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

2. Previous Lecture Summary
Analysis of Profitability
DuPont Return on Assets,
Interpretation through DuPont Analysis,
Operating Income Margin,
Operating Asset Turnover,
Return on Operating Assets,
Sales to Fixed Assets
Practical Exercises

3. Analysis of Profitability
Today's Lecture Topics
Analysis of Profitability
Return on Investment,
Return on Total Equity,
Return on Common Equity,
The relationship between profitability ratios,
Gross Profit Margin,
Trends in Profitability,
Segment Reporting,
Gains and Losses that Bypass the Income Statement,
Interim Reports
Practical Exercises

4. Return on Investment (ROI)
The return on investment applied to ratios measuring the income earned on the invested capital.
These types of measures are widely used to evaluate enterprise performance.
Measures the earnings on investment and indicates how well the firm utilizes its asset base.
Evaluates enterprise performance

5. 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

6. Return on Total Equity
The return on total equity measures the return to both common and preferred stockholders
Adjustments for redeemable preferred stock
Deduct dividends from net income (numerator)
Deduct stock value from total equity (denominator)

7. Return on Common Equity
This ratio measures the return to the common stockholder
Common equity:
Total stockholders’ equity
less preferred capital
less minority interest reported as equity

8. 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

9. Gross Profit Margin Sales – Cost of Goods Sold = Gross Profit
Beginning Inventory
+ Purchases of Inventory
– Ending Inventory

10. Why Gross Profit Margin Decline
The cost of buying inventory has Increased more rapidly then have the selling price.
Selling price decline due to competition
The mix of goods has changed to include more products with lower margins.
Theft is occurring. If sales are not recorded, the cost of good sold figure in relation to the sales figure is high. If inventory is being stolen, the ending inventory will be low and the cost of goods sold will be high.

11. Gross profit margin Uses….?
Managers budget gross profit levels into their prediction of Profitability.
Used to cost control
Helpful to determine inventory levels for interim statement in merchandising industry.
Used to estimated inventory involved in insured losses.
Used by Auditors & Internal Revenue Services to judge the accuracy of accounting system

12. Segment Reporting Operating segments
Firms frequently operate in more than one line of business. When a firm is diversified in this manner, the results of operations of the individual segments may vary among one another.
Separate financial information is available
Evaluated by the chief decision making officer
Geographical information means statement also requires data on foreign operations by geographic area, export sales and major customers.
Revenues earned
Asset concentration
Major customers
Products and services

13. Gains and Losses from Prior Period Adjustments
There are a few gains and losses that are not reported on the income statement under GAAP. Like, gains and losses from prior period adjustments, unrealized declines in the market value of investments, and foreign currency translations adjustments.
Charged directly to retained earnings
Changes in accounting principles
Realization of net operating loss carry forward tax benefits from purchased subsidiaries
Changes in accounting entity
Correction of errors originating in prior periods

14. 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

15. 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

16. Pro Forma Financial Information
Non-GAAP-based financial information
Release timed to accord 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

17. 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

18. Research and development Other income (expense)
Practical Exercise
Fluctuation, Inc., recorded the following profit figures in 2008–2010.
2010
2009
2008
Net sales
$30,500
$25,600 
$22,900 
Costs and expenses:
Cost of products sold
$12,600
$10,300 
$8,350 
Selling
7,875
5,025 
4,580 
General
2,950
2,325 
2,150 
Research and development
 4,100
 3,190 
2,840 
$27,525
$20,840 
$17,920 
Operating income
$ 2,975
$ 4,760 
$ 4,980 
Other income (expense)
    525
(300)
(400)
Earnings before tax
$ 3,500
$ 4,460 
$ 4,580 
Income tax
 1,480
  1,990 
 2,100 
Net income
$ 2,020
$ 2,470 
$ 2,480 

19. Practical Exercise (Cont’d)
Required: a.
Compute the net profit margin for 2008–2010. b.
Compute the gross profit margin for 2008–2010. c.
Describe the trend in profitability and pinpoint its causes.

21. Both net profit margin and gross profit margin have declined in the three years.
A major factor has been the rising cost of goods which causes gross profit to fall.
Selling expenses, general expenses, research and development expenses have all increased in relation to net sales.

