,600 $2,889,000
Average Inventory 730,550 778,100 797,500
Change in Sales from previous year 3.50% -5.12% 0.59%

Required:
1. Calculate the inventory turnover ratio for each firm for year 2010, 2009, 2008.
2. Suggest reasons for the differences in the Inventory turnover ratios for these two firms.

ANS:
1.
2010 2009 2008
Inventory
Turnover-- $1,144,200 / 372,550 $1,134,100 / 397,050 $1,169,400 / 436, 870
Sensitron =3.07 =2.86 =2.68
Inventory

4-18
 Turnover-- $2,876,100 / 730,550 $2,846,600 / 778,100 $2,889,000 / 797,500
Douglas Tools =3.94 =3.66 =3.62

2.
The main reason for the difference is that Sensitron sells more of a specialty product.

PTS: 1

4. Linda’s Clothing is a retailer of contemporary women’s clothing. Selected financial information for
Linda’s appears below:

2011 2010 2009 2008

Net Income $ 56,759 $ 31,150 $ 15,375 $14,750
Total Assets at year-end $381,500 $246,250 $145,490 $71,268
Weighted Average number of shares
Outstanding 84,215 80,546 77,965 75,888
Total Liabilities at year-end 205,967 119,657 60,522 17,623
Common Stockholders' Equity at year-end $175,533 $126,593 $ 84,968 $53,645
Interest Expense 165 195 258 368

Required:
a. Compute the rate of return on assets for the years 2009-2011. Linda’s has an effective tax
rate of 35%.
b. Compute the rate of return on common shareholders’ equity for the years 2009-2011.
c. Compute basic earnings per share for the years 2009-2011.
d. Interpret the changes in ROA versus ROCE and EPS over the three-year period.

ANS:
2011 2010 2009
a. ROA 18.12% 15.97% 14.34%
b. ROCE 37.57% 29.45% 22.18%
c. EPS $0.67 $0.39 $0.20
d. As Linda’s Clothing begins to finance more of its assets with liabilities the gap between
ROA and ROCE increases. The company is extremely profitable and all ratios are
increasing. As the company has become more profitable it has been able to fund operations
and expansion with internally generated funds as opposed to issuing large amounts of
additional equity (relative to the increase in assets). This allows the company to increase
EPS.

PTS: 1

5. Explain the difference between a simple and complex capital structure as the terms are used in the
calculation of EPS.

ANS:

A simple capital structure consists only of common stock and includes no potentially dilutive
securities such as stock warrants, convertible bonds, etc that can dilute earnings per share. A complex
capital structure includes convertible bonds, stock rights, stock warrants, and stock options that when
exercised can potentially lower (dilute) the company’s earnings per share.
PTS: 1

4-19
6. Discuss the economic characteristics of firms that have the following mix of profit margin and asset
turnover. In addition provide an example of an industry that would have the relevant profit margin
asset turnover mix:
A. High profit margin and low asset turnover.
B. Low profit margin and high asset turnover

ANS:
1. Firms and industries characterized by heavy fixed capacity costs and lengthy periods
required to add new capacity operate under a capacity constraint. There is an upper
limit on the size of assets turnover achievable. In order to attract sufficient capital,
these firms must generate a relatively high profit margin. Some of the industries in this
space are oil and gas extraction, hotels, and utilities.
2. Firms whose products are commodity-like in nature, where there are few entry barriers,
and where competition is intense, operate under a competitive constraint. There is an
upper limit on the level of profit margin for ROA achievable. In order to attract
sufficient capital, these firms must strive for high assets turnovers. Some of the
industries in this space are retailers and wholesalers.

PTS: 1

7. Below is financial information for two sporting goods retailers. Extreme Sports Company operates a
retail business and franchising business. At the end 2011, Extreme Sports had 263 Company-owned
and 120 franchise-operated retail stores. Extreme’s stores are located in suburban, strip mall and
regional mall locations, the company operates in 32 states. All Sports Corporation sells sporting goods
and related products at over 2,500 Company-operated retail stores.

