Profitability Analysis

9
CHAPTER
 Analyzing Profitability
Focus of Profitability Analysis

 Profitability analysis is a key part of

financial statement analysis
 All financial statements are pertinent to
profitability analysis
 Emphasis of profitability analysis is on the
income statement
 Analyzing Profitability
Focus of Profitability Analysis
Profitability analysis helps address questions such as:
 What is a company’s relevant income measure?
 What is the quality of income?
 What income components are important for
forecasting?
 How persistent are income and its components?
 What is a company’s earning power?
 Analyzing Profitability
Measuring Income

Income is defined as revenues less expenses over a

reporting period

This definition does not yield a unique amount because

of:
 Estimation Issues
 Accounting Methods
 Incentives for Disclosure
 Diversity across Users
 Analyzing Profitability
Measuring Income--Estimation Issues

Income measurement depends on estimates of future

events

These estimates require:

• Use of judgment and probabilities

• Allocations of revenues and expenses across periods
• Prediction of the future usefulness of many assets
• Forecasts of future obligations
 Analyzing Profitability
Measuring Income--Estimation Issues

Management discretion is part of income measurement

Estimates of skilled and experienced professionals 

Some consensus (less variability)
 Analyzing Profitability
Measuring Income--Accounting Methods

Professional Social
experience Influences

Accounting
standards
Regulatory governing Political
agendas income pressures
measurement

Business Academic
happenings research
 Analyzing Profitability
Measuring Income--Accounting Methods

Methods reflect the outcome of numerous factors,

including compromises

Discretion is permitted to accommodate different

business circumstances

Methods geared toward “general-purpose”

financial statements
 Analyzing Profitability
Measuring Income--Incentives for Disclosure

Ideally:
 Financial statements fairly present transactions and
events
 Accounting is neutral—not affecting how
transactions and events are perceived
 Methods chosen that are most applicable to the
circumstances
 Relevant information is disclosed—favorable and
unfavorable
 Analyzing Profitability
Measuring Income--Incentives for Disclosure

Reality:
 Each of us possess opinions--we see the world from different
perspectives
 Managers bring strong views to the table
 Managers feel pressures of competition and society
 Directors expect results
 Shareholders concentrate on the bottom line
 Creditors want safeguards
 Financial analysts dislike surprises
 Accounting preparers and auditors demand acceptable
practices
 Analyzing Profitability
Measuring Income--Incentives for Disclosure

Result:

“Acceptable” methods, not necessarily

“appropriate” methods
 Analyzing Profitability
Measuring Income--Diversity Across Users

• Financial statements are general‑purpose reports

serving diverse needs of many users

• Diversity of views implies an analysis uses income

as an initial measure of profitability

• Use available information adjust income

measurement consistent with one’s objectives
 Analyzing Revenues
Two-Phase Analysis of Income

Analysis of income and its components involves two phases

1. Analysis of accounting and its measurements

Purpose: To apply knowledge of accounting to yield a measure of

income, and its components, consistent with the analysis objectives

2. Applying analysis tools to income (and its components) and

interpreting the analytical results

Purpose: To apply analysis tools to aid achieve the analysis

objectives—such as income forecasting and estimating earning
power
 Analyzing Revenues
Revenue Sources

Analysis of revenues (sales) helps address questions

such as:

 What are the major sources of revenue?

 How persistent are revenue sources?
 How are revenues, receivables, and inventories
related?
 When is revenue recorded?
 How is revenue measured?
 Analyzing Revenues
Revenue Sources

 Knowledge of major sources of revenues is important

to profitability analysis

 Each market and product line often has its own growth
pattern, profitability, and future potential

 Common-size analysis of revenues shows the percent

of each major class of revenue to its total

 Graphical analysis is a useful tool to interpret the

sources of revenues
 Analyzing Revenues
Revenue Sources

Diversified Companies present special challenges

• Different segments usually experience varying rates of
profitability, risk, and growth
• Asset composition and financing requirements of segments
often vary
• Evaluation, projection, and valuation of income is aided by
segment analysis
• Segments share characteristics of variability, growth, and risk
• Income forecasting benefits from forecasts by segments
• Must separate and interpret the impact of individual segments
 Analyzing Revenues
Revenue Sources

Full disclosure by segments is rare because of:

• Difficulties in separating segments

• Management’s reluctance to release information

that can harm its competitive position
 Analyzing Revenues
Revenue Sources

Reporting requirements exist for:

• Industry segments
• International activities
• Export sales
• Major customers

GAAP
 Analyzing Revenues
Revenue Sources

Reporting requirements consider a segment

significant if its sales, operating income, or
identifiable assets comprise 10 percent or more of
their relevant totals

Notes:
Combined sales of all segments reported must be at
least 75 percent of the company’s total sales
Ten segments is viewed as a practical limit on the
number of segments reported

GAAP
 Analyzing Revenues
Revenue Sources
Information disclosed for each segment:
(1) sales—both intersegment and to unaffiliated
customers
(2) operating income—revenues less operating
expenses
(3) identifiable assets
(4) capital expenditures
(5) depreciation, depletion, and amortization

