Financial Statement Analysis

- Ratio Analysis (Profitability Ratios)

Dr Andy Wang
BCom(Hons), MAccg, PhD, CPA
Profitability ratios
• Profitability ratios measure the profit or operating success of an entity for a
given period of time.
– Size of entity’s profit affects its:
• Ability to obtain debt and equity financing.
• Liquidity position.
• Ability to grow.
– Profitability is often regarded as the ultimate test of management’s operating
effectiveness.

• Relationships among profitability measures:

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 Profitability ratios
12. Return on ordinary shareholders’ equity ratio (ROE):
• Indicates earnings per dollar invested by the owners.
• Affected by:
– Return on assets ratio.
– Degree of leverage.

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Profitability ratios
13. Return on assets (ROA):
• Measures overall profitability with respect to investment in assets.
• Affected by:
– degree of leverage (interest expense)
– profit margins
– asset base.

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Profitability ratios
14. Profit margin:
• Measures percentage of each dollar of sales that results in profit:
– High volume firms (e.g. supermarkets) generally experience low profit margins.
– Low volume firms (e.g. white goods) have high profit margins.

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Profitability ratios
15. Asset turnover:
• Asset turnovers vary considerably between industries.

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Profitability ratios
16. Gross profit rate:
• Indicates entity’s ability to maintain an adequate selling price above its costs.
• Ratio declines as industry becomes more competitive.

17. Operating expenses to sales ratio:

• Measures costs incurred to support each dollar of sales.

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Profitability ratios
18. Cash return on sales ratio:
• Similar to net profit ratio.
• Uses cash numerator instead of accrual profit.

19. Earnings per share (EPS):

• Measures profit earned on each ordinary share.

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Profitability ratios
20. Price-earnings (P/E) ratio:
• Measures ratio of market price of each ordinary share to earnings per share.
• Reflects investors’ assessments of an entity’s future earnings.

21. Dividend payout rate:

• Measures the percentage of profit distributed in the form of cash
dividends.
• Entities with high growth rates generally have low payout ratios because
they reinvest most of their profit in the firm.