Selected Data for All Sports and Extreme Sports

(amounts in millions)
All Sports Extreme Sports
Sales $5,320 $1,344
Cost of Goods Sold 3,897 887
Interest Expense 138 43
Net Income 212 33
Average Accounts Receivable 114 18
Average Inventory 998 286
Average Fixed Assets 1,163 130
Average Total Assets 2,472 662
Average Tax Rate 40% 40%

Calculate the following ratios for All Sports and Extreme Sports:

a. Return on assets
b. Profit margin for ROA
c. Assets turnover
d. Accounts receivable turnover
e. Inventory turnover
f. Fixed asset turnover

ANS:
All Sports Extreme Sports
a. Return on assets 0.119 0.089
b. Profit Margin for ROA 0.055 0.044
c. Assets turnover 2.15 2.03

4-20
 d. Accounts Receivable turnover 46.67 74.67
e. Inventory turnover 3.90 3.10
f. Fixed Asset turnover 4.57 10.34

PTS: 1

PROBLEM

1. Grundig Technologies is a manufacturer. Below are the company’s two most recent balance sheets and
its most recent income statement. Use this information to answer the following questions:

a. Calculate the rate of return on assets (ROA) for 2011. Disaggregate ROA into the profit
margin for ROA and total assets turnover components.
b. Calculate the rate of return on common stockholders’ equity (ROCE) for 2011. Disaggregate
ROCE into the profit margin for ROCE, total assets turnover and capital structure leverage
components.
c. Did financial leverage work to the advantage of the common shareholders during 2011?
Explain.

Grundig Technologies
Balance Sheet
As of December 31

ASSETS 2011 2010

Cash $ 69,000 $ 22,000
Accounts Receivable 82,000 66,000
Supplies 15,000 19,000
Inventories 180,000 189,000
Land 75,000 110,000
Equipment 260,000 200,000
Accumulated Deprec.-EQ. (69,000) (42,000)
TOTAL ASSETS $612,000 $564,000

LIABILITIES
Accounts Payable $ 34,000 $ 47,000
Unearned Rent 15,000 19,000
Bonds Payable 150,000 200,000
Stockholders' Equity
Common Stock( $1 Par Value) 214,000 164,000
Retained Earnings 199,000 134,000
TOTAL LIABILITIES AND EQUITY $612,000 $564,000

Grundig Technologies
Income Statement
For the year ended December 31, 2011

Sales $560,000
Cost of Goods Sold ($320,000)
Gross Profit $240,000

General and Administrative Expense ($38,000)

Selling Expense ($27,000)

4-21
 Interest Expense ($17,000)

Income before Income taxes $158,000

Income Tax Expense (35%) ($55,300)
Net Income $102,700

ANS:
a. ROA = 19.3%, Profit Margin = 20.3%, Assets Turnover = .95

b. ROCE =28.9%, Profit margin = 18.3%, Assets Turnover = .95, Capital Structure
Leverage = 1.65

c. Financial leverage worked to the advantage of common stockholders because ROCE

exceeded ROA.

PTS: 1

2. Use the following information about Sanibel Corporation to calculate the following ratios for 2011
(assume an effective tax rate of 35%):

a. Return on Assets
b. Profit margin for ROA
c. Assets Turnover
d. Return on Common Shareholders’ Equity
e. Profit Margin for ROCE
f. Accounts Receivable Turnover
g. Inventory Turnover
h. Fixed Asset Turnover

Sanibel Corporation
Balance Sheet
As of December 31, 2011 2010
Assets:
Cash and cash equivalents $ 712,300 $ 425,000
Accounts Receivable 408,000 106,250
Inventory 510,000 612,000
Current Assets 1,630,300 1,143,250

Equipment 714,000 654,500

Less: Accumulated depreciation (238,000) (119,000)
Land 425,000 170,000

Total assets $2,531,300 $1,848,750

Liabilities
Accounts Payable $ 297,500 $ 382,500
Accrued Salaries Payable 93,500 136,000
Rent Expense Payable 37,400 17,000
Income Tax Payable 117,300 68,000
Current Liabilities 545,700 603,500

Long-term note payable 850,000 510,000

Total Liabilities 1,395,700 1,113,500

4-22
 Stockholders’ Equity:
Common stock 714,000 510,000
Retained earnings 421,600 225,250

Total liabilities and stockholders’ equity $2,531,300 $1,848,750

Sanibel Corporation
Income Statement
For the year ended December 31, 2011

Revenues $2,499,000
Cost of goods sold (1,428,000)
Gross Profit 1,071,000

Operating Expenses
Depreciation expense (112,000)
Salary expense (233,600)
Insurance Expense (40,000)
Rent Expense (160,000)
Interest Expense (67,200)
Total Operating Expenses (612,800)

Income from Operations 458,200

Income Tax Expense (160,370)

Net income $ 297,830

ANS:
a. Return on Assets--297,830 + 67,200 ( 1-.35) / $2,190,025 = 15.6%

b. Profit margin for ROA--$341,510 / $2,499,000 = 13.7%

c. Assets Turnover--$2,499,000 / $2,190,025 = 1.14

d. Return on Common Shareholders’ Equity--$297, 830 / ($1,870,850/2) = 31.8%

e. Profit Margin for ROCE--$297,830 / $2,499,000 = 11.9%

f. Accounts Receivable Turnover--$2,499,000 / ((408,000+106,250)/2) = 9.72

g. Inventory Turnover--$1,428,000 / ((510,000+612,000)/2) = 2.55

h. Fixed Asset Turnover--$2,499,000 / ($1,606,500/2) = 3.11

PTS: 1

3. The following balance sheets and income statements are for Net Devices Inc., a manufacturer of small
electronic devices, including calculators, personal digital assistants and mp3 players. Use the
information to calculate the following information:

a. Compute the rate of return on assets for Net Devices for both 2011 and 2010. Disaggregate
the rate of return on assets into the profit margin on ROA and asset turnover components.

4-23
 The income tax rate is 35%.
b. Calculate the accounts receivable turnover ratio for Net Devices for 2011 and 2010. All of
the company’s sales were made on account.
c. Calculate the inventory turnover ratio for Net Devices for 2011 and 2010.
d. Calculate the fixed assets turnover ratio for Net Devices for 2011 and 2010.
e. Calculate the rate of return on common shareholders’ equity for Net Devices for 2011 and
2010. The amount of preferred dividends paid each year appear after the income statement.
Calculate profit margin for ROCE.
f. Determine Net Devices capital structure leverage for 2011 and 2010.
g. Calculate Net Devices earnings per share for 2011 and 2010.

ASSETS (in thousands)

Fiscal year end 2011 2010 2009

Cash $ 875,650 $ 571,250 $ 154,230
Marketable securities 6,560 0 0
Receivables 771,580 775,250 902,000
Inventories 1,320,150 1,254,600 1,418,500
Other current assets 249,000 231,200 229,900
Total current assets 3,222,940 2,832,300 2,704,630

Property, plant & equipment 1,118,750 1,100,300 1,122,400

Intangibles 263,050 241,000 215,600

Deposits & other assets 184,500 168,250 168,900
Total assets $4,789,240 $4,341,850 $4,211,530

LIABILITIES (in thousands)

Fiscal year end 2011 2010 2009

Accounts payable $1,178,540 $1,061,100 $1,138,250
Current long term debt 18,100 316,500 150,900
Accrued expenses 664,100 615,900 585,400
Income taxes payable 138,900 108,400 38,200
Other current liabilities 0 0 0
Total current liabilities 1,999,640 2,101,900 1,912,750

Long term debt 478,250 378,400 599,630

Other long term liabilities 13,350 0 0
Total liabilities 2,491,240 2,480,300 2,512,380

Preferred stock 850,000 850,000 550,000

Common stock net 4,000 3,950 3,800
Additional Paid-in Capital 869,000 758,000 689,500
Retained earnings 1,430,500 1,055,000 1,245,050
Treasury stock (855,500) (805,400) (789,200)
Shareholders' equity 2,298,000 1,861,550 1,699,150

Total Liab. & Equity $4,789,240 $4,341,850 $4,211,530

INCOME STATEMENT (in thousands)

Fiscal year end 2011 2010

Net sales $11,455,500 $11,082,100

4-24
Cost of Goods Sold (8,026,450) (7,940,065)
Gross profit 3,429,050 3,142,035

Selling, general & admin. Exp. (1,836,400) (1,789,200)

Income before deprec. & amort. 1,592,650 1,352,835

Depreciation & amortization (785,250) (757,250)

Interest expense (46,195) (43,340)

Income before tax 761,205 552,245

Provision for income taxes (157,725) (112,290)
Minority interest -- --

Net income $ 603,480 $ 439,955

ADDITIONAL INFORMATION
Outstanding shares 308,515,000 303,095,000
Preferred Dividends--Total $85,000,000 $85,000,000

ANS:
Return on Assets 13.88% 10.95%
Profit Margin for ROA 5.53% 4.22%
Assets Turnover 2.51 2.59

Accounts Receivable Turnover 14.81 13.21

Inventory Turnover 6.23 5.94
Fixed Assets Turnover 10.32 9.97

ROCE 42.16% 32.86%

Profit Margin on ROCE 4.53% 3.20%
Capital Structure Leverage 3.71 3.96

Earnings per share $1.68 $1.17

a. Return on Assets:
2011: [603,480 + (1-.35) 46,195] / [( 4,789,240 + 4,341,850)/2] = 13.88%
2010: [ 439,955 + (1-.35) 43,340] / [(4,341,850 + 4,211,530)/2] = 10.95%

Profit Margin on ROA:

2011: [ 603,480 + (1-.35) 46,195] / 11,455,500 = 5.53%
2010: [ 439,955 / (1-.35) 43,340] / 11,082,100 = 4.22 %

Assets Turnover:
2011: 11,455,500 / [( 4,789,240 + 4,341,850)/2] = 2.51
2010: 11,082,100 / [( 4,341,850 + 4,211,530)/2] = 2.59

b. Accounts Receivable Turnover:

2011: 11,455,500 / [(771,580 + 775,250) / 2 ] = 14.81
2010: 11,082,100 / [(775,250 + 902,000) / 2 ] = 13.21

c. Inventory Turnover:
2011: 8,026,450 / [(1,320,150 + 1,254,600) / 2] = 6.23
2010: 7,940,065 / [(1,254,600 + 1,418,500) / 2] = 5.94

4-25
 d. Fixed Assets Turnover:
2011: 11,455,500 / [(1,118,750 + 1,100,300) / 2] = 10.32
2010: 11,082,100 / [(1,100,300+ 1,122,400) / 2] = 9.97

e. ROCE:
2011: [ 603,480 - 85,000] / [( 1,448,000 + 1,011,550)/2] = 42.16%
2010: [ 439,955 - 85,000] / [( 1,011,550 + 1,149,150)/2] = 32.86%

Profit Margin on ROCE:

2011: [ 603,480 - 85,000] / 11,455,500 = 4.53%
2010: [ 439,955 - 85,000] / 11,082,100 = 3.20%

f. Capital Structure Leverage:

2011: [( 4,789,240 + 4,341,850)/2] / [( 1,448,000 + 1,011,550)/2] = 3.71
2010: [( 4,341,850 + 4,211,530)/2] / [( 1,011,550 + 1,149,150)/2] = 3.96

g. Earnings per Share:

2011: 603,480,000 - 85,000,000 / 308,515,000 = $ 1.68
2010: 439,955,000 - 85,000,000 / 303,095,000 = $1.17

PTS: 1

4. Discuss how the following three elements of risk help us understand return on assets differs across
firms and changes over time:
1. Operating leverage
2. Cyclicality of sales
3. Product life cycle

