1. Profitability Analysis 9 CHAPTER

2. Analyzing Profitability Focus of Profitability Analysis  Profitability analysis is a key part of financial statement analysis  All financial statements are pertinent to profitability analysis  Emphasis of profitability analysis is on the income statement

3. Analyzing Profitability 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? How persistent are income and its components? What is a company’s earning power?

4. Analyzing Profitability Measuring Income Income is defined as revenues less expenses over a reporting period This definition does not yield a unique amount because of:  Estimation Issues  Accounting Methods  Incentives for Disclosure  Diversity across Users

5. Analyzing Profitability Measuring Income--Estimation Issues Income measurement depends on estimates of future events These estimates require: Use of judgment and probabilities Allocations of revenues and expenses across periods Prediction of the future usefulness of many assets Forecasts of future obligations

6. Analyzing Profitability Measuring Income--Estimation Issues Management discretion is part of income measurement Estimates of skilled and experienced professionals  Some consensus (less variability)

7. Analyzing Profitability Measuring Income--Accounting Methods Professional experience Regulatory agendas Business happenings Academic research Social Influences Political pressures Accounting standards governing income measurement

8. Analyzing Profitability Measuring Income--Accounting Methods Methods reflect the outcome of numerous factors, including compromises Discretion is permitted to accommodate different business circumstances Methods geared toward “general-purpose” financial statements

9. Analyzing Profitability Measuring Income--Incentives for Disclosure Ideally:  Financial statements fairly present transactions and events  Accounting is neutral—not affecting how transactions and events are perceived  Methods chosen that are most applicable to the circumstances  Relevant information is disclosed—favorable and unfavorable Ideally:  Financial statements fairly present transactions and events  Accounting is neutral—not affecting how transactions and events are perceived  Methods chosen that are most applicable to the circumstances  Relevant information is disclosed—favorable and unfavorable

10. Analyzing Profitability Measuring Income--Incentives for Disclosure Reality:  Each of us possess opinions--we see the world from different perspectives  Managers bring strong views to the table  Managers feel pressures of competition and society  Directors expect results  Shareholders concentrate on the bottom line  Creditors want safeguards  Financial analysts dislike surprises  Accounting preparers and auditors demand acceptable practices Reality:  Each of us possess opinions--we see the world from different perspectives  Managers bring strong views to the table  Managers feel pressures of competition and society  Directors expect results  Shareholders concentrate on the bottom line  Creditors want safeguards  Financial analysts dislike surprises  Accounting preparers and auditors demand acceptable practices

11. Analyzing Profitability Measuring Income--Incentives for Disclosure Result: “Acceptable” methods, not necessarily “appropriate” methods Result: “Acceptable” methods, not necessarily “appropriate” methods

12. Analyzing Profitability Measuring Income--Diversity Across Users Financial statements are general ‑ purpose reports serving diverse needs of many users Diversity of views implies an analysis uses income as an initial measure of profitability Use available information adjust income measurement consistent with one’s objectives Financial statements are general ‑ purpose reports serving diverse needs of many users Diversity of views implies an analysis uses income as an initial measure of profitability Use available information adjust income measurement consistent with one’s objectives

13. Analyzing Revenues Two-Phase Analysis of Income Analysis of income and its components involves two phases 1. Analysis of accounting and its measurements Purpose: To apply knowledge of accounting to yield a measure of income, and its components, consistent with the analysis objectives 2. Applying analysis tools to income (and its components) and interpreting the analytical results Purpose: To apply analysis tools to aid achieve the analysis objectives—such as income forecasting and estimating earning power Analysis of income and its components involves two phases 1. Analysis of accounting and its measurements Purpose: To apply knowledge of accounting to yield a measure of income, and its components, consistent with the analysis objectives 2. Applying analysis tools to income (and its components) and interpreting the analytical results Purpose: To apply analysis tools to aid achieve the analysis objectives—such as income forecasting and estimating earning power

14. Analyzing Revenues Revenue Sources Analysis of revenues (sales) helps address questions such as:  What are the major sources of revenue?  How persistent are revenue sources?  How are revenues, receivables, and inventories related?  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?  How are revenues, receivables, and inventories related?  When is revenue recorded?  How is revenue measured?

