1. Profits might be compared with sales, assets, or stockholder's equity. Why might all three bases be used? Will trends in these ratios always move in the same direction?

Profits can be compared to the sales from which they are the residual. They can be compared to the assets that generate sales. Or, they can be viewed as return to the owner. Each measure looks at profits differently. The trends might move in different directions, depending on the base.

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

Extraordinary items are by nature nonrecurring. They should be segregated in order to concentrate on profit that will be expected in the next period. Recurring earnings should be used in trend analysis of profitability.

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

Expenses as a percent of sales must have increased if profits as a percent of sales declined.

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

Profit margin in jewelry is usually much higher than in groceries. Groceries generate total profits based on volume of sales rather than high markup.

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.

A drop in profits or a rise in the asset base could cause a decline in the ratio. For example, higher cost of sales could cause a decline; or, a substantial investment in fixed assets that are not yet fully utilized could cause a decline.

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

DuPont analysis relates return on assets to turnover and margin. It allows for further analysis of return on assets by this breakdown.

7. How does operating income differ from net income? How do operating assets differ from total assets?

Operating income is sales minus cost of sales and operating expenses. It does not include nonoperating items, such as other income, interest, and taxes. Operating assets are basically current assets plus plant, property, and equipment. They do not include investments, intangibles, and other assets.

Removing non-operating items from the DuPont analysis gives a clearer picture of productive operations and the efficient use of the company's assets.

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

Equity earnings are the owner's proportionate share of the nonconsolidated subsidiary earnings. These earnings are usually greater than the cash from dividends from the nonconsolidated subsidiary.

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

Return on assets is a function of net profit margin and total asset turnover. Return on assets could decline, given an increase in net profit margin, if the total asset turnover declined sufficiently.

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

Return on investment measures return to all long-term supplies of funds. It includes net income plus tax-adjusted interest in the numerator and all long-term funds in the denominator. Return on total equity is just return to shareholders.

Return on common equity is return only to common shareholders. Net income is reduced by preferred dividends in the numerator, and only common equity is in the denominator.