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Chapter 8 Profitability PROBLEMS PROBLEM 8-1 Net Profit Margin = 2004 2003 5.00% 4.00% Return on Assets = 2004 2003 22.83% 20.00% Total Asset Turnover = 2004 2003 4.57 times 5.00 times per year per year  = Return on Common Equity = 2004 2003 30.88% 25.00% Ahl Enterprise has had a substantial rise in profit to sales. This is somewhat tempered by a reduction in asset turnover. Given a slight rise in common equity, there is a substantial rise in return on common equity. PROBLEM 8-2 a. 2004 2003 Sales Cost of goods sold Gross profit Selling expense General expense Operating income Income tax Net income 100.0% 60.7 39.3 14.6 10.0 14.7 5.9 8.8% 100.0% 60.8 39.2 20.0 8.3 10.9 4.2 6.7% b. Starr Canning has had a sharp decrease in selling expense coupled with only a modest rise in general expenses giving an overall rise in the net profit margin. PROBLEM 8-3 Earnings Before interest and tax $245,000 Interest (750,000 x 6%) 45,000 Earnings before tax $200,000 Tax 80,000 Net income $120,000 Preferred dividends 15,000 Income available to common $105,000 a. b. c. d. = 5.44 times per year PROBLEM 8-4 Vent Molded Plastics Vent Molded Plastics Sales Sales returns Cost of goods sold Selling expense General expense Other income Other expense Income tax Net income 101.0% 7.0 72.1 9.4 7.0 .4 1.5 4.8 5.6% 100.3% .3 67.1 10.1 7.9 .4 1.3 5.5 8.5% Sales returns are higher than the industry. Cost of sales is much higher, offset some by lower operating expenses. Other expense (perhaps interest) is somewhat higher. Lower taxes are perhaps caused by lower income. Overall profit is less, primarily due to cost of sales. PROBLEM 8-5 a. 2004 sales were 122.72% of those in 2003. b. 2004 net earnings were 100.80% of those in 2003. c. 1. Net Profit Margin = 2004 2003 2. Return on Assets = 2004 2003 3. Total Asset Turnover = 2004 2003 4. DuPont Analysis: Return on = Net Profit x Total Asset Assets Margin Turnover 2004 10.42* = 9.39% x 1.11 2003 12.72* = 11.56% x 1.10 *Rounded causes the difference from the 10.38% and 12.67% computed in part 2.  5. 2004 2003 Operating income Net sales Less: Cost of product sold Research and develop- ment expenses General and selling Operating income $1,589,150 651,390 135,314 526,680 $ 275,766 $1,294,966 466,250 113,100 446,110 $ 269,506 Operating Income Margin = 2004 2003 6. Return on Operating Assets = 2004 2003 = 19.53% = 23.24% 7. Operating Asset Turnover = 2004 2003 = 1.13 times = 1.12 times per year per year  8. DuPont Analysis: Return on = Net Profit x Total Asset Assets Margin Turnover 2004 19.61%* = 17.35% x 1.13 2003 23.31%* = 20.81% x 1.12 *Rounding causes the difference from the 19.53% and 23.24% computed in part 6. 9. 2004 2003 Net earnings before minority share Interest expense Earnings before tax Provision for income tax Tax rate 1 – tax rate (interest expense x (1 – tax rate) Net earnings before minority share + (interest expense) x (1 – tax rate) Long-term debt + equity Return on investment $ 149,260 18,768 263,762 114,502 43.4% 56.6% 10,623 159,883 1,019,420 15.7% $ 149,760 11,522 271,500 121,740 44.8% 55.2% 6,360 156,120 933,232 16.7% 10. Return on Common Equity = 2004 2003 = 17.06% = 19.03% d. Profits in relation to sales, assets, and equity have all declined. Turnover has remained stable. Overall, although absolute profits have increased in 2004, compared with 2003, the profitability ratios show a decline. PROBLEM 8-6 a. 1. Net Profit Margin = 2004 2003 2002 = 6.07% = 3.96% = 3.76% 2. Return on Assets = 2004 2003 2002 = 6.04% = 4.21% = 3.82% 3. Total Asset Turnover = 2004 2003 2002 = 1.11 times per year = 1.07 times per year = 1.02 times per year 4. DuPont Analysis Return on Assets = Net Profit Margin x Total Asset Turnover 2004: 6.74% 2003: 4.24% 2002: 3.84% = = = 6.07% 3.96%* 3.76%* x x x 1.11 times 1.07 times 1.02 times *Rounding difference from the 4.21% and 3.82% computed in 2.  