Chapter 18 Exercise Review

Question 1

Define: Profitability

Answer 1

The ability of the business to earn profit, measured by comparing its profit against a base, such as sales, assets or owner’s equity

Question 2

Define: Return On Owners Investment

Answer 2

Return on Owners Investment is a profitability indicator that measures how effectively a business has used the owners capital to earn profit

Question 3

ROI Formula

Answer 3

ROI = (Net Profit / Average Capital) x 100

Question 4

Define: Debt Ratio

Answer 4

Debt ratio is a stability indicator that measures the percentage of a firms assets that are financed by liabilities

Question 5

Debt Ratio Formula

Answer 5

Debt Ratio = (Total Liabilities / Total Assets) x 100

Question 6

Define: Return On Assets

Answer 6

Return on Assets is a profitability indicator that measures how efficiently a business has used its assets to earn profit

Question 7

ROA Formula

Answer 7

ROA = (Net Profit / Average Total Assets) x 100

Question 8

Define: Asset Turnover

Answer 8

Asset Turnover is an efficiency indicator that measures how productively a business has used its assets to earn revenue

Question 9

Asset Turnover Formula

Answer 9

Asset Turnover: Sales / Average Total Assets

Question 10

Define: Net Profit Margin

Answer 10

Net profit margin is a profitability indicator that measures expense control by calculating the percentage of Sales revenue that is retained as Net Profit

Question 11

Net Profit Margin Formula

Answer 11

NPM = (Net Profit / Sales Revenue) x 100

Question 12

Define: Gross Profit Margin

Answer 12

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

Question 13

GPM Formula

Answer 13

GPM = (Gross Profit / Sales Revenue) x 100

Question 14

Two bases that profit could be compared against when assessing profitability

Answer 14

Level of Assets
Level of Sales
Owner’s Investment

Question 15

Reasons why the owner should be happy with the firms profitability (increased)

Answer 15

His ROI has increased (from 10% to 12%)

His ROI is higher than the return on the alternative investment (8% on the property trust).

Question 16

Explain the effect on the increase of the firms debt ratio on the long term stability of the business

Answer 16

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.

Question 17

Explain the effect on the increase of the firms debt ratio on the profitability of the business

Answer 17

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.

Question 18

Discuss whether the owner should be pleased about the performance of the business
Net Profit - De
ROI- In
Total Liabilities - In

Answer 18

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.

Question 19

Explain why a firms Return on Owners Investment will always be higher

Answer 19

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.)

Question 20

Indicators the accountant must consider before giving advice on whether to improve profitability

Answer 20

· 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.

Question 21

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

Answer 21

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.

Question 22

Strategies the owner could use to improve Net Profit without changing Asset Turnover

Answer 22

Cheaper supplier – cheaper Cost of Sales

Reduce stock loss

Better control over advertising/wages

Question 23

Benchmarks other than industry average which can be used to assess Return on Assets

Answer 23

The Return on Assets from a previous period

The budgeted Return on Assets

Question 24

Strategies that the owner could use to improve Asset Turnover

Answer 24

Increase advertising

Reduce selling prices (provided Qty sold increases to offset the lower SP)

Question 25

Explain why an improvement in expense control could still see an increase in total expenses

Answer 25

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.

Question 26

Strategies the owner could use to increase Gross Profit Margin

Answer 26

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)

Question 27

Explain how increasing selling prices could lead to an increase in the Gross Profit Margin but a decrease in Gross Profit

Answer 27

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.

Question 28

Strategies the owner could adopt to improve the Adjusted Gross Profit Margin without changing the Gross Profit Margin

Answer 28

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)

Question 29

Reasons for change in the Gross Profit Margin

Answer 29

Increase in cost prices

Higher period costs

Decrease in selling prices (any reason that would cause a decrease in the average mark-up)

Question 30

Explain why an increase in advertising will not increase Gross Profit Margin

Answer 30

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.

Question 31

A way of increasing the Gross Profit Margin without affecting asset turnover

Answer 31

Decrease cost prices by finding a cheaper supplier or finding a cheaper delivery company

Question 32

Explain how an increase in advertising could increase Net Profit Margin or decrease it

Answer 32

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.

Question 33

Non - financial information that assesses the quality of stock

Answer 33

The number of sales returns

The number of purchase returns

The number of customer complaints

Question 34

Limitations of relying on the Gross Profit Margin to assess the firms profitability

Answer 34

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

Question 35

Possible reasons for increase in sales revenue

Answer 35

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

Question 36

An indicator of whether expense control has worsened

Answer 36

Worsened

The Net Profit Margin has decreased (from 15% to 14%), indicating less of every dollar of Sales revenue is retained as Net Profit.

Question 37

Explain how a reduction in Gross Profit Margin has been beneficial for the firm

Answer 37

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

Question 38

Explain whether profitability has improved or worsened

Answer 38

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