ANS:
1. Firms with high levels of operating leverage experience greater variability in their
ROAs than firms with low levels of operating leverage. All else being equal (see the
discussion of cyclicality of sales in the next section), firms with high levels of
operating leverage incur more risk in their operations and should earn higher rates of
return.
2. The cyclicality of sales represents how the sales of certain goods and services are
sensitive to conditions in the economy. Companies with cyclical products do well when
the economy is in an upswing because customers purchase relatively high-priced items
and sales of these firms grow accordingly. When the economy enters a recession,
customers curtail their purchases and the sales of these firms decrease significantly.
Firms with cyclical sales patterns incur more risk than firms with noncyclical sales.
3. As products move through their life cycles, their ROAs should move from being
negative during the introduction period and become positive during the growth period.
ROA should reach a peak during the maturity stage, and then decline in the decline
phase. This movement in ROA appears negatively correlated with the level of risk.
Risks are probably highest in the introduction and growth stages, when ROA is low or
negative, and least in the maturity phase, when ROA is high.

PTS: 1

5. Examine the four following conditions involving inventory turnover. Discuss what economic factors
might be leading to the condition and whether it suggests positive or negative future economic
conditions.

4-26
 Condition A: Increasing cost of goods sold Condition B: Decreasing cost of goods sold
to sales percentage, coupled with an to sales percentage, coupled with a
increasing inventory turnover. decreasing inventory turnover.
Condition C: Increasing cost of goods sold Condition D: Decreasing cost of goods sold
to sales percentage, coupled with a to sales percentage, coupled with an
decreasing inventory turnover. increasing inventory turnover.

ANS:
Condition A: Increasing cost of goods sold to sales percentage, coupled with an increasing
inventory turnover. Firm lowers prices to sell inventory more quickly. Firm shifts its product mix
toward lower margin, faster moving products. Firm outsources the production of a higher proportion of
its products, requiring the firm to share profit margin with the outsourcer but reducing the amount of
raw materials and work-in-process inventories.

Condition B: Decreasing cost of goods sold to sales percentage, coupled with a decreasing
inventory turnover. Firm raises prices to increase its gross margin but inventory sells more slowly.
Firm shifts its product mix toward higher margin, slower moving products. Firm produces a higher
proportion of its products instead of outsourcing, thereby capturing more of the gross margin but
requiring the firm to carry raw materials and work-in-process inventories.

Condition C: Increasing cost of goods sold to sales percentage, coupled with a decreasing
inventory turnover. Weak economic conditions lead to reduced demand for a firm’s products,
necessitating price reductions to move goods. Despite price reductions, inventory builds up.

Condition D: Decreasing cost of goods sold to sales percentage, coupled with an increasing
inventory turnover. Strong economic conditions lead to increased demand for a firm’s products,
allowing price increases. An inability to replace inventory as fast as the firm sells it leads to an
increased inventory turnover. Firm implements a just-in-time inventory system, reducing storage costs,
product obsolescence, and the amount of inventory held.

PTS: 1

6. Carridine Company reported net income of $1,903 on revenues of $55,618 for Year 4. Interest expense
totaled $459, and preferred dividends totaled $13.5. Average total assets for Year 4 were $17,500. The
income tax rate is 40 percent. Average preferred shareholders’ equity totaled $250, and average
common shareholders’ equity totaled $7,500. Assume that all the following amounts are in thousands.

REQUIRED:
a. Compute the rate of ROA. Disaggregate ROA into profit margin for ROA and assets
turnover components.
b. Compute the rate of ROCE. Disaggregate ROCE into profit margin for ROCE, assets
turnover, and capital leverage ratio components.
c. Calculate the amount of net income to common shareholders derived from the
excess return on creditors’ capital, the excess return on preferred shareholders’ capital,
and the return on common shareholders’ capital.

