Ebook Financial reporting & analysis using financial accounting information (11th edition): Part 2

Chapter 8
Profitability

P

rofitability is the ability of the firm
to generate earnings. Analysis of
profit is of vital concern to stockholders since they derive revenue in
the form of dividends. Further,
increased profits can cause a rise in
market price, leading to capital gains. Profits
are also important to creditors because profits

are one source of funds for debt coverage.
Management uses profit as a performance
measure.
In profitability analysis, absolute figures are
less meaningful than earnings measured as a percentage of a number of bases: the productive
assets, the owners’ and creditors’ capital employed,
and sales.

Profitability Measures
The income statement contains several figures that might be used in profitability analysis. In
general, the primary financial analysis of profit ratios should include only the types of income
arising from the normal operations of the business. This excludes the following:

1. Discontinued operations
2. Extraordinary items
Exhibit 4-3 in Chapter 4 illustrates an income statement with these items. Review this
section on special income statement items in Chapter 4 before continuing with the discussion
of profitability. Equity in earnings of nonconsolidated subsidiaries and the minority share of

earnings are also important to the analysis of profitability. Chapter 4 covers these items, and
Exhibits 4-5 and 4-9 illustrate the concepts.
Trend analysis should also consider only income arising from the normal operations of the
business. An illustration will help justify this reasoning. XYZ Corporation had net income of
$100,000 in Year 1 and $150,000 in Year 2. Year 2, however, included an extraordinary gain
of $60,000. In reality, XYZ suffered a drop in profit from operating income.

NET PROFIT MARGIN
A commonly used profit measure is return on sales, often termed net profit margin. If a
company reports that it earned 6% last year, this statistic usually means that its profit was 6%
of sales. Calculate net profit margin as follows:

Net Profit Margin =

Net Income Before Minority Share of Earnings,
Equity Income and Nonrecurring Items
Net Sales


298

Chapter 8

Profitability

This ratio gives a measure of net income dollars generated by each dollar of sales. While it
is desirable for this ratio to be high, competitive forces within an industry, economic conditions, use of debt financing, and operating characteristics such as high fixed costs will cause
the net profit margin to vary between and within industries.
Exhibit 8-1 shows the net profit margin using the 2007 and 2006 figures for Nike. This
analysis shows that Nike’s net profit margin declined moderately, but would still be considered high.

Exhibit

8-1

NIKE, INC.
Net Profit Margin
Years Ended May 31, 2007 and 2006
(In millions)
Net income [A]
Net sales [B]
Net profit margin [A Ϭ B]

2007

2006

$ 1,491.5
$16,325.9

$ 1,392.0
$14,954.9

9.14%

9.31%

Several refinements to the net profit margin ratio can make it more accurate than the ratio
computation in this book. Numerator refinements include removing “other income” and
“other expense” items from net income. These items do not relate to net sales (denominator).
Therefore, they can cause a distortion in the net profit margin.

This book does not adjust the net profit margin ratio for these items because this often
requires an advanced understanding of financial statements beyond the level intended.
Also, this chapter covers operating income margin, operating asset turnover, and return on
operating assets. These ratios provide a look at the firm’s operations.
When working the problems in this book, do not remove “other income” or “other
expense” when computing the net profit margin unless otherwise instructed by the problem.
In other analyses, if you elect to refine a net profit margin computation by removing “other
income” or “other expense” items from net income, remove them net of the firm’s tax rate.
This is a reasonable approximation of the tax effect.
If you do not refine a net profit margin computation for “other income” and “other
expense” items, at least observe whether the company has a net “other income” or a net
“other expense.” A net “other income” distorts the net profit margin on the high side, while
a net “other expense” distorts the profit margin on the low side.
The Nike statement can be used to illustrate the removal of items that do not relate to net
sales. Exhibit 8-2 shows the net profit margin computed with these items removed for 2007
and 2006. The adjusted computation results in the 2007 net profit margin being decreased by
0.29% and the 2006 net profit margin being decreased by 0.14%. Both of these decreases are
likely to be considered immaterial, but the 2007 decrease was over twice the 2006 decrease.
The trend between 2006 and 2007 was negative, and this negative trend increased with the
revised computation.

TOTAL ASSET TURNOVER
Total asset turnover measures the activity of the assets and the ability of the firm to generate
sales through the use of the assets. Compute total asset turnover as follows:
Total Asset Turnover =

Net Sales
Average Total Assets

Exhibit 8-3 shows total asset turnover for Nike for 2007 and 2006. The total asset turnover

decreased from 1.60 to 1.59. This decrease would be considered to be immaterial.
The total asset turnover computation has refinements that relate to assets (denominator)
but do not relate to net sales (numerator). Examples would be the exclusion of investments


Chapter 8

Exhibit

8-2

Profitability

299

NIKE, INC.
Net Profit Margin (Revised Computation)
Years Ended May 31, 2007 and 2006
(In millions)
Net income
Tax rate:
Provision for income taxes [A]
Income before income taxes [B]
Tax rate [A ÷ B]∗
Items not related to net sales:
Interest (income) expense, net
Other (income) expense, net
Net (income) expense not related to net sales
Net (income) expense not related to net sales × (1 − Tax rate)
Net income minus net of tax items not related to net sales [C]

Net sales [D]
Adjusted net profit margin [C ÷ D]

2007

2006

$1,491.5

$1,392.0

708.4
2,199.9
32.20%

749.6
2,141.6
35.00%

(67.2)
(0.9)
(68.1)
(46.17)
1,445.33
16,325.9
8.85%

(36.8)
4.4
(32.4)

(21.06)
1,370.94
14,954.9
9.17%

∗ The tax rate could also be determined from the income tax note.

Exhibit

8-3

NIKE, INC.
Total Asset Turnover
Years Ended May 31, 2007 and 2006
(In millions)

2007

2006

Net sales [A]
Average total assets:
Beginning of year
End of year
Total
Average [B]

$16,325.9

$14,954.9

$ 9,869.6
10,688.3
$20,557.9
$10,279.0

$ 8,793.6
9,869.6
$18,663.2
$ 9,331.6

Total asset turnover [A Ϭ B]

1.59 times

1.60 times

and construction in progress. This book does not make these refinements. This chapter covers
operating income margin, operating asset turnover, and return on operating assets.
If the refinements are not made, observe the investment account, Construction in Progress,
and other assets that do not relate to net sales. The presence of these accounts distorts the total
asset turnover on the low side. (Actual turnover is better than the computation indicates.)

RETURN ON ASSETS
Return on assets measures the firm’s ability to utilize its assets to create profits by comparing
profits with the assets that generate the profits. Compute the return on assets as follows:

Return on Assets =

Net Income Before Minority Share

of Earnings and Nonrecurring Items
Average Total Assets

Exhibit 8-4 shows the 2007 and 2006 return on assets for Nike. The return on total assets
for Nike decreased moderately in 2007.
Theoretically, the best average would be based on month-end figures, which are not available to the outside user. Computing an average based on beginning and ending figures provides


300

Exhibit

Chapter 8

8-4

Profitability

NIKE, INC.
Return on Assets
Years Ended May 31, 2007 and 2006
(In millions)
Net income [A]
Average total assets [B]
Return on assets [A Ϭ B]

2007

2006

$ 1,491.5
$10,279.0

$1,392.0
$9,331.6

14.51%

14.92%

a rough approximation that does not consider the timing of interim changes in assets. Such
changes might be related to seasonal factors.
However, even a simple average based on beginning and ending amounts requires two figures. Ratios for two years require three years of balance sheet data. Since an annual report
only contains two balance sheets, obtaining the data for averages may be a problem. If so,
ending balance sheet figures may be used consistently instead of averages for ratio analysis.
Similar comments could be made about other ratios that utilize balance sheet figures.

DUPONT RETURN ON ASSETS
The net profit margin, the total asset turnover, and the return on assets are usually reviewed
together because of the direct influence that the net profit margin and the total asset turnover
have on return on assets. This book reviews these ratios together. When these ratios are
reviewed together, it is called the DuPont return on assets.
The rate of return on assets can be broken down into two component ratios: the net profit
margin and the total asset turnover. These ratios allow for improved analysis of changes in
the return on assets percentage. E. I. DuPont de Nemours and Company developed this
method of separating the rate of return ratio into its component parts. Compute the DuPont
return on assets as follows:
Net Income Before
Minority Share of Earnings
and Nonrecurring Items

Average Total Assets

=

Net Income Before
Minority Share of
Earnings and Nonrecurring Items
Net Sales

×

Net Sales
Average Total Assets

Exhibit 8-5 shows the DuPont return on assets for Nike for 2007 and 2006. Separating the
ratio into the two elements allows for discussion of the causes for the increase in the percentage of return on assets. Exhibit 8-5 indicates that Nike’s return on assets decreased primarily
because of a decrease in net profit margin. The decrease in return on assets was slightly caused
by the very slight decrease in total asset turnover.

Exhibit

8-5

NIKE, INC.
DuPont Return on Assets
Years Ended May 31, 2007 and 2006

2007
2006

Return on
Assets∗

‫؍‬

Net Profit
Margin

؋

Total Asset
Turnover

14.51%
14.92%

=
=

9.14%
9.31%

×
×

1.59
1.60

∗ There are some minor differences due to rounding.

Chapter 8

Profitability

INTERPRETATION THROUGH DUPONT ANALYSIS
The following examples help to illustrate the use of this analysis:

Example 1
Return on
‫؍‬
Assets
Year 1
Year 2

10%
10%

=
=

Net Profit
Margin

؋

Total Asset
Turnover

5%

4%

×
×

2.0
2.5

Example 1 shows how a more efficient use of assets can offset rising costs such as labor or
materials.

Example 2
Return on
‫؍‬
Assets

Net Profit
Margin

؋

Total Asset
Turnover

Firm A
Year 1
Year 2

10%
8%

=
=

4.0%
4.0%

×
×

2.5
2.0

Firm B
Year 1
Year 2

10%
8%

=
=

4.0%
3.2%

×
×

2.5

2.5

Example 2 shows how a trend in return on assets can be better explained through the
breakdown into two ratios. The two firms have identical returns on assets. Further analysis
shows that Firm A suffers from a slowdown in asset turnover. It is generating fewer sales for
the assets invested. Firm B suffers from a reduction in the net profit margin. It is generating
less profit per dollar of sales.

VARIATION IN COMPUTATION OF DUPONT RATIOS
CONSIDERING ONLY OPERATING ACCOUNTS
It is often argued that only operating assets should be considered in the return on asset calculation. Operating assets exclude construction in progress, long-term investments, intangibles, and the other assets category from total assets. Similarly, operating income—the profit
generated by manufacturing, merchandising, or service functions—that equals net sales less
the cost of sales and operating expenses should also be used instead of net income.
The DuPont analysis, considering only operating accounts, requires a computation of operating income and operating assets. Exhibit 8-6 shows the computations of operating income
and operating assets for Nike. This includes operating income for 2007 and 2006 and operating assets for 2007, 2006, and 2005.
The operating ratios may give significantly different results from net earnings ratios if a firm
has large amounts of nonoperating assets. For example, if a firm has heavy investments in unconsolidated subsidiaries, and if these subsidiaries pay large dividends, then other income may be a
large portion of net earnings. The profit picture may not be as good if these earnings from other
sources are eliminated by analyzing operating ratios. Since earnings from investments are not
derived from the primary business, the lower profit figures that represent normal earnings will
typically be more meaningful.

OPERATING INCOME MARGIN
The operating income margin includes only operating income in the numerator. Compute the
operating income margin as follows:
Operating Income Margin =

Operating Income
Net Sales

Exhibit 8-7 indicates the operating income margin for Nike in 2007 and 2006. It shows a
substantial decrease in 2007 in the operating income margin percentage.

301


302

Exhibit

Chapter 8

8-6

Profitability

NIKE, INC.
Operating Income and Operating Assets
Years Ended May 31, 2007 and 2006
(In millions)
Operating income:
Net sales [A]
Operating expenses:
Cost of products sold
Selling, general and administrative
Total operating expenses [B]
Operating income [A − B]

Operating assets:
Total assets [A]

Less: Construction in progress, identifiable
intangible assets, net, goodwill, deferred
income taxes and other assets [B]
Operating assets [A − B]

Exhibit

8-7

2007

2006

$16,325.9

$14,954.9

$ 9,165.4
5,028.7
$14,194.1
$ 2,131.8

$ 8,367.9
4,477.8
$12,845.7
$ 2,109.2

2007

2006

2005

$10,688.3

$9,869.6

$8,793.6

1,027.9
$ 9,660.4

947.3
$8,922.3

909.8
$7,883.8

NIKE, INC.
Operating Income Margin
Years Ended May 31, 2007 and 2006
(In millions)
Operating income [A]
Net sales [B]
Operating income margin [A Ϭ B]

2007

2006

$ 2,131.8
$16,325.9

$ 2,109.2
$14,954.9

13.06%

14.10%

OPERATING ASSET TURNOVER
This ratio measures the ability of operating assets to generate sales dollars. Compute operating asset turnover as follows:
Operating Asset Turnover =

Net Sales
Average Operating Assets

Exhibit 8-8 shows the operating asset turnover for Nike in 2007 and 2006. It indicates a
slight decrease from 2006 to 2007. This slight decrease is similar to the slight decrease in total
asset turnover.

RETURN ON OPERATING ASSETS
Adjusting for nonoperating items results in the following formula for return on operating
assets:
Return on Operating Assets =

Operating Income
Average Operating Assets

Exhibit 8-9 shows the return on operating assets for Nike for 2007 and 2006. It indicates

a decrease in the return on operating assets from 2006 to 2007.


Chapter 8

Exhibit

8-8

Profitability

NIKE, INC.
Operating Asset Turnover
Years Ended May 31, 2007 and 2006
(In millions)
Net sales [A]
Average operating assets:
Beginning of year
End of year
Total [B]
Average [B Ϭ 2] = [C]
Operating asset turnover [A Ϭ C]

Exhibit

8-9

2007

2006

$16,325.9

$14,954.9

$ 8,922.3
9,660.4
$18,582.7
$ 9,291.4

$ 7,883.8
8,922.3
$16,806.1
$ 8,403.5

1.76 times per year

1.78 times per year

NIKE, INC.
Return on Operating Assets
Years Ended May 31, 2007 and 2006
(In millions)
Operating income [A]
Average operating assets [B]
Return on operating assets [A Ϭ B]

2007

2006

$2,131.8
$9,291.4

$2,109.2
$8,403.1

22.94%

25.10%

The return on operating assets can be viewed in terms of the DuPont analysis that follows:
DuPont Return
=
on Operating Assets

Operating
Operating
Income
×
Asset
Margin
Turnover

Exhibit 8-10 indicates the DuPont return on operating assets for Nike for 2007 and 2006.
This figure supports the conclusion that a substantial decrease in operating income margin
and a slight decrease in operating asset turnover resulted in a substantial decrease in return
on operating assets.
Exhibit

8-10

NIKE, INC.
DuPont Analysis with Operating Accounts
Years Ended May 31, 2007 and 2006
Return on
Operating Assets∗

‫؍‬

Operating
Income Margin

؋

22.94%
25.10%

=
=

13.06%
14.10%

×
×

2007
2006

Operating
Asset Turnover
1.76
1.78

∗ There are some differences due to rounding.