15. Analyzing Revenues Revenue Sources  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  Common-size analysis of revenues shows the percent of each major class of revenue to its total  Graphical analysis is a useful tool to interpret the sources 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  Common-size analysis of revenues shows the percent of each major class of revenue to its total  Graphical analysis is a useful tool to interpret the sources of revenues

16. Analyzing Revenues Revenue Sources Diversified Companies present special challenges Different segments usually experience varying rates of profitability, risk, and growth Asset composition and financing requirements of segments oftenvary Evaluation, projection, and valuation of income is aided by segment analysis Segments share characteristics of variability, growth, and risk Income forecasting benefits from forecasts by segments Must separate and interpret the impact of individual segments Diversified Companies present special challenges Different segments usually experience varying rates of profitability, risk, and growth Asset composition and financing requirements of segments oftenvary Evaluation, projection, and valuation of income is aided by segment analysis Segments share characteristics of variability, growth, and risk Income forecasting benefits from forecasts by segments Must separate and interpret the impact of individual segments

17. Analyzing Revenues 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

18. Analyzing Revenues Revenue Sources Reporting requirements exist for: Industry segments International activities Export sales Major customers Reporting requirements exist for: Industry segments International activities Export sales Major customers GAAP

19. Analyzing Revenues Revenue Sources Reporting requirements consider a segment significant if its sales, operating income, or identifiable assets comprise 10 percent or more of their relevant totals Notes: Combined sales of all segments reported must be at least 75 percent of the company’s total sales Ten segments is viewed as a practical limit on the number of segments reported Reporting requirements consider a segment significant if its sales, operating income, or identifiable assets comprise 10 percent or more of their relevant totals Notes: Combined sales of all segments reported must be at least 75 percent of the company’s total sales Ten segments is viewed as a practical limit on the number of segments reported GAAP

20. Analyzing Revenues Revenue Sources Information disclosed for each segment: (1 ) sales—both intersegment and to unaffiliated customers (2) operating income—revenues less operating expenses (3)identifiable assets (4 ) capital expenditures (5 ) depreciation, depletion, and amortization Similar disclosures are required for international operations and export sales (except capital expenditures and depreciation) Revenues from a single customer are disclosed if they comprise 10 percent or more of total revenues Information disclosed for each segment: (1 ) sales—both intersegment and to unaffiliated customers (2) operating income—revenues less operating expenses (3)identifiable assets (4 ) capital expenditures (5 ) depreciation, depletion, and amortization Similar disclosures are required for international operations and export sales (except capital expenditures and depreciation) Revenues from a single customer are disclosed if they comprise 10 percent or more of total revenues

21. Analyzing Revenues Revenue Sources Limitations of segment data: Difficult to define segments Arbitrary allocations of costs across segments Limitations of segment data: Difficult to define segments Arbitrary allocations of costs across segments

22. Analyzing Revenues Revenue Sources Useful applications of segment data include: Analysis of sales growth Analysis of asset growth Analysis of profitability

23. Persistence (stability and trend) of revenues is important to profitability analysis Analysis tools for assessing persistence in revenues include: (1)trend percent analysis (2) evaluation of Management’s Discussion and Analysis Persistence (stability and trend) of revenues is important to profitability analysis Analysis tools for assessing persistence in revenues include: (1)trend percent analysis (2) evaluation of Management’s Discussion and Analysis Analyzing Revenues Persistence of Revenues

24. Revenues for a prior period are set equal to 100 percent Revenues for other periods are compared to it Revenue trends by segments are often: Correlated Compared to industry norms Compared to competitors Revenues for a prior period are set equal to 100 percent Revenues for other periods are compared to it Revenue trends by segments are often: Correlated Compared to industry norms Compared to competitors Analyzing Revenues Persistence of Revenues--Trend Percent Analysis

25. Other related measures: (Auto)correlations of revenues across periods Assess sensitivity of revenues to business conditions Customer analysis—concentration, dependence, and stability Revenues’ concentration or dependence on one segment Revenues’ reliance on sales staff Geographical diversification of markets Other related measures: (Auto)correlations of revenues across periods Assess sensitivity of revenues to business conditions Customer analysis—concentration, dependence, and stability Revenues’ concentration or dependence on one segment Revenues’ reliance on sales staff Geographical diversification of markets Analyzing Revenues Persistence of Revenues--Trend Percent Analysis