22. Practical Exercise
The Clothes Clutch, a retail clothier, has had average sales of $400,000 for the last five years, 2006–2010. The firm's total assets at the end of 2010 were $400,000,
An internal staff cost analyst has prepared the following financial data from the annual reports. You have been hired as a consultant to help analyze the financial position.
2010
2009
2008
2007
2006
Current Ratio
2.80 
2.43 
2.36 
2.10 
2.00 
Acid Test Ratio
2.03 
1.93 
1.82 
1.61 
1.47 
Days' Sales in Receivables
61 
58 
54 
42 
35 
Merchandise Inventory Turnover
4.20 
4.10 
3.90 
3.70 
Debt Ratio
0.48 
0.50 
0.49 
0.47 
Times Interest Earned
4.60 
4.80 
5.90 
5.70 
6.00 
Sales as a Percent of 1996 Sales
1.46 
1.23 
1.12 
1.06 
1.00 
Net Income as a Percent of 1996 Income
1.31 
1.20 
1.10 
Gross Profit Margin
38.5%
38.8%
38.9%
40.0%
39.7%
Operating Expenses to Net Sales
11.4%
11.3%
11.5%
11.7%
Net Profit Margin
7.6%
8.6%
8.9%
9.4%
9.3%
Return on Total Assets
9.6%
10.0%
10.7%

23. Practical Exercise (Cont’d)
Required:
Has the firm utilized its total assets effectively? Discuss the ability of the firm to generate sales based on total assets. (Use DuPont analysis.)

25. Practical Exercise
Dexall Company recently had a fire in its store. Management must determine the inventory loss for the insurance company. Since the firm did not have perpetual inventory for the insurance company has suggested that it might accept an estimate using the gross profit test. The beginning inventory, as determined from the last financial statements, was $10,000. Purchase invoice indicate purchases of $100,000. Credit and cash sales during the period were $120,000. Last years, the gross profit for the firm was 40%, which was also the industry average.
Required:
Based on these data estimate the inventory loss
If the industry average gross profit was 50%, why might the insurance company be leery of the estimated loss?
If gross profit were higher, the loss would be higher.

28. Practical Exercise
D.H. Muller Company presented the following income statement in its 2004 annual report:
(Dollars in thousands expect For the Years Ended
Per-share amounts)
Net sales $297,580 $256,360 $242,150
Cost of sales 206, , ,970
Gross profit $91,580 $80,060 $ 76,180
Selling, administrative and
Other expenses 65, , ,000
Operating earnings 26, ,180
Interest expense (5,990) (5,100) (4,000)
Other deductions, net (320) (1,100) (800)
Earnings before income taxes, minority
interests, and extraordinary items , , ,380
Income taxes (8,028) (6,830) (6,229)
Net earnings of subsidiaries
Applicable to minority interests (700) (670) (668)
Earnings before extraordinary items $11, $9, $8,483

29. Practical Exercise (Cont’d)
Extraordinary Items:
Gain on sale of Investment,
Net of federal and state
Income taxes of $520
Loss due to damages to south
American facilities net of
Minority interest of $ (1,600)
Net earnings $11, $ 8,610 $ 8,483
Earnings per common share
Earnings before extra
Ordinary items $2.20 $1.82 $1.65
Extra ordinary items (.06)
Net earnings $2.20 $1.76 $1.65

30. Practical Exercise (Cont’d)
The assets side of the balance sheet is summarized as follows:
(Dollars in thousands)
Current assets $89, $84, $83,100
Property, plant, and
Equipment 45, , ,800
Other assets (including investments
Deposits, deferred
Charges and intangibles) 10, , ,100
Total assets $145,760 $137, $136,000

31. Practical Exercise (Cont’d)
Required:
Based on these data, compute the following for 2004, 2003 and 2002
Net profit margin Return on operating assets (using
Return on assets (using end of year operating assets)
total assets) Operating assets turnover (using
3. Total asset turnover (using end of year operating assets)
total assets) DuPont analysis wit
4. DuPont analysis operating ratios
Operating income margin Gross profit margin
b. Discuss your findings.

36. Net profit margin and total asset turnover both improved
Net profit margin and total asset turnover both improved. This resulted in a substantial improvement to return on assets.
Operating income margin declined slightly in 2003 after a substantial improvement in Operating asset turnover improved each year.
The result of the improvement in operating income margin and operating asset turnover was a substantial improvement in return on operating assets.
Gross profit margin declined slightly each year. Overall profitability improved substantially over the three-year period.

37. Analysis of Profitability
Lecture Summary
Analysis of Profitability
Return on Investment,
Return on Total Equity,
Return on Common Equity,
The relationship between profitability rations,
Gross Profit Margin,
Trends in Profitability,
Segment Reporting,
Gains and Losses that Bypass the Income
Statement,
Interim Reports
Practical Exercise