Profitability Measures

Profitability Measures

a-     Gross Profit Margin

b-    Operating profit margin

c-     Net Profit Margin

d-    Earnings Per Share (EPS)

e-     Return on Total Assets (ROA)

f-      Return On Common Equity (ROE)

Sales – Revenue	We divide Gross Profit , Operating Profit Margin and Net Profit on Sales  to calculate Margin
Less: Cost of goods sold
Gross Profit
Less Operating expenses
Operating Profit
Less Interest
Less Tax
Less Preferred stock Dividends
Net Profit

-        DuPont Analysis

Examples

Example 1

The data presented below shows actual figures for selected accounts of McKeon Company for the fiscal year ended May 31, 2004, and selected budget figures for the 2005 fiscal year. McKeon's controller is in the process of reviewing the 2005 budget and calculating some key ratios based on the budget. McKeon Company monitors yield or return ratios using the average financial position of the company. (Round all calculations to three decimal places if necessary.)

Sales*	$350,000
Cost of goods sold	160,000
Interest expense	3,000
Income taxes (40% rate)	48,000
Dividends declared and paid in 2005	60,000
Administrative expense	67,000
*All sales are credit sales.

   Composition of Current Assets

	5/31/05	5/31/04
Cash	$20,000	$10,000
Accounts receivable	100,000	70,000
Inventory	70,000	80,000
Other	20,000	20,000
	$210,000	$180,000

   McKeon Company's total asset turnover for 2005 is
A - 0.805
B - 0.761
C - 0.722
D - 0.348
The 2005 return on assets for McKeon Company is
A - 0.261
B - 0.148
C - 0.157
D - 0.166

B - correct
0.761Total asset turnover is calculated as sales divided by average assets. Sales were $350,000 and average assets were $460,000 ($485,000 in 2002 and $435,000 in 2001). This gives us $350,000 ? $460,000 = .761.
C - correct
0.157The return on assets is net income after taxes and interest divided by average total assets of $460,000 ($485,000 in 2002 and $435,000 in 2001). Net income is $72,000 ($350,000 - $160,000 - $3,000 - $48,000 - $67,000). This gives us $72,000 ? $460,000 = .156. Dividends are not included in the calculation of net income because they are a distribution of that income.

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Example 2

Return on investment may be calculated by multiplying total asset turnover by

A - Average collection period.
B - Profit margin.
C - Debt ratio.
D - Fixed-charge coverage.

B - correct
Profit margin. Return on investment is calculated as the profit of the company divided by the average total assets. The profit margin is calculated as profit divided by net sales. Total asset turnover is calculated as net sales divided by average total assets. Putting all of the formulas together, if we multiply the total asset turnover by profit margin we eliminate the net sales figure from each of the numbers and are left with the formula for return on investment – profit divided by average total assets.

Example 3

The ratio that measures a firm's ability to generate earnings from its resources is

A - Days' sales in inventory.
B - Sales to working capital.
C - Days' sales in receivables.
D - Asset turnover.

D - correct
Asset turnover. Asset turnover is calculated as sales divided by total assets and is a measure of the company’s ability to generate earnings from all of its resources.

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Example 4

Book value per common share represents the amount of shareholders' equity assigned to each outstanding share of common stock. Which one of the following statements about book value per common share is correct?

A - Market price per common share usually approximates book value per common share.
B - Book value per common share can be misleading because it is based on historical cost.
C - A market price per common share that is greater than book value per common share is an indication of an overvalued stock.
D - Book value per common share is the amount that would be paid to shareholders if the company were sold to another company.

B - correct
Book value per common share can be misleading because it is based on historical cost.Because the calculation of book value per share is based off of balance sheet amounts, it is very possible that the book value per share will not reflect the current situation of the company. This is demonstrated by assuming that a company owns an asset that has appreciated greatly in value while the company has held it. This asset will be recorded on the boos at its lower cost of acquisition and this will lead to an understated book value per share.

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Example 5

Return on investment (ROI) is a term often used to express income earned on capital invested in a business unit. A company's ROI is increased if

A - Sales increase by the same dollar amount as expenses and total assets.
B - Sales remain the same and expenses are reduced by the same dollar amount that total assets increase.
C - Sales decrease by the same dollar amount that expenses increase.
D - Net profit margin on sales increases by the same percentage as total assets.

