{g,0}10.0 Part 10 Analysis of Financial Statements {s}
{d}
{b}Learning Objectives
In this final part you will learn:
1. The nature of the Statement of Changes in Financial Position.
2. The limitations of financial statement information.
3. An approach to analyzing financial statements.
4. Overall measures of performance.
5. Other ratios used in financial statement analysis.
@
10.1 Statement of Changes in Financial Position
An income statement reports revenues and expenses during an
accounting period. Revenues increase {1,17} [what
balance sheet item?][two words], and expenses decrease this item.
*1
OWNERS' EQUITY - OK - Fine.
OWNER'S EQUITY - OK - Fine.
OWNERS EQUITY - OK - Fine.
RETAINED EARNINGS - OK - Fine.
- HINT - Revenues increase owners' equity.
@
10.2
Most entities prepare another financial statement. It summarizes
changes in other balance sheet items during the accounting period. Since
the balance sheet shows the entity's {b}financial position{n} at one moment
of time, the statement of {b}changes{n} in balance sheet items is called
a Statement of Changes in F{1,19} [two words].
*1
INANCIAL POSITION - OK - Good.
FINANCIAL POSITION - OK - Good.
@
10.3
A Statement of Changes in Financial Position (abbreviated {b}SCFP{n})
may focus either on events that changed cash or on events that changed
working capital. In your manual, Exhibit 12 shows the SCFP for
General Mills, Inc., which was prepared on a {1,16} basis.
(A) cash (B) working capital
*1
- POST - {b}{a,10,12}cash
CASH - OK - Yes, that's correct.
A - OK - Yes, that's correct.
WORKING CAPITAL - QUIT - No, look again. The statement focuses on CASH.
B - QUIT - No, look again. The statement focuses on CASH.
@
10.4
As you can see from Exhibit 12, the SCFP has two main sections,
one showing the amount of cash P{1,8,3} during the period from operations,
and the other showing the amount of cash U{2,4,1} during the period for
various purposes.
*1
ROVIDED - OK - Ok.
PROVIDED - OK - Ok.
- HINT - Look again at Exhibit 12.
*2
SED - OK - Fine.
USED - OK - Fine.
- HINT - Look again at Exhibit 12.
@
10.5
In most businesses, the principal source of cash during a period
is the profitable operation of the business. The results of operations
are summarized in the "bottom line" of the income statement. This
amount is the first item in Exhibit 12; it is labelled N{1,12}.
*1
ET EARNINGS - OK - Correct.
NET EARNINGS - OK - Correct.
- HINT - Profit is another name for net earnings.
@
10.6
However, some transactions that affected net earnings in the
current year did not require the use of cash in that year. For
example, most of the plant assets used in the current year were
acquired in previous years. When these assets were acquired, cash or
its equivalent was paid for them, but the depreciation expense for
these plant assets during the current year {1,7} involve a cash
payment during the current year.
(A) did (B) did not
*1
- POST - {b}{a,16,28}did not{n}
DID NOT - OK - You got it right.
DIDN'T - OK - You got it right.
B - OK - You got it right.
DID - QUIT - No, depreciation does NOT involve cash in the current year.
A - QUIT - No, depreciation does NOT involve cash in the current year.
@
10.7
Therefore, as shown in Exhibit 12, depreciation expense, a non-cash
item, is {1,17,3} net earnings to find the amount of
cash provided by operations.
(A) added to (B) subtracted from
*1
- POST - {a,8,13}{b}added to
ADDED TO - OK - Fine.
A - OK - Fine.
SUBTRACTED FROM - OK - No, depreciation expense {b}adds to{n} the net earnings.
B - OK - No, depreciation expense {b}adds to{n} the net earnings.
@
10.8
Because depreciation expense is added to net earnings, some
people think that depreciation is a source of cash. {b}This is
{b}absolutely incorrect.{n} The source of cash is profitable operations.
The depreciation item merely adjusts this number to a cash basis.
@
10.9
As you learned in Part 8, income tax expense reported on the
income statement is calculated by applying the income tax rate to the
corporation's reported earnings. If this amount is greater than the
amount of income tax paid, the difference is called Deferred Income
Taxes. Since Deferred Income Taxes is only an accounting calculation,
not requiring cash in the current year, this amount is {1,16,3}
net earnings in calculating the cash provided by operations.
(A) added to (B) subtracted from
*1
- POST - {a,16,13}{b}added to
ADDED TO - OK - Correct.
A - OK - Correct.
SUBTRACTED FROM - QUIT - No, deferred income taxes is also added to net earnings.
B - QUIT - No, deferred income taxes is also added to net earnings.
@
10.10
As shown by the lower part of the statement, General Mills {b}used{n}{s}
{d}
funds to buy land, buildings, and equipment, ${1,-5} million. It{s}
{d}
{b}obtained{n} funds by the issuance of long-term debt, ${2,-4} million{s}
{d}
and common stock, ${3,-4} million.
*1
246.6 - OK - Correct.
- HINT - No, look again.
*2
37.0 - OK - Fine.
37 - OK - Fine.
- HINT - No, look again.
*3
23.0 - OK - Good.
23 - OK - Good.
- HINT - No, look again.
@
10.11
As a review of earlier parts, you should study each item in
Exhibit 12. Although in some cases different words have been used,
the nature of each has been described earlier. If any term is not clear,
look it up in the Glossary in your manual.
@
10.12
The SCFP (Statement of Changes in Financial Position) is a
rearrangement of information collected in the accounts for the main
purpose of preparing the balance sheet and income statement. It
{1,8,7} require additional accounts or journal entries.
(A) does (B) does not
*1
- POST - {a,10,29}{b}does not
DOES NOT - OK - Well done.
B - OK - Well done.
DOES - QUIT - No, that's wrong.
A - QUIT - No, that's wrong.
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10.13 Limitations on Financial Statement Analysis
In the remainder of this part, we shall describe how
information in financial statements is used. Before doing this,
let's review the reasons why accounting cannot provide a complete
picture of the status or performance of an entity.
@
10.14
One limitation is suggested by the word {b}financial{n}; that is,
financial statements report only events that can be measured in
M{1,8} amounts.
*1
ONETARY - OK - Good.
MONETARY - OK - Good.
ONEY - OK - Good.
MONEY - OK - Good.
- HINT - Financial statements measure monetary amounts.
@
10.15
A second limitation is that financial statements report only events
that {1,13,3}, whereas we are also interested in estimating events
(A) have happened (B) will happen
that {2,13,3}.
(A) have happened (B) will happen
The fact that an entity earned $1 million last year
{3,30,3} what it will earn next year.
(C) definitely predicts (D) does not necessarily indicate
*1
- POST - {a,6,13}{b}have happened
- POST - {s}{a,21,1}This is a function of the {b}Money Measurement Concept{n} which states that {a,22,1}accounting reports only those {b}facts{n} that can be stated in money amounts.