5. Operating Income Margin = 2004 2003 2002 (2) Net sales Less: Material and manufacturing costs of products sold Research and development General and selling (1) Operating income (1) Dividend by (20) $1,600,000 740,000 90,000 600,000 1,430,000 170,000 10.63% $1,300,000 624,000 78,000 500,500 1,202,500 97,500 7.50% $1,200,000 576,000 71,400 465,000 1,112,400 87,600 7.30% 6. Return on Operating Assets = 2004 2003 2002 Operating Income_____ Average Operating Income $ 170,000 $1,390,200 12.23% $ 97,500 $1,160,000 8.41% $ 87,000 $1,090,000 7.98% 7. Operating Asset Turnover = 2004 2003 2002 Net Sales_________ Average Operating Assets $1,600,000 $1,390,200 1.15 times $1,300,000 $1,160,000 1.12 times $1,200,000 $1,090,000 1.10 times 8. DuPont Analysis with operating ratios Return on Assets = Net Profit Margin x Total Asset Turnover 2004: 12.22%* 2003: 8.40%* 2002: 8.03% = = = 10.63% 7.50% 7.30% x x x 1.15 1.12 1.10 *Rounding difference from the 12.23%, 8.41%, and 8.04% computed in 6. 9. Estimated tax rate: 2004 2003 2002 (1) Provision for income taxes (2) Earnings before income taxes and Minority equity (1) divided by (2) 1 – tax rate (3) Interest expense x (1-tax rate) $19,000 x 6.00% $18,200 x 59.00% $17,040 x 58.00% (4) Earnings before minority equity (3) plus (4) (A) (5) Total long-term debt (6) Total stockholders’ equity (5) plus (6) (B) (A) divided by (B) $ 62,049 $ 159,100 39.00% 61.00% 11,590 97,051 108,641 211,100 811,200 1,022,300 10.63% $ 35,731 $ 87,150 41.00% 59.00% 10,738 51,419 62,157 212,800 790,100 1,002,900 6.20% $ 32,659 $ 77,760 42.00% 58.00% 9,883 45,101 54,984 214,000 770,000 984,000 5.59% 10. 2004 2003 2002 Net income etc. Average total equity $ 86,851 $811,200 $ 42,919 $790,100 $ 37,001 $770,000 b. All ratios computed indicate a significant improvement I profitability. PROBLEM 8-7 a. 1. 2004 2003 2002 $ 171,115 $1,002,100 = 17.08% $163,497 $980,500 = 16.67% $143,990 $900,000 = 16.00% 2. 2004 2003 2002 $171,115 $839,000 = 20.40% $163,497 $770,000 = 21.23% $143,990 $765,000 = 18.82% 3. 2004 2003 2002 $1,002,100 $ 839,000 = 1.19 times per year $980,500 $770,000 = 1.27 times per year $900,000 $$765,000 = 1.18 times per year 4. DuPont Analysis Return on Assets = Operating Income Margin x Total Asset Turnover 2004: 20.88%* 2003: 21.17%* 2002: 18.88%* = = = 17.08% 16.67% 16.00% x x x 1.19 times per year 1.27 times per year 1.18 times per year *Rounding difference from the 20.40%, 21.23%, and 18.82% computed in 2.  5. Estimated tax rate: 2004 2003 2002 (1) Provision for income taxes (2) Earnings before income taxes tax rate [(1) divided by (2)] 1 – tax rate (3) Interest expense x (1-tax rate) $14,620 x 59.50% $12,100 x 59.00% $11,250 x 57.70% (4) Net earnings (3) plus (4) (A) (5) Average long-term debt (6) Average shareholders’ equity (5) plus (6) (B) (A) divided by (B) $116,473 $287,588 40.50% 59.50% 8,699 171,115 179,814 120,000 406,000 526,000 34.19% $113,616 $277,113 41.00% 59.00% 7,139 163,497 170,636 112,000 369,500 481,500 35.44% $105,560 $249,550 42.30% 57.70% 6,491 143,990 150,481 101,000 342,000 443,000 33.97% 6. 2004 2003 2002 Net earnings Average total equity $171,115 $406,000 $163,497 $369,500 $143,990 $342,000 7. 