SALES TO FIXED ASSETS
This ratio measures the firm’s ability to make productive use of its property, plant, and equipment by generating sales dollars. Since construction in progress does not contribute to current
sales, it should be excluded from net fixed assets. This ratio may not be meaningful because

303


304

Chapter 8

Profitability

of old fixed assets or a labor-intensive industry. In these cases, the ratio is substantially higher
because of the low fixed asset base. Compute the sales to fixed assets as follows:
Sales to Fixed Assets =

Net Sales
Average Net Fixed Assets
(Exclude Construction in Progress)

Exhibit 8-11 shows the sales to fixed assets for Nike for 2007 and 2006. It increased substantially between 2006 and 2007. Sales increases more than kept up with net fixed assets increases.
Exhibit

8-11

NIKE, INC.
Sales to Fixed Assets (Exclude Construction in Progress)
Years Ended May 31, 2007 and 2006
(In millions)
Net sales [A]
Net fixed assets: (Exclude Construction in Progress)
Beginning of year
End of year
Total [B]
Average [B Ϭ 2] = [C]
Sales to fixed assets [A Ϭ C]

2007

2006

$16,325.9

$14,954.9

$ 1,576.3
1,583.9
$ 3,160.2
$ 1,580.1

$ 1,532.7
1,576.3

$ 3,109.0
$ 1,554.5

10.33 times per year

9.62 times per year

RETURN ON INVESTMENT (ROI)
The return on investment (ROI) applies to ratios measuring the income earned on the invested
capital. These types of measures are widely used to evaluate enterprise performance. Since
return on investment is a type of return on capital, this ratio measures the ability of the firm
to reward those who provide long-term funds and to attract providers of future funds.
Compute the return on investment as follows:

Return on Investment =

Net Income Before Minority Share of
Earnings and Nonrecurring Items +
[(Interest Expense) × (1 − Tax Rate)]
Average (Long-Term Liabilities + Equity)

This ratio evaluates the earnings performance of the firm without regard to the way the
investment is financed. It measures the earnings on investment and indicates how well the firm
utilizes its asset base. Exhibit 8-12 shows the return on investment for Nike for 2007 and
2006. This ratio decreased slightly between 2006 and 2007.

RETURN ON TOTAL EQUITY
The return on total equity measures the return to both common and preferred stockholders.
Compute the return on total equity as follows:
Return on Total Equity =

Net Income Before Nonrecurring Items −
Dividends on Redeemable Preferred Stock
Average Total Equity

Preferred stock subject to mandatory redemption is termed redeemable preferred stock.
The SEC requires that redeemable preferred stock be categorized separately from other
equity securities because the shares must be redeemed in a manner similar to the repayment
of debt. Most companies do not have redeemable preferred stock. For those firms that do,
the redeemable preferred is excluded from total equity and considered part of debt. Similarly,
the dividends must be deducted from income. They have not been deducted on the income


Chapter 8

Exhibit

8-12

Profitability

305

NIKE, INC.
Return on Investment
Years Ended May 31, 2007 and 2006
(In millions)

2007

Interest expense [A]∗
Net income
Tax rate (see note 8 in 10-K)
1 − Tax rate [B]
(Interest expense∗) × (1 − Tax rate) [A × B]
Net income + [(Interest expense∗) × (1 − Tax rate)] [C]
Long-term liabilities and stockholders’ equity
Beginning of year:
Long-term liabilities
Total stockholders’ equity
End of year:
Long-term liabilities
Total stockholders’ equity
Total [D]
Average [D Ϭ 2] = [E]

2006

$
49.7
$ 1,491.5
32.2%
67.8%
$ 33.70
$1,525.20

$
50.5
$ 1,392.0
35.0%

65.0%
$ 32.83
$1,424.83

$

972.0
6,285.2

$ 1,150.2
5,644.2

1,078.9
7,025.4

972.0
6,285.2

$15,361.5
$ 7,680.8

$14,051.6
$ 7,025.8

Return on investment [C Ϭ E]

19.86%

20.28%

∗Nike did not disclose interest expense. Used cash paid during the year for interest, net of capitalized interest.

statement, despite the similarity to debt and interest, because they are still dividends and
payable only if declared.
Exhibit 8-13 shows the return on total equity for Nike for 2007 and 2006. It decreased
moderately from 23.34% to 22.41%.

Exhibit

8-13

NIKE, INC.
Return on Total Equity
Years Ended May 31, 2007 and 2006
(In millions)
Net income
Less: Redeemable preferred dividends
Adjusted income [A]
Total equity:
Beginning of year
End of year
Total equity [B]
Average [B Ϭ 2] = [C]
Return on total equity [A Ϭ C]

2007

2006

$ 1,491.50

0.03
$ 1,491.47

$ 1,392.00
0.03
$ 1,391.97

$ 6,285.20
7,025.40
$13,310.60
$ 6,655.30

$ 5,644.20
6,285.20
$11,929.40
$ 5,964.70

22.41%

23.34%

RETURN ON COMMON EQUITY
This ratio measures the return to the common stockholder, the residual owner. Compute the
return on common equity as follows:

Return on Common Equity =

Net Income Before Nonrecurring Items −
Preferred Dividends
Average Common Equity

306

Chapter 8

Profitability

The net income appears on the income statement. The preferred dividends appear most
commonly on the statement of stockholders’ equity. Common equity includes common capital stock and retained earnings less common treasury stock. This amount equals total equity
minus the preferred capital and any minority interest included in the equity section.
Exhibit 8-14 shows the return on common equity for Nike for 2007 and 2006. Nike’s
return on common equity is the same as its return on total equity.
Exhibit

8-14

NIKE, INC.
Return on Common Equity
Years Ended May 31, 2007 and 2006
(In millions)
Net income
Less: Redeemable preferred dividends
Adjusted income [A]
Total common equity:
Beginning of year
End of year
Total [B]
Average common equity [B Ϭ 2] = [C]
Return on common equity [A Ϭ C]

2007

2006

$ 1,491.50
0.03
$ 1,491.47

$ 1,392.00
0.03
$ 1,391.97

$ 6,285.20
7,025.40
$13,310.60

$ 5,644.20
6,285.20
$11,929.40

$ 6,655.30

$ 5,964.70

22.41%

23.34%

THE RELATIONSHIP BETWEEN PROFITABILITY RATIOS

Technically, a ratio with a profit figure in the numerator and some type of “supplier of
funds” figure in the denominator is a type of return on investment. Another frequently used
measure is a variation of the return on total assets. Compute this return on total assets
variation as follows:
Return on Total Assets Variation =

Net Income + Interest Expense
Average Total Assets

This ratio includes the return to all suppliers of funds, both long- and short-term, by both
creditors and investors. It differs from the return on assets ratio previously discussed because it
adds back the interest. It differs from the return on investment in that it does not adjust interest for the income tax effect, it includes short-term funds, and it uses the average investment. It
will not be discussed or utilized further here because it does not lend itself to DuPont analysis.
Rates of return have been calculated on a variety of bases. The interrelationship between
these ratios is of importance in understanding the return to the suppliers of funds. Exhibit 8-15
displays a comparison of profitability measures for Nike.
The return on assets measures the return to all providers of funds since total assets equal
total liabilities and equity. This ratio will usually be the lowest since it includes all of the assets.
Exhibit

8-15

NIKE, INC.
Comparison of Profitability Measures
Years Ended May 31, 2007 and 2006

Return
Return
Return
Return

on
on
on
on

assets
investment
total equity
common equity

2007

2006

14.51%
19.86%
22.41%
22.41%

14.92%
20.28%
23.34%
23.34%


Chapter 8

Profitability

307

The return on investment measures the return to long-term suppliers of funds, and it is usually higher than the return on assets because of the relatively low amount paid for short-term
funds. This is especially true of accounts payable.
The rate of return on total equity will usually be higher than the return on investment
because the rate of return on equity measures return only to the stockholders. A profitable use
of long-term sources of funds from creditors provides a higher return to stockholders than the
return on investment. In other words, the profits made on long-term funds from creditors
were greater than the interest paid for the use of the funds.
Common stockholders absorb the greatest degree of risk and, therefore, usually earn the
highest return. For the return on common equity to be the highest, the return on funds obtained
from preferred stockholders must be more than the funds paid to the preferred stockholders.