B - correct
Sales remain the same and expenses are reduced by the same dollar amount that total assets increase.ROI is calculated as net income divided by total assets. One way to solve this problem is to simply set up a basic ROI of, for example, $100,000 ? $400,000 = .25, and then go through the choices changing these figures outlined in each option. If the sales remain the same and expenses are reduced, this will increase the net income to $150,000. This makes the ROI .375.

Example 6

A company has a 50% gross margin, general and administrative expenses of $50, interest expense of $20, and net income of $10 for the year just ended. If the corporate tax rate is 50%, the level of sales revenue for the year just ended was

A - $90
B - $135
C - $150
D - $180

D - correct
$180If net income is $10 and the tax rate is 50%, we know that income before taxes is $20. We also know that the cost of goods sold is 50% of the sales price since the gross margin is 50%. Total expenses are $70 (general and administrative and interest). The formula for the calculation of the revenue is as follows (where R represents revenue): R - .5R – 70 = 20. Solving for R we get $180, which is the revenue of this company.

Cash Ratios and Activity Ratios

Cash Ratios  & Activity Ratios

1-  Cash Ratios

a.     Cash Ratio

b.     Cash to Current Liability ratio

c.      Cash Flow Ratio

d.     Restricted Cash to total Cash ratio

Cash Ratios are more restrictive methods in measuring liquidity

Other Ratios

1-   Working Capital turnover. (Sales – to – working capital ratio)

-         A high turnover ratio may indicate very high sale relative to current Working capital and it is good sign of the effectiveness of management but very high ratio may mean the company in undercapitalized because company needs more Working capital to respond to high sales otherwise many customers will be lost for insufficient inventory to meet this high demand.

-         Working Capital Turnover is an aggregate liquidity measure (Working Capital = CA-CL)

-         Working Capital Turnover is liquidity & Activity measure because it measure the movement in current assets

2-  Doubtful Accounts to gross A/R Ratio

 

Note that Provision for doubtful account

It can be calculated by many way as indicated above (% of sales or % of AR or Aging Method)

3-    Liquidity Index Ratio ( is discussed after Activity ratios)

Example 1

The ratio of sales to working capital is a measure of

A - Collectibility.
B - Financial leverage.
C - Liquidity.
D - Profitability.

C - Correct
Liquidity. Liquidity relates to the ability of the company to meet its liabilities as they come due. Most ratios that involve working capital are liquidity measures, as is this one.

Example 2
A high sales-to-working-capital ratio could indicate

A - Unprofitable use of working capital.
B - Sales are not adequate relative to available working capital.
C - The firm is undercapitalized.
D - The firm is not susceptible to liquidity problems.

C - correct
The firm is undercapitalized.

Activity Ratios

1-   Inventory Turnover

It means how many times inventory purchased and sold.

And it means how many days inventory is stored in store.

2-  Accounts Receivable Turnover

It means how many times you make sales on credit and collect your receivables.

3-  Accounts Payable Turnover

It means how many times you make Purchases on credit and Pay your Payables

4-  Total Assets Turnover

it indicates the efficiency with which the firm uses it is assets to generate Sales

 

Note that

-         Time required to convert AR to Cash is AR period or (Days Sales outstanding period)

-         More time for AR to collect your cash is bad indicator for credit policy, and more time for inventory to sell (Inventory period) is bad indicator for management of inventory & Sales

-         Times required to convert Inventory to Cash is AR period + Inventory Period (Because you need time to sell inventory which is inventory period and you need time to collect your cash which is AR period) and it is called Operating Cycle

-         So Operating Cycle = AR period + Inventory period

-         AP period is the period that you pay your payable, and more time is good indicator for using the organization resource but very high period may indicate bad relationship with suppliers.

-         AP period is considered period that you have money so it decreases cash cycle

-         Cash Cycle is period is the length of time it takes to convert an investment in cash into inventory to cash again (from purchasing to selling

-         Cash Cycle = AR period + Inventory Period – AP period

-         Cash Cycle = Operating Cycle – AP Period , SO Cash Cycle < Operating Cycle.

