Week 3

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Chapter 8

Profitability

The primary financial analysis of profit ratios should include only those items of income arising from normal operations

Excludes

Discontinued operations

Extraordinary items

Profitability Measures

Also referred to as return on sales

Reflects net income dollars generated by each dollar of sales

Potential distortion can be caused by “other income” and “other expense” items from net income, as these do not relate to net sales

Net Profit Margin

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

Total Asset Turnover

Measures the ability to utilize assets to create profits

Average total assets

For internal analysis use month-end amounts

For external analysis use beginning and ending amounts

If necessary, consistent use of end-of-year amounts, instead of averages

Return on Assets

DuPont analysis separates return on assets into net profit margin and total asset turnover

Separating the ratio into the two elements allows for improved analysis of the causes for the change in the percentage of return on assets

DuPont Return on Assets

DuPont Return on Assets—Continued

Consider only operating assets and income

Operating assets exclude

Construction in progress

Long-term investments

Intangibles

‘Other’ assets

Operating income includes only

Net sales less the cost of sales

Operating expenses

May give significantly different results

Reflective of ROA from primary business

DuPont Analysis Variation

Includes only operating income in the numerator

Operating Income Margin

Measures the ability of operating assets to generate sales dollars

Operating Asset Turnover

Measures the ability of operating assets to generate operating income

Return on Operating Assets

DuPont analysis of the return on operating assets:

Measures the ability to make productive use of property, plant, and equipment by generating sales dollars

Exclude construction in progress from net fixed assets

Possible distortions

Old fixed assets

Labor-intensive industry

Sales to Fixed Assets

Measures income earned on invested capital and how well the firm utilizes its asset base

Evaluates enterprise performance without regard to financing sources

Return on Investment (ROI)

Measures the return to common and preferred stockholders

Return on Total Equity

Adjustments for redeemable preferred stock

Deduct dividends from net income (numerator)

Deduct stock value from total equity (denominator)

Measures the return to the common stockholder

Return on Common Equity

Common equity = Total Stockholders’ Equity

− Preferred Capital − Noncontrolling Interest

Includes the return to all suppliers of funds, both long- and short-term, by both creditors and investors

Return on Total Asset Variation

Differs from the return on assets ratio and return on investment

It does not lend itself to DuPont Analysis

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)

The Relationship Between Profitability Ratios

The Relationship Between Profitability Ratios—Continued

Rate of return on	Measures return to providers of	Typical result
Common equity	Common equity	Highest Common shareholders absorb greatest degree of risk Requires that return to preferred shareholders exceed funds paid to preferred shareholders

Comparing gross profit with net sales is termed the gross profit margin

Gross Profit Margin

Net Sales Revenue

− Cost of Goods Sold

= Gross Profit

Beginning Inventory

+ Purchases of Inventory

− Ending Inventory

Analysis helps the following ways:

Managers budget gross profit levels into their predictions of profitability

Used in cost control

Estimate inventory levels for interim financial statements and insured losses in merchandising industries

Used by auditor and Internal Revenue Service to judge accuracy of accounting systems

Gross Profit Margin Analysis

Operating segments

Separate financial information is available

Evaluated by the chief operating decision maker

Requires information about

Countries in which the firm earns revenues and holds assets

Major customers

Segment Reporting

Disclosures

The way the operating segments are determined

Products and services by the operating segments

Differences between the measurements used in reporting segment and firm’s general-purpose financial information

Profitability trends can also be shown as revenues by major product lines

Segment Reporting—Continued

Charged directly to retained earnings

Changes in accounting principles

Realization of income tax benefits of preacquisition operating loss carryforwards of purchased subsidiaries

Changes in accounting entity

Correction of errors in prior periods

Gains and Losses from Prior Period Adjustments

Items not included in net income

Reported as a separate component of shareholders’ 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

Comprehensive Income

Traditional profitability analysis includes items related to 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

Comprehensive Income—Continued

It is a hypothetical or projected amount

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 Financial Information

Unaudited financial reports covering fiscal periods of less than one year

SEC requires limited financial data be provided on Form 10-Q

Certain quarterly information is disclosed in notes to the annual report

Interim reports are an integral part of the annual report

Less reliable than annual reports as contain more estimates

Interim Reports

Net Income Before Noncontrolling Interes

Equity Income, and Nonrecurring Items

Net Profit Margin =

Net Sales

Total Asset Turnover =

Average Total Assets

Net Income Before Noncontrolling

Interest and Nonrecurring Items

Return on Assets =

Average Total Assets

Return on Assets = Net Profit Margin To

tal Asset Turnover

Return on Net Profit Total Asset

Assets = Margin × Turnover

Firm A

Year 1 10% = 4.0% × 2.5

Year 2 8% = 4.0% × 2.0

Firm B

Year 1 10% = 4.0% × 2.5

Year 2 8% = 3.2% × 2.5

Net Income BeforeNet Income Before

Noncontrolling InterestNoncontrolling In

terest

and Nonrecurring Itemsand Nonrecurring I

temsNet Sales

= ×

Average Total AssetsNet salesAverage Tot

al Assets

Return on Net Profit Total Asset

Assets = Margin × Turnover

Firm A

Year 1 10% = 4.0% × 2.5

Year 2 8% = 4.0% × 2.0

Firm B

Year 1 10% = 4.0% × 2.5

Year 2 8% = 3.2% × 2.5

Operating Income

Operating Income Margin =

Net Sales

Operating Asset Turnover =

Average Operating Assets

Return on Operating assets =

Operating Income

Average Operating Assets

DuPont ReturnOperatingOperating

On = Income × Asset

Operating AssetsMarginTurnover

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Net Sales

Sales to Fixed Assets =

Average Net Fixed Assets

(Exclude Construction in Progress)

Net Income Before Noncontrolling

Interest and Nonrecurring Items +

[(Interest Expense) × (1 Tax Rate)]

Return on Investment =

Average (Long-Term Liabilities + Equity)

Net Income Before Nonrecurring Items

Dividends on Redeemable Preferred Stock

Return on Equity =

Average Total Equity

Net income Before Nonrecurring

Items Preferred Dividends

Return on Common Equity =

Average Common Equity

Net Income + Interest Expense

Return on Total Asset Variation =

Average Total Assets

Gross Profit

Gross Profit Margin =

Net Sales