© 2015 Cengage Learning. All Rights Reserved. Learning Objective © 2015 Cengage Learning. All Rights Reserved. LO2 Analyze the profitability of a business. LESSON13-2 Measuring and Analyzing Profitability

© 2015 Cengage Learning. All Rights Reserved. Profitability Analysis ●The amounts and consistency of earnings are important measures of a business’s success. ●Five profitability measures include: (1) gross margin, (2) operating margin, (3) rate earned on average total assets, (4) rate earned on average stockholders’ equity, and (5) free cash flow. SLIDE 2 LO2 Lesson 13-2 © 2015 Cengage Learning. All Rights Reserved.

Gross Margin ●Gross profit as a percent of net sales is called gross margin. ●Gross profit must be high enough to cover operating expenses, other expenses, taxes, and profit. ●Gross margin can be improved by increasing sales at a faster rate than the cost of merchandise sold. Gross Profit÷Net Sales=Gross Margin $254,982.02÷$646,017.54=39.5% $246,612.12÷$645,212.32=38.2% $247,126.30÷$642,578.45=38.5% Lesson 13-2 Year 20X3 20X2 20X1 LO2 © 2015 Cengage Learning. All Rights Reserved.

Operating Margin ●Income from operations as a percent of net sales is called operating margin or rate of return on sales. ●Operating margin is used by investors to determine how effective a business is at earning a profit from its normal operations. Income from Operations ÷Net Sales= Operating Margin $119,493.88÷$646,017.54=18.5% $118,925.68÷$645,212.32=18.4% $120,892.82÷$642,578.45=18.8% Lesson 13-2 Year 20X3 20X2 20X1 LO2 © 2015 Cengage Learning. All Rights Reserved.

Rate Earned on Average Total Assets 1.Calculate average total assets. Average total assets is the average amount of assets held during a year. a.Add January 1 total assets and December 31 total assets. (Total assets for January 1 are the same as the total assets on the prior year’s December 31 balance sheet.) b.Divide the total by 2. 2.Divide net income by average total assets to determine the rate earned on average total assets. SLIDE 5 Lesson 13-2 © 2015 Cengage Learning. All Rights Reserved The relationship between net income and average total assets is called the rate earned on average total assets. LO2

© 2015 Cengage Learning. All Rights Reserved. Rate Earned on Average Stockholders’ Equity 1.Calculate average stockholders’ equity. a.Add January 1 stockholders’ equity and December 31 stockholders’ equity. (Stockholders’ equity for January 1 is the same as the stockholders’ equity on the prior year’s December 31 balance sheet.) b.Divide the total by 2. 2.Divide net income by average stockholders’ equity to determine the rate earned on average stockholders’ equity. SLIDE 6 Lesson 13-2 © 2015 Cengage Learning. All Rights Reserved. 2 2 The relationship between net income and average stockholders’ equity is called the rate earned on average stockholders’ equity. LO2 1 1

© 2015 Cengage Learning. All Rights Reserved. Free Cash Flow ●Free cash flow is a measure equal to cash flows from operations less cash used for capital expenditures. ●Capital expenditures are purchases of plant assets used in the operation of a business. Cash Flow From Operating ÷ Capital Expenditures = Free Cash Flow $64, $107,987.00=($43,601.22) $56, $122,853.00=($65,966.87) Lesson 13-2 Year 20X3 20X2 LO2 © 2015 Cengage Learning. All Rights Reserved.

Lesson 13-2 Audit Your Understanding 1. What is the formula for operating margin? SLIDE 8 ANSWER Income from operations divided by net sales. Lesson 13-2 © 2015 Cengage Learning. All Rights Reserved.

Lesson 13-2 Audit Your Understanding 2.What does the rate earned on average total assets show? SLIDE 9 ANSWER How well a business is using its assets to earn net income. Lesson 13-2 © 2015 Cengage Learning. All Rights Reserved.

Lesson 13-2 Audit Your Understanding 3.What does the rate earned on average stockholders’ equity show? SLIDE 10 ANSWER How much net income the stockholders’ investment is earning. Lesson 13-2 © 2015 Cengage Learning. All Rights Reserved.