-         Effective working capital management involves shortening the cash conversion cycles as much as possible without harming operations. This strategy improves profitability because the longer the cash conversion cycle , the greater the need for financing thus financing charges increases which lead to a decreased profitability

-         Using LIFO in Increase Prices (Inflation times) will lead to Increase Cost of sales, and decrease inventory hold so CA is decreased (So CR will decrease), and Inventory turnover is increased

-         For example you have 3 units and their prices 10 , 20 , 30 if you use FIFO you will sell unit $10 and cost of sales will be low and high inventory (20 + 30= $50) so Lower inventory turnover (due to Lower Cost of sales recorded). If you use LIFO you will sell unit cost $30 so Cost of sales will increase, Low profit , Low taxes, and Lower inventory (10+20=30) so Higher Inventory Turnover due to higher Cost of sales is recorded)

Using LIFO in increasing Prices
Inventory remained	Cost of sales (Sold)
Low (Because the remaining item is recorded with low cost)	High (Because unit sold is the high cost units )
Current Asset is Decreased because inventory is understated so Current Ratio is decreased but Quick ratio is not affected	Gross Profit (= Sales – Cost of sales) will decrease and so EBIT will decrease so Taxes will decrease and NI will increase (in finance using NPV it is better to use LIFO in Increasing Prices times because low tax today and high tax later years)
Inventory turnover is increased because Cost of sales is increased & Inventory on average is reduced

-         Using Just In Time (JIT) inventory is Maximum and Inventory period is minimum

-         Days sales in receivable would be Understated if the company uses its Business Year as an accounting period

-         Increase in Cash discount may incentive customers to pay early so it may lead to Decrease Days Sales in Receivable

-         Extending Credit Period will lead to increase Days Sales in Receivable because customers will late in payment

-         2/10-30 terms mean that 2% cash discount is made if cash payment is made within first 10 days and maximum period allowed is 30 days and net credit period is 20 days (30-10 =20 days)

Examples

Example 1

The following inventory and sales data are available for the current year for Volpone Company. Volpone uses a 365-day year when computing ratios.

	November 30, 2005	November 30,2004
Net credit sales	$6,205,000
Gross receivables	350,000	320,000
Inventory	960,000	780,000
Cost of goods sold	4,380,000

Volpone Company's average number of days to collect accounts receivable for the current year is

A - 18.87 days.
B - 19.43 days.
C - 19.71 days.
D - 21.17 days.

C - correct
19.71 days. The average number of days to collect receivables is calculated as 365 divided by the receivables turnover. Receivables turnover is calculated as credit sales divided by average receivables. Credit sales were $6,205,000 and average receivables were $335,000. This gives a receivables turnover of 18.52. Dividing 365 by 18.52 gives us 19.71 days as the number of days to collect receivables.

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Example 2
The following inventory and sales data are available for the current year for Volpone Company. Volpone uses a 365-day year when computing ratios.

	November 30, 2005	November 30,2004
Net credit sales	$6,205,000
Gross receivables	350,000	320,000
Inventory	960,000	780,000
Cost of goods sold	4,380,000

Volpone Company's average number of days to sell inventory for the current year is

A - 51.18 days.
B - 65.00 days.
C - 72.50 days.
D - 80.00 days.

Volpone Company's operating cycle for the current year is

A - 70.61 days.
B - 86.17 days.
C - 92.21 days.
D - 98.87 days.

C - correct
72.50 days.The average number of days to sell inventory is calculated as 365 divided by the inventory turnover. Inventory turnover is calculated as the cost of goods sold divided by average inventory. Cost of goods sold was $4,380,000 and average inventory was $870,000. This gives an inventory turnover of 5.03. Dividing 365 by 5.03 gives us 72.5 days as the number of days to sell inventory.
C - correct

Example 3
In computing inventory turnover, the preferred base to use is the

A - Sales base because it is more likely to reflect a change in trend.
B - Sales base because it provides turnover rates that are considerably higher.
C - Sales base because it more clearly represents operational activity.
D - Cost of sales base because it eliminates any changes due solely to sales price changes.

D - correct

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Example 4
A ratio that measures the movement of current assets is

A - Working capital turnover.
B - Working capital to total assets.
C - Return on owners' equity.
D - The current ratio.

