Financial Analysis and Reporting 1

Financial Ratios

Module 4 Week 4 FINANCIAL RATIOS Part 2B

Profitability and Market Ratios

Course Learning Outcomes:

At the end of this module, the student should be able to:

1. apply the different tools in measuring company’s profitability.

2. calculate the different financial ratios as tools for financial analysis.
3. evaluate company’s activity and profitability using different financial
tools.
4. explain why and how the ratios are used to analyze company’s activity
and profitability.

PROFITABILITY RATIOS

Profitability ratios are among the most closely watched and widely quoted financial ratios.
Many firms link employee bonuses to profitability ratios, and stock prices react sharply to
unexpected changes in these measures. The firm’s profitability could attract outside capital.
Owners, creditors, and management pay close attention to boosting profits because of the
great importance the market places on earnings.

Gross Profit Margin

The gross profit margin measures the percentage of each sales dollar remaining after
the firm has paid for its goods.

Gross profit margin = Sales - Cost of goods sold = Gross Profits

Sales Sales

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Operating Profit Margin

The operating profit margin measures the percentage of each peso sales remaining
after all costs and expenses other than interest, taxes, and preferred stock dividends
are deducted. It represents “pure profits” earned on each peso sales. Operating profits
are “pure” because they measure only the profits earned on operations and ignore
interest, taxes, and preferred stock dividends.

Operating profit margin = Operating profits

Sales

Net Profit Margin

The net profit margin measures the percentage of each peso sales remaining after all
costs and expenses, including interest, taxes, and preferred stock dividends, have been
deducted.

Net profit margin = Earnings available for common stockholders

Sales

Earnings Per Share

The firm’s earnings per share (EPS) is generally of interest to present or prospective
stockholders and management. EPS represents the number of pesos earned during the
period in behalf of each outstanding share of common stock.

Earnings per share = Earnings available to common stockholders

Number of shares of common stock outstanding

Return on Total Assets

The return on assets (ROA), often called the return on investment (ROI), measures the
overall effectiveness of management in generating profits with its available resources.

Return on Total Assets = Earnings available to common stockholders

Total assets
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Financial Ratios

Return on Common Equity

The return on common equity (ROE) measures the return earned on the common
stockholders’ investment in the firm.

Return on common equity = Earnings available for common stockholders

Common stock equity

MARKET RATIOS

Stockholders and investors are usually interested in the market price of the corporation’s
common stock and the ratios that indicate the stocks’ performance attractiveness in the market.

Market ratios relate the firm’s market value, as measured by the current share price, to certain
accounting values. These ratios give ingsight into how well investors in the market place feel
the firm is doing in terms of risk and return

Price/ Earnings (P/E) Ratio

The price/ earnings (P/E) ratio is commonly used to assess the owners’ appraisal of
share value. The P/E ratio measures the amount that investors are willing to pay for
each peso of a firm’s earnings.

The price-earnings ratio is the ratio of the current price per share to the earnings per
share of stocks.

Price/ Earnings (P/E) ratio = Market price per share of common stock

Earnings per share

Market/ Book Value (M/B) Ratio

The market/ book (M/B) ratio provides asn assessment of how investors view the firm’s
performance. It relates the market value of the firm’s share to their book.

Book value per share = Common stock equity

Number of shares of common stock outstanding

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 Market/ book(M/B) ratio = market value per share of common stock

Book value per share of common stock

Illustration:

AAA Corporation disclose the following data in December 31, 2019 and 2020 is as follows:
AAA International Corporation
Balance Sheet
December 31, 2019 and 2020
(In millions)

2020 2019

ASSETS

Current assets

Cash and cash equivalents P 880 P 426

Marketable securities 70 56

Accounts receivable 3,238 2,406

Inventories 1,230 1,060

Other (mostly prepaid expenses) 340 352

Total current assets P 5,758 P 4,300

Noncurrent Assets

Property, plant, equipment P 19,840 P 18,048

Less: Accumulated depreciation 7,936 6,670

Net Property, plant and equipment P 11,904 P 11,378

Intangible assets 7,936 942

Total noncurrent assets P 13,420 P 12,320

Total Assets P 19,178 P 16,620

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Financial Ratios

LIABILITIES AND STOCKHOLDERS’ EQUITY

Current Liabilities

Accounts payable P 3,394 P 2,608

Notes payable 954 1,174

Accrued expenses 880 758

Total current liabilities P 5,228 P 4,540

Non-current Liabilities

Deferred taxes P 1,814 P 1,586

Long-term debt 3,520 2,948

Total non-current liabilities P 5,534 P 4,534

Total Liabilities P 10,562 P 9,074

Stockholders’ Equity

Preferred stock P 60 P 60

Common stock (P 2 par value) 746 684

Paid-in capital in excess of par 496 458

Retained earnings 8,542 7,340

Less: Treasury stock 1,228 996

Total Stockholders’ Equity P 8,616 P 7,546

Total Liabilities and Stockholders’ Equity P19, 178 P 16,620

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 AAA International Corporation
Income Statement
For the years ended December 31, 2019 and 2020
(In millions)

2020 2019

Sales revenue P 25, 686 P 18,220

Less: Cost of Goods Sold 17,038 11,266

Gross Profit P 8,648 P 6,954

Less: Operating & Other Expenses P 3,088 P 3,042

Selling and Administrative

Expenses 2,498 2,384

Total Operating Expenses P 5,586 P 5,426

Operating Profit P 3,062 P 1,528

Add: Other Income 280 164

Earnings before interest & taxes(EBIT) P 3,342 P 1,692

Less: Interest expense 246 224

Pre-tax income P 3,096 P 1,468

Less: Taxes

Current P 734 P 316

Deferred 464 210

Total taxes P 1,198 P 526

Net income(net profit after tax) P 1,898 P 942

Less: Preferred stock dividends 6 6

Earnings available for common stockholders P 1,892 P 936

Less: Dividends 690 652

To Retained earnings P 1,202 P 284

Additional information:

Price per share P 76.25 P 71.50

 Financial Analysis and Reporting 7
Financial Ratios

Compute the following:

1. Profitability ratios

a. Gross profit margin

b. Operating profit margin

c. Net profif margin

d. Earnings per share

e. Return on total assets

f. Return on common equity

2. Market ratios

a. Price/ Earnings (P/E) ratio

b. Market/book value per share

Answer:

1.Profitability ratios

a. Grosss profit margin = Gross profit = P 8,648,000 = 0.337 = 33.7%

Sales P25,686,000

AAA gross profit margin in 2018 is 33.7. Gross profit margin measures the
percentage of each peso sales remaining after the firm has paid for its
goods. The higher the gross profit margin, the better.

b. Operating profit margin = Operating profits = P 3,062,000

Sales P25,686.000

= 0.119 = 11.9%

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 As with the gross profit margin, the higher the operating profit margin the
better. This ratio tells analysts what a firm’s bottom line looks like before
deductions for payments to creditors and tax authorities. AAA operating
margin in 2018 is 11.9 percent.

c. Net profit margin = Earnings available for common stockholders

Sales

= P 1,892,000 = 0.074 = 7.4 %

P25,686,000

The net profit margin is commonly cited measure of the firm’s measure of
the firm’s success with respect to earnings on sales. Good net profit
margins differ considerably across industries. A net profit of 1 percent or
less would not be unusual for a grocery store, whereas a net profit of 10
percent would be low for a retail jewelry store. AAA’s net profit margin in
2018 is 7.4 percent.

d. Earnings per share = Earnings available for common stockholders

Number of shares of common stock outstanding

= P 1,892,000 = P 5.07

373,000

The value of AAA’s earning per share is P 5.07. This amount represents
the peso amount earned on behalf of each share outstanding.

e. Return on total assets = Earnings available for common stockholders

Total assets

= P 1,892,000 = 0.99 = 9.9%

P19,178,000
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Financial Ratios

The return on total assets (ROA) or return on investment (ROI) of AAA is

9.9 percent. This value indicates that the company earned 9.9 centavos
on each peso of asset invested.

f. Return on common equity = Earnings available for common stockholders

Common Stockholders’ Equity

= P 1,892,000 = 0.221 = 22.1%

P 8,556,000

The return on common stockholders’ equity is 22.1 percent which is substantially

above the AAA’s return on total assets. For a firm that uses only common stock
to finance its operations, the ROE and ROA figures are identical. These ratios
usually differ when there are debts or preferred stocks on the balance sheet.
When the firm earn a profit, even afer making interest payments to creditors and
paying dividends to preferred stockholders, the firm’s use of leverage magnifies
the return earned by common stockholders, and ROE exceeds ROA.

2.Market ratios

a. Price/ Earnings (P/E) ratio = Market price per share of common stock

Earnings per share

= P 76.25 = P 15.04

P 5.07

This figure indicates that investors were paying P 15.04 for each P 1.00 of
AAA’s earnings.

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b. Book value per share = Common stockholders equity

Number of common shares outstanding

= P 8,556,000 = P 22.93

373,000

Market to book value is then computed by dividing this book value into the
current price of the firm’s stock.

c. Market/book value per share = Market value per share of common stock

Book value per share of common stock

= P 76.25 = 3.32

P 22.93

The result shows that the investors are currently paying P 3.32 for each P1.00
of AAA’s stock.
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Financial Ratios

References and Supplementary Materials

Books and Journals
1. Trotman, Ken, Carson, Elizabeth, Morgan, Kate; Finanacial Analysis; 2019;
Financial Accounting: An Integrated Approach.;

2. Gitman, Lawrence J;Finanacial Analysis; 2019; Principles of Managerial Finance;

Jurong, Singapore; Pearson Education, Inc.

3. Smart, Scott B., Megginson, William L.; Finanacial Analysis; 2009; Financial
Management: An Introduction ; Singapore; Cengage Learning Asia Pte Ltd

Online Instructional Materials

1. Profitability ratios; https://www.s-cool.co.uk/a-level/business-studies/ratio-

analysis/ revise-it/profitability-ratios; 25November2019

2. How to Analyze Profitability; https://edwardlowe.org/how-to-

analyzeprofitability-2/; 25November 2019

3. Market Value Ratios; https://www.stock-analysis-on.net/Knowledge-

Base/Market-Value-Ratios; 25November2020

Online Instructional Video

1. Ratio Analysis Profitability; https://www.youtube.com/watch?v=ROqkmlVuXKU;

25November2019

2. Financial Statement Analysis: Ratio Analysis - Market Value Measures

https://www.youtube.com/watch?v=GUVbPr88rOA; 25November2019

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