Unit 3: Profitability Analysis & Analytical Issues

Question 1

Define

Gross Profit Margin

Answer 1

The percentage of gross revenues that remains w/ the firm after paying for merchandise

Question 2

Define

Operating Profit Margin

Answer 2

The percentage that remains after SG&A expenses have been paid

Question 3

Define

Net Profit Margin

Answer 3

The percentage that remains after other gains and losses (including int. expense) and income taxes have been added or deducted

Question 4

Define

EBITDA Margin Percentage

Answer 4

EBITDA Margin Percentage =

(EBITDA)

———————————————

Net Sales

Question 5

Define

Return on Assets = ?

Answer 5

Return on Assets =

(Net Income)

———————————————

Avg total assets

Question 6

Define

Return on Equity = ?

Answer 6

Return on Equity =

(Net Income)

———————————————

Avg total equity

*ROE will always be greater than ROA

Question 7

Under the various return ratios, what can the numerator be adjusted by?

Answer 7

1. Subtacting preferred dividends to leave only income available to common stockholders
2. Adding back minority interest in the income of a consolidated subsidiary
3. Adding back int. expense
4. Adding back both int. expense and taxes so numerator is EBIT –> enhances comparability of firms with different capital structures/tax planning strategy

Question 8

Under the various return ratios, what can the denominator be adjusted by?

Answer 8

1. Excluding nonoperating assets
2. Excluding unpoductive assets
3. Excluding current liabilities to emphasize long-term capital
4. Excluding debt & preferred stock to get equity capital
5. Stating invested capital at market value

Question 9

Calculate the DuPont Model for Return on Assets.

Answer 9

Question 10

Calculate the DuPont Model for Return on Equity

Answer 10

Question 11

Describe the three components for the DuPont Model for Return on Equity.

Answer 11

1. The net profit margin examines a company’s efficiency in generating earnings from sales
2. Asset turnover component examines how efficiently the company is deploying the totality of its resources to generate revenue
3. The equity multiplier measures a company’s financial leverage. High financial leverage means that the company relies more of debt to finance its assets

Question 12

Define

Return on Common Equity

Answer 12

• Think income available to common shareholders (IACS)

Question 13

Define

DuPont Model for ROCE

Answer 13

Question 14

Define

Sustainable Equity Growth Rate

Answer 14

• The highest growth rate a company can sustain without increasing leverage

Question 15

Define

Book Value Per Share

Answer 15

• The amount of net assets attributable to the common shareholders per share oustanding

Question 16

Define

Market/Book Ratio

Answer 16

Measures how much an investor must spend to ‘own’ a dollar of net assets

Question 17

Define

Price/Earnings Ratio

Answer 17

It measures how much an investor must spend to ‘buy’ a dollar of EBITDA

Question 18

Define

Price/EBITDA Ratio

Answer 18

Benefits to using EBITDA, including operational comparability and as a proxy for cash flows.

Disadvantages:

• Overstates income: EBITDA distorts reality
• Neglects working capital requirements (does not account for the working capital needs of a business - i.e. inventories, receivables, payables)
• Not effective for valuation: serves the bankers’ and clients’ best interests

Question 19

Define Basic Earnings Per Share (BEPS) = ?

Common Stock vs. Preferred Stock

[Single Capital Structure Firm]

*DEPS should be used if available

Answer 19

• Only calculated for common stock because common shareholders are the residual owners of a corporation
• Amounts associated w/ preferred stock must be removed during the calulation of EPS
• IACS: income from cont. operations or net income minus dividends on preferred stock
• Weight shares for the portion of the reporting period that they were outstanding

Question 20

Define

Earnings Yield

Answer 20

Used to determine if a given stock is comparable to others in the industry or to alternative uses of investment money

Question 21

Define

Dividend Payout Ratio = ?

Answer 21

Measures what portion of accrual-basis earnings was actually paid out to common shareholders in the form of dividends

Question 22

Define

Dividend Yield = ?

Answer 22

Question 23

What are some limitations of ratio analysis?

Answer 23

• Effects of inflation
• Seasonal factors
• “Window dressing” financial statements
• Firms choosing different accounting policies
• Accounting profit vs. economic profit

*Economic profit is the excess of revenues over the costs of land, labor, and capital.

*A company using LIFO will have a higher level of earnings quality than FIFO ► LIFO presents more conservative numbers on IS & BS

*Inflation casuses misstatement of a firm’s IS & BS

Question 24

What is the largest cost element for any seller of merchandise?

