University of San Carlos

School of Business and Economics

Department of Accountancy

RCMA 4- Financial Analysis and Decisions Atty. Cymon P. Argawanon, CPA

Profitability Analysis February 15, 2024 (THU PM)
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PROFITABILITY ANALYSIS

Profitability is a firm’s ability to generate earnings over a period of time with a

given set of resources.

• ROI/ARR – Return on Investment/ Accounting Rate of Return

The degree of profit in relation to the capital deployed by the business.

ROI = Income of Business Unit

Assets of Business Unit

When ROI uses average total assets as investments, it becomes ROA. If it uses
ownership interest as denominator, it is ROE.

• RETURN ON ASSETS
Return on Assets = Net Income
Average Total Assets

Alternatively DuPont Model:

Return on Assets = Return on Sales (ROS) x Total Assets Turnover

Return on Assets = Net Income x Sales

Sales Average Total Assets

The DuPont Model breaks apart the simpler formula for ROA. It shows profitability
in relation to revenue and asset efficiency. Profit margin tells how much the firm is
earning in relation to revenues, that is, how well management did at controlling
costs during the accounting period. Asset turnover shows how well management
did at using assets efficiently.

• RETURN ON EQUITY
Return on Equity = Net Income
Average SHE

Return on equity shows return on stockholders. Generally this refers to corporations

with common equity owners. However, if preferred stock exists, the ROE can be
modified to shows as follows:
Return on Common Equity: Net Income – Preferred Dividends
Average Equity – Average Preferred Equity

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Alternatively DuPont Model:

Return on Equity = Return on Sales (ROS) x Total Assets Turnover x Equity Multiplier

Return on Equity = Net Income x Sales x Average Total Assets

Sales Average Total Assets Average Equity

The Dupont Model for calculating ROE helps users better understand the reasons
for a change in ROE over a period of time. The last part is called the equity
multiplier or the financial leverage ratio. It shows how much of a company’s assets
are financed by the Shareholder’s Equity. A low EM indicates that a company is
using more equity than debt.

If the company is financed entirely by equity and no debt exists, ROA will be the
same as ROE. It is up to financial managers to determine the best mix of debt and
equity to keep the company competitive in the marketplace and attractive to
shareholders and creditors.

• GROSS MARGIN PERCENTAGE

It is a measurement of gross profit as a percentage of sales.

Gross profit = Sales – Cost of Sales

Gross margin percentage = Gross Profit/Sales

Implications of Gross Margin Percentage changes

o Sales prices not changing at the same rate as unit costs
o Sales prices increasing/decreasing due to intensity of competition
o Mix of products sold shifting to products with lower/ higher margins
o Changes in inventory shrinkage

• OPERATING PROFIT MARGIN PERCENTAGE

Operating Profit Margin Percentage = Operating Income

Sales

This takes into account the operating expenses of the company such as general
and administrative expenses, distribution costs, and finance costs.

DuPont is useful in analyzing the results of an entity’s operation over time.

However, when the firm uses DuPont Analysis to make comparisons against other
firms in the industry, the analysis may not be that useful. In order to address this
the following analysis may be employed.

• NET OPERATING PROFIT AFTER TAX

It calculates how much income would remain after income taxes if the company
were taxed on all its operating income. By using this, performance of two or more
entities can be compared regardless of how the companies choose to finance
themselves

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NOPAT = Operating Profit x (1-Tax Rate)

NOPAT Ratio = NOPAT/Sales

• INVESTED CAPITAL TURNOVER

Invested Capital = Assets less operating liabilities

Or

Invested Capital = Stockholder’s Equity plus-interest bearing liabilities.

Invested Capital Turnover = Sales / Invested Capital

The former is the net resources financed by expensive sources of capital, and the
latter is the sources of financing for those resources. They must produce the same
value, given that the balance sheet must balance.