HAVE HAPPENED - OK - Right.
A - OK - Right.
WILL HAPPEN - QUIT - {a,23,1}No, that's incorrect.
B - QUIT - {a,23,1}No, that's incorrect.
*2
- POST - {a,10,37}{b}will happen
- POST - {a,20,1}The {b}Going-Concern Concept{n} states that accounting assumes that an entity {a,21,1}will continue to operate indefinitely, so we are interested in estimating {a,22,1}future events.
WILL HAPPEN - OK - Good.
B - OK - Good.
HAVE HAPPENED - QUIT - Incorrect.
A - QUIT - Incorrect.
*3
- POST - {a,16,39}{b}does not necessarily indicate
- POST - {a,20,1}{c,32,79}
DOES NOT NECESSARILY INDICATE - OK - Correct.
D - OK - Correct.
DEFINITELY PREDICTS - QUIT - No, that's wrong.
C - QUIT - No, that's wrong.
@
10.16
Third, the balance sheet does {u}not{n} show the {1,12,3}
of most assets.
(A) cost (B) market value
Plant assets are reported at their {2,14,3},
(C) unexpired cost (D) market value
whereas their real worth is their {3,14,3}.
(C) unexpired cost (D) market value
*1
- POST - {a,6,28}{b}market value
- POST - {s}{a,21,1}The {b}Cost Concept{n} states that accounting focuses on cost {a,22,1}of assets, not market value.
MARKET VALUE - OK - Correct.
B - OK - Correct.
COST - QUIT - Incorrect.
A - QUIT - Incorrect.
*2
- POST - {a,10,12}{b}unexpired cost
UNEXPIRED COST - OK - Good.
C - OK - Good.
MARKET VALUE - QUIT - No, that's incorrect.
D - QUIT - No, that's incorrect.
*3
- POST - {a,14,38}{b}market value
MARKET VALUE - OK - That's right.
D - OK - That's right.
UNEXPIRED COST - QUIT - That's incorrect.
C - QUIT - That's incorrect.
@
10.17
Also, depreciation is a write-off of {1,12,3}. It is {u}not{n}
an indication of changes in the real value of plant assets.
(A) cost (B) market value
*1
- POST - {a,6,13}{b}cost
COST - OK - Correct.
A - OK - Correct.
MARKET VALUE - QUIT - Incorrect.
B - QUIT - Incorrect.
@
10.18
Fourth, the accountant and management have some latitude in choosing
among alternative ways of recording an event in the accounts. An example
of flexibility in accounting is that in determining inventory values and
cost of sales, the entity may use the LIFO (Last In, First Out), FIFO
(First In, First Out), {u}or{n} average cost method.
@
10.19
Fifth, many accounting amounts are estimates. In calculating
the depreciation expense of a plant asset, for example, one must
estimate its S{1,12} and its R{2,14} [two words].
*1
ERVICE LIFE - OK - Well done.
SERVICE LIFE - OK - Well done.
- HINT - Service life must be used in calculating the depreciation expense.{s}
*2
ESIDUAL VALUE - OK - Very good.
RESIDUAL VALUE - OK - Very good.
- HINT - In calculating the depreciation expense of a plant asset, residual value {a,22,1}must be estimated.
@
10.20 Auditing
All large companies and many smaller ones have their accounting
records reviewed by independent, certified public accountants. This
process is called {b}auditing{n}, and the independent accountants are called
A{1,8,2}.
*1
UDITORS - OK - Correct.
AUDITORS - OK - Correct.
- HINT - The independent accountants are called auditors.
@
10.21
Ordinarily, after completing their examination, the
A{1,8,1} write a letter giving their opinion. This O{2,7,1}
letter is reproduced in the company's annual report. A typical
opinion letter is shown in Exhibit 13. Find it in your booklet
before proceeding.
*1
UDITORS - OK - Correct.
AUDITORS - OK - Correct.
- HINT - Auditors write an opinion letter.
*2
PINION - OK - Good.
OPINION - OK - Good.
- HINT - Auditors write an opinion letter.
@
10.22
The letter says that the auditors {1,8,2} the financial
statements.
(A) prepared (B) examined
*1
- POST - {a,6,32}{b}examined
- POST - {a,21,1}The company, not the auditor, is responsible for {b}preparing{n} the statements.{s}
EXAMINED - OK - Good.
B - OK - Good.
PREPARED - QUIT - Incorrect.
A - QUIT - Incorrect.
@
10.23
The letter says that the financial statements {1,10,2}
present the financial results.
(A) accurately (B) fairly
*1
- POST - {a,6,35}{b}fairly
- POST - {a,20,1}Because judgments and estimates are involved, no one can say that the {a,21,1}financial statements are entirely {b}accurate{n}.
FAIRLY - OK - Correct.
B - OK - Correct.
ACCURATELY - QUIT - That's incorrect.
A - QUIT - That's incorrect.
@
10.24
In the last paragraph of the letter, the auditors assure
the reader that the statements were prepared in conformity with
G{1,41,20} [four words whose acronym is GAAP].
*1
ENERALLY ACCEPTED ACCOUNTING PRINCIPLES - OK - Very good.
GENERALLY ACCEPTED ACCOUNTING PRINCIPLES - OK - Very good.
- HINT - Auditors are supposed to audit according to generally accepted {a,22,1}accounting principles.{s}
@
10.25
If any of the statements on the previous screens cannot be made, the
auditors call attention to the exceptions.
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10.26 Overall Measures of Performance
Although they have limitations, the financial statements usually
provide the most useful information about an entity. We shall focus first
on what they tell about its {b}overall performance{n}.
@
10.27
Shareholders invest money in a business in order to earn a
profit, or {b}return{n}, on that {b}investment{n}. Thus, from the viewpoint
of the shareholders, the best overall measure of the entity's performance
is the R{1,6} that was earned {u}on{n} the owners' I{2,10,2}.
(This is abbreviated as ROI.)
*1
ETURN - OK - That's right.
RETURN - OK - That's right.
- HINT - ROI stands for Return on Owners' Investment.
*2
NVESTMENT - OK - Good.
INVESTMENT - OK - Good.
- HINT - ROI stands for Return on Owners' Investment.
@
10.28
Choose from the following to fill in the blanks:
(A) owners' equity (B) net income
Earlier, you learned that the accounting term for the profit or return
earned in a year is {1,14}. The amount of owners' investment
is reported on the balance sheet with the label {2,14}.
Return on Owners' Investment is the percentage obtained by dividing
{3,14} by {4,14}.
*1
- POST - {a,4,39}{b}net income
NET INCOME - OK - Good.
B - OK - Good.
OWNERS' EQUITY - QUIT - No, Owners' equity is the balance sheet item.
A - QUIT - No, Owners' equity is the balance sheet item.
*2
- POST - {a,4,39}net income {a,4,13}{b}owners' equity
OWNERS' EQUITY - OK - Correct.
OWNER'S EQUITY - OK - Correct.
OWNERS EQUITY - OK - Correct.
A - OK - Correct.
NET INCOME - QUIT - No, owners' investment is a claim or "equity" against the assets.
B - QUIT - No, owners' investment is a claim or "equity" against the assets.
*3
- POST - {a,4,13}owners' equity {a,4,39}{b}net income
NET INCOME - OK - That's right.
B - OK - That's right.
OWNERS' EQUITY - QUIT - No, the other way around.
A - QUIT - No, the other way around.
*4
- POST - {a,4,39}net income {a,4,13}{b}owners' equity
OWNERS' EQUITY - OK - Fine.
A - OK - Fine.
NET INCOME - QUIT - No, the denominator is owners' equity.
B - QUIT - No, the denominator is owners' equity.
@
10.29
In 19x2 Arlen Company had net income of $20,000, and its owners'
equity was $130,000. Calculate its ROI for 19x2. Choose the correct answer
from the following when the blank highlights:
(A) 15.4 (B) owners' equity (C) 20,000
(D) 130,000 (E) net income (F) 6.5
{1,-14,1} ${3,-7}
{c,196,16} = {c,196,10} = {5,-4} % ROI
{2,-14,1} ${4,-7}
*1
NET INCOME - OK - Fine.
E - OK - Fine.
- HINT - No, net income goes here.
*2
OWNERS' EQUITY - OK - Correct.
B - OK - Correct.
- HINT - Owners' equity goes here.
*3
20,000 - OK - That's right.
20000 - OK - That's right.
C - OK - That's right.
- HINT - Look again, net income is $20,000.
*4
130,000 - OK - Good.
130000 - OK - Good.
D - OK - Good.
- HINT - No, owners' equity is $130,000.
*5
15.4 - OK - Right. Not bad, huh?
A - OK - Right. Not bad, huh?
- HINT - ROI = $20,000/$130,000 = 15.4%
@
10.30
In order to judge how well Arlen Company performed, its 15.4%
ROI must be compared with something. If in 19x1 Arlen Company had an ROI of
10%, we can say that its performance in 19x2 was {1,6,4} than in 19x1.
This is the {b}historical{n} basis of comparison.
(A) better (B) worse
*1
- POST - {a,10,13}{b}better
BETTER - OK - Good.
A - OK - Good.
WORSE - QUIT - No, 15.4% is more than 10% so the company did {b}better{n}.
B - QUIT - No, 15.4% is more than 10% so the company did {b}better{n}.
@
10.31
If in 19x2 another company had an ROI of 18%, Arlen's ROI
was {1,6} than the other company's. Or if in 19x2 the average
(A) better (B) worse
ROI of companies in the same industry as Arlen was 18%, Arlen's ROI
was {2,6} than the industry average. This is the {b}external{n}
basis of comparison.
(A) better (B) worse
*1
- POST - {a,6,30}{b}worse
WORSE - OK - Correct.
B - OK - Correct.
BETTER - QUIT - No, 15.4% is less than 18%.
A - QUIT - No, 15.4% is less than 18%.
*2
- POST - {a,14,30}{b}worse
WORSE - OK - Yes, that's correct.
B - OK - Yes, that's correct.
BETTER - QUIT - No, Arlen is behind the industry in 19x2.
A - QUIT - No, Arlen is behind the industry in 19x2.
@
10.32
Finally, if from our experience, we {u}judge{n} that a company like
Arlen should have earned an ROI of 20%, we conclude that Arlen's ROI was
{1,6} than this {b}judgmental standard{n}.
(A) better (B) worse
*1
- POST - {a,8,30}{b}worse
WORSE - OK - Right.
B - OK - Right.
BETTER - QUIT - No, it's 15.4% is less than the expected 20%.
A - QUIT - No, it's 15.4% is less than the expected 20%.
@
10.33
Most comparisons are made in one or more of the three ways
described above. When the space next to each term highlights, type the
letter of its meaning.
1) {b}HISTORICAL{n}: comparing {1,2}{s}
2) {b}EXTERNAL{n}: comparing {2,2}{s}
3) {b}JUDGMENTAL{n}: comparing {3,2}
(A) another entity's performance, or an industry average.
(B) its own performance in the past
(C) a standard based on our judgment
*1
B - OK - Correct.
A - QUIT - No, the answer is B.
C - QUIT - No, the answer is B.
*2
A - OK - Yes, that's right.
B - QUIT - No, the answer is A.
C - QUIT - No, the answer is A.
*3
C - OK - Right.
A - QUIT - No, the answer is C.
B - QUIT - No, the answer is C.
@
10.34
Arlen Company's net income in 19x2 was $20,000. Baker Company's
net income in 19x2 was $50,000. From this information we {1,6}
tell which company performed better.
(A) can (B) cannot
*1
- POST - {a,8,28}{b}cannot
- POST - {a,20,1}We {b}cannot{n} tell because we do not know Baker Company's investment (or {a,21,1}owners' equity).
CANNOT - OK - Right.
B - OK - Right.
CAN - NO - Incorrect.
A - NO - Incorrect.
@
10.35
Baker Company's owners' equity was $1,000,000. Its net income{s}
in 19x2 was $50,000. Find Baker's ROI by typing in the correct number
when the blank highlights:{d}
${1,-9}
{c,196,12} = {3,-3} %
${2,-9}
Arlen Company with an ROI of 15.4% performed {4,6} than
Baker Company.
(A) better (B) worse
*1
50,000 - OK - Correct.
50000 - OK - Correct.
50 - OK - Correct.
- HINT - Net income is $50,000.
*2
1,000,000 - OK - Correct.
1000000 - OK - Correct.
1,000 - OK - Correct.
- HINT - Owners' equity is $1,000,000.
*3
5 - OK - That's right.
- HINT - $50,000 divided by $1,000,000 is 5%.
*4
- POST - {a,20,13}{b}better
BETTER - OK - Good.
A - OK - Good.
WORSE - NO - 15.4% is more than 5%.
B - NO - 15.4% is more than 5%.
@
10.36
The comparison of Arlen Company and Baker Company illustrates
an important point. Most comparisons require the use of {u}percentages{n}
or R{1,6,2}, rather than dollar amounts.
*1
ATIOS - OK - Fine.
RATIOS - OK - Fine.
- HINT - Comparisons are made using percentages or ratios.
@
10.37 Factors Affecting Return on Investment
Ratios can be calculated that help explain the factors that{s}
influenced return on investment. Some of these were explained in earlier
parts. We shall review these ratios and introduce others, using the
financial statements of Arlen Company in Exhibit 14, as well as the diagram
of influential factors and chart of common ratios in Exhibit 15.
We have already described the Return on Equity Investment ratio, which is:
{1,-18}
{c,196,19} = ROI
{2,-18}
*1
NET INCOME - OK - Well done.
- HINT - The numerator of the ROI ratio is net income.
*2
SHAREHOLDER EQUITY - OK - Good.
- HINT - The denominator of the ROI ratio is shareholder equity.
@
10.38
Several factors affect net income. One is gross margin. In an
earlier part you calculated the {b}gross margin percentage{n}. Calculate
it for Arlen Company. Choose the correct answer from the following when
the blank highlights. (If you have difficulty with this or other calculations,
refer to Exhibit 15, where the amounts are calculated.)
(A) sales revenue (B) 40 (C) $300,000
(D) $120,000 (E) 166 (F) gross margin
{1,-13,3} ${3,-7}
{c,196,15} = {c,196,10} = {5,-3} % GROSS MARGIN
{2,-13,3} ${4,-7}
*1
GROSS MARGIN - OK - Good.
F - OK - Good.
- HINT - Gross margin goes here.
*2
SALES REVENUE - OK - Fine.
A - OK - Fine.
- HINT - Sales revenue goes here.
*3
120,000 - OK - Correct.
120000 - OK - Correct.
D - OK - Correct.
- HINT - Look again, gross margin is $120,000.
*4
300,000 - OK - Right.
300000 - OK - Right.
C - OK - Right.
- HINT - No, sales revenue is $300,000.
*5
40 - OK - That's correct.
B - OK - That's correct.
- HINT - Gross margin percentage = $120,000/$300,000 or 40%.
@
10.39
Fill in the numerator and denominator of the gross margin percentage
below:
{1,-13}
{c,196,14} = GROSS MARGIN PERCENTAGE
{2,-13}
*1
GROSS MARGIN - OK - Good.
- HINT - Gross margin percentage = Gross margin/Sales revenue.
*2
SALES REVENUE - OK - Fine.
- HINT - Gross margin percentage = Gross margin/Sales revenue.
@
10.40
Gross margin percentages vary widely. A profitable supermarket
may have a gross margin of only 15%. Many manufacturing companies have
gross margins of about 35%. Compared with these numbers, the gross margin
of Arlen Company, which was 40%, was {1,4}.
(A) low (B) high
*1
- POST - {a,10,28}{b}high
HIGH - OK - Correct.
B - OK - Correct.
LOW - QUIT - No, 40% is quite high.
A - QUIT - No, 40% is quite high.
@
10.41
A high gross margin does not necessarily lead to a high net
income. Net income is what remains after expenses have been deducted
from the gross margin, and the higher the expenses, the {1,6}
net income will be.
(A) lower (B) higher
*1
- POST - {a,10,13}{b}lower
LOWER - OK - Right.
A - OK - Right.
HIGHER - QUIT - No, net income is the amount left {b}after{n} expenses.
B - QUIT - No, net income is the amount left {b}after{n} expenses.
@
10.42
The {b}profit margin percentage{n} is a useful number for
analyzing net income. You calculated it in an earlier part. Calculate
it for Arlen Company by referring to Exhibit 14. Choose the correct answer
from the following when the blank highlights:
(A) 6.7 (B) 300,000
(C) 20.5 (D) 20,000
NET INCOME ${1,-7}
{c,196,11} = {c,196,9} = {3,-4} % PROFIT MARGIN
SALES REVENUE ${2,-7}
*1
20,000 - OK - Correct.
20000 - OK - Correct.
20 - OK - Correct.
D - OK - Correct.
- HINT - Net income is $20,000.
*2
300,000 - OK - Good.
300000 - OK - Good.
300 - OK - Good.
B - OK - Good.
- HINT - Look again, sales revenue is $300,000.
*3
6.7 - OK - You got it.
A - OK - You got it.
- HINT - No, the profit margin percentage = $20,000/$300,000 =6.7%.
@
10.43
Type in the numerator and denominator of the profit margin percentage
below:
{1,-13}
{c,196,14} = PROFIT MARGIN PERCENTAGE
{2,-13}
*1
NET INCOME - OK - Well done.
- HINT - Profit margin percentage = Net income/Sales revenue.
*2
SALES REVENUE - OK - That's correct.
- HINT - Profit margin percentage = Net income/Sales revenue.
@
10.44
Statistics on the average profit margin percentage in various
industries are published and can be used by Arlen Company as a basis
for comparison. Statistics on the average {u}dollar{n} amount of net
income are not published, because such statistics {1,7}
useful in judging a company's profitability.
(A) are (B) are not
*1
- POST - {a,12,29}{b}are not
ARE NOT - OK - Right.
B - OK - Right.
ARE - QUIT - {a,22,1}No. Net income dollars must be related to the company's size and {a,23,1}are therefore expressed as percentages, not dollar amounts.
A - QUIT - {a,22,1}No. Net income dollars must be related to the company's size and {a,23,1}are therefore expressed as percentages, not dollar amounts.
@
10.45 Test of Capital Utilization
The bottom section of the diagram in Exhibit 15 shows the main
components of Arlen Company's capital. The information is taken from its
{1,16,3}. We shall examine ratios useful in understanding these
components.
(A) income statement (B) balance sheet
*1
- POST - {a,10,41}{b}balance sheet
BALANCE SHEET - OK - Good.
B - OK - Good.
INCOME STATEMENT - QUIT - {a,21,1}No, look again and compare Exhibit 14 to the amounts in the capital {a,22,1}utilization section.
A - QUIT - {a,21,1}No, look again and compare Exhibit 14 to the amounts in the capital {a,22,1}utilization section.
@
10.46
As background for this analysis, let us examine some relationships
in Camden Company with the following condensed balance sheet.
{b}ASSETS EQUITIES{n}
Total Liabilities 400,000
Owners' equity 600,000{s}
{c,196,8}{d}
Total Assets 1,000,000 Total equities 1,000,000
If net income is $60,000, Camden Company's return on owners' equity
(ROI) is Net income/Owners' equity, or {1,-3} %.
*1
10 - OK - Correct.
- HINT - No, 60,000/600,000 = 10%.
@
10.47
If Camden Company could reduce its owners' equity to $500,000,
still maintaining its net income of $60,000, its ROI would become
{1,-3} %.
*1
12 - OK - Right.
- HINT - No, 60,000/500,000 = 12%.
@
10.48
Evidently, with {u}net income{n} held constant, Camden Company can increase
its ROI by {1,10} its owners' equity.
(A) increasing (B) decreasing
*1
- POST - {a,6,34}{b}decreasing
DECREASING - OK - Yes, that's right.