Define Gross Profit Margin

Answer 24

• COGS is the single largest cost element for any seller of merchandise and has the greatest impact on profitability
• Gross profit margin is the percentage of its net sales that it is able to keep after paying for merchandise

Question 25

Define Reporting Currency

Answer 25

* The currency an entity prepares its financial statements in

Question 26

Define Foreign Currency Translation

Answer 26

* expresses the reporting currency in amounts that 1. are denominated in (fixed in units of) a different currency or 2. are measured in a difference currency

Question 27

Define Functional Currency

Answer 27

* Currency of the primary economic environment in whch an entity operates

Question 28

Define Foreign Currency Transactions

Answer 28

* Fixed in a currency other than the financial currency * Results when an entity buys/sells on credit * Borrow/lends * Party to derivative instrument * Acquires/disposes of assets

Question 29

Define Current Exchange Rate

Answer 29

* Rate used for currency conversion

Question 30

Define Spot Rate

Answer 30

* Rate for immediate exchange of currencies

Question 31

Define Transaction date

Answer 31

* Time when a transaction is recorded under GAAP * The gain or loss incurred at the settlement date, which effects the firm's cash flows, is termed a transaction gain or loss

Question 32

What two exchange rates are needed to calculate a translation?

Answer 32

1. Historical rate - The rate i.e. on the date of the transaction 2. Current rate - The rate i.e. on the reporting (BS) date * Reported as OCI * Foreign denominated receivable/payable is adjusted for difference between historical rate and current rate

Question 33

Define Transaction gain (loss)

Answer 33

* Results from a change in exchange rates between the functional currency and the currency in which the transaction is denominated

Question 34

Detail the foreign exchange transaction that has: (Using ¥15m) FX rate on transaction date of $0.1015 per yen FX rate on reporting date of $0.0101 per yen FX rate on settlement date of $$0.0102 per yen

Answer 34

Transaction Date Dr Inventory $152,250 Cr A/P $152,250 Reporting Date Dr A/P $750 Cr Foreign Cur Translation Adj $750 Settlement Date Dr A/P ($152,250 - $750) $151,500 Dr Foreign Cur Translation Adj. $1,500 Cr Cash $153,000

Question 35

Detail for FX rate fluctuations when: * A transaction is settled in a foreign currency * Sale, Purchase * Resuts in a foreign denominated * Payable, Receivable * Foreign currency appreciates when: * Translation Gain * Translation Loss * Foreign currency depreciates * Translation Gain * Translation Loss

Answer 35

Question 36

What are the two remeasurement method? Describe each

Answer 36

Temporal method: make financial satement items look as if the underlying transactions had been recorded in the functional currency to begin with Translation (All-Current Method): assets/liabilities are restated using the current exchange rate on the reporting date; SE is restated at historical rate \*NOTE: * BS items carried at historical cost are remeasured at the historical rate * BS items carried at their current/future values are remeasured using current rate on the reporting date

Question 37

List the four types of off-balance sheet financing:

Answer 37

1. Investment in unconsolidated subsidiaries 2. Special purpose entities 3. Operating leases 4. Factoring receivables with recourse

Question 38

What is "Investment in unconsolidated subsidiaries" with regard to off-balance sheet financing?

Answer 38

Any equity ownership of less than 50% in a subsidiary results in the parent of the firm reporting the equity investment as an asset; thus not reflected as a liability

Question 39

What are "special purpose entities" used for with respect to off-balance sheet financing?

Answer 39

A firm may create another firm for the sole purpose of keeping the liabilities associated with a specific project off the parent firm's books; then have an arrangement to either buy all the output or make guaranteed payments

Question 40

What is the significane of "operating leases" in regards to off-balance sheet financing?

Answer 40

Long-term contracts to acquire property or equipment is structured so the full amount of debt does not appear on the balance sheet.

Question 41

Describe "factoring receivables with recourse" in regards to off-balance sheet financing.

Answer 41

When a company sells account receivables to a finance company with recourse and leaves the firm contingently liable to the finance company, but does not have to be reported on the company's balance sheet.

Question 42

List the the main differences between GAAP and IFRS?

Answer 42

Revenue recognition - the general rule Revenue recognition - contstruction contracts Expense recognition - share-based payments Intangible assets - R&D costs Intangible assets - measurement Inventories - costing method Inventories - valuation & write-down Leases Long-lived assets - measurement and depreciation Impairment of assets Financial statement presenation - extraordinary items

Question 43

List the 5 measurement attributes for assets & liabilities when using fair value accounting:

Answer 43

1. Historical cost (assets) or historical proceeds (liabilities) 2. Current cost 3. Current market value 4. Net realizable value 5. Present value of future cash flows Fair value as a measurement basis (investment security) * held to maturity * trading * available for sale These must be remeasured at fair value at every reporting date