• Return on Invested Capital (ROIC)

ROIC =NOPAT Ratio x Invested Capital Turnover

If a firm’s ROIC is greater than the firm’s WACC, the firm should be creating
shareholder value; conversely, a firm earning a ROIC that is lower than its WACC
is likely to be destroying shareholder value.

• SUSTAINABLE GROWTH RATE

It indicates the maximum earnings growth affirm can achieve without resorting
to other means of financing.

Sustainable Growth Rate = (1 – Dividend Payout Ratio) x ROE

Implications:

If the firm pays out dividends at a arate of 30% of earnings, for example, it retains
the other 70%. The resulting increase in shareholder’s equity will also earn a rate
of return and can continue to generate growth in earnings . The ability to take on
debt grows as shareholders’ equity grows, allowing for more borrowing without
dangerous changes to the ratio of debt to total assets or debt to equity. If a firm
grows at a rate greater than its sustainable growth rate, it will need additional
capital from debt or equity.

To illustrate, refer to the following table:

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Assume that this entity earns about 14% ROE and pays out 1/3 of its income as
dividends while retaining two-thirds. The two columns shows that changes to its
financial position caused by an increase of 10% and 13%, respectively.

Notice that if there is an increase of 13%, there exists a capital shortfall. How to
solve this?

1. Borrow additional money.

2. Issue additional shares.
3. Cut the dividend.

This shows that Sustainable Growth Rate is the highest rate at which Sales can
grow while :

1. Not changing the capital structure

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 2. Not issuing new common stock

Given that:
1. Profitability (as measured by NOPAT Margin) doesn’t improve.
2. Asset intensity (as measured by Invested capital turnover doesn’t improve).

• REVENUE ANALYSIS

Revenue is an indicator of resources generated by a business from its

customers through its operations. Therefore, revenue must be correctly and
appropriately determined as it is used in a number of analysis.

Now, it begs the question, “when do we record revenue?”

In a recently issued standard IFRS 15 Revenue from Contracts with Customers,

it states that the core principle of the guidance is that an entity should
recognize revenue for the transfer of promised goods or service to customers
in an amount that reflects the consideration the entity expects to receive for
the goods or services. To achieve this, the entity applies the following steps:

1. Identify the contract with customer

2. Identify the performance obligations in the contract
3. Determine the transaction price
4. Allocate the transaction price to the performance obligations in the
contract
5. Recognize revenue as the entity satisfies a performance obligation

• INCOME MEASUREMENT ANALYSIS

The income and expenses presented in the income statement are subject to
a variety of judgments and accounting methods. Further, financial accounting
and reporting contains considerable need for estimations. Further, companies
may appropriately wish to change between two or more acceptable
accounting and reporting methods for a particular type of transactions. Thus,
income measurement is complicated. These factors need to be considered in
measuring income
1. Estimates – Depreciation, Bad Debts, etc.
2. Accounting Methods – Straight-line vs. Accelerated Depreciation, or LIFO
vs. FIFO
3. Disclosures – The degree of informative disclosure about the results of
operations and the asset base of segments of business can vary widely. Full
disclosure would call for providing detailed income statements for each
segment . However, there is management’s reluctance to divulge
information that could harm the business’s competitive position.
4. Different Needs of Users
a. Investing public
b. Creditors
c. Suppliers
d. Union representatives
e. Government

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 PRACTICE EXERCISES

1. The profit figure that is preferred in connection with the analysis of a

division or department is:
a. income before income tax
b. taxable profit
c. net income
d. operating income
e. net income exclusive of bond interest

2. The return on investment (ROI) ratio measures:

a. both asset turnover and earnings as a percentage of sales
b. asset turnover and earnings as a percentage of sales, correcting for
the effects of differing depreciation methods
c. only asset turnover
d. only earnings as a percentage of sales
e. none of the above

3. Return on investment (ROI) is a term often used to express income earned

on capital invested in a business unit. A company's ROI would be
increased if:
a. sales decreased by the same dollar amount that expenses
increased
b. sales and expenses increased by the same percentage that total
assets increased
c. net profit margin on sales increased by the same percentage that
total assets increased
d. sales increased by the same dollar amount that expenses and total
assets increased
e. sales remained the same and expenses were reduced by the same
dollar amount that total assets decreased

