Profitability Analysis 9 CHAPTER

Analyzing Profitability  Profitability analysis is a key part of financial statement analysis  Emphasis of profitability analysis is on the income statement  Relationship between revenues and expenses  Extent to which a business generates a profit from the use of labor, management and capital  Focus on level of profits in relation to the amount of investment

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?

Analyzing Profitability Income is defined as revenues less expenses over a reporting period This definition does not yield a unique amount because of:  Estimates of future events  Prediction of the future usefulness of many assets  Allocations of revenues and expenses across periods  Accounting Methods  Depreciation mehods  Incentives for Disclosure:  Directors and mangers expect results  Shareholders concentrate on the bottom line  “Acceptable” methods, not necessarily “appropriate” methods  Diversity across Users  Use available information adjust income measurement consistent with one’s objectives

Capitol Tour Bus (Bought Bus for $ 50000) Income Statement ( Two methods of depreciation) Y1Y 2Y3Y4Y5 Net income before Depreciation and Repair Straight Line Method of Depreciation ( Rate 20%) Depreciation10000 Repair Net income Double Decline Method of Depreciation Rate30%25%20%15%10% Depreciation Repair Net income15000 Which method of depreciation is better and Why?

Analyzing Revenues Analysis of revenues (sales) helps address questions such as:  What are the major sources of revenue?  How persistent are revenue sources?  When is revenue recorded?  How is revenue measured? Analysis of revenues (sales) helps address questions such as:  What are the major sources of revenue?  How persistent are revenue sources?  When is revenue recorded?  How is revenue measured? 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  Analysis of sales growth  Analysis of profitability  Persistence (stability and trend) of revenues 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  Analysis of sales growth  Analysis of profitability  Persistence (stability and trend) of revenues

Analyzing Revenues Revenue Sources Earnings Contribution and Growth Rates by Segments EarningsGrowth Rate of EarningContributionsContribution for Past Segments($ thousands)Three Years Leisure goods: Camping equipment$10011% Fishing equipment502 Boats and accessories7215 Sporting goods123 $234 Clothing apparel: Dress$852 Casual728 Sports1215 $169 Education: Textbook publishing$403 Papers and supplies176 $57 Total$460 Earnings Contribution and Growth Rates by Segments EarningsGrowth Rate of EarningContributionsContribution for Past Segments($ thousands)Three Years Leisure goods: Camping equipment$10011% Fishing equipment502 Boats and accessories7215 Sporting goods123 $234 Clothing apparel: Dress$852 Casual728 Sports1215 $169 Education: Textbook publishing$403 Papers and supplies176 $57 Total$460

Analyzing Revenues Revenue Sources Segmented Earnings Contribution Matrix Growth Rate (in percent) Segment0–55–1010–15Total Leisure goods$62$0$172$234 Clothing apparel Education Total$187$89$184$460 Segmented Earnings Contribution Matrix Growth Rate (in percent) Segment0–55–1010–15Total Leisure goods$62$0$172$234 Clothing apparel Education Total$187$89$184$460

Lucky Super Market Earnings Contribution and Growth Rates by Segments SegmentsEarnings Contributions for Past Three Years (in $ 000) Growth Rate of Earning Cosmetics & Toiletries12020% Bakery & milk products805% Baby Food15015% Fruits, Vege & Meat707% Home products20012% Apparel1705% Total790  Is it easy to collect such information? How?  If you are manager of lucky Super market,  Will you show this segment information in the Annual Report? Why

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 Full disclosure by segments is rare because of: Difficulties in separating segments Management’s reluctance to release information that can harm its competitive position Reporting requirements exist for: Industry segments International activities Export sales Major customers Reporting requirements exist for: Industry segments International activities Export sales Major customers

 Correlations of revenues across periods: Relationship between revenue and time  Assess sensitivity of revenues to business conditions  If Price decreases, what will happen to Revenue?  Customer analysis—  Are our customer concentrated in few industry?  Are we dependent on few customer?  Cambodian Garment Factory export main Customer  Is revenue from cutomers stable?  Lucky Super Market main customer  Revenues’ reliance on sales staff  Sales Person A15% Sales Person B25%  Sales Person C40% Sales Person D20%  Correlations of revenues across periods: Relationship between revenue and time  Assess sensitivity of revenues to business conditions  If Price decreases, what will happen to Revenue?  Customer analysis—  Are our customer concentrated in few industry?  Are we dependent on few customer?  Cambodian Garment Factory export main Customer  Is revenue from cutomers stable?  Lucky Super Market main customer  Revenues’ reliance on sales staff  Sales Person A15% Sales Person B25%  Sales Person C40% Sales Person D20% Analyzing Revenues: Other related measures

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

Measuring Gross Profit Gross profits vary across industries depending on factors such as: Analysis of gross profit directs attention at the factors explaining variations in: Sales Costs of sales IndustriesGross Profit Margin Example High Competition LowCold Drink, Toiletries and cosmetics High Capital investment (Machine Intensive) HighCar, Electricity, Oil, More Fixed Cost HighTele communication, University More Variable Cost LowRetail Business

Analyzing Gross Profit Analysis Statement of Changes in Gross Profit—Illustration Year Ended December 31Year-to-Year Change Item Year 1Year 2IncreaseDecrease 1.Sales ($ millions)$657.6$687.5$ Cost of sales ($ millions) Gross profit ($ millions)$420.3$442.2$ Units sold (in millions) Sales price per unit (1 ÷ 4)$3.05 $2.97 $ Cost per unit (2 ÷ 4) Analyzing Costs of Revenues Calculate Gross Profit Margin Ratio.

Interpreting Changes in Gross Profit Changes in gross profit are often driven by one or more of the following factors: By Identification of factors driving gross profit, Business can Improved business strategies Better assessment of future performance Changes in gross profit are often driven by one or more of the following factors: By Identification of factors driving gross profit, Business can Improved business strategies Better assessment of future performance FactorsTotal Gross Profit Increase in sales volume Increase Decrease in sales volume Decrease Increase in unit selling price Elastic Demand Inelastic Demand Decrease Increase Decrease in unit selling price Elastic Demand Inelastic Demand Increase Decrease Increase in cost per unit Decrease Decrease in cost per unit Increase

Tools for Analysis of Expenses Analyzing 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 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 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 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

Selling Expenses Analyzing 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 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

Maintenance and Repairs Expense Analyzing Expenses Relation of sales to maintenance and repairs expense, both across companies and time, must be interpreted with care Bear on productivity and earnings quality assessments Impacts asset valuations 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 Relation of sales to maintenance and repairs expense, both across companies and time, must be interpreted with care Bear on productivity and earnings quality assessments Impacts asset valuations 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

General and Administrative Expenses Analyzing Expenses Analysis of G&A should focus on: Trend in these expenses Percent of revenues they consume Most are fixed—such as rent and salary Tendency for increases, especially in prosperous times Analysis of G&A should focus on: Trend in these expenses Percent of revenues they consume Most are fixed—such as rent and salary Tendency for increases, especially in prosperous times