ANS:
a. Rate of Return on Assets: [$1,903 + (1 – .40)($459)]/$17,500 = 12.4%
Profit Margin for ROA: [$1,903 + (1 – .40)($459)]/$55,618 = 3.9%
Assets Turnover: $55,618/$17,500 = 3.2

b. Rate of Return on Common Shareholders’ Equity: ($1,903 – $13.5)/$7,500 = 25.2%

4-27
 Profit Margin for ROCE: ($1,903 – $13.5)/$55,618 = 3.4%
Assets Turnover: $55,618/$17,500 = 3.2
Capital Structure Leverage Ratio: $17,500/$7,500 = 2.3

c. Average total liabilities equal $9,750 (= $17,500 – $250 – $7,500). Carridine Company earned
$1,209 (= .124 x $9,750; allow for rounding) on assets financed by liabilities
(calculations taken to more decimal places than shown), while the liabilities cost $275.4
[= (1 – .40)($459)]. Therefore, the excess return generated for the common shareholders
on assets financed with liabilities is $933.6 (= $1,209 – $275.4). Carridine Company earned $31 (= .
124 x $250) on assets financed by preferred shareholders’ equity, while this capital costs $13.5.
Therefore, the excess return generated for the common shareholders on assets financed with preferred
shareholders’ capital is $17.5 (= $31 – $13.5). The assets financed by common shareholders’ capital
generated a return for the common shareholders of $930 (= .124  $7,500). Thus net income
available to the common shareholders equals $1,867.6 (= $933.6 + $17.5 + $930 = $1,881.1 – $13.5 of
net income available to the common shareholders). Carridine Company generated about one-half of
the net income available to the common shareholders from the successful use of financial leverage.

PTS: 1 TOP: Problem 4.14

7. Freedom Company reported net income for 2010 of $2,031 million on sales of $25,600 million.
Interest expense for 2010 was $235 million, and minority interest was $344 million for 2010. The
income tax rate is 40 percent. Total assets were $10,800 million at the beginning of 2010 and $14,874
million at the end of 2010. Compute the rate of ROA for 2010 and disaggregate
ROA into profit margin for ROA and asset turnover components.

ANS:
Rate of Return = Profit Margin  Assets
on Assets Turnover

[2,031+ (1+.40)(235) + 344]

0.5 ($14,874 + $10,800) = [2,031+ (1+.40)(235) + 344]
$25,600  $25,600
0.5 ($14,874 +10,800)

21.2% = 10.6%  2.0

PTS: 1 TOP: Problem 4.10

8. Rattigan Industries reported net income (amounts in thousands) for Year 4 of $60,615 on sales of
$1,560,235. It declared preferred dividends of $22,100. Preferred shareholders’
equity totaled $265,750 at both the beginning and end of Year 4. Common shareholders’ equity totaled
$298,150 at the beginning of Year 4 and $365,000 at the end of Year
4. Rattigan had no minority interest in its equity. Total assets were $1,440,000 at the beginning of Year
4 and $1,550,000 at the end of Year 4.

ANS:
Rate of Return on Common Shareholders’ Equity:
($60,615 – $22,100)/[.5($298,150 + $365,000)] = 11.6%
Profit Margin for ROCE:
($60,615 – $22,100)/($1,560,235) = 2.5%
Assets Turnover:
$1,560,235/[.5($1,440,000 + $1,550,000)] = 1.04

4-28
 Capital Structure Leverage Ratio:
[.5($1,440,000 + $1,550,000)]/[.5($298,150 + $365,000)] = 4.5

PTS: 1 TOP: Problem 4.11

9. Krane, [Link] net income (amounts in thousands) of $619,700 for Year [Link] in net income
was income tax expense of $10,400. During the year the company paid the preferred shareholders
$9,000 in dividends. The weighted average of common shares outstanding during Year 4 was 468,810
shares. Krane Inc., subtracted interest expense net of tax saving on convertible debt of $4,820. If the
convertible debt had been converted into common stock, it would have increased the weighted average
common shares outstanding by 20,905 shares. Krane Inc., has outstanding stock options that, if
exercised, would increase the weighted average of common shares outstanding by 7,335 shares.