4. What is the most appropriate base to use in computing a return on

investment for a business segment?
a. total segment assets employed
b. total segment assets employed less allocated liabilities of the
company
c. current assets of the segment
d. noncurrent assets of the segment
e. none of the above

5. The calculation of a company's return on investment is affected by a

change in:

Capital Turnover Profit Margin on Sales

a. A. yes yes
b. B. no yes
c. C. no no
d. D. yes no

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 6. If profits are $20,000, sales are $100,000, and capital employed is $50,000,
the capital-employed turnover rate would be:
a. 4
b. 5
c. 0.40
d. 0.20
e. 2

7. If profits are $100,000, sales are $500,000, and capital employed is

$400,000, the rate of return on capital employed would be:
a. 400%
b. 125%
c. 25%
d. 20%
e. 500%

8. The following data relate to the Happy Division of Euphoria, Inc.:

Sales $10,000,000
Variable costs 3,000,000
Direct fixed costs 5,000,000
Invested capital 2,000,000
Capital charge 12 %

The divisional residual income is:

a. $7,000,000
b. $240,000
c. $2,000,000
d. $1,760,000
e. none of the above

9. The following data relate to the Happy Division of Euphoria, Inc.:

Sales $10,000,000
Variable costs 3,000,000
Direct fixed costs 5,000,000
Invested capital 8,000,000
Capital charge 12 %

The divisional return on investment is:

a. 50%
b. 25%
c. 20%
d. 12%
e. none of the above

10. The biggest challenge in making a decentralized organization

function effectively is:
a. earning maximum profits through fair practices.
b. minimizing losses.
c. taking advantage of the specialized knowledge and skills of highly
talented managers.
d. obtaining goal congruence among division managers.

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 e. developing an adequate budgetary control system.
11. What practice is present when divisional managers throughout an
organization work together in an effort to achieve the organization's
goals?
a. Participatory management.
b. Goal attainment.
c. Goal congruence.
d. Centralization of objectives.
e. Negotiation by subordinates.

12. Consider the following statements about goal congruence:

I.Goal congruence is obtained when managers of subunits throughout an

organization strive to achieve the goals set by top management.
II.Managers are often more concerned about the performance of their own
subunits rather than the performance of the entire organization.
III.Achieving goal congruence in most organizations is relatively straightforward
and easy to accomplish.

Which of the above statements is (are) true?

a. I only.
b. II only.
c. I and II.
d. II and III.
e. I, II, and III.

13. Which of the following performance measures is (are) used to evaluate

the financial success or failure of investment centers?
a. Residual income.
b. Return on investment.
c. Number of suppliers.
d. Economic value added.
e. All of the above measures are used except "C."

14. ROI is most appropriately used to evaluate the performance of:

a. cost center managers.
b. revenue center managers.
c. profit center managers.
d. investment center managers.
e. both profit center managers and investment center managers.

15. Which of the following is not considered in the calculation of divisional

ROI?
a. Divisional income.
b. Earnings velocity.
c. Capital turnover.
d. Sales margin.
e. Sales revenue.

16. Which of the following is the correct mathematical expression for return on
investment?
a. Sales margin ÷ capital turnover.
b. Sales margin + capital turnover.

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 c. Sales margin - capital turnover.
d. Sales margin x capital turnover.
e. Capital turnover ÷ sales margin.

17. The ROI calculation will indicate:

a. the percentage of each sales dollar that is invested in assets.
b. the sales dollars generated from each dollar of income.
c. how effectively a company used its invested capital.
d. the invested capital generated from each dollar of income.
e. the overall quality of a company's earnings.

18. A company's sales margin:

a. must, by definition, be greater than the firm's net sales.
b. has basically the same meaning as the term "contribution margin."
c. is computed by dividing sales revenue into income.
d. is computed by dividing income into sales revenue.
e. shows the sales dollars generated from each dollar of income.

19. Which of the following is the correct mathematical expression to derive a

company's capital turnover?
a. Sales revenue ÷ invested capital.
b. Contribution margin ÷ invested capital.
c. Income ÷ invested capital.
d. Invested capital ÷ sales revenue
e. Invested capital ÷ income

20. Capital turnover shows:

a. the amount of income generated by each dollar of capital
investment.
b. the number of sales dollars generated by each dollar of capital
investment.
c. the amount of contribution margin generated by each dollar of
capital investment.
d. the amount of capital investment generated by each sales dollar.
e. the amount of capital investment generated by each dollar of
income.

21. Webster Company had sales revenue and operating expenses of

$5,000,000 and $4,200,000, respectively, for the year just ended. If
invested capital amounted to $6,000,000, the firm's ROI was:
a. 13.33%.
b. 83.33%.
c. 120.00%.
d. 750.00%.
e. some other figure.

22. Zang Enterprises had a sales margin of 7%, sales of $5,000,000, and
invested capital of $4,000,000. The company's ROI was:
a. 5.60%.
b. 8.75%.
c. 11.43%.
d. 17.86%.
e. some other figure.

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 23. Mission, Inc., reported a return on investment of 12%, a capital turnover of
5, and income of $180,000. On the basis of this information, the
company's invested capital was:
a. $300,000.
b. $900,000.
c. $1,500,000.
d. $7,500,000.
e. some other amount.

24. The information that follows relates to Katz Corporation:

Sales margin: 7.5%

Capital turnover: 2
Invested capital: $20,000,000

On the basis of this information, the company's sales revenue

is:
a. $1,500,000.
b. $3,000,000.
c. $10,000,000.
d. $40,000,000.
e. some other amount.

25. A division's return on investment may be improved by increasing:

a. cost of goods sold and expenses.
b. sales margin and cost of capital.
c. sales revenue and cost of capital.
d. capital turnover or sales margin.
e. capital turnover or cost of capital.

26. All of the following actions will increase ROI except:

a. an increase in sales revenues.
b. a decrease in operating expenses.
c. a decrease in a company's invested capital.
d. a decrease in the number of units sold.
e. an improvement in manufacturing efficiency.

27. The following information relates to the Mountain Division of Adler

Enterprises:

Income for the period just ended: $1,500,000

Invested capital: $12,000,000

If the firm has an imputed interest rate of 11%, Mountain's

residual income would be:
a. $165,000.
b. $180,000.
c. $187,500.
d. some other dollar amount.
e. a percentage greater than 11%.

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 28. Extron Division reported a residual income of $200,000 for the year just
ended. The division had $8,000,000 of invested capital and $1,000,000 of
income. On the basis of this information, the imputed interest rate was:
a. 2.5%.
b. 10.0%.
c. 12.5%.
d. 20.0%.
e. some other figure.

29. Barber Corporation uses an imputed interest rate of 13% in the calculation
of residual income. Division X, which is part of Barber, had invested
capital of $1,200,000 and an ROI of 16%. On the basis of this information,
X's residual income was:
a. $24,960.
b. $36,000.
c. $156,000.
d. $192,000.
e. some other amount.

30. The following information pertains to Bingo Concrete:

Sales revenue $1,500,000

Gross margin 600,000
Income 90,000
Invested capital 450,000

The company's imputed interest rate is 8%.

The capital turnover is:
a. 3.33.
b. 5.00.
c. 16.67.
d. 20.00.
e. 30.00.

31. The sales margin is:

a. 6%.
b. 15%.
c. 20%.
d. 30%.
e. 40%.

32. The ROI is:

a. 6%.
b. 15%.
c. 20%.
d. 30%.
e. 40%.

33. The residual income is:

a. $30,000.
b. $36,000.
c. $42,000.
d. $54,000.

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 e. $82,800.

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