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Chapter 8

Profitability
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© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
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Profitability Measures

• Exclude items of income not arising from


normal operations
– Discontinued operations
– Extraordinary items

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
http://iiqtisad.blogspot.com/ Chapter 8, Slide #2
Net Profit Margin

Net Income Before Noncontrolling Interest,


Equity Income, and Nonrecurring Items
Net Sales

• Also referred to as return on sales


• Reflects net income dollars generated by each
dollar of sales
• Potential distortion
– Net “other” income or loss

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
http://iiqtisad.blogspot.com/ Chapter 8, Slide #3
Net Profit Margin

Net Income Before Noncontrolling Interest,


Equity Income, and Nonrecurring Items
Net Sales

• Also referred to as return on sales


• Reflects net income dollars generated by each
dollar of sales
• Potential distortion
– Net “other” income or loss

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
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Total Asset Turnover

Net Sales
Average Total Assets

• 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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
Chapter 8, Slide #5
Return on Assets

Net Income Before Noncontrolling Interest


and Nonrecurring Items
Average Total 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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
http://iiqtisad.blogspot.com/ Chapter 8, Slide #6
DuPont Return on Assets

Return on Assets = Net Profit Margin  Total Asset Turnover

Net Income Before Net Income Before


Noncontrolling Noncontrolling
Interest and Interest and
Nonrecurring Items Nonrecurring Items Net Sales
= 
Average Total Assets Net Sales Average Total Assets

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
http://iiqtisad.blogspot.com/ Chapter 8, Slide #7
DuPont Return on Assets (cont’d)

• DuPont analysis separates return on assets


into net profit margin and total 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

• Separating the ratio into the two elements


allows evaluation of the causes for the change
in return on assets
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part. http://iiqtisad.blogspot.com/ Chapter 8, Slide #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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
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Operating Income Margin

Operating Income
Net Sales

• Use operating income in the numerator

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
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Operating Asset Turnover

Net Sales
Average Operating Assets

• Measures the ability of operating assets to


generate sales dollars

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
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Return on Operating Assets

Operating Income
Average Operating Assets

• Measures the ability of operating assets to


generate operating income
• DuPont analysis of the return on operating
assets:
DuPont Return Operating Operating
on = Income × Asset
Operating Assets Margin Turnover

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
http://iiqtisad.blogspot.com/ Chapter 8, Slide #12
Sales to Fixed Assets

Net Sales
Average Net 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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
http://iiqtisad.blogspot.com/ Chapter 8, Slide #13
Return on Investment (ROI)

Net Income Before Noncontrolling


Interest and Nonrecurring Items
+ Interest Expense   1-Tax Rate  
Average Long-Term Liabilities + Equity 

• Measures income earned on investment and


how well the firm utilizes its asset base
• Evaluates enterprise performance

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
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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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
http://iiqtisad.blogspot.com/ Chapter 8, Slide #15
Return on Total Equity

Net Income Before Nonrecurring Items


- Dividends on Redeemable Preferred Stock
Average 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)

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
http://iiqtisad.blogspot.com/ Chapter 8, Slide #16
Return on Common Equity

Net Income Before Nonrecurring Items


- Preferred Dividends
Average Common Equity

• Measures the return to the common


stockholder
• Common equity:
Total stockholders’ equity
less preferred capital
less minority interest reported as equity

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
http://iiqtisad.blogspot.com/ Chapter 8, Slide #17
The Relationship Between Profitability
Ratios
Measures
Rate of return to
return on 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 Common equity Highest
• Common shareholders absorb
greatest degree of risk
• Requires that return to preferred
shareholders exceed funds paid to
preferred shareholders
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part. http://iiqtisad.blogspot.com/ Chapter 8, Slide #18
Gross Profit Margin

Gross Profit
Net Sales

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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
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Gross Profit Margin Analysis

• Analysis helps the following ways:


– Managers budget gross profit levels in projections
– Cost control
– Estimate inventory levels for interim financials and
insurance losses in merchandising industries
– Used by auditor and IRS to judge accuracy of
accounting systems

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
http://iiqtisad.blogspot.com/ Chapter 8, Slide #20
Segment Reporting

• Operating segments
– Separate financial information is available
– Evaluated by the chief decision making officer
• Geographical information
– Revenues earned
– Asset concentration
• Major customers
• Products and services

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
http://iiqtisad.blