Profitability Analysis Chapter 4 Profitability Analysis

Overview of Profitability Analysis Evaluates whether managers are effectively executing a firm’s strategy. Helps to develop an understanding of a firm’s performance to enable forecasts of future performance. Approaches to understanding firm’s net income: Chapter: 04

Overview of Profitability Analysis (Contd.) Alternative transformations of measured net income: Earnings per share analysis Common-size analysis Percentage change analysis Alternative definitions of profits Rate of Return Metrics: Return on total assets Return on common equity Chapter: 04

Alternative Approaches to Analyzing Net Income Chapter: 04

Earnings Per Share One of the most frequently used measures of profitability. The only financial ratio that GAAP requires firms to disclose on the face of the income statement. Covered explicitly by the opinion of the independent auditor. Types of EPS: Basic EPS (Simple Capital Structure) Diluted EPS (Complex Capital Structure) Chapter: 04

Calculating EPS Basic EPS (Simple Capital Structure) For firms that do not have: Outstanding convertible bonds or convertible preferred stock that can be exchanged for shares of common stock. Options or warrants that holders can use to acquire common stock. Basic EPS is calculated as: Chapter: 04

Calculating EPS (Contd.) Diluted EPS (Complex Capital Structure) For the firms that have Convertible securities and/or stock options or warrants outstanding. Presents two EPS amounts: Basic EPS & Diluted EPS Diluted EPS reflects the dilution potential of convertible securities, options, and warrants. Diluted EPS is calculated as: Chapter: 04

Criticisms of EPS It does not consider the amount of assets or capital required to generate a particular level of earnings. Two firms with the same earnings and EPS are not necessarily equally profitable. The number of shares of common stock outstanding serves as a poor measure of the amount of capital in use. Despite the above criticisms of EPS as a measure of profitability, it remains one of the focal points of announcements and is frequently used valuing firms. Chapter: 04

Common-Size Analysis Simple way of creating greater comparability across firms and for same firm through time. Most frequently utilized in: Income statement: by expressing all line items scaled by revenues. Balance sheet: by expressing all line items scaled by total assets. Common scaling enables figures across firms and across time to be more comparable. Chapter: 04

Percentage Change Analysis Computes percentage changes in individual line items. Can be compared across firms or across time. Focus is not on the financial data themselves, but on the changes in individual line items through time. Chapter: 04

Alternative Definitions Of Profits Analysts use measures of past profitability to forecast the firm’s future profitability. These may include: Comprehensive Income Operating Income, EBIT, EBITDA, and Other Profit Measures Segment Profitability Pro Forma, Adjusted, or Street Earning Chapter: 04

Return On Assets Independent of firm’s financing decisions. Measures ongoing profitability. Unusual or nonrecurring items (such as restructuring charges), may be removed, net of tax. Return on Assets is calculated as: Chapter: 04

Disaggregating ROA ROA can be further disaggregated into: Chapter: 04

Realized ROA versus Expected ROA Realized ROA is derived from financial statement data for a particular period and will not necessarily correlate perfectly with expected returns. Reasons for this may be: Faulty assumptions were used in deriving expected ROAs. Changes in the environment. ROA is an incomplete measure of economic rates of return. Chapter: 04

Elements of risk - differences in ROAs Three elements of risk help in understanding differences across firms and changes over time in ROAs: Operating leverage: Refers to proportion of fixed costs relative to variable costs. Cyclicality of Sales: Are sales sensitive to economic conditions. Product Life Cycle: Relates to the stage and length of firm’s product life. Chapter: 04

Trade-Offs between Profit Margin and Assets Turnover Important to examine the differences between the relative mix of profit margin and assets turnover. Differences in ROA due to relative mix of profit margin and assets turnover can be explained by: Microeconomic Theory Business Strategy Chapter: 04

Microeconomic Theory Capacity Constraint Heavy fixed capacity costs and lengthy periods required to add new capacity. There is an upper limit on the size of assets turnover achievable. Only way to increase ROA is to increase profit margin. The firms usually achieve the high profit margin through some form of entry barrier. Chapter: 04

Microeconomic Theory (Contd.) Competitive Constraint For firms whose products are commodity- like. Few entry barriers and intense competition. There is an upper limit on the achievable level of profit margin for ROA. Only way to improve ROA is to achieve high asset turnover. Firms achieve the high assets turnovers by controlling costs with aggressively low prices to gain market share. Chapter: 04

Business Strategy Two generic alternative strategies for a particular product are: Product differentiation strategy- Differentiate a product to obtain market power over revenues and, therefore, profit margins. Low-cost leadership strategy- Enabling the firm to charge the lowest prices and to achieve higher sales volumes. Chapter: 04

Analyzing the Profit Margin for ROA Sales Individual expenses Cost of goods sold Selling, General, and Administrative Expenses Income taxes Profit margin Segment data: Permits the analyst to examine ROA, profit margin, and assets turnover at an additional level of depth. Chapter: 04

Analyzing Total Assets Turnover Captures how efficiently assets are being utilized to generate revenues. Provides insight into changes in the total assets turnover by examining turnover ratios: Accounts receivable turnover- Indicates the average time until firms collect accounts receivable in cash. Inventory turnover- Indicates the length of time needed to produce, hold, and sell inventories. Fixed assets turnover- Measures the relation between sales and the investment in property, plant, and equipment. Chapter: 04

Return on Common Equity Measures the return to common stock holders after subtracting operating expenses and costs of debt financing and preferred stock. It should adjust net income for nonrecurring charges, as in ROA. Explicitly accounts for the cost of debt and preferred stock financing. ROCE is calculated as: Chapter: 04

Relating ROA to ROCE ROA measures operating performance independent of financing. ROCE considers the cost of debt and preferred stock financing. Chapter: 04

Disaggregating ROCE ROCE can be further disintegrated into: ROCE = Leverage refers to use of debt to increase return to common stockholders ROCE > ROA When ROA > Cost of debt and Preferred stock financing. Chapter: 04

Interpreting Financial Statement Ratios Comparing with Earlier Periods Raise the following questions: Has the firm made a significant change in its product, geographic, or customer mix? Has the firm made a major acquisition or divestiture? Has the firm changed its methods of accounting over time? Are there any unusual or nonrecurring amounts that impair a comparable analysis of financial results across? Chapter: 04

Interpreting Financial Statement Ratios (Contd.) Comparing with Other Firms Consider the following: Definition of the industry Calculation of industry average Distribution of ratios around the mean Definition of financial statement ratios Chapter: 04