Topic 8

Profitability Analysis
Profitability Measures
• The primary financial analysis of profit ratios
should include only those items of income
arising from normal operations
• Excludes
– Discontinued operations
– Extraordinary items
Net Profit Margin
• Also referred to as return on sales
• Reflects net income dollars generated by each
dollar of sales
• Potential distortion can be caused by “other
income” and “other expense” items from net
income, as these do not relate to net sales
Net Income Before Noncontrolling Interest,
Equity Income, and Nonrecurring Items
Net Profit Margin =
Net Sales
Total Asset Turnover
• Measures the activity of the assets and the
ability of the firm to generate sales through the
use of the assets
• Potential distortion
– Investments
– Construction in progress
– Other assets that do not relate to net sales
Net Sales
Total Asset Turnover =
Average Total Assets
Return on Assets
• Measures the ability to utilize assets to create
profits
• Average total assets
– For internal analysis use month-end amounts
– For external analysis use beginning and ending
amounts
– If necessary, consistent use of end-of-year amounts,
instead of averages
Net Income Before Noncontrolling
Interest and Nonrecurring Items
Return on Assets =
Average Total Assets
DuPont Return on Assets
• DuPont analysis separates return on assets into
net profit margin and total asset turnover
• Separating the ratio into the two elements allows
for improved analysis of the causes for the
change in the percentage of return on assets
Return on Assets = Net Profit Margin  Total Asset Turnover
DuPont Return on Assets—
Continued
Net Income Before Net Income Before
Noncontrolling Interest Noncontrolling Interest
and Nonrecurring Items and Nonrecurring Items Net Sales
= ×
Average Total Assets Net sales Average Total Assets

Return on Net Profit Total Asset

Assets = Margin × Turnover
Firm A
Year 1 10% = 4.0% × 2.5
Year 2 8% = 4.0% × 2.0

Firm B
Year 1 10% = 4.0% × 2.5
Year 2 8% = 3.2% × 2.5
DuPont Analysis Variation
• Consider only operating assets and income
– Operating assets exclude
• Construction in progress
• Long-term investments
• Intangibles
• ‘Other’ assets
– Operating income includes only
• Net sales less the cost of sales
• Operating expenses
• May give significantly different results
• Reflective of ROA from primary business
Operating Income Margin
• Includes only operating income in the numerator

Operating Income
Operating Income Margin =
Net Sales
Operating Asset Turnover
• Measures the ability of operating assets to
generate sales dollars

Net Sales
Operating Asset Turnover =
Average Operating Assets
Return on Operating Assets
• Measures the ability of operating assets to
generate operating income
Operating Income
Return on Operating assets =
Average Operating Assets

• DuPont analysis of the return on operating

assets:
 DuPont Return   Operating   Operating 
 On  =  Income  ×  Asset 
     
 Operating Assets   Margin   Turnover 
     
Sales to Fixed Assets
• Measures the ability to make productive use of
property, plant, and equipment by generating
sales dollars
– Exclude construction in progress from net fixed
assets
• Possible distortions
– Old fixed assets
– Labor-intensive industry
Net Sales
Sales to Fixed Assets =
Average Net Fixed Assets
(Exclude Construction in Progress)
Return on Investment (ROI)
• Measures income earned on invested capital
and how well the firm utilizes its asset base
• Evaluates enterprise performance without
regard to financing sources

Net Income Before Noncontrolling

Interest and Nonrecurring Items +
[(Interest Expense) × (1  Tax Rate)]
Return on Investment =
Average (Long-Term Liabilities + Equity)
Return on Total Equity
• Measures the return to common and preferred
stockholders
Net Income Before Nonrecurring Items 
Dividends on Redeemable Preferred Stock
Return on Equity =
Average Total Equity

• Adjustments for redeemable preferred stock

– Deduct dividends from net income (numerator)
– Deduct stock value from total equity (denominator)
Return on Common Equity
• Measures the return to the common stockholder
Net income Before Nonrecurring
Items  Preferred Dividends
Return on Common Equity =
Average Common Equity

Common equity = Total Stockholders’ Equity

− Preferred Capital
− Noncontrolling Interest
Return on Total Asset Variation
• Includes the return to all suppliers of funds, both
long- and short-term, by both creditors and
investors
Net Income + Interest Expense
Return on Total Asset Variation =
Average Total Assets

• Differs from the return on assets ratio and return

on investment
• It does not lend itself to DuPont Analysis
The Relationship Between
Profitability Ratios
Measures
Rate of
return to Typical result
return on
providers of
Assets All funds Lowest (includes all assets)
Investment Long-term funds Higher than ROA (relative small
amount of short-term funds)
Total equity Equity Higher than ROI (measures return
only to shareholders)
The Relationship Between
Profitability Ratios—Continued
Measures
Rate of
return to Typical result
return on
providers of
Common Common equity Highest
equity • Common shareholders absorb
greatest degree of risk
• Requires that return to preferred
shareholders exceed funds paid to
preferred shareholders
Gross Profit Margin
• Comparing gross profit with net sales is termed
the gross profit margin

Net Sales Revenue Beginning Inventory

− Cost of Goods Sold + Purchases of Inventory
− Ending Inventory
= Gross Profit

Gross Profit
Gross Profit Margin =
Net Sales
Gross Profit Margin Analysis
• Analysis helps the following ways:
– Managers budget gross profit levels into their
predictions of profitability
– Used in cost control
– Estimate inventory levels for interim financial
statements and insured losses in merchandising
industries
– Used by auditor and Internal Revenue Service to
judge accuracy of accounting systems
Segment Reporting
• Operating segments
– Separate financial information is available
– Evaluated by the chief operating decision maker
– Requires information about
• Countries in which the firm earns revenues and holds assets
• Major customers
Segment Reporting—Continued
• Disclosures
– The way the operating segments are determined
– Products and services by the operating segments
– Differences between the measurements used in
reporting segment and firm’s general-purpose
financial information
• Profitability trends can also be shown as
revenues by major product lines
Gains and Losses from Prior
Period Adjustments
• Charged directly to retained earnings
– Changes in accounting principles
– Realization of income tax benefits of preacquisition
operating loss carryforwards of purchased
subsidiaries
– Changes in accounting entity
– Correction of errors in prior periods
Comprehensive Income
• Items not included in net income
• Reported as a separate component of
shareholders’ equity
– Foreign currency translation adjustments
– Unrealized holding gains and losses from available-
for-sale marketable securities
– Changes to stockholders’ equity resulting from
additional minimum pension liability adjustments
– Unrealized gains and losses from derivative
instruments
Comprehensive Income—
Continued
• Traditional profitability analysis includes items
related to net income
– Items of accumulated other comprehensive income
are excluded from analysis
• Consider supplemental analysis including other
comprehensive income items for
– Return on assets
– Return on investment
– Return on total equity
– Return on common equity
Pro-Forma Financial Information
• It is a hypothetical or projected amount
• Release timed to coincide with release of GAAP
financial results
• Sarbanes-Oxley Act of 2002 requires
– Reconciling of pro forma data to GAAP financial
condition and results of operations
Interim Reports
• Unaudited financial reports covering fiscal
periods of less than one year
– SEC requires limited financial data be provided on
Form 10-Q
– Certain quarterly information is disclosed in notes to
the annual report
– Interim reports are an integral part of the annual
report
• Less reliable than annual reports as contain
more estimates