26. Management’s Discussion and Analysis (MD&A) is often useful in analysis of persistence in revenues Aids in understanding and evaluating period-to-period changes Report on changes in revenue components Discloses uncertainties affecting or likely to affect revenues Explains growth in revenues to prices, volume, inflation, or new product introduction Reports some forward ‑ looking information Discusses trends and forces not evident from financial statements Management’s Discussion and Analysis (MD&A) is often useful in analysis of persistence in revenues Aids in understanding and evaluating period-to-period changes Report on changes in revenue components Discloses uncertainties affecting or likely to affect revenues Explains growth in revenues to prices, volume, inflation, or new product introduction Reports some forward ‑ looking information Discusses trends and forces not evident from financial statements Analyzing Revenues Persistence of Revenues--MD&A

27. Revenues and Accounts Receivable Relation Bears on: Earnings quality Collectibility of receivables Revenues and Accounts Receivable Relation Bears on: Earnings quality Collectibility of receivables Analyzing Revenues Key Revenue Relations

28. Revenues and Inventories Relation Bears on: Future revenues Analysis of operations Revenues and Inventories Relation Bears on: Future revenues Analysis of operations Analyzing Revenues Key Revenue Relations

29. Profitability analysis must adjust for different revenue recognition methods in: Comparative analysis—both temporal and cross-sectional Forecasting revenues Chapter 6 discusses revenue recognition criteria and measurement Profitability analysis must adjust for different revenue recognition methods in: Comparative analysis—both temporal and cross-sectional Forecasting revenues Chapter 6 discusses revenue recognition criteria and measurement Analyzing Revenues Revenues Recognition

30. 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

31. Measuring Gross Profit Gross profits vary across industries depending on factors such as: Competition Capital investment Level of costs that must be recovered from gross profit Analyzing Costs of Revenues

32. Analyzing Gross Profit Analysis of gross profit directs attention at the factors explaining variations in: Sales Costs of sales Analyzing Costs of Revenues

33. Analyzing Gross Profit Analysis Statement of Changes in Gross Profit Step 1. Focus on year ‑ to ‑ year change in volume assuming unit selling price is unchanged—Volume change is multiplied by the constant unit selling price to yield change in sales Step2. Focus on year-to-year change in selling price assuming volume is constant--Change in selling price is multiplied by the constant volume to yield change in sales Step3. Focus on joint changes in volume and unit price— Volume change is multiplied by the change in unit selling price to yield net change in sales Step 4. Steps 1 to 3 explain the net change in sales. Analyzing Costs of Revenues

34. 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$29.9 2.Cost of sales ($ millions) 237.3245.38.0 3.Gross profit ($ millions)$420.3$442.2$21.9 4.Units sold (in millions)215.6231.515.9 5.Sales price per unit (1 ÷ 4)$3.05 $2.97 $0.08 6.Cost per unit (2 ÷ 4)1.10 1.06 0.04 Analyzing Costs of Revenues

35. Analyzing Gross Profit Analysis Statement of Changes in Gross Profit Year 2 versus Year 1 Analysis of Variation in Sales 1.Change in volume of products sold: Change in volume (15.9)  Year 1 unit selling price ($3.05)$48.5 2..Change in selling price: Change in selling price ($0.08)  Year 1 sales volume (215.6)17.2 $31.3 3.Combined change in sales volume (15.9) and unit price ($0.08)1.3 Increase in net sales$30.0* Analysis of Variation in Cost of Sales 1.Change in volume of products sold: Change in volume (15.9)  Year 1 cost per unit ($1.10)$17.5 2.Change in cost per unit sold: Change in cost per unit ($0.04)  Year 1 sales volume (215.6)8.6 $8.9 3.Combined change in volume (15.9) and cost per unit ($0.04)0.6 Increse in cost of sales$8.3* Net variation in gross profit$21.7* * Differences are due to rounding. Analyzing Costs of Revenues

36. Interpreting Changes in Gross Profit Analyzing Costs of Revenues Changes in gross profit are often driven by one or more of the following factors: Increase in sales volume Decrease in sales volume Increase in unit selling price Decrease in unit selling price Increase in cost per unit Decrease in cost per unit Changes in gross profit are often driven by one or more of the following factors: Increase in sales volume Decrease in sales volume Increase in unit selling price Decrease in unit selling price Increase in cost per unit Decrease in cost per unit

37. Interpreting Changes in Gross Profit Analyzing Costs of Revenues Identification of factors driving gross profit yields Improved business strategies Better assessment of future performance Identification of factors driving gross profit yields Improved business strategies Better assessment of future performance