2004 2003 2002 $1,002,100 $ 302,500 = 3.31 $980,500 $281,000 = 3.49 $900,000 $173,000 = 5.20 b. The ratios computed indicate a very profitable firm. Most ratios indicate A very slight reduction in profitability in 2003. Sales to fixed assets has declined materially, but this is the only ratio for which the trend appears to be negative. PROBLEM 8-8 a. 1. 2004 2003 2002 $20,070-$8,028 $297,580 = 4.05% $16,660-$6,830 $256,360 = 3.83% $15,380-$6,229 $242,150 = 3.78% 2. 2004 2003 2002 $20,070-$8,028 $145,760 = 8.26% $16,660-$6,830 $137,000 = 7.18% $15,380-$6,229 $136,000 = 6.73% 3. 2004 2003 2002 $297,580 $145,760 = 2.04 times per year $256,360 $137,000 = 1.87 times per year $242,150 $136,000 = 1.78 times per year  4. DuPont Analysis Return on Assets = Operating Income Margin x Total Asset Turnover 2004: 8.26% 2003: 7.16%* 2002: 6.73% = = = 4.05% 3.83% 3.78% x x x 2.04 times 1.87 times 1.78 times *Rounding difference from the 7.18% computed in 2. 5. 2004 2003 2002 $ 26,380 $297,580 = 8.86% $ 22,860 $256,360 = 8.92% $ 20,180 $242,150 = 8.33% 6. 2004 2003 2002 $26,380_____ $89,800+$45,850 = 19.45% $ 22,860____ $84,500+$40,300 = 28.32% $ 20,180____ $83,100+$39,800 = 16.42% 7. 2004 2003 2002 = 2.19 times per year = 2.05 times per year = 1.97 times per year  8. DuPont Analysis with Operating Ratios Return on Assets = Operating Income Margin x Total Asset Turnover 2004: 19.40%* 2003: 18.29%* 2002: 16.41%* = = = 8.86% 8.92% 8.33% x x x 2.19 times 2.05 times 1.97 times *Rounding difference from the 19.45%, 18.32%, and 16.42% computed in 6. 9. 2004 2003 2002 $ 91,580 $297,580 = 30.77% $ 80,060 $256,360 = 31.23% $ 76,180 $242,150 = 31.46% b. Net profit margin and total asset turnover both improved. This resulted in a substantial improvement to return on assets. Operating income margin declined slightly in 2003 after a substantial improvement in 2002. Operating asset turnover improved each year. The result of the improvement in operating income margin and operating asset turnover was a substantial improvement in return on operating assets. Gross profit margin declined slightly each year. Overall profitability improved substantially over the three-year period. PROBLEM 8-9 a. 1. 2004 2003 2002 (A) (B) $ 2,100,000 $ 2,600,000 7,000,000 100,000 10,000,000 $19,700,000 $ 1,950,000 $ 2,300,000 6,200,000 100,000 9,000,000 $17,600,000 $ 1,700,000 $ 2,200,000 5,800,000 100,000 8,300,000 $16,400,000 2. Estimated tax rate: 2004 2003 2002 (1) Provision for income taxes (2) Income before tax tax rate = (1) divided by (2) 1 – tax rate (3) Interest expense x (1-tax rate) $80,000 x 58.33% $600,000 x 57.35% $550,000 x 61.82% (4) Net income (3) plus (4) (A) Long-term debt Preferred stock Common equity (B) (A) divided by (B) $ 1,500,000 3,600,000 41.67% 58.33% $ 466,640 $ 2,100,000 $ 2,566,640 $ 7,000,000 100,000 10,000,000 $17,100,000 15.01% $ 1,450,000 3,400,000 42.65% 57.35% $ 344,100 $ 1,950,000 $ 2,294,100 $ 6,200,000 100,000 9,000,000 $15,300,000 14.99% $ 1,050,000 2,750,000 38.18% 61.82% $ 340,000 $ 1,700,000 $ 2,040,010 $ 5,800,000 100,000 8,300,000 $14,200,000 14.37% 3. 2004 2003 2002 = 20.79% = 21.43% = 29.24% 4. 2004 2003 2002 = 20.86% = 21.51% = 20.31% b. Return on assets improved in 2003 and then declined in 2004. Return on investment improved each year. Return on total equity improved and then declined. Return on common equity improved and then declined. In general, profitability has improved in 2003 over 2002 but was down slightly in 2004. c. The use of long-term debt and preferred stock both benefited profitability. Return on common equity is slightly more than return on total equity, indicating a benefit from preferred stock. Return on total equity is substantially higher than return on investment, indicating a benefit from long-term debt. PROBLEM 8-10 a. Sales $120,000 Gross profit (40%) 48,000 Cost of goods sold (60%) 72,000 Beginning inventory $ 10,000 + purchase 100,000 Total available 110,000 - Ending inventory ?