Similar disclosures are required for international operations

and export sales (except capital expenditures and
depreciation)

Revenues from a single customer are disclosed if they

comprise 10 percent or more of total revenues
Analyzing Revenues
Revenue Sources

Limitations of segment data:

• Difficult to define segments

• Arbitrary allocations of costs
across segments
 Analyzing Revenues
Revenue Sources

Useful applications of segment data include:

 Analysis of sales growth

 Analysis of asset growth

 Analysis of profitability
 Analyzing Revenues
Persistence of Revenues

Persistence (stability and trend) of revenues is

important to profitability analysis

Analysis tools for assessing persistence in revenues

include:
(1) trend percent analysis
(2) evaluation of Management’s Discussion and
Analysis
 Analyzing Revenues
Persistence of Revenues--Trend Percent Analysis

Revenues for a prior period are

set equal to 100 percent

Revenues for other periods are

compared to it

Revenue trends by segments are often:

Correlated
Compared to industry norms
Compared to competitors
 Analyzing Revenues
Persistence of Revenues--Trend Percent Analysis

Other related measures:

 (Auto)correlations of revenues
across periods
 Assess sensitivity of revenues to
business conditions
 Customer analysis—concentration,
dependence, and stability
 Revenues’ concentration or dependence on one
segment
 Revenues’ reliance on sales staff
 Geographical diversification of markets
 Analyzing Revenues
Persistence of Revenues--MD&A

Management’s Discussion and Analysis (MD&A) is often

useful in analysis of persistence in revenues

• Aids in understanding and evaluating period-to-period

changes
• Report on changes in revenue components
• Discloses uncertainties affecting or likely to affect
revenues
• Explains growth in revenues to prices, volume,
inflation, or new product introduction
• Reports some forward‑looking information
• Discusses trends and forces not evident from
financial statements
 Analyzing Revenues
Key Revenue Relations

Revenues and Accounts Receivable Relation

Bears on:

Earnings quality
Collectibility of receivables
 Analyzing Revenues
Key Revenue Relations

Revenues and Inventories Relation

Bears on:

Future revenues
Analysis of operations
 Analyzing Revenues
Revenues Recognition

Profitability analysis must adjust for different

revenue recognition methods in:

• Comparative analysis—both temporal and

cross-sectional
• Forecasting revenues

Chapter 6 discusses revenue recognition criteria

and measurement
Analyzing Costs of Revenues
Measuring Gross Profit

Gross profit, or gross margin, is measured as

revenues less cost of sales

All other costs must be recovered from gross profit

Any income earned is the

balance remaining after these costs

Gross profit must finance essential future‑directed

discretionary expenditures
Analyzing Costs of Revenues
Measuring Gross Profit

Gross profits vary across industries depending on

factors such as:

• Competition

• Capital investment

• Level of costs that must be

recovered from gross profit
Analyzing Costs of Revenues
Analyzing Gross Profit

Analysis of gross profit directs attention at the

factors explaining variations in:

• Sales

• Costs of sales
 Analyzing Costs of Revenues
Analyzing Gross Profit
Analysis Statement of Changes in Gross Profit

Step 1. Focus on year‑to‑year change in volume assuming unit

selling price is unchanged—Volume change is
multiplied by the constant unit selling price to yield
change in sales
Step 2. Focus on year-to-year change in selling price
assuming volume is constant--Change in selling price
is multiplied by the constant volume to yield change in
sales
Step 3. Focus on joint changes in volume and unit price—
Volume change is multiplied by the change in unit
selling price to yield net change in sales
Step 4. Steps 1 to 3 explain the net change in sales.
 Analyzing Costs of Revenues
Analyzing Gross Profit

Analysis Statement of Changes in Gross Profit—Illustration

Year Ended December 31 Year-to-Year Change

Item Year 1 Year 2 Increase Decrease

1. Sales ($ millions) $ 657.6 $ 687.5 $ 29.9

2.Cost of sales ($ millions) 237.3 245.3 8.0
3.Gross profit ($ millions) $ 420.3 $ 442.2 $ 21.9
4.Units sold (in millions) 215.6 231.5 15.9
5.Sales price per unit
(1 ÷ 4) $ 3.05  $ 2.97  $ 0.08
6.Cost per unit (2 ÷ 4) 1.10  1.06  0.04
 Analyzing Costs of Revenues
Analyzing Gross Profit

Analysis Statement of Changes in Gross Profit

Year 2 versus Year 1

Analysis of Variation in Sales

1. Change in volume of products sold:
Change in volume (15.9)  Year 1 unit selling price ($3.05) $ 48.5
2..Change in selling price:
Change in selling price ($0.08)  Year 1 sales volume (215.6) 17.2
$ 31.3
3. Combined change in sales volume (15.9) and unit price ($0.08) 1.3
Increase in net sales $ 30.0*
Analysis of Variation in Cost of Sales
1. Change in volume of products sold:
Change in volume (15.9)  Year 1 cost per unit ($1.10) $ 17.5
2. Change in cost per unit sold:
Change in cost per unit ($0.04)  Year 1 sales volume (215.6) 8.6
$ 8.9
3. Combined change in volume (15.9) and cost per unit ($0.04) 0.6
Increse in cost of sales $ 8.3*
Net variation in gross profit $ 21.7*
* Differences are due to rounding.
Analyzing Costs of Revenues
Interpreting Changes in Gross Profit

Changes in gross profit are often driven by one or more

of the following factors:

 Increase in sales volume

 Decrease in sales volume
 Increase in unit selling price
 Decrease in unit selling price
 Increase in cost per unit
 Decrease in cost per unit
Analyzing Costs of Revenues
Interpreting Changes in Gross Profit

• Identification of factors driving gross profit yields

• Improved business strategies

• Better assessment of future performance

 Analyzing Expenses
Tools for Analysis of Expenses
  Common-size analysis
Common‑size income statements express expenses in terms of their percent relation
with revenues
Traced over several periods or compared with competitors

  Index number analysis

Index number analysis of income statements expresses income and its components in
an index number related to a base period
Highlights relative changes across time
Changes in expenses are readily compared with changes in both revenues and related
expenses

  Operating ratio analysis

Operating ratio measures the relation between operating expenses (or its
components) and revenues
Equals cost of goods sold plus other operating expenses divided by net revenues
Interest and taxes are normally excluded from this measure due to its focus on
operating efficiency (expense control) and not financing and tax management
Useful for analysis of expenses within and across companies
 Analyzing Expenses
Selling Expenses

Analysis of selling expenses focuses on three areas:

 Evaluating the relation between key selling

expenses and revenues

 Assessing bad debts expense

 Evaluating the trend and productivity of

future‑directed marketing expenses
 Analyzing Expenses
Depreciation Expense

Relation of depreciation to gross plant and equipment

helps reveal changes in the composite rate of
depreciation—this is useful in evaluating depreciation
levels and in detecting adjustments (smoothing) to
income:
Depreciation expense
Depreciabl e assets

It is often useful to compute this ratio by asset

categories
 Analyzing Expenses
Maintenance and Repairs Expense

Maintenance and repairs expense:

• Varies with investment in plant and equipment and

with the level of productive activity

• Affect costs of sales and other expenses

• Comprise both variable and fixed costs

• Do not vary directly with sales

 Analyzing Expenses
Maintenance and Repairs Expense
Relation of sales to maintenance and repairs expense,
both across companies and time, must be interpreted
with care

• Analysis and interpretation using this ratio

• Is enhanced if we can distinguish between variable
and fixed portions of these expenses
• Must recognize the discretionary nature of these
expenses
• Bear on productivity and earnings quality
assessments
• Impacts asset valuations
 Analyzing Expenses
Amortization of Special Costs

Expenditure for special costs can be related to and

expressed as a percent of:

(1) revenues
(2) net property and equipment

Amortization of special costs can be related to and

expressed as a percent of:

(1) revenues
(2) unamortized special costs
(3) net property and equipment
 Analyzing Expenses
Amortization of Special Costs

Ratios involving special costs are useful in:

Comparison of annual trends in these relations

Analysis of consistency in income reporting

Evaluation of income for two or more competitors

 Analyzing Expenses
General and Administrative Expenses

Most are fixed—such as rent and salary

Tendency for increases, especially in

prosperous times
 Analyzing Expenses
General and Administrative Expenses

Analysis of G&A should focus on:

• Trend in these expenses

• Percent of revenues they consume

 Analyzing Expenses
Financing Expenses

Most are fixed—exception is variable-rate interest

Most creditor financing is eventually refinanced and

not removed

Interest expense often includes amortization of a

premium or
discount
 Analyzing Expenses
Financing Expenses

Average effective interest rate:

Total interest incurred
Average interest-bearing indebtedness

Useful tool for:

• Analysis of the cost of borrowed money

• Credit standing
• Comparisons across years and companies
• Assessing sensitivity to interest rate changes
 Analyzing Expenses
Income Tax Expenses

Income tax expenses:

 Reflect a distribution of profits between a company

and governmental agencies

 Usually comprise a substantial portion of a

company’s pre-tax income
 Analyzing Expenses
Income Tax Expenses

Effective Tax Rate (ETR)

Income tax expense

Income before income taxes

ETR (also called tax ratio) reflects

relation between the income tax
accrual and pre‑tax income
 Analyzing Expenses
Income Tax Expenses

Differences in ETR from normal or expected rate affects

assessments of income

• Level
• Trend
• Forecasts

Small changes in ETR can yield major

changes in income
 Analyzing Expenses
Income Tax Expenses

Analysis of income tax disclosures aims to:

 Assess tax implications for income, assets,

liabilities, and cash sources and uses
 Evaluate tax effects for future income and cash
flows
 Appraise the effectiveness of tax management
 Identify unusual gains or losses only revealed in tax
disclosures
 Signal areas of concern requiring further analysis or
management inquiry