B - OK - Yes, that's right.
INCREASING - QUIT - No, 12% is greater than 10%, and was achieved by {b}decreasing{n} owners' equity.
A - QUIT - No, 12% is greater than 10%, and was achieved by {b}decreasing{n} owners' equity.
@
10.49
Since total assets always equal total equities, owners' equity can
be decreased only (1) if assets are {1,9}, (2) if liabilities
(A) increased (B) decreased
are {2,9}, or (3) if there is some combination of these two types
of changes.
(A) increased (B) decreased
*1
- POST - {a,6,34}{b}decreased
DECREASED - OK - Correct.
B - OK - Correct.
INCREASED - QUIT - No, if owners' equity is to be decreased, then assets should also be decreased.
A - QUIT - No, if owners' equity is to be decreased, then assets should also be decreased.
*2
- POST - {a,12,13}{b}increased
INCREASED - OK - That's right.
A - OK - That's right.
DECREASED - QUIT - {a,21,1}No, if assets remain constant and owners' equity is to be decreased, then {a,22,1}liabilities (the other part of total equities) would have to be increased.
B - QUIT - {a,21,1}No, if assets remain constant and owners' equity is to be decreased, then {a,22,1}liabilities (the other part of total equities) would have to be increased.
@
10.50
For example, owners' equity would be decreased by $100,000
(to $500,000) if assets were decreased by $40,000 (to $960,000) and
liabilities were {1,9} by $60,000 (to $460,000). As shown
in an earlier frame, if owners' equity was $500,000 and net income was
$60,000, ROI would be 12%.
(A) increased (B) decreased
*1
INCREASED - OK - That's correct.
A - OK - That's correct.
DECREASED - QUIT - No, owners' equity is decreased if liabilities are increased.
B - QUIT - No, owners' equity is decreased if liabilities are increased.
@
10.51
Thus, in examining how well an entity used its capital, we
need to ask two types of questions:
1) Were assets kept reasonably {1,4}?
(A) high (B) low
2) Were liabilities kept reasonably {2,4}?
(A) high (B) low
*1
- POST - {a,8,29}{b}low
LOW - OK - That's correct.
B - OK - That's correct.
HIGH - QUIT - No, to maximize the ROI, assets must be kept low.
A - QUIT - No, to maximize the ROI, assets must be kept low.
*2
- POST - {a,12,13}{b}high
HIGH - OK - Right.
A - OK - Right.
LOW - QUIT - {a,22,1}No, we want to keep liabilities --other than owners' equity--{a,23,1}reasonably {b}high{n}.
B - QUIT - {a,22,1}No, we want to keep liabilities --other than owners' equity--{a,23,1}reasonably {b}high{n}.
@
10.52
{b}CAUTION:{n} Our focus here is solely on factors that affect
return on owners' investment (ROI). Later we shall discuss other
factors that must be taken into account in judging how well the entity
managed its assets and liabilities. The final appraisal must consider
these factors as well as the impact on ROI.
@
10.53
Let's start with the current assets. If current assets are reasonably
low, in relation to sales volume, this has a(n) {1,11} effect on
ROI.
(A) favorable (B) unfavorable
*1
- POST - {a,8,13}{b}favorable
FAVORABLE - OK - Correct.
A - OK - Correct.
UNFAVORABLE - QUIT - No, an entity uses its capital well when it keeps assets low.
B - QUIT - No, an entity uses its capital well when it keeps assets low.
@
10.54
In earlier parts, two ratios for measuring current assets were
described. One related to accounts receivable and was called the
{b}days' receivables{n} ratio. It shows how many days of sales revenue
were tied up in accounts receivable. Calculate days' receivables for Arlen
Company. Refer to Exhibit 14 and type the number when the blank highlights.
ACCOUNTS RECEIVABLE ${1,-6}
{c,196,19} = {c,196,9} = {3,-3} DAYS' RECEIVABLES
SALES REVENUE/365 ${2,-7}/365
*1
40,000 - OK - Correct.
40000 - OK - Correct.
40 - OK - Correct.
- HINT - Exhibit 14 shows accounts receivable for Arlen to be $40,000.{s}
*2
300,000 - OK - Good.
300000 - OK - Good.
300 - OK - Good.
- HINT - Exhibit 14 shows sales revenue to be $300,000 for Arlen.{s}
*3
49 - OK - Right!
- HINT - No, check your calculations: 40,000/(300,000/365) = 49 {a,22,1}(to the nearest day).{s}
@
10.55
Type in the numerator and denominator of the days' receivable ratio
below:
{1,-19}
{c,196,20} = DAYS' RECEIVABLE RATIO
{2,-14} /365
*1
ACCOUNTS RECEIVABLE - OK - That's right.
- HINT - Days' receivable ratio = Accounts receivable/(Sales revenue/365).{s}
*2
SALES REVENUE - OK - Fine.
- HINT - Days' receivable ratio = Accounts receivable/(Sales revenue/365).{s}
@
10.56
The amount of capital tied up in inventory can be examined by
calculating the {b}inventory turnover{n} ratio. Since inventory is recorded
at cost, this ratio is calculated in relation to cost of sales, rather
than to sales revenue. Calculate the inventory turnover ratio for Arlen
Company (refer to Exhibit 14 and type the answer when the blank highlights).
COST OF SALES ${1,-7}
{c,196,13} = {c,196,8} = {3,-2} TIMES
INVENTORY ${2,-7}
*1
180,000 - OK - That's correct.
180000 - OK - That's correct.
180 - OK - That's correct.
- HINT - Exhibit 14 shows that cost of sales is $180,000.
*2
60,000 - OK - Right.
60000 - OK - Right.
60 - OK - Right.
- HINT - Exhibit 14 shows that inventory is $60,000.
*3
3 - OK - Good.
- HINT - Check your calculations: $180,000/$60,000 = 3.
@
10.57
Type in the numerator and denominator of the inventory turnover ratio
below:
{1,-13}
{c,196,14} = INVENTORY TURNOVER RATIO
{2,-13}
*1
COST OF SALES - OK - Fine.
- HINT - Inventory turnover ratio = Cost of sales/Inventory.
*2
INVENTORY - OK - Correct.
- HINT - Inventory turnover ratio = Cost of sales/Inventory.
@
10.58
If Arlen Company had maintained an inventory of $90,000 to
support $180,000 cost of sales, its inventory turnover would have been
{1,-2} [how many?] times, rather than 3 times. If other items were
unchanged, its ROI would have been {2,6} than the amounts
shown in Exhibit 15.
(A) higher (B) lower
*1
2 - OK - Correct.
TWO - OK - Correct.