GROSS PROFIT MARGIN
Gross profit equals the difference between net sales revenue and the cost of goods sold. The
cost of goods sold is the beginning inventory plus purchases minus the ending inventory. It is
the cost of the product sold during the period. Changes in the cost of goods sold, which represents such a large expense for merchandising and manufacturing firms, can have a substantial impact on the profit for the period. Comparing gross profit to net sales is termed the gross
profit margin. Compute the gross profit margin as follows:
Gross Profit Margin =

Gross Profit
Net Sales

This ratio should then be compared with industry data or analyzed by trend analysis.
Exhibit 8-16 illustrates trend analysis. In this illustration, the gross profit margin has declined
substantially over the three-year period. This could be attributable to a number of factors:

1.
2.
3.

4.

The cost of buying inventory has increased more rapidly than have selling prices.
Selling prices have declined due to competition.
The mix of goods has changed to include more products with lower margins.
Theft is occurring. If sales are not recorded, the cost of goods sold figure in relation to the
sales figure is very high. If inventory is being stolen, the ending inventory will be low and the
cost of goods sold will be high.
Exhibit

8-16

EXAMPLE GROSS PROFIT MARGIN
Years Ended May 31, 2007, 2006, and 2005
2007

2006

2005

Net sales [B]
Less: Cost of goods sold

$5,000,000
3,500,000

$4,500,000
2,925,000

$4,000,000

2,200,000

Gross profit [A]

$1,500,000

$1,575,000

$1,800,000

30.00%

35.00%

45.00%

Gross profit margin [A Ϭ B]

Gross profit margin analysis helps a number of users. Managers budget gross profit levels
into their predictions of profitability. Gross profit margins are also used in cost control.
Estimations utilizing gross profit margins can determine inventory levels for interim statements in the merchandising industries. Gross profit margins can also be used to estimate
inventory involved in insured losses. In addition, gross profit measures are used by auditors
and the Internal Revenue Service to judge the accuracy of accounting systems.
Gross profit margin analysis requires an income statement in multiple-step format.
Otherwise, the gross profit must be computed, which is the case with Nike. Exhibit 8-17 presents Nike’s gross profit margin, which decreased between 2005 and 2006 and between 2006
and 2007. This represents a slight decrease in profitability. This slight decrease is from very
high numbers.


308

Exhibit

Chapter 8

8-17

Profitability

NIKE, INC.
Gross Profit Margin
Years Ended May 31, 2007, 2006, and 2005
(In millions)
Net sales [B]
Less: Cost of products sold
Gross profit [A]
Gross profit margin [A Ϭ B]

2007

2006

2005

$16,325.9
9,165.4
$ 7,160.5

$14,954.9
8,367.9

$ 6,587.0

$13,739.7
7,624.3
$ 6,115.4

43.86%

44.05%

44.51%

Trends in Profitability
Exhibit 8-18 shows profitability trends for manufacturing for the period 1965–2006.
Operating profit compared with net sales declined substantially over this period. Net income
compared with net sales fluctuated substantially. Notice the material decline in this ratio in
1992 and 2001 and the substantial increase in this ratio for 2002, 2003, 2004, and 2006.

Text not available due to copyright restrictions

Segment Reporting
A public business enterprise reports financial and descriptive information about reportable
operating segments. Operating segments are segments about which separate financial information is available that is evaluated by the chief operating decision maker in deciding how to
allocate resources and in assessing performance. It requires information about the countries
in which the firm earns revenues and holds assets, and about major customers.
Descriptive information must be disclosed about the way the operating segments were determined. Disclosure is required for products and services by the operating segments. Disclosure is
also required about the differences between the measurements used in reporting segment information and those used in the firm’s general-purpose financial information.
Segment data can be analyzed both in terms of trends and ratios. Vertical and horizontal
common-size analyses can be used for trends. Examples of ratios would be relating profits to
sales or identifiable assets.

Chapter 8

Profitability

309

Segment trends would be of interest to management and investors. The maximum benefits
from this type of analysis come when analyzing a nonintegrated company in terms of product lines, especially with segments of relatively similar size.
Nike reported operating segments and related information in Note 17. Note 17 is partially
included in Exhibit 8-19. These data should be reviewed, and consideration should be given
to using vertical and horizontal analyses and to computing ratios that appear meaningful.
This type of review is illustrated in Exhibits 8-20 and 8-21 on pages 310 and 311.
Exhibit

8-19

NIKE, INC.
Segment Information

Note 17 Operating Segments and Related Information (in Part)
Year Ended May 31,
2007

2006

2005

(In millions)

Net Revenue
United States
Europe, Middle East and Africa
Asia Pacific
Americas
Other
Pretax Income
United States
Europe, Middle East and Africa
Asia Pacific
Americas
Other
Corporate
Additions to Long-Lived Assets
United States
Europe, Middle East and Africa
Asia Pacific
Americas
Other
Corporate

$ 6,107.1
4,723.3
2,283.4
952.5
2,259.6
$16,325.9

$ 5,722.5
4,326.6

2,053.8
904.9
1,947.1
$14,954.9

$ 5,129.3
4,281.6
1,897.3
695.8
1,735.7
$13,739.7

$ 1,300.3
1,000.7
483.7
187.4
303.7
(1,075.9)
$ 2,199.9

$ 1,244.5
960.7
412.5
172.6
153.6
(802.3)
$ 2,141.6

$ 1,127.9
917.5

399.8
116.5
154.8
(856.7)
$ 1,859.8

$

$

$

$
Property, Plant and Equipment, net
United States
Europe, Middle East and Africa
Asia Pacific
Americas
Other
Corporate

$

67.3
94.9
20.7
5.3
36.0
89.3
313.5

232.7
325.4
326.1
16.9
103.6
673.6
$ 1,678.3

$

59.8
73.6
16.8
6.9
33.2
143.4
333.7

$

219.3
266.6
354.8
17.0
98.2
701.8
$ 1,657.7

Exhibit 8-20 presents some Nike information in vertical common-size analysis. Net revenue, pretax income, additions to long-lived assets, and property, plant and equipment, net,

are included. Based on this analysis, the United States is the dominant segment, followed by
the segment of Europe, Middle East, and Africa. The proportion of revenue coming from
the United States has been reasonably steady. The relatively small Americas segment had a
substantial increase as did the Other segment.
Pretax income increased materially in the Americas and Other segments.
Corporate represented a substantial proportion of additions to long-lived assets and property,
plant and equipment, net. The Europe, Middle East and Africa segment had a material increase
in additions to long-lived assets and property, plant and equipment, net.

