1. Course Title:
Financial Statement Analysis
Course Code:
MGT-537
Course Instructor:
Dr. Hafiz Muhammad Ishaq
Total Lectures: 32

2. Previous Lecture Summary
Long Term Debt-Paying Ability
Joint Ventures
Contingencies
Financial Instruments with Concentrations of Credit
Risk,
Disclosures About Fair Value of Financial Instruments
Practical Exercises

3. Today's Lecture Topics Profitability Profitability Measures
Net Profit Margin
Total Assets Turnover
Return on Assets
Practical Exercises

4. Profitability Ability of the firm to generate earnings.
Vital concern to stockholders, they drive revenue in form of dividends.
High profit lead to increase in market price leads to capital gains.
Important to creditors… Profits are one source of funds for debt coverage.
Performance measure for management
Meaningful, measured as percentage of number of basis: the productive assets, the owner’s & creditor’s capital employed and sales.

5. Profitability Measures
Exclude items of income not arising from normal operations
Discontinued operations
Extraordinary items

6. 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

7. 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

8. 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

9. Practical Exercise
Ahl Enterprise lists the following data for 2004 and 2003
Net Income $52,500 $40,000
Net sales 1,050, ,000,000
Average total assets , ,000
Average common equity 170, ,000
Required: Calculate the net profit margin, return on assets, total asset turnover and return on common equity for both years. Comment on the results. (For return on assets and total asset turnover, use end of year total assets for return on common equity, use end of year common equity)

12. Practical Exercise
The balance sheet for Schultz Bone Company at December 31st, 1996, had the following account balances:
Total current liabilities (non interest bearing) $450,000
Bonds payable, 6% (issued in 1972; due in 2000) ,000
Preferred stock, 5%,$100 par ,000
Common stock, $10 par ,000
Premium on common stock ,000
Retained earnings ,000
Income before income tax was $200,000, and income taxes were $80,000 for the current year.
Required: Calculate each of the following:
Return on assets (using ending assets)
Return on total equity(using ending total equity)
Return on common equity (using ending common equity)
Time interest earned

15. Practical Exercise
Revenue and expense data for Vent Molded Plastics and for the plastics and for the industry as a whole are as follows:
Vent Molded Plastics
Plastics Industry
Sales $462, %
Sales returns ,
Cost of goods sold ,
Selling expenses ,
General expenses ,
Other income ,
Other expense ,
Income tax ,
Required: Convert the dollar figures for Vent Molded Plastics into percentages based on net sales. Compute these with the industry average, and comment on you findings.

18. Practical Exercise 2010 2009 2008 Net sales $233,000 $204,000
The following are extracted from the financial statements of Frem, Inc., for 2010, 2009, and 2008.
2010   
2009   
2008   
Net sales
$233,000 
$204,000 
Cost of sales
(124,000)
(110,000)
Selling and administrative expenses
(95,000)
(81,500)
Other income:
  Interest
(3,700)
(3,050)
  Other
100 
1,175 
Earnings before tax and extraordinary credit
$ 10,400
$ 10,625 
Provision for income tax
(4,800)
(4,740)
Earnings before extraordinary credit
5,600 
5,885 
Extraordinary credit —
1,510
$  5,600 
$  7,395 

19. Practical Exercise (Cont,d)
Total assets
$202,000 
$173,000 
$161,000 
Long-term debt
24,600 
17,400 
15,200 
Common equity
123,000 
116,800 
112,800 
Preferred stock
4,000 
Preferred dividends
280 

20. Practical Exercise (Cont’d)
Required: a.
Compute the following ratios for 2010 and 2009. 1.
Net profit margin 2.
Total asset turnover 3.
Return on assets 4.
Return on investment 5.
Return on total equity 6.
Return on common equity 7.
Gross profit margin b.
Discuss the trend in profitability and identify specific causes for the trend.

21. Practical Exercise (Cont’d)
Required: a.
Compute the following ratios for 2010 and 2009. 1.
Net profit margin 2.
Total asset turnover 3.
Return on assets 4.
Return on investment 5.
Return on total equity 6.
Return on common equity 7.
Gross profit margin b.
Discuss the trend in profitability and identify specific causes for the trend.

24. Net profit margin, return on total assets, return on investment, return on total equity, and return on common equity have declined.
Total asset turnover and gross profit margin rose slightly. The problem appears to be in selling and administrative expenses, other income, and taxes, since gross profit margin rose.
Of particular concern is the very low return to common shareholders.
It is lower than return on total equity and investment, which indicates that preferred owners and creditors, who bear less risk, are getting a higher return.

25. Practical Exercise
The following data are taken from the financial statements of Motorise, Inc., for 2010 and 2009
2010
2009
Net sales
$65,000
$61,000
Equity income (dividends: $65,$62)
   320
   365
Total
$65,320
$61,365
Total expenses, including taxes
63,800
59,700
Net income
$ 1,520
$ 1,665
Total assets
$32,200
$30,600
Investment (using equity method)
3,800
2,800
Required: a.
Compute the following ratios for both years, using total net income and assets. Use ending balance sheet figures. 1.
net profit margin 2.
return on total assets (use year-end total assets) b.
Recomputed the ratios, removing the effect of equity income on investments. (For return on total assets, use year-end total assets.) c.
Discuss the change. Why is it advisable to remove equity earnings in this case?

28. Net profit margin declined when equity income was removed.
Return on total assets also declined when equity income and investments were removed.
The trend stays the same, however, The main reason for removing equity earnings is that they are not derived from the primary business and do not represent cash flow, since dividends are much lower.

29. Lecture Summary Profitability Profitability Measures Net Profit Margin
Total Assets Turnover
Return on Assets
Practical Exercises