38. 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 Index number analysis Index number analysis of income statements expresses income and its components in an index number related to a base period Highlights relative changes across time Changes in expenses are readily compared with changes in both revenues and related expenses 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 Index number analysis Index number analysis of income statements expresses income and its components in an index number related to a base period Highlights relative changes across time Changes in expenses are readily compared with changes in both revenues and related expenses 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

39. 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

40. Depreciation Expense Analyzing Expenses Relation of depreciation to gross plant and equipment helps reveal changes in the composite rate of depreciation—this is useful in evaluating depreciation levels and in detecting adjustments (smoothing) to income: It is often useful to compute this ratio by asset categories Relation of depreciation to gross plant and equipment helps reveal changes in the composite rate of depreciation—this is useful in evaluating depreciation levels and in detecting adjustments (smoothing) to income: It is often useful to compute this ratio by asset categories

41. Maintenance and Repairs Expense Analyzing Expenses Maintenance and repairs expense: Varies with investment in plant and equipment and with the level of productive activity Affect costs of sales and other expenses Comprise both variable and fixed costs Do not vary directly with sales Maintenance and repairs expense: Varies with investment in plant and equipment and with the level of productive activity Affect costs of sales and other expenses Comprise both variable and fixed costs Do not vary directly with sales

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

43. Amortization of Special Costs Analyzing Expenses Expenditure for special costs can be related to and expressed as a percent of: (1) revenues (2) net property and equipment Amortization of special costs can be related to and expressed as a percent of: (1) revenues (2) unamortized special costs (3) net property and equipment Expenditure for special costs can be related to and expressed as a percent of: (1) revenues (2) net property and equipment Amortization of special costs can be related to and expressed as a percent of: (1) revenues (2) unamortized special costs (3) net property and equipment

44. Amortization of Special Costs Analyzing Expenses Ratios involving special costs are useful in:  Comparison of annual trends in these relations  Analysis of consistency in income reporting  Evaluation of income for two or more competitors Ratios involving special costs are useful in:  Comparison of annual trends in these relations  Analysis of consistency in income reporting  Evaluation of income for two or more competitors

45. General and Administrative Expenses Analyzing Expenses Most are fixed—such as rent and salary Tendency for increases, especially in prosperous times Most are fixed—such as rent and salary Tendency for increases, especially in prosperous times

46. General and Administrative Expenses Analyzing Expenses Analysis of G&A should focus on: Trend in these expenses Percent of revenues they consume Analysis of G&A should focus on: Trend in these expenses Percent of revenues they consume

47. Financing Expenses Analyzing Expenses  Most are fixed—exception is variable-rate interest  Most creditor financing is eventually refinanced and not removed  Interest expense often includes amortization of a premium or discount  Most are fixed—exception is variable-rate interest  Most creditor financing is eventually refinanced and not removed  Interest expense often includes amortization of a premium or discount

48. Average effective interest rate: Useful tool for: Analysis of the cost of borrowed money Credit standing Comparisons across years and companies Assessing sensitivity to interest rate changes Financing Expenses Analyzing Expenses

49. Income Tax Expenses Analyzing Expenses Income tax expenses:  Reflect a distribution of profits between a company and governmental agencies  Usually comprise a substantial portion of a company’s pre-tax income Income tax expenses:  Reflect a distribution of profits between a company and governmental agencies  Usually comprise a substantial portion of a company’s pre-tax income

50. Income Tax Expenses Analyzing Expenses Effective Tax Rate (ETR) ETR (also called tax ratio) reflects relation between the income tax accrual and pre ‑ tax income Effective Tax Rate (ETR) ETR (also called tax ratio) reflects relation between the income tax accrual and pre ‑ tax income

51. Income Tax Expenses Analyzing Expenses Differences in ETR from normal or expected rate affects assessments of income Level Trend Forecasts Small changes in ETR can yield major changes in income Differences in ETR from normal or expected rate affects assessments of income Level Trend Forecasts Small changes in ETR can yield major changes in income

52. Income Tax Expenses Analyzing Expenses Analysis of income tax disclosures aims to: Assess tax implications for income, assets, liabilities, and cash sources and uses Evaluate tax effects for future income and cash flows Appraise the effectiveness of tax management Identify unusual gains or losses only revealed in tax disclosures Signal areas of concern requiring further analysis or management inquiry Analysis of income tax disclosures aims to: Assess tax implications for income, assets, liabilities, and cash sources and uses Evaluate tax effects for future income and cash flows Appraise the effectiveness of tax management Identify unusual gains or losses only revealed in tax disclosures Signal areas of concern requiring further analysis or management inquiry