$
$

54.8
38.8
22.0
6.8
31.3
103.4
257.1

216.0
230.0
380.4
15.7
93.4
670.3
$ 1,605.8


310

Exhibit

Chapter 8

8-20

Profitability

NIKE, INC.
Segment Information
Vertical Common-Size Analysis∗
Year Ended May 31,

Net Revenue
United States
Europe, Middle East, and Africa
Asia Pacific
Americas
Other
Pretax Income
United States
Europe, Middle East, and Africa
Asia Pacific
Americas
Other
Corporate
Additions to Long-Lived Assets
United States
Europe, Middle East, and Africa

Asia Pacific
Americas
Other
Corporate
Property, Plant and Equipment, net
United States
Europe, Middle East, and Africa
Asia Pacific
Americas
Other
Corporate

2007

2006

2005

37.4%
28.9
14.0
5.8
13.8
100.0%

38.3%
28.9
13.7
6.1
13.0

100.0%

37.3%
31.2
13.8
5.1
12.6
100.0%

59.1%
45.5
22.0
8.5
13.8
(48.9)
100.0%

58.1%
44.9
19.3
8.1
7.2
(37.5)
100.0%

60.6%
49.3
21.5
6.3
8.3

(46.1)
100.0%

21.5%
30.3
6.6
1.7
11.5
28.5
100.0%

17.9%
22.1
5.0
2.1
9.9
43.0
100.0%

21.3%
15.1
8.6
2.6
12.2
40.2
100.0%

13.9%
19.4
19.4

1.0
6.2
40.1
100.0%

13.2%
16.1
21.4
1.0
5.9
42.3
100.0%

13.5%
14.3
23.7
1.0
5.8
41.7
100.0%

∗There are some rounding differences.

A review of Exhibit 8-21 (Segment Information—Ratio Analysis) indicates that Americas
and Other had material increases when relating pretax income to net revenue. The Europe,
Middle East, and Africa segment materially increased when relating additions to long-lived
assets to property, plant and equipment, net.

Revenues by Major Product Lines
Exhibit 8-22 shows revenues by major product lines presented by Nike. Revenues by Major

Product Lines—Horizontal Common-Size Analysis is presented in Exhibit 8-23. Footwear is
the dominate segment representing over half the revenues. The fastest growth was experienced
in the Other segment.

Gains and Losses from Prior Period Adjustments
Prior period adjustments result from certain changes in accounting principles, the realization
of income tax benefits of preacquisition operating loss carryforwards of purchased subsidiaries, a change in accounting entity, and corrections of errors in prior periods. Prior period
adjustments are charged to retained earnings.


Chapter 8

Exhibit

8-21

Profitability

311

NIKE, INC.
Segment Information—Ratio Analysis
Years Ended May 31,

Exhibit

8-22

2007

2006

2005

Pretax income to net revenue:
United States
Europe, Middle East, and Africa
Asia Pacific
Americas
Other

21.3%
21.2
21.2
19.7
13.4

21.7%
22.2
20.1
19.1
7.9

22.0%
21.4
21.1
16.7
8.9

Additions to long-lived assets to property,

plant and equipment, net:
United States
Europe, Middle East, and Africa
Asia Pacific
Americas
Other
Corporate

28.9%
29.2
6.3
31.4
34.7
13.3

27.3%
27.6
4.7
40.6
33.8
20.4

25.4%
16.9
5.8
43.3
33.5
15.4

NIKE, INC.

Segment Information
Revenues by Major Product Lines (Note 17—in Part)
Revenues by Major Product Lines. Revenues to external customers for NIKE brand
products are attributable to sales of footwear, apparel and equipment. Other revenues
to external customers primarily include external sales by Cole Haan Holdings
Incorporated, Converse Inc., Exeter Brands Group LLC (beginning August 11, 2004),
Hurley International LLC, NIKE Bauer Hockey Corp., and NIKE Golf.
Year Ended May 31,
(In millions)
Footwear
Apparel
Equipment
Other

Exhibit

8-23

2007

2006

2005

$ 8,514.0
4,576.5
975.8
2,259.6
$16,325.9

$ 7,965.9
4,168.0
873.9
1,947.1
$14,954.9

$ 7,299.7
3,879.4
824.9
1,735.7
$13,739.7

NIKE, INC.
Segment Information
Revenues by Major Product Lines (Prepared from Note 17—in Part)
Horizontal Common-Size Analysis
Year Ended May 31,

Footwear
Apparel
Equipment
Other

2007

2006

2005

116.6%

118.0
118.3
130.2

109.1%
107.4
106.0
112.2

100.0%
100.0
100.0
100.0


312

Chapter 8

Profitability

These items are a type of gain or loss but they never go through the income statement.
They are not recognized on the income statement. If material, they should be considered
in analysis. Current period ratios would not be revised because these items relate to prior
periods.
A review of the retained earnings account presented in the statement of stockholders’
equity will reveal prior period adjustments.
Exhibit 8-24 presents a prior period adjustment of Kohl’s Corporation.

Exhibit

8-24

KOHL’S CORPORATION ∗
Prior Period Adjustment
Kohl’s Corporation included this information in its financial statements for the year
ended January 28, 2006.
Note: In addition to the notes, the Consolidated Statement of Changes in Shareholders’
Equity disclosed the cumulative effect of restatement in prior years.
Notes to Consolidated Financial Statements (in Part)
1. Summary of Accounting Policies (in Part)
Stock Options
In December 2004, the Financial Accounting Standards Board (FASB) issued Statement
of Financial Accounting Standards (SFAS) No. 123 (revised 2004) (SFAS No. 123R),
“Share Based Payment,” which is a revision of SFAS No. 123, “Accounting for StockBased Compensation.” SFAS No. 123R supersedes Accounting Principles Board (APB)
Opinion No. 25, “Accounting for Stock Issued to Employees,” and amends SFAS No. 95,
“Statement of Cash Flows.” Generally, the approach in SFAS No. 123R is similar to
the approach described in SFAS No. 123. However, SFAS No. 123R requires all
share-based payments to employees, including grants of employee stock options, to be
recognized in the income statement based on their fair values.
Effective January 30, 2005, the Company adopted the fair value recognition provisions of SFAS No. 123R using the “modified retrospective” method, which requires
the prior period financial statements to be restated to recognize the compensation
cost in the amounts previously reported in the pro forma footnote disclosures. See
Note 2 for the effect of the adoption on the fiscal 2004 and 2003 results.
2. Restatement of Financial Statements (in Part)
Effective January 30, 2005, the Company adopted the fair value recognition provisions of SFAS No. 123R using the “modified retrospective” method, which requires
the prior period financial statements to be restated to recognize compensation cost
in the amounts previously reported in the pro forma footnotes.
Below is a summary of the effects of the restatement on the Company’s consolidated balance sheet as of January 29, 2005, as well as the effects of these changes on
the Company’s consolidated statements of income and consolidated statements of

cash flows for fiscal years 2004 and 2003. The cumulative effect of the restatement
relating to fiscal years 1995 through 2002 is an increase in paid-in capital of $167.0
million, an increase in deferred income taxes of $52.3 million and an increase in selling, general and administrative expenses (S,G&A) of $185.9 million. As a result,
retained earnings at January 31, 2004 decreased by $114.7 million.
Note: This note also included detail of adjustments to consolidated balance sheets,
consolidated statement of income, and consolidated statement of cash flows.

