1. L 9 - Chapter 8 Profitability
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2. Profitability Measures
Exclude items of income not arising from normal operations
Discontinued operations
Extraordinary items
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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
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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
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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
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6. DuPont Return on Assets
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7. DuPont Return on Assets (cont’d)
DuPont analysis separates return on assets into net profit margin and total asset turnover
Separating the ratio into the two elements allows evaluation of the causes for the change in return on assets
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8. DuPont Analysis Variation
Consider only operating assets and income
Operating assets exclude
Construction in progress
Long-term investments
Intangibles
‘Other’ assets
Operating income includes only
Net sales
Operating expenses
May give significantly different results
Reflective of ROA from primary business
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9. Operating Income Margin
Use operating income in the numerator
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10. Operating Asset Turnover
Measures the ability of operating assets to generate sales dollars
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11. Return on Operating Assets
Measures the ability of operating assets to generate operating income
DuPont analysis of the return on operating assets:
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12. 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
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13. Return on Investment (ROI)
Measures the earnings on investment and indicates how well the firm utilizes its asset base
Evaluates enterprise performance
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14. 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
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15. 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)
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16. Return on Common Equity
Measures the return to the common stockholder
Common equity:
Total stockholders’ equity
less preferred capital
less minority interest reported as equity
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17. The Relationship Between Profitability Ratios
Rate of return on
Measures return to providers of
Typical result
Assets
All funds
Lowest (includes all assets)
Investment
Long-term funds
Higher than ROA (relative small amount of short-term funds)
Total equity
Equity
Higher 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
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18. Gross Profit Margin Sales – Cost of Goods Sold = Gross Profit
Beginning Inventory
+ Purchases of Inventory
– Ending Inventory
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19. Segment Reporting Operating segments Geographical information
Separate financial information is available
Evaluated by the chief decision making officer
Geographical information
Revenues earned
Asset concentration
Major customers
Products and services
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20. 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
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21. Comprehensive Income Items not included in net income
Reported as a separate component of stockholders’ equity
Foreign currency translation adjustments
Unrealized holding gains and losses from available-for-sale marketable securities
Changes to stockholders’ equity resulting from additional minimum pension liability adjustments
Unrealized gains and losses from derivative instruments
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22. Comprehensive Income (cont’d)
Traditional profitability analysis utilizes net income
Items of accumulated other comprehensive income are excluded from analysis
Consider supplemental analysis including other comprehensive income items for
Return on assets
Return on investment
Return on total equity
Return on common equity
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23. Pro Forma Financial Information
Non-GAAP-based financial information
Release timed to coincide with release of GAAP financial results
Sarbanes-Oxley Act of 2002 requires
Reconciling of pro forma data to GAAP financial condition and results of operations
Pro forma data is not misleading or untrue
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24. Interim Reports
Unaudited financial reports covering fiscal periods of less than one year
Interim reports are an integral part of the annual report
Quarterly information is disclosed in the annual report
SEC requires quarterly information be filed on Form 10-Q
Produced quickly; rely on more estimates
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