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CHAPTER 4

PROFITABILITY ANALYSIS

Solutions to Questions, Exercises, Problems, and Teaching Notes to Cases

4.1

Common-Size Analysis. Restating income statement line items as a percentage of

sales and balance sheets as a percentage of total assets enables the analyst to compare different firms regardless of size. However, at least three possible limitations

could impact the benefits of common-size analysis. First, firms often categorize or

group expenses in different line items, which can make it difficult to force dissimilar financial statements into a standardized format. Second, firms do not always

share the same fiscal year-ends; so balance sheets and income statements may be

misaligned in time, which could matter in rapidly changing economic environments. Third, firms may use or be subject to different accounting practices that may

affect the comparability of common-size financial statements.

4.2

Earnings per Share. Firms can be identical in all respects but report different earnings per share due simply to different decisions regarding the number of shares outstanding. Furthermore, one firm could have higher earnings per share than another

firm, but without knowledge about the relative levels of assets invested, it is difficult

to draw any inferences about relative performance. The ubiquity of earnings per share

in the financial press is due to the comparability of earnings per share with price per

share, the ultimate concern of investors in common stock. The inevitable use of earnings per share is the computation of price-to-earnings ratios, which signal information

about the way investors, on average, are valuing the firm’s earnings series.

4.3

Pro Forma Earnings. Analysts often want managers to highlight any unusual or

nonrecurring components of reported income because the analyst is interested in

drawing inferences from the current performance for future performance, which will

be an input into valuation estimates and buy/sell decisions. Thus, managers...