____ Cost of goods sold $ 72,000 Ending inventory (110,000-72,000) $ 38,000 b. If gross profit were 50%, the analysis would be as follows: Sales $120,000 Gross profit (50%) 60,000 Cost of goods sold (50%) 60,000 Beginning inventory $ 10,000 Purchases 100,000 Total available $110,000 - Ending inventory 50,000 Cost of goods sold $ 60,000 If gross profit were higher, the loss would be higher. PROBLEM 8-11 Net Profit Retained Earnings Total Stockholders’ Equity a. a stock dividend is declared and paid. b. Merchandise is purchased on credit. c. Marketable securities are sold above cost. d. Accounts receivable are collected. e. A cash dividend is declared and paid. f. Treasury stock is purchased and recorded at cost. g. Treasury stock is sold above cost. h. Common stock is sold. i. A fixed asset is sold for less than book value. j. Bonds are converted into common stock. 0 0 + 0 0 0 0 0 - 0 - 0 + 0 - 0 0 0 - 0 0 0 + 0 - - + + - + PROBLEM 8-12 a. 1. 2004: 2003: 2002: 2001: 2000: 2. 2004: 2003: 2002: 2001: 2000: Cannot compute average assets.  Year-End Balance Sheet Figures 2004: 2003: 2002: 2001: 2000: 3. Average Balance Sheet Figures 2004: 2003: 2002: 2001: 2000: Cannot compute average assets.  Year-End Balance Sheet Figures 2004: 2003: 2002: 2001: 2000: 4. Average Balance Sheet Figures 2004: 7.42% x 1.14 times = 8.46% 2003: 6.76% x 1.11 times = 7.50% 2002: 6.15% x 1.08 times = 6.64% 2001: 5.69% x 1.04 times = 5.92% 2002: Cannot compute average assets Year-End Balance Sheet Figures 2004: 7.42% x 1.14 times = 8.46% 2003: 6.76% x 1.11 times = 7.50% 2002: 6.15% x 1.08 times = 6.64% 2001: 5.69% x 1.04 times = 5.92% 2000: 5.10% x 1.02 times = 5.20%  5. 2004: 2003: 2002: 2001: 2000: 6. 2004: 2003: 2002: 2001: 2000: Average assets cannot be computed.  Year-End Balance Sheet Figures 2004: 2003: 2002: 2001: 2000: 7. 2004: 2003: 2002: 2001: 2000: Average Assets cannot be computed.  Year-End Balance Sheet Figures 2004: 2003: 2002: 2001: 2000: 8. DuPont Return on Operating Assets = Operating Income Margin x Operating Asset Turnover Average Balance Sheet Figures 2004: 11.73% x 1.26 = 14.78% 2003: 10.94% x 1.23 = 13.46% 2002: 10.11% x 1.21 = 12.23% 2001: 9.00% x 1.17 = 10.53% 2000: Average assets cannot be computed. Year-End Balance Sheet Figures 2004: 11.73% x 1.26 = 14.78% 2003: 10.94% x 1.24 = 13.57% 2002: 10.11% x 1.21 = 12.23% 2001: 9.00% x 1.17 = 10.53% 2000: 8.98% x 1.15 = 10.33%  9. 2004: 2003: 2002: 2001: 2000: Average net fixed assets cannot be computed. Year-End Balance Sheet Figures 2004: 2003: 2002: 2001: 2000:  10. Average Balance Sheet Figures 2004: 2003: 2002: 2001: 2000: Average (Long-Term Liabilities + Equity cannot be computed. Year-End Balance Sheet Figures 2004: 2003: 2002: 2001: 2000:  11. Average Balance Sheet Figures 2004: 2003: 2002: 2001: 2000: Average total equity cannot be computed. Year-End Balance Sheet Figures 2004: 2003: 2002: 2001: 2000:  12. Average Balance Sheet Figures 2004: 2003: 2002: 2001: 2000: Average common equity cannot be computed. Year-End Balance Sheet Figures 2004: 2003: 2002: 2001: 2000:  13. 2004: 2003: 2002: 2001: 2000: b. In general, the profitability appears to be very good and the trend is positive. There was not a significant difference in results between using average balance sheet figures and year-end figures. The year-end figure allowed for an additional year was not a very profitable year in relation to subsequent years. 28