Chapter 18 Exercise Review Flashcards
Define: Profitability
The ability of the business to earn profit, measured by comparing its profit against a base, such as sales, assets or owner’s equity
Define: Return On Owners Investment
Return on Owners Investment is a profitability indicator that measures how effectively a business has used the owners capital to earn profit
ROI Formula
ROI = (Net Profit / Average Capital) x 100
Define: Debt Ratio
Debt ratio is a stability indicator that measures the percentage of a firms assets that are financed by liabilities
Debt Ratio Formula
Debt Ratio = (Total Liabilities / Total Assets) x 100
Define: Return On Assets
Return on Assets is a profitability indicator that measures how efficiently a business has used its assets to earn profit
ROA Formula
ROA = (Net Profit / Average Total Assets) x 100
Define: Asset Turnover
Asset Turnover is an efficiency indicator that measures how productively a business has used its assets to earn revenue
Asset Turnover Formula
Asset Turnover: Sales / Average Total Assets
Define: Net Profit Margin
Net profit margin is a profitability indicator that measures expense control by calculating the percentage of Sales revenue that is retained as Net Profit
Net Profit Margin Formula
NPM = (Net Profit / Sales Revenue) x 100
Define: Gross Profit Margin
Gross Profit Margin is a profitability indicator that measures the average mark-up by calculating the percentage of sales revenue that is retained as gross profit
GPM Formula
GPM = (Gross Profit / Sales Revenue) x 100
Two bases that profit could be compared against when assessing profitability
Level of Assets
Level of Sales
Owner’s Investment
Reasons why the owner should be happy with the firms profitability (increased)
His ROI has increased (from 10% to 12%)
His ROI is higher than the return on the alternative investment (8% on the property trust).
Explain the effect on the increase of the firms debt ratio on the long term stability of the business
The increase in the Debt Ratio means a decrease in the firm’s long-term stability because there is a greater reliance on borrowed funds, and thus a greater risk that the business will be unable to repay both its debts and any interest charges.
Explain the effect on the increase of the firms debt ratio on the profitability of the business
The increase in the Debt Ratio has led to an increase in the Return on Owner’s Investment and an increase in profitability from an investor’s perspective as the business is using borrowed funds to finance its operations, but the owner still receives any profits.
Discuss whether the owner should be pleased about the performance of the business
Net Profit - De
ROI- In
Total Liabilities - In
The owner may be pleased with the increase in the Return on Owner’s Investment as it indicates that she is earning more profit per dollar she has invested. However, Net Profit has actually fallen, so the increase in the ROI is at the cost of a higher Debt Ratio and less stability, which means a greater risk that the business will be unable to meet its debts; and assets have remained the same, so the Return on Assets has actually fallen, indicating less profitable use of assets – none of which is pleasing.
Explain why a firms Return on Owners Investment will always be higher
Because its Owner’s Equity will always be lower than its assets due to its liabilities.
(The extent of this difference will depend on the level of liabilities, and the Debt Ratio.)
Indicators the accountant must consider before giving advice on whether to improve profitability
· Return on Owners Investment (ROI) · Return on Assets (ROA) · Asset Turnover (ATO) · Net Profit Margin (NPM) · Gross Profit Margin (GPM)
This will allow the owner to identify whether the owner should focus on revenue generation or expense control.
Referring to Asset Turnover and Return on Assets, explain why the owners assertion is correct
(Owners Assertion: Expense control improved as net profit increased)
AT - In
ROA - De
Asset Turnover increased indicating an improved ability to generate revenue, but Return on Assets actually decreased indicating worsening profitability. Given that revenue increased, the only reason for a lower Return on Assets is poorer expense control.
Strategies the owner could use to improve Net Profit without changing Asset Turnover
Cheaper supplier – cheaper Cost of Sales
Reduce stock loss
Better control over advertising/wages
Benchmarks other than industry average which can be used to assess Return on Assets
The Return on Assets from a previous period
The budgeted Return on Assets
Strategies that the owner could use to improve Asset Turnover
Increase advertising
Reduce selling prices (provided Qty sold increases to offset the lower SP)
Explain why an improvement in expense control could still see an increase in total expenses
Some expenses such as Cost of Sales and possibly wages are variable, and must increase in line with Sales volume. If these expenses increase in proportion to, or less than Sales, it indicates satisfactory expense control.
Strategies the owner could use to increase Gross Profit Margin
Decrease cost prices by finding a cheaper supplier or finding a cheaper delivery company
Increase selling prices (any strategy that would increase the average mark-up)
Explain how increasing selling prices could lead to an increase in the Gross Profit Margin but a decrease in Gross Profit
A higher selling price will increase the average mark-up and the Gross Profit Margin. However, customers may be unwilling to pay the higher prices, leading to a decrease in the volume/quantity of sales, i.e. more profit per sale may be offset by fewer sales.
Strategies the owner could adopt to improve the Adjusted Gross Profit Margin without changing the Gross Profit Margin
Use of security measures to reduce theft
Staff training to reduce damage
Careful checking of sales/purchases against invoice (any strategy to reduce stock loss)
Reasons for change in the Gross Profit Margin
Increase in cost prices
Higher period costs
Decrease in selling prices (any reason that would cause a decrease in the average mark-up)
Explain why an increase in advertising will not increase Gross Profit Margin
Increasing advertising will not change the average mark-up as it does not affect selling prices or cost prices. It may generate greater sales volume and thus greater Sales revenue, but will not affect the gross profit per dollar of Sales revenue.
A way of increasing the Gross Profit Margin without affecting asset turnover
Decrease cost prices by finding a cheaper supplier or finding a cheaper delivery company
Explain how an increase in advertising could increase Net Profit Margin or decrease it
Higher advertising will increase expenses, but should also mean more Sales revenue (as more potential customers know about the business and its products). If the increase in Sales revenue is proportionately more than the increase in Advertising, the Net Profit Margin will increase. If not, it will decrease.
Non - financial information that assesses the quality of stock
The number of sales returns
The number of purchase returns
The number of customer complaints
Limitations of relying on the Gross Profit Margin to assess the firms profitability
It only reflects the average mark-up
It relies on historical data
It doesn’t assess revenue earning ability
It doesn’t assess control of Other Expenses
Possible reasons for increase in sales revenue
Increase in advertising meaning more people know about the business and its products
Decrease in Gross Profit Margin indicating decrease in selling prices
Higher wages meaning better service/Higher rent meaning better location
An indicator of whether expense control has worsened
Worsened
The Net Profit Margin has decreased (from 15% to 14%), indicating less of every dollar of Sales revenue is retained as Net Profit.
Explain how a reduction in Gross Profit Margin has been beneficial for the firm
A lower Gross Profit Margin, possibly due to lower selling prices, has generated greater Sales volume, leading to higher Sales revenue and higher Net Profit
Explain whether profitability has improved or worsened
Improved:
+ higher Sales revenue and Asset Turnover indicates ability to earn revenue increased
+ constant Net Profit Margin indicates control of Other Expenses improved
+ higher Sales revenue and constant Net Profit Margin means higher Net Profit
+ higher Net Profit and constant assets means higher Return on Assets
+ higher Net Profit and lower Owner’s Equity means higher Return on Owner’s Investment
Worsened:
– lower Gross Profit Margin indicates a lower average mark-up