∗“The Company operates family-oriented specialty department stores that feature quality, exclusive and national brand merchandise priced
to provide value to customers.” 10-K


Chapter 8

Profitability

Comprehensive Income
Chapter 4 explained that the categories within accumulated other income are: (1) foreign currency
translation adjustments, (2) unrealized holding gains and losses on available-for-sale marketable
securities, (3) changes to stockholders’ equity resulting from additional minimum pension liability
adjustments, and (4) unrealized gains and losses from derivative instruments. Chapter 4 also
explained that there is considerable flexibility in reporting comprehensive income. One format
uses a single income statement to report net income and comprehensive income. The second
format reports comprehensive income in a separate statement of financial activity. The third
format reports comprehensive income within the statement of changes in stockholders’ equity.
Review the reporting of comprehensive income to determine which items are reported.
Nike presents comprehensive income within the statement of changes in stockholders’ equity.
The two comprehensive income items reported by Nike are foreign currency translation
adjustments and adjustment for fair value of hedge derivatives.
Note that comprehensive income includes items not in net income. Our traditional profitability analysis includes items that related to net income. This excludes other comprehensive
income items. Ratios in which you may want to consider including comprehensive income are:

(1) return on assets, (2) return on investment, (3) return on total equity, and (4) return on
common equity. For some firms, these ratios will change substantially. Exhibit 8-25 presents
these ratios for Nike. For Nike, there was a moderate increase for these profitability ratios.
Exhibit

8-25

NIKE, INC.
Selected Ratios Considering Comprehensive Income
Year Ended May 31, 2007
2007

Return
Return
Return
Return

on
on
on
on

assets
investment
total equity
common equity

Prior
Computation

Including
Comprehensive
Income

14.51%
19.86%
22.41%
22.41%

15.17%
20.74%
23.43%
23.43%

Pro Forma Financial Information
Pro forma financial information is a hypothetical or projected amount. Synonymous with “what
if” analysis, pro forma data indicate what would have happened under specified circumstances.
Used properly, pro forma financial information makes a positive contribution to financial
reporting—for example, what would be the net income if additional shares were issued?
Used improperly, pro forma financial information can be a negative contribution to financial
reporting. For example, releasing pro forma earnings can be misleading if not explained.
It became popular in the United States for companies to release pro forma earnings at
approximately the time that financial results were released that used GAAP. Typically, how the
company arrived at the pro forma earnings was not adequately disclosed. It was inferred that
this was the better number for investors to follow. Many investors did make decisions based
on the pro forma earnings as opposed to the GAAP earnings.
The Sarbanes-Oxley Act required the Commission (SEC) to adopt rules requiring that if a company publicly discloses non-GAAP financial measures or includes them in a Commission filing:

1. the company must reconcile those non-GAAP financial measures to a company’s financial
condition and results of operations under GAAP.

2. that any public disclosure of a non-GAAP financial measure not contain an untrue statement
of a material fact or omit to state a material fact necessary in order to make the non-GAAP
financial measure, in light of circumstances under which it is presented, not misleading.1

313


314

Chapter 8

Profitability

A June 2004 article in Accounting Horizons compared S&P Companies’ own reported earnings data (pro forma) with U.S. GAAP net income, 1990–2003. In each year, the pro forma
earnings were higher. In some years, the pro forma earnings were materially more than the
U.S. GAAP net income.2
The Wall Street Journal made the following comment in a September 2003 article:
“If you thought the Sarbanes-Oxley Act, that sweeping package of overhauls adopted
in response to U.S. corporate scandals, got rid of the “pro forma”-like tactics by which
companies were able to make their earnings look better, you thought wrong.”3
One example in the article was “Sanmina-SCI Corp., which strips restructuring costs out
of its GAAP earnings to help reach its pro forma earnings—and has done so every quarter for
the past 2 1/2 years. ‘Restructuring’ costs might seem to imply a one-time event, but Sanmina
has stripped out restructuring costs in each of its last 10 quarters, back to 2001.”4

Interim Reports
Interim reports are an additional source of information on profitability. These are reports that
cover fiscal periods of less than one year. The SEC requires that limited financial data be provided on Form 10-Q. The SEC also requires that these companies disclose certain quarterly
information in notes to the annual report.
The same reporting principles used for annual reports should be employed for interim

reports, with the intent that the interim reporting be an integral part of the annual report. For
interim financial reports, timeliness of data offsets lack of detail. Some data included are:

1. Income statement amounts:
a. Sales or gross revenues
b. Provision for income taxes
c. Extraordinary items and tax effect
d. Cumulative effect of an accounting change
e. Net income
2. Earnings per share
3. Seasonal information
4. Significant changes in income tax provision or estimate
5. Disposal of segments of business and unusual items material to the period
6. Contingent items
7. Changes in accounting principles or estimates
8. Significant changes in financial position
Interim reports contain more estimates in the financial data than in the annual reports. Interim
reports are also unaudited. For these reasons, they are less reliable than annual reports.
Income tax expense is an example of a figure that can require considerable judgment and
estimation for the interim period. The objective with the interim income tax expense is to use
an annual effective tax rate, which may require considerable estimation. Some reasons for this
are foreign tax credits and the tax effect of losses in an interim period.
Interim statements must disclose the seasonal nature of the activities of the firm. It is also recommended that firms that are seasonal in nature supplement their interim report by including
information for 12-month periods ended at the interim date for the current and preceding years.
Interim statements can help the analyst determine trends and identify trouble areas before
the year-end report is available. The information obtained (such as a lower profit margin) may
indicate that trouble is brewing.
Nike included a section called “Selected Quarterly Financial Data” in its annual report. It
indicates that the fourth quarter has the highest volume and is most profitable. This would be
the months of March, April, and May. Revenue was up in each quarter compared with 2006.

Net income was down in the first quarter compared with 2006. Net income was up in the
second quarter, third quarter, and fourth quarter in relation to 2006.


Chapter 8

Profitability

Summary
Profitability is the ability of a firm to generate earnings. It is measured relative to a number
of bases, such as assets, sales, and investment.
The ratios related to profitability covered in this chapter follow:
Net Profit Margin =

Net Income Before Minority Share of Earnings,
Equity Income and Nonrecurring Items
Net Sales

Total Asset Turnover =

Return on Assets =
Net Income Before
Minority Share of Earnings
and Nonrecurring Items
Average Total Assets

=

Net Sales
Average Total Assets

Net Income Before Minority Share
of Earnings and Nonrecurring Items
Average Total Assets

Net Income Before
Minority Share of
Earnings and Nonrecurring Items
Net Sales

Operating Income Margin =

Operating Asset Turnover =

=

Sales to Fixed Assets =

Return on Investment =

Return on Total Equity =

Net Sales
Average Total Assets

Operating Income
Net Sales
Net Sales

Average Operating Assets

Return on Operating Assets =
DuPont Return
on Operating Assets

×

Operating Income
Average Operating Assets

Operating
Income
Margin

×

Operating
Asset
Turnover

Net Sales
Average Net Fixed Assets
(Exclude Construction in Progress)

Net Income Before Minority Share of
Earnings and Nonrecurring Items +
[(Interest Expense) × (1 − Tax Rate)]
Average (Long-Term Liabilities + Equity)
Net Income Before Nonrecurring Items −
Dividends on Redeemable Preferred Stock

Return on Common Equity =

Average Total Equity
Net Income Before Nonrecurring Items −
Preferred Dividends
Average Common Equity