REQUIRED:
Compute basic and diluted earnings per share for Year 4, showing supporting computations.

ANS:
Basic EPS: ($619,700-9,000)/468,810=$1.30
Diluted EPS: ($619,700 + $4,820-9,000)/ (468,810 + 20,905 + 7,335)=$1.24

PTS: 1 TOP: Problem 4.12

10. Raleigh Manufacturing reported net income (amounts in millions) of $1,166 on sales of $5,520 during
Year 4. Interest expense totaled $75. The income tax rate was 30 percent. Average total assets were
$7,135, and average common shareholders’ equity was $3,405. The firm did not have preferred stock
outstanding or minority interest in its equity.

REQUIRED:

a. Compute the rate of ROA. Disaggregate ROA into profit margin for ROA and assets
turnover components.
b. Compute the rate of ROCE. Disaggregate ROCE into profit margin for ROCE, assets
turnover, and capital structure leverage ratio components.
c. Calculate the amount of net income to common shareholders derived from the
excess return on creditors’ capital and the amount from the return on common
shareholders’ capital.

ANS:
a. Rate of Return on Assets: [$1,166 + (1 – .30)($75)]/$7,135 = 17.1%
Profit Margin for ROA: [$1,166 + (1 – .30)($75)]/$5,520 = 22.1%
Assets Turnover: $5,520/$7,135 = 0.77

b. Rate of Return on Common Shareholders’ Equity: $1,166/$3,405 = 34.2%

Profit Margin for ROCE: $1,166/$5,520 = 21.1%
Assets Turnover: $5,520/$7,135 = .77
Capital Structure Leverage Ratio: $7,135/$3,405 =2.1

c. Average total liabilities equal $3,730 (= $7,135 – $3,405). Raleigh earned $637.8 (= .171 x $3,730)
on assets financed by liabilities, while the liabilities cost $52.5 [= (1 – .30)($75)].
Therefore, the excess return generated for the common shareholders on assets financed with liabilities
is $585.3 (= $637.8 – $52.5). The assets financed by common shareholders’ capital generated a return
for the common shareholders of $582.3 (= .171  $3,405). Thus, net income available to the common
shareholders equals $1,167.6 (= $585.3 + $582.3).

4-29
 About one-half of the return to the common shareholders results from the successful use of financial
leverage.

PTS: 1 TOP: Problem 4.13

11. Below are three relationships that are important to the determination of profitability. Assume assets
were $22,900,000 on Dec. 31, 2008.

1. Operating leverage = Earnings before interest but after taxes

Average assets.
2. Financial structure leverage = Net income available to common shareholders
Earnings before interest but after taxes

3. ROCE = ROA  Common earnings leverage  Financial structure leverage

REQUIRED:
Compute the operating leverage, financial structure leverage, and ROCE (rounded to two places).
Then use these relationships to analyze how the profitability of X-Mart changed over the three year
period below. What does the company need to do to reverse this trend? What are the risks of your
strategy?

As of Dec. 31 2009 2010 2011

ROA 0.10 0.10 0.08
Assets $27,500,000 $23,000,000 $27,600,000
Net income available to common $67,250,000 $68,960,210 $70,910,840
shareholders
Earnings after taxes but before $25,000,000 $24,541,000 $24,794,000
interest

ANS:

ROCE has deteriorated somewhat over the three years in question. The drop in 2011 is due to the
decline in ROA that was not accompanied by the increased use of financial leverage. Had the company
increased its financial structure leverage to 3.44 in 2011, the leverage increase would have fully offset
the ROA decline (3.44  0.98  0.08 = 0.27 ROCE rounded). The financial leverage is increased when
a company’s cost of debt is less than what the company earns on borrowed funds. The company must
weigh this additional borrowing against the possibility of a higher credit risk assigned by lenders,
which could potentially harm shareholders.

Common earnings leverage 0.99 0.97 0.98

Financial structure leverage 2.69 2.81 2.86
ROCE 0.27 0.27 0.22

PTS: 1

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