A - correct

Example 5

Lisa, Inc.
   Statement of Financial Position
   December 31, 2002
   (in thousands)

Assets Current Assets	2005	2004
Cash	$30	$25
Trading securities	20	15
Accounts receivable (net)	45	30
Inventories (at lower of cost of market)	60	50
Prepaid items	15	20
Total current assets	170	140
Long-term investments Securities (at lost)	25	20
Property, plant & equipment Land (at cost)	75	75
Building (net)	80	90
Equipment (net)	95	100
Intangible assets Patents (net)	35	17
Goodwill (net)	20	13
Total long-term assets	330	315
Total assets	$500	$455
Liabilities & equity Current liabilities
Notes payable	$23	$12
Accounts payable	47	28
Accrued interest	15	15
Total current liabilities	85	55
Long-term debt
Notes payable 10% due 12/31/2005	10	10
Bonds payable 12% due 12/31/2004	15	15
Total long-term debt	25	25
Total liabilities	110	80
Equity
Preferred - 5% cumulative, $100 par, nonparticipating, authorized, issued and outstanding, 1,000 shares	100	100
Common - $10 par 20,000 shares authorized, 15,000 issued and outstanding shares	150	150
Additional paid-in capital - common	75	75
Retained earnings	65	50
Total equity	390	375
Total liabilities & equity	$500	$455

 
1- Lisa Inc.'s acid test (quick) ratio at December 31, 2005 was

A - .6 : 1.0
B - 1.1 : 1.0
C - 1.8 : 1.0
D - 2.0 : 1.0

2- Assume net credit sales and cost of goods sold for 2005 were $300,000 and $220,000 respectively. Lisa Inc.'s accounts receivable turnover for 2005 was

A - 4.9 times.
B - 5.9 times.
C - 6.7 times.
D - 8.0 times.

Assume net credit sales were $300,000 for 2005, Lisa Inc.'s average collection period for 2005, using a 360-day year was

A - 36 days.
B - 45 days.
C - 54 days.
D - 61 days.

5-    Assume sales and cost of goods sold for 2005 were $300,000 and $220,000, respectively. Lisa Inc.'s inventory turnover was

A - 3.7 times.
B - 4.0 times.
C - 4.4 times.
D - 5.0 times.

B - correct
1.1 : 1.0The acid test (or quick) ratio is calculated as follows: (Cash + Receivables + Trading Securities) ё Current Liabilities. Given the information in this question, we get ($30,000 + $20,000 + $45,000) ё $85,000. This is 1.1.

D - correct
8.0 times. Accounts receivable turnover is calculated as net credit sales divided by average accounts receivable. Average accounts receivable was $37,500, and given information that credit sales were $300,000, we get a receivables turnover of 8

B - correct
45 days.The average collection period is calculated as average accounts receivable divided by the average daily sales. Average receivables were 37,500 (45,000 + 30,000 divided by 2) and the average sales were $833.33 ($300,000 divided by 360). Dividing $37,500 by $833.33 gives us 45 days of sales in receivables. This means that it takes 45 days to collect receivables.

B -correct
4.0 times.The inventory turnover is calculated as average the cost of sales divided by the average annual inventory. They give us in the problem the annual cost of sales of $220,000. The average inventory is $55,000. The inventory turnover is calculated as $220,000 divided by $55,000, or 4 times. This means that Lisa sells their inventory four times a year

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Example 6
The ratio of sales to working capital is a measure of

A - Collectibility.
B - Financial leverage.
C - Liquidity.
D - Profitability.

C - Correct
Liquidity. Liquidity relates to the ability of the company to meet its liabilities as they come due. Most ratios that involve working capital are liquidity measures, as is this one.

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Example 7
If a company decided to change from the first-in, first-out (FIFO) inventory method to the last-in, first-out (LIFO) method during a period of rising prices, its

A - Current ratio would be reduced.
B - Inventory turnover ratio would be reduced.
C - Cash flow would be decreased.
D - Debt-to-equity ratio would be decreased.

A - correct.

Example 8

To determine the operating cycle for a retail department store, which one of the following pairs of items is needed?
A - Days' sales in accounts receivable and average merchandise inventory.
B - Cash turnover and net sales.
C - Accounts receivable turnover and inventory turnover.
D - Asset turnover and return on sales.

C - correct

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Example 9
Accounts receivable turnover will normally decrease as a result of

A - The write-off of an uncollectible account (assume the use of the allowance for doubtful accounts method).
B - A significant sales volume decrease near the end of the accounting period.
C - An increase in cash sales in proportion to credit sales.
D - A change in credit policy to lengthen the period for cash discounts.