Gross Profit Margin =

Gross Profit
Net Sales

315


316

Chapter 8

Profitability

to the net

1. Go to the SEC Web site ().
Under “Filings & Forms (EDGAR),” click on “Search
for Company Filings.” Click on “Companies & Other
Filers.” Under Company Name, enter “Google Inc.”
(or under Ticker Symbol, enter “GOOG”). Select the
10-K filed March 1, 2007.

a. Determine the standard industrial classification.
b. Copy the first sentence in the “Item 1. Business
Overview” section.
c. Prepare a horizontal common-size analysis
for the following (use 2004 as the base):
2004

2005

2006

Revenue
Income from operations
Net income

Intel Corporation
Consolidated Statements of Income (in Part)
Three Years Ended December 30, 2006
(In millions)

d. Comment on the trends in (c).
2. Go to the SEC Web site ().
Under “Filings & Forms (EDGAR),” click on “Search
for Company Filings.” Click on “Companies & Other
Filers.” Under Company Name, enter “Flowers
Foods Inc” (or under Ticker Symbol, enter “FLO”).
Select the 10-K filed February 28, 2007.
a. Determine the standard industrial classification.
b. Copy the first sentence in “Item 1. Business,”
the Company.

c. Complete this schedule:
Flowers Foods, Inc. and Subsidiaries
Consolidated Statements of Income (in Part)
For the 52 Weeks Ended
(Amounts in thousands)

“Companies & Other Filers.” Under Company
Name, enter “Intel Corp” (or under Ticker
Symbol, enter “INTC”). Select the 10-K filed
February 26, 2007.
1. Determine the standard industrial classification.
2. Copy the first sentence in the “Industry”
subsection from the “Item 1. Business”
section.
3. Complete the following schedule:

December 30,
2006

December 31,
2005

January 1,
2005

Sales
Materials, supplies,
labor and other
production costs
(exclusive of depreciation

and amortization shown
separately below)
Selling, marketing and
administrative expenses
Depreciation and
amortization
Asset impairment
Income from operations

d. Complete the schedule in (c) using horizontal
common-size analysis. Use January 1, 2005,
as the base.
e. Comment on the comparability of these
years.
f. Comment on the trends observed in (c) and (d).
3. a. Go to the SEC Web site ().
Under “Filings & Forms (EDGAR),” click on
“Search for Company Filings.” Click on

2006(1)

2005

2004

Net revenue
Cost of sales
Gross margin
Operating income
(1)Cost of sales and operating expenses for the year ended,

December 31, 2006, include share-based compensation.

b. Go to the SEC Web site ().
Under “Filings & Forms (EDGAR),” click on
“Search for Company Filings.” Click on
“Companies & Other Filers.” Under Company
Name, enter “Advanced Micro Devices Inc”
(or under Ticker Symbol, enter “AMD”).
Select the 10-K filed March 1, 2007.
1. Determine the standard industrial
classification.
2. Copy the first sentence in the “General”
subsection from the “Item 1. Business”
section.
3. Complete the following schedule:
Advanced Micro Devices, Inc.
Consolidated Statements of Operations (in Part)
Three Years Ended December 31, 2006
(In thousands)

2006

2005

2004

Total net revenue
Cost of sales
Gross margin
Operating income (loss)

c. Which firm appears to have performed
better? Comment.
4. a. Go to the SEC Web site ().
Under “Filings & Forms (EDGAR),” click on
“Search for Company Filings.” Click on
“Companies & Other Filers.” Under Company
Name, enter “Ford Motor Company” (or under
Ticker Symbol, enter “F”). Select the 10-K filed
February 28, 2007.
1. Determine the standard industrial
classification.


Chapter 8

Ford Motor Company and Subsidiaries
Consolidated Statement of Income (in Part)
For the Years Ended December 31,
2006, 2005 and 2004
(In millions)
2005

317

2. Complete the following schedule:

2. Complete the following schedule:

2006

Profitability

2004

Automotive:
Sales
Total costs and expenses
Operating income (loss)
Financial services
Revenues
Total costs and expenses
Income/(loss) before income
taxes—financial services

3. Comment on the trends for automotive
and financial services.
b. Go to the SEC Web site ().
Under “Filings & Forms (EDGAR),” click on
“Search for Company Filings.” Click on
“Companies & Other Filers.” Under Company
Name, enter “General Motors Corp” (or under
Ticker Symbol, enter “GM”). Select the 10-K
filed March 15, 2007.

General Motors Corporation and Subsidiaries
Consolidated Statement of Operations
(Dollars in millions, except per share amounts)
2006

2005

2004

Net sales and revenues
Automotive sales
Financial services and insurance
revenues
Total net sales and revenues
Cost and expenses
Automotive cost of sales
Selling, general, and administrative
expenses
Interest expense
Provisions for credit and insurance
losses related to financing and
insurance operations
Other expenses
Total costs and expenses
Operating loss

3. Comment on trends for automotive sales
and financial services and insurance
revenues.
c. Which firm appears to have performed
better? Comment.

1. Determine the standard industrial
classification.

Questions
Q 8-1.

Profits might be compared to sales, assets, or stockholders’ equity. Why might all three bases be used? Will
trends in these ratios always move in the same direction?

Q 8-2.

What is the advantage of segregating extraordinary items in the income statement?

Q 8-3.

If profits as a percent of sales decline, what can be said about expenses?

Q 8-4.

Would you expect the profit margin in a quality jewelry store to differ from that of a grocery store?
Comment.

Q 8-5.

The ratio return on assets has net income in the numerator and total assets in the denominator. Explain
how each part of the ratio could cause return on assets to fall.

Q 8-6.

What is DuPont analysis, and how does it aid in financial analysis?

Q 8-7.

How does operating income differ from net income? How do operating assets differ from total assets? What
is the advantage in removing nonoperating items from the DuPont analysis?

Q 8-8.

Why are equity earnings usually greater than cash flow generated from the investment? How can these
equity earnings distort profitability analysis?

Q 8-9.

Explain how return on assets could decline, given an increase in net profit margin.

Q 8-10.

How is return on investment different from return on total equity? How does return on total equity differ
from return on common equity?


318

Q 8-11.

Chapter 8

Profitability

What is return on investment? What are some of the types of measures for return on investment? Why is
the following ratio preferred?
Net Income Before Minority Share of
Earnings and Nonrecurring Items +

[(Interest Expense) × (1 − Tax Rate)]
Average (Long-Term Debt + Equity)
Why is the interest multiplied by (1 – Tax Rate)?

Q 8-12.

G. Herrich Company and Thomas, Inc., are department stores. For the current year, they reported a net
income after tax of $400,000 and $600,000, respectively. Is Thomas, Inc., a more profitable company than
G. Herrich Company? Discuss.

Q 8-13.

Since interim reports are not audited, they are not meaningful. Comment.

Q 8-14.

Speculate on why accounting standards do not mandate full financial statements in interim reports.

Q 8-15.

Why may comprehensive income fluctuate substantially more than net income?

Q 8-16.

Why can pro forma financial information be misleading?

Problems
P 8-1.

Ahl Enterprise lists the following data for 2007 and 2006:

Net income
Net sales
Average total assets
Average common equity

$

2007

2006

52,500
1,050,000
230,000
170,000

$ 40,000
1,000,000
200,000
160,000

Required

Calculate the net profit margin, return on assets, total asset turnover, and return on common equity for
both years. Comment on the results. (For return on assets and total asset turnover, use end-of-year total
assets; for return on common equity, use end-of-year common equity.)

P 8-2.

Income statement data for Starr Canning Corporation are as follows:

Sales
Cost of goods sold
Selling expenses
General expenses
Income tax expense

2007

2006

$1,400,000
850,000
205,000
140,000
82,000

$1,200,000
730,000
240,000
100,000
50,000

Required

a. Prepare an income statement in comparative form, stating each item for both years as a percent of sales
(vertical common-size analysis).
b. Comment on the findings in (a).