- HINT - Cost of sales ($180,000) divided by inventory ($90,000) equals 2.{s}
*2
- POST - {b}{a,12,31}lower
- POST - {a,21,1}Inventory is higher ($90,000 instead of $60,000) {a,22,1}and it is an {b}asset{n}.
LOWER - OK - Correct.
B - OK - Correct.
HIGHER - QUIT - Remember that {b}higher{n} assets result in a {b}lower{n} ROI.
A - QUIT - Remember that {b}higher{n} assets result in a {b}lower{n} ROI.
@
10.59
The {b}current ratio{n} is another way of examining the current
section of the balance sheet. In an earlier part we pointed out that
if the ratio of current liabilities to current assets was too low, the
company might not be able to pay its bills. However, if the current ratio
was too high, the company would not be taking advantage of the opportunity
to finance current assets with current L{1,11,3,}. Additional
current liabilities would {2,8,1} its ROI.
(A) increase (B) decrease
*1
IABILITIES - OK - Well done.
LIABILITIES - OK - Well done.
- HINT - Companies can finance current assets with current liabilities.{s}
*2
- POST - {a,16,13}{b}increase
INCREASE - OK - Correct.
A - OK - Correct.
DECREASE - QUIT - No, higher current liabilities {b}increase{n} ROI as we saw in 10.51.
B - QUIT - No, higher current liabilities {b}increase{n} ROI as we saw in 10.51.
@
10.60
Calculate the current ratio for Arlen Company, referring to Exhibit 14.
Type in the answer when the blank highlights.
CURRENT ASSETS ${1,-7}
{c,196,19} = {c,196,8} = {3,-3}
CURRENT LIABILITIES ${2,-7}
*1
140,000 - OK - That's correct.
140000 - OK - That's correct.
140 - OK - That's correct.
- HINT - Exhibit 14 shows that current assets are $140,000.
*2
60,000 - OK - Fine.
60000 - OK - Fine.
60 - OK - Fine.
- HINT - Current liabilities are $60,000 according to Exhibit 14.
*3
2.3 - OK - Good.
- HINT - No, $140,000/$60,000 = 2.3.
@
10.61
Type in the numerator and denominator of the current ratio below:
{1,-19}
{c,196,20} = CURRENT RATIO
{2,-19}
*1
CURRENT ASSETS - OK - You got it right.
- HINT - Current ratio = Current assets/Current liabilities.
*2
CURRENT LIABILITIES - OK - That's correct.
- HINT - Current ratio = Current assets/Current liabilities.
@
10.62
If Arlen Company decreased its current ratio to 1.5, this
would {1,8} its ROI. However, such a low current ratio
(A) increase (B) decrease
would {2,8} the possibility that Arlen would not be able to
pay its current liabilities when they came due.
(A) increase (B) decrease
*1
- POST - {a,6,13}{b}increase
INCREASE - OK - {a,22,1}Correct. A lower current ratio indicates higher current {b}liabilities{n}{a,23,1} and lower current {b}assets{n}.
A - OK - {a,22,1}Correct. A lower current ratio indicates higher current {b}liabilities{n}{a,23,1} and lower current {b}assets{n}.
DECREASE - QUIT - {a,22,1}Incorrect. A lower current ratio indicates higher current {b}liabilities{n}{a,23,1} and lower current {b}assets{n}.
B - QUIT - {a,22,1}Incorrect. A lower current ratio indicates higher current {b}liabilities{n}{a,23,1} and lower current {b}assets{n}.
*2
- POST - {a,12,13}{b}increase
INCREASE - OK - That's right. A lower ratio indicates a higher liability -- a debt to pay!
A - OK - That's right. A lower ratio indicates a higher liability -- a debt to pay!
DECREASE - OK - Incorrect. A lower ratio indicates a higher liability -- a debt to pay!
B - OK - Incorrect. A lower ratio indicates a higher liability -- a debt to pay!
@
10.63
The final ratio we shall use in examining capitalization is the
{b}debt ratio{n}. As explained in Part 9, this is the ratio of debt
capital to total permanent capital. Noncurrent liabilities are debt
capital, and noncurrent liabilities plus shareholder equity are total
permanent capital. Calculate the debt ratio for Arlen Company by referring
to Exhibit 14. Type the answer when the blank highlights.
NONCURRENT LIABILITIES (NL) ${1,-6}
{c,196,28} = {c,196,21} = {4,-4} %
NL + SHAREHOLDER EQUITY ${2,-6} + ${3,-7}
*1
40,000 - OK - Correct.
40000 - OK - Correct.
40 - OK - Correct.
- HINT - Exhibit 14 shows noncurrent liabilities to be $40,000.
*2
40,000 - OK - Correct.
40000 - OK - Correct.
40 - OK - Correct.
- HINT - Exhibit 14 shows noncurrent liabilities to be $40,000.
*3
130,000 - OK - Right.
130000 - OK - Right.
130 - OK - Right.
- HINT - Shareholder equity is $130,000 according to Exhibit 14.
*4
23.5 - OK - Good.
- HINT - Check your calculations: $40,000/$170,000 = 23.5%.
@
10.64
Type in the numerator and denominator of the debt ratio below:
{1,-23}
{c,196,44} = DEBT RATIO
{2,-23} + {3,-14}
{a,10,2}N{a,10,29}O
*1
NONCURRENT LIABILITIES - OK - Correct.
- HINT - Debt ratio = Noncurrent liabilities/(Noncurrent liabilities + Owners'{a,22,1}equity).
*2
ONCURRENT LIABILITIES - OK - Right.
- HINT - Debt ratio = Noncurrent liabilities/(Noncurrent liabilities + Owners'{a,22,1}equity).
*3
WNERS' EQUITY - OK - That's correct.
OWNER'S EQUITY - OK - That's correct.
OWNERS EQUITY - OK - That's correct.
- HINT - Debt ratio = Noncurrent liabilities/(Noncurrent liabilities + Owners' {a,22,1}equity).
@
10.65
The larger the proportion of permanent capital that is obtained
from debt, the smaller is the amount of equity capital that is needed.
Thus, if Arlen had obtained $85,000 of its $170,000 permanent capital
from debt, its debt ratio would have been {1,-5}% and its ROI would
have been {2,6} than the 15.4% shown in Exhibit 14.
(A) higher (B) lower
*1
50 - OK - Good.
50.0 - OK - Good.
FIFTY - OK - Good.
FIFTY - OK - Good.
- HINT - No, look again at 10.63: $85,000/($85,000+$85,000) = 50%{s}
*2
- POST - {b}{a,12,12}higher
HIGHER - OK - Correct.
A - OK - Correct.
LOWER - QUIT - No, the higher the debt ratio, the higher the ROI.
B - QUIT - No, the higher the debt ratio, the higher the ROI.
@
10.66
However, as you learned in Part 9, a high debt ratio results
in a {1,4} risky capital structure than does a low debt ratio.