D - correct
A change in credit policy to lengthen the period for cash discounts

Example 10

The data presented below shows actual figures for selected accounts of McKeon Company for the fiscal year ended May 31, 2004, and selected budget figures for the 2005 fiscal year. McKeon's controller is in the process of reviewing the 2005 budget and calculating some key ratios based on the budget. McKeon Company monitors yield or return ratios using the average financial position of the company. (Round all calculations to three decimal places if necessary.)

	5/31/05	5/31/04
Current assets	$210,000	$180,000
Noncurrent assets	275,000	255,000
Current liabilities	78,000	85,000
Long-term debt	75,000	30,000
Common stock ($30 par value)	300,000	300,000
Retained earnings	32,000	20,000

  
   2005 Operations

Sales*	$350,000
Cost of goods sold	160,000
Interest expense	3,000
Income taxes (40% rate)	48,000
Dividends declared and paid in 2005	60,000
Administrative expense	67,000
*All sales are credit sales.

   Composition of Current Assets

	5/31/05	5/31/04
Cash	$20,000	$10,000
Accounts receivable	100,000	70,000
Inventory	70,000	80,000
Other	20,000	20,000
	$210,000	$180,000

The 2005 accounts receivable turnover for McKeon Company is

A - 1.882
B - 3.500
C - 5.000
D - 4.118

Using a 365-day year, McKeon's inventory turnover is
A - 171 days.
B - 160 days.
C - 183 days.
D - 78 days.

D - correct
4.118Accounts receivable turnover is net credit sales divided by average accounts receivable. For McKeon, budgeted credit sales for 2005 are $350,000 and the average accounts receivable is $85,000 ($70,000 actual at the end of 2004 and $100,000 projected at the end of 2005). This gives us $350,000 ? $85,000 = 4.118.

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A - correct
171 days.In order to calculate the days sales in inventory for 2005, we first need to calculate how many times the inventory turns over during the year. This is COGS divided by average inventory. COGS is budgeted at $160,000 and average inventory is $75,000 ($70,000 actual at year-end 2004 and $80,000 planned for year-end 2005). This gives us an inventory turnover ratio of $160,000 ? $75,000 = 2.13. If the inventory turns over 2.13 times during the year, then the days sales in inventory equals 171 days (365 ? 2.13).

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Example 11
Using the data p

resented below, calculate the cost of sales for the Beta Corporation for the past year.

Current ratio	3.5
Acid test ratio	3.0
Current liabilities at year end	$600,000
Beginning inventory	$500,000
Inventory turnover	8.0

A - $1,600,000
B - $2,400,000
C - $3,200,000
D - $6,400,000

C - correct
 

So CA = 2,100,000

Inventory = 300,000

S0

Cost of sales = 2,400,000

Example 12

A high sales-to-working-capital ratio could indicate

A - Unprofitable use of working capital.
B - Sales are not adequate relative to available working capital.
C - The firm is undercapitalized.
D - The firm is not susceptible to liquidity problems.

C - correct
The firm is undercapitalized. Because the company is generating such a high return on the working capital, it may indicate that the company does not have enough capital to invest in what it could invest in. This is not necessarily the case, but a possible situation of the company. The company may be able to utilize additional capital to further increase sales, to reduce the risk related to the high sales-to-working-capital ratio, or for other purposes.

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Example 13
The days' sales in receivables ratio will be understated if the company

A - Uses a natural business year for its accounting period.
B - Uses a calendar year for its accounting period.
C - Uses average receivables in the ratio calculation.
D - Does not use average receivables in the ratio calculation.

A - correct
Business Year = 240 < Natural Business year = 360 days

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Example 14
Which one of the following inventory cost flow assumptions will result in a higher inventory turnover ratio in an inflationary economy?

A - FIFO.
B - LIFO.
C - Weighted average.
D - Specific identification.

B - correct

For example you have 3 units and their prices 10 , 20 , 30 if you use FIFO you will sell unit $10 and cost of sales will be low and high inventory (20 + 30= $50) so Lower inventory turnover (due to Lower Cost of sales recorded). If you use LIFO you will sell unit cost $30 so Cost of sales will increase, Low profit , Low taxes, and Lower inventory (10+20=30) so Higher Inventory Turnover due to higher Cost of sales is recorded)