P 8-3.

The balance sheet for Schultz Bone Company at December 31, 2007, had the following account balances:
Total current liabilities (non-interest-bearing)
Bonds payable, 6% (issued in 1982; due in 2013)
Preferred stock, 5%, $100 par
Common stock, $10 par
Premium on common stock
Retained earnings

$450,000
750,000
300,000
750,000
150,000
600,000

Income before income tax was $200,000, and income taxes were $80,000 for the current year.


Chapter 8

Profitability

319

Required

Calculate each of the following:
a. Return on assets (using ending assets)

b. Return on total equity (using ending total equity)
c. Return on common equity (using ending common equity)
d. Times interest earned

P 8-4.

Revenue and expense data for Vent Molded Plastics and for the plastics industry as a whole follow:
Vent Molded Plastics

Plastics Industry

$462,000
4,500
330,000
43,000
32,000
1,800
7,000
22,000

100.3%
0.3
67.1
10.1
7.9
0.4
1.3
5.5

Sales

Sales returns
Cost of goods sold
Selling expenses
General expenses
Other income
Other expense
Income tax

Required

Convert the dollar figures for Vent Molded Plastics into percentages based on net sales. Compare these
with the industry average, and comment on your findings.

P 8-5.

Day Ko Incorporated presented the following comparative income statements for 2007 and 2006:
For the Years Ended

Net sales
Other income
Costs and expenses:
Material and manufacturing costs of products sold
Research and development
General and selling
Interest
Other
Earnings before income taxes and minority equity
Provision for income taxes
Earnings before minority equity
Minority equity in earnings

Net earnings

2007

2006

$1,589,150
22,334
1,611,484

$1,294,966
20,822
1,315,788

651,390
135,314
526,680
18,768
15,570
1,347,722
263,762
114,502
149,260
11,056
$ 138,204

466,250
113,100
446,110
11,522

7,306
1,044,288
271,500
121,740
149,760
12,650
$ 137,110

Other relevant financial information follows:
For the Years Ended
Average common shares issued
Total long-term debt
Total stockholders’ equity (all common)
Total assets
Operating assets
Dividends per share
Stock price (December 31)

Required

a. How did 2007 net sales compare to 2006?
b. How did 2007 net earnings compare to 2006?
c. Calculate the following for 2007 and 2006:
1. Net profit margin
2. Return on assets (using ending assets)
3. Total asset turnover (using ending assets)
4. DuPont analysis
5. Operating income margin
6. Return on operating assets (using ending assets)

2007

2006

29,580
$ 209,128
810,292
1,437,636
1,411,686
1.96
533/4

29,480
$ 212,702
720,530
1,182,110
1,159,666
1.86
761/8


320

Chapter 8

Profitability

7. Operating asset turnover (using ending assets)
8. DuPont analysis with operating ratios
9. Return on investment (using ending liabilities and equity)

10. Return on equity (using ending common equity)
d. Based on the previous computations, summarize the trend in profitability for this firm.

P 8-6.

Dorex, Inc., presented the following comparative income statements for 2007, 2006, and 2005:
For the Years Ended

Net sales
Other income
Costs and expenses:
Material and manufacturing costs of products sold
Research and development
General and selling
Interest
Other

2007

2006

2005

$1,600,000
22,100
1,622,100

$1,300,000
21,500
1,321,500

$1,200,000
21,000
1,221,000

740,000
90,000
600,000
19,000
14,000
$1,463,000

624,000
78,000
500,500
18,200
13,650
$1,234,350

576,000
71,400
465,000
17,040
13,800
$1,143,240

For the Years Ended

Earnings before income taxes and minority equity
Provision for income taxes

Earnings before minority equity
Minority equity in earnings
Net earnings

2007

2006

2005

$159,100
62,049
97,051
10,200
86,851

$87,150
35,731
51,419
8,500
42,919

$77,760
32,659
45,101
8,100
37,001

For the Years Ended

Other relevant financial information:
Average common shares issued
Average long-term debt
Average stockholders’ equity (all common)
Average total assets
Average operating assets

2007

2006

2005

29,610
$ 211,100
811,200
1,440,600
1,390,200

29,100
$ 121,800
790,100
1,220,000
1,160,000

28,800
$ 214,000
770,000
1,180,000
1,090,000

Required

a. Calculate the following for 2007, 2006, and 2005:
1. Net profit margin
2. Return on assets
3. Total asset turnover
4. DuPont analysis
5. Operating income margin
6. Return on operating assets
7. Operating asset turnover
8. DuPont analysis with operating ratios
9. Return on investment
10. Return on total equity
b. Based on the previous computations, summarize the trend in profitability for this firm.

P 8-7.

Selected financial data for Squid Company are as follows:

Summary of operations:
Net sales
Cost of products sold
Selling, administrative, and general expenses
Nonoperating income

2007

2006

2005

$1,002,100
520,500
170,200
9,192

$980,500
514,762
167,665
8,860

$900,000
477,000
155,700
6,500


Chapter 8

Interest expense
Earnings before income taxes
Provision for income taxes
Net earnings
Financial information:
Working capital
Average property, plant, and equipment
Average total assets
Average long-term debt
Average stockholders’ equity

Profitability

2007

2006

2005

14,620
287,588
116,473
171,115

12,100
277,113
113,616
163,497

11,250
249,550
105,560
143,990

$ 190,400
302,500
839,000
120,000
406,000

$189,000
281,000
770,000
112,000
369,500

$180,000
173,000
765,000
101,000
342,000

Required

a. Compute the following for 2007, 2006, and 2005:
1. Net profit margin
2. Return on assets
3. Total asset turnover
4. DuPont analysis
5. Return on investment
6. Return on total equity
7. Sales to fixed assets
b. Discuss your findings in (a).

P 8-8.

D. H. Muller Company presented the following income statement in its 2007 annual report:
For the Years Ended

(Dollars in thousands except

per-share amounts)
Net sales
Cost of sales
Gross profit
Selling, administrative, and other expenses
Operating earnings
Interest expense
Other deductions, net
Earnings before income taxes, minority
interests, and extraordinary items
Income taxes
Net earnings of subsidiaries
applicable to minority interests
Earnings before extraordinary items
Extraordinary items:
Gain on sale of investment, net of federal
and state income taxes of $520
Loss due to damages to South American
facilities, net of minority interest of $430
Net earnings
Earnings per common share:
Earnings before extraordinary items
Extraordinary items
Net earnings

321

2007

2006

2005

$297,580
206,000
91,580
65,200
26,380
(5,990)
(320)

$256,360
176,300
80,060
57,200
22,860
(5,100)
(1,100)

$242,150
165,970
76,180
56,000
20,180
(4,000)
(800)

20,070
(8,028)

16,660
(6,830)

15,380
(6,229)

(700)

(670)

(668)

11,342

9,160

8,483

—

1,050

—

—
$ 11,342
$2.20
—
$2.20

$

(1,600)
8,610
$ 1.82
(0.06)
$ 1.76

$

—
8,483
$1.65
—
$1.65

The asset side of the balance sheet is summarized as follows:
(Dollars in thousands)
Current assets
Property, plant, and equipment
Other assets (including investments, deposits,
deferred charges, and intangibles)
Total assets

2007

2006

2005

$ 89,800
45,850

$ 84,500
40,300

$ 83,100
39,800

10,110
$145,760

12,200
$137,000

13,100
$136,000