(A) more (B) less
*1
- POST - {a,6,13}{b}more
MORE - OK - That's correct.
A - OK - That's correct.
LESS - QUIT - No, more debt means a higher risk.
B - QUIT - No, more debt means a higher risk.
@
10.67
In the calculations above, we used balance sheet amounts taken
from the ending balance sheet. For some purposes, it is more informative
to use an {b}average{n} of beginning and ending balance sheet amounts. Arlen
Company had $130,000 of shareholder equity at the end of 19x2. If it had
$120,000 at the beginning of 19x2, its {u}average{n} shareholder equity during
19x2 was $125,000. Since its net income in 19x2 was $20,000, its return on
{u}average{n} equity investment was {1,-3}%.
*1
16 - OK - Correct.
16.0 - OK - Correct.
- HINT - No, ROI = Net income/Shareholders' equity = $20,000/$125,000 = 16%.
@
10.68
The return on equity investment in typical American corporations
is roughly 15%. Arlen Company's performance in 19x2 was
{1,18,3}.
(A) much above average (B) about average (C) much below average
*1
- POST - {a,8,34}{b}about average
ABOUT AVERAGE - OK - That's right.
B - OK - That's right.
MUCH ABOVE AVERAGE - QUIT - No, 16% is {b}close to{n} 15%, so it was about average.
A - QUIT - No, 16% is {b}close to{n} 15%, so it was about average.
MUCH BELOW AVERAGE - QUIT - No, 16% is {b}close to{n} 15%, so it was about average.
C - QUIT - No, 16% is {b}close to{n} 15%, so it was about average.
@
10.69 Other Measures of Performance
Another measure of performance is {b}earnings per share{n}. As
the name suggests, the ratio is simply the total {1,10} for a given
period, divided by the number of {2,6} of common stock outstanding.
*1
EARNINGS - OK - Good.
NET INCOME - OK - Good.
- HINT - The numerator of the ratio is total earnings or total net income.
*2
SHARES - OK - Fine.
- HINT - The denominator of the ratio is the number of shares of outstanding {a,22,1}stock.
@
10.70
Exhibit 14 shows the earnings (i.e., net income) of Arlen Company
during 19x2 was ${1,-6}. It shows that the number of shares outstanding
during 19x2 was {2,-5}. Therefore earnings per share was ${3,-3}.
*1
20,000 - OK - Right.
20000 - OK - Right.
- HINT - Look again -- net income is $20,000 on Exhibit 14, bottom line.{s}
*2
5,000 - OK - Correct.
5000 - OK - Correct.
- HINT - No, total outstanding shares are 5,000.
*3
4 - OK - Right.
- HINT - No, $20,000 (net income) divided by 5,000 (# of outstanding shares) = $4.{s}
@
10.71
Type in the numerator and denominator of the earnings-per-share ratio
below:
{1,-10}
{c,196,29} = EARNINGS-PER-SHARE RATIO
{2,-28}
*1
NET INCOME - OK - Fine.
- HINT - Earnings-per-share ratio = Net income/Number of shares outstanding.{s}
*2
NUMBER OF SHARES OUTSTANDING - OK - Well done.
NUMBER OF SHARES - OK - Well done.
# OF SHARES - OK - Well done.
# OF SHARES OUTSTANDING - OK - Well done.
- HINT - Earnings-per-share ratio = Net income/Number of shares outstanding.{s}
@
10.72
{b}Earnings per share{n} is used in calculating another ratio --
the {b}price-earnings ratio{n}. It is obtained by dividing the average
market price of the stock by the earnings per share. If the average
market price for Arlen Company stock during 19x2 was $28, then the
price-earnings ratio is the ratio of $28 to $4 or {1,-3} to 1.
*1
7 - OK - Correct.
- HINT - $28/$4 = $7.
@
10.73
Type in the numerator and denominator of the price-earnings ratio
below:
{1,-20}
{c,196,21} = PRICE-EARNINGS RATIO
{2,-20}
*1
AVERAGE MARKET PRICE - OK - That's right.
- HINT - Price-earnings ratio = Average market price/Earnings per share.
*2
EARNINGS PER SHARE - OK - Fine.
- HINT - Price-earnings ratio = Average market price/Earnings per share.
@
10.74
Price-earnings ratios of many companies are published daily
in the financial page of newspapers. Typically, the ratio is less than
8 to 1. However, if investors thought that earnings per share would
increase, this ratio could be much higher. Apparently, investors are
willing to pay {1,4} per dollar of earnings in a growing company.
(A) more (B) less
*1
- POST - {a,12,13}{b}more
MORE - OK - Fine.
A - OK - Fine.
LESS - QUIT - No, they are willing to pay {b}more{n}.
B - QUIT - No, they are willing to pay {b}more{n}.
@
10.75
We have focused on the return on owners' equity (ROI) as an
overall measure of performance. It is also useful to consider the
{b}return on permanent capital{n}. This shows how well the entity
used its capital, without considering how much of its permanent capital
came from each of these two sources: (1) D{1,4} and (2) E{2,6}.
*1
EBT - OK - Right.
DEBT - OK - Right.
- HINT - Part of permanent capital comes from debt.
*2
QUITY - OK - Good.
EQUITY - OK - Good.
- HINT - Permanent capital comes from debt and equity.
@
10.76
The {u}return{n} portion of this ratio is {u}not{n} net income. Net income
includes a deduction for interest expense, but interest expense {u}is{n} the
return on debt capital. Therefore net income {1,11,12} the
return earned on all permanent capital. Also, income tax expense often is
disregarded so as to focus on purely operating activities.
(A) understates (B) overstates
*1
- POST - {a,12,13}{b}understates
UNDERSTATES - OK - That's correct.
A - OK - That's correct.
OVERSTATES - QUIT - No, the interest expense portion of net income {b}understates{n} the return.
B - QUIT - No, the interest expense portion of net income {b}understates{n} the return.
@
10.77
Thus the return used in this calculation is {b}Earnings Before{n}
the deduction of {b}Interest{n} and {b}Taxes{n} on income. It is abbreviated
by the first letters of the words in boldface, that is, {1,4}.
*1
EBIT - OK - Correct.
- HINT - The abbreviation is {b}EBIT.
@
10.78
As with other income statement numbers, EBIT is calculated as
the percentage of sales revenue. This gives the EBIT margin. Calculate
it for the Arlen Company by looking at Exhibit 14.
EBIT ${1,-7}
{c,196,13} = {c,196,9} = {3,-3} % EBIT MARGIN
SALES REVENUE ${2,-7}
*1
42,000 - OK - Correct.
42000 - OK - Correct.
42 - OK - Correct.
- HINT - No, the earnings before interest and taxes is $42,000.
*2
300,000 - OK - Right.
300000 - OK - Right.
300 - OK - Right.
- HINT - Sales revenue in Exhibit 14 is $300,000.
*3
14 - OK - You got it right.
- HINT - No, 42/300 = 14%.
@
10.79
Type in the numerator and denominator of the EBIT margin ratio below:
{1,-13}
{c,196,14} = EBIT MARGIN RATIO
{2,-13}
*1
EBIT - OK - Correct.
- HINT - EBIT margin ratio = EBIT/Sales revenue.
*2
SALES REVENUE - OK - That's right.
- HINT - EBIT margin ratio = EBIT/Sales revenue.
@
10.80
The permanent capital as of December 31, 19x2, is the debt
capital (i.e., noncurrent liabilities) of $40,000 plus the equity capital
(i.e., shareholder equity) of $130,000, a total of $170,000. The
{b}return on permanent capital{n} is found by dividing EBIT by this total:
EBIT ${1,-7}
{c,196,17} = {c,196,10} = {3,-3} %
PERMANENT CAPITAL ${2,-7}
*1
42,000 - OK - That's correct.
42000 - OK - That's correct.
42 - OK - That's correct.
- HINT - EBIT is $42,000.
*2
170,000 - OK - Yes, that's it.
170000 - OK - Yes, that's it.
170 - OK - Yes, that's it.
- HINT - Permanent capital as calculated above is $170,000.
*3
25 - OK - Good.
25.0 - OK - Good.
- HINT - No, $42,000/$170,000 = 25%.
@
10.81
Type in the numerator and denominator of the return on permanent
capital below:
{1,-17}
{c,196,18} = RETURN ON PERMANENT CAPITAL
{2,-17}
*1
EBIT - OK - Fine.
- HINT - Return on permanent capital = EBIT/Permanent capital.
*2
PERMANENT CAPITAL - OK - That's correct.
- HINT - Return on permanent capital = EBIT/Permanent capital.
@
10.82
Another ratio shows how much sales revenue was generated by each
dollar of permanent capital. This ratio is called the {b}capital turnover{n}
ratio. Calculate it for Arlen Company.
SALES REVENUE = ${1,-7}
CAPITAL TURNOVER = {c,196,28} = {2,-4} times
PERMANENT CAPITAL = $170,000
*1
300,000 - OK - Correct.
300000 - OK - Correct.
300 - OK - Correct.
- HINT - No, sales revenue is still $300,000 in Exhibit 14.
*2
1.8 - OK - Good.
1.76 - OK - Good, but we round off to 1.8.
- HINT - No, $300,000 /$170,000 = 1.76 (rounded off to 1.8).
@
10.83
Type in the numerator and denominator of the capital turnover ratio
below:
{1,-17}
{c,196,18} = CAPITAL TURNOVER RATIO
{2,-17}
*1
SALES REVENUE - OK - Good.
- HINT - Capital turnover ratio = Sales revenue/Permanent capital.
*2
PERMANENT CAPITAL - OK - Ok.
- HINT - Capital turnover ratio = Sales revenue/Permanent capital.
@
10.84
The typical American manufacturing company has a capital
turnover of roughly two times. A company that has a large capital
investment in relation to its sales revenue is called a {b}capital-
{b}intensive{n} company. A capital-intensive company, such as a steel
manufacturing company or a public utility, has a relatively {1,4}
capital turnover.
(A) high (B) low
*1
- POST - {a,14,29}{b}low
LOW - OK - Right.
B - OK - Right.
HIGH - QUIT - {a,22,1}No, permanent capital in such a company is high. The higher the {a,23,1}denominator in the relationship, the lower the ratio.
A - QUIT - {a,22,1}No, permanent capital in such a company is high. The higher the {a,23,1}denominator in the relationship, the lower the ratio.
@
10.85
Another way of finding the return on permanent capital is to
multiply the EBIT margin ratio by the capital turnover:
{b}EBIT margin{n} (14%){b} x Capital turnover{n} (1.8){b} = Return on permanent
{b}capital{n} (25%)
@
10.86
This formula suggests two fundamental ways in which the
profitability of a business can be improved:
(1) {1,8} the EBIT margin ratio;
(2) {2,8} the capital turnover.
Fill in the highlighted blank with one of the answers below:
(A) increase (B) decrease
*1
- POST - {a,12,13}{b}increase
INCREASE - OK - Good.
A - OK - Good.
DECREASE - QUIT - To improve profitability, a business can increase the EBIT margin ratio.
B - QUIT - To improve profitability, a business can increase the EBIT margin ratio.
*2
INCREASE - OK - Well done.
A - OK - Well done.
DECREASE - QUIT - {a,22,1}Another way a business can improve profitability is by increasing the capital {a,23,1}turnover.
B - QUIT - {a,22,1}Another way a business can improve profitability is by increasing the capital {a,23,1}turnover.
@
10.87 Comments on Performance Measurements
In the analysis above, we made much use of ratios because
absolute dollar amounts are {1,6} useful in understanding
what has happened in a business.
(A) rarely (B) often
*1
- POST - {a,8,13}{b}rarely
RARELY - OK - Right.
A - OK - Right.
OFTEN - QUIT - No, because dollar amounts don't show the relationships.
B - QUIT - No, because dollar amounts don't show the relationships.
@
10.88
Also, we focused on {u}both{n} profits and the capital used in earning
those profits. Focusing on just one of these elements can be {1,12,13}.
(A) just as good (B) misleading
*1
- POST - {a,6,37}{b}misleading
MISLEADING - OK - You're right.
B - OK - You're right.
JUST AS GOOD - QUIT - No, one in relationship to the other is meaningful.
A - QUIT - No, one in relationship to the other is meaningful.
@
10.89
For example, consider the following results for a supermarket
and a department store, each with $10 million of sales revenue.
{b}Supermarket{n} {b}Department store{n}{s}
Sales revenue $10,000 $10,000
EBIT 400 2,000 (000 omitted)
Permanent capital 1,000 5,000{d}
The EBIT margin is only {1,-3}% for the supermarket and {2,-3}% for
the department store. The ratio for the department store is much
{3,6}.
(A) lower (B) higher
*1
4 - OK - Correct.
- HINT - EBIT margin = EBIT/Sales revenue or 400/10,000 = 4%.
*2
20 - OK - Right.
- HINT - EBIT margin for the department store is 2,000/10,000 = 20%.
*3
- POST - {a,19,28}{b}higher
HIGHER - OK - You got it right.
B - OK - You got it right.
LOWER - QUIT - No, 20% is much greater than 4%.
A - QUIT - No, 20% is much greater than 4%.
@
10.90
However, the department store has more expensive fixtures, a
larger inventory, and a lower inventory turnover than the supermarket,
so its capital turnover is low. The capital turnover of each is:
