Profitability COPYRIGHT ©2007 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 8
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 8, Slide #2 Profitability Measures Exclude items of income not arising from normal operations –Discontinued operations –Extraordinary items
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 8, Slide #3 Net Profit Margin Also referred to as return on sales Reflects net income dollars generated by each dollar of sales Potential distortion –Net “other” income or loss
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 8, Slide #4 Total Asset Turnover Measures the activity of the assets and the ability of the firm to generate sales through the use of the assets Potential distortion –Investments –Construction in progress –Other assets that do not relate to net sales
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 8, Slide #5 Return on Assets Measures the ability to utilize assets to create profits Average total assets –Internal analysis: month-end amounts –External analysis: beginning and ending amounts –If necessary, consistent use of end-of-year amounts
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 8, Slide #6 Operating Income Margin Use operating income in the numerator
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 8, Slide #7 Operating Asset Turnover Measures the ability of operating assets to generate sales dollars
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 8, Slide #8 Return on Operating Assets Measures the ability of operating assets to generate operating income
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 8, Slide #9 Sales to Fixed Assets Measures the ability to make productive use of property, plant, and equipment by generating sales dollars –Exclude construction in progress Possible distortions –Old fixed assets –Labor-intensive industry
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 8, Slide #10 Return on Investment (ROI) Measures the earnings on investment and indicates how well the firm utilizes its asset base Evaluates enterprise performance
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 8, Slide #11 Return on Investment (ROI) (cont’d) Measures ability to reward investors and to attract providers of future funds Evaluates the earnings performance without regard to financing sources
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 8, Slide #12 Return on Total Equity Measures the return to common and preferred stockholders Adjustments for redeemable preferred stock –Deduct dividends from net income (numerator) –Deduct stock value from total equity (denominator)
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 8, Slide #13 Return on Common Equity Measures the return to the common stockholder Common equity: Total stockholders’ equity lesspreferred capital lessminority interest reported as equity
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 8, Slide #14 The Relationship Between Profitability Ratios Rate of return on Measures return to providers ofTypical result AssetsAll fundsLowest (includes all assets) InvestmentLong-term fundsHigher than ROA (relative small amount of short-term funds) Total equityEquityHigher than ROI (measures return only to shareholders) Common equity Highest Common shareholders absorb greatest degree of risk Requires that return to preferred shareholders exceed funds paid to preferred shareholders
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 8, Slide #15 Gross Profit Margin Sales –Cost of Goods Sold =Gross Profit Beginning Inventory +Purchases of Inventory –Ending Inventory
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 8, Slide #16 Segment Reporting Operating segments –Separate financial information is available –Evaluated by the chief decision making officer Geographical information –Revenues earned –Asset concentration Major customers Products and services
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 8, Slide #17 Gains and Losses from Prior Period Adjustments Charged directly to retained earnings –Changes in accounting principles –Realization of net operating loss carryforward tax benefits from purchased subsidiaries –Changes in accounting entity –Correction of errors originating in prior periods
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 8, Slide #18 Pro Forma Financial Information Non-GAAP-based financial information “What if” Financial Statements
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved. Chapter 8, Slide #19 Interim Reports Unaudited financial reports covering fiscal periods of less than one year SEC requires quarterly information be filed on Form 10-Q Produced quickly; rely on more estimates