Vol. 3 LM 4 Profitability Ratios

Question 1

Ratio

measure the return earned by the company during a period

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Answer 1

profitability ratio

Question 2

List

two categories of profitability ratios

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Answer 2

• return on sales ratios
• return on investment ratios

Question 3

Ratio classification

pretax margin

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Answer 3

profitability ratio - return on sales

Question 4

Ratio classification

net profit margin

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Answer 4

profitability ratio - return on sales

Question 5

Ratio classification

operating ROA

p. 219

Answer 5

profitability ratio - return on investment

Question 6

Ratio classification

ROA

p. 219

Answer 6

profitability ratio - return on investment

Question 7

Ratio classification

return on total capital

p. 219

Answer 7

profitability ratio - return on investment

Question 8

Ratio classification

ROE

p. 219

Answer 8

profitability ratio - return on investment

Question 9

Ratio classification

return on common equity

p. 219

Answer 9

profitability ratio - return on investment

Question 10

Calculate

pretax margin

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Answer 10

numerator EBT
denominator Revenue

Question 11

Calculate

net profit margin

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Answer 11

numerator net income
denominator revenue

Question 12

Calculate

operating ROA

p. 219

Answer 12

numerator operating income
denominator average total assets

Question 13

Calculate

ROA

p. 219

Answer 13

numerator net income
denominator average total assets

Question 14

Calculate

return on total capital

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Answer 14

numerator EBIT
denominator average short- and long-term debt and equity

Question 15

Calculate

ROE

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Answer 15

numerator net income
denominator average total equity

Question 16

Calculate

return on common equity

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Answer 16

numerator net income - preferred dividends
denominator average common equity

Question 17

Concept

indicates the percentage of revenue available to cover operating and other expenses and to generate profit

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Answer 17

gross profit margin

Question 18

what does it indicate

higher gross profit margin

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Answer 18

• some combination of higher product pricing and lower product costs
• a company has a competitive advantage in products costs

Question 19

what does it indicate

an operating profit margin increasing faster than the gross profit margin

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Answer 19

improvements in controlling operating costs, such as administrative overheads

Question 20

what does it indicate

a declining operating profit margin

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Answer 20

an indicator of deteriorating control over operating costs

Question 21

alternate names

pretax income

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Answer 21

earnings before tax
OR
EBT

Question 22

Concept

is the ratio of pretax income to revenue

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Answer 22

pretax margin

Question 23

analyst next steps

a company’s pretax margin is increasing primarily as a result of increasing amounts of non-operating income

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Answer 23

evaluate whether this increase reflects a deliberate change in a company’s business focus and, therefore, the likelihood that the increase will continue

Question 24

Describe

net profit margin

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Answer 24

net income is adjusted for non-recurring items
* net income includes both recurring and non-recurring components

Question 25

what does it indicate

the higher the ROA

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Answer 25

the more income is generated by a given level of assets

Question 26

Calculate

ROA

p. 220

Answer 26

numerator net income + interest expense(1 - tax rate)
denominator average total assets

Question 27

issue with this computation

ROA = net income / average total assets

p. 220

Answer 27

• net income is the return to equity holders
• assets are financed by both equity holders and creditors
• interest expense (the return to creditors) has already been subtracted in the numerator
• some analysts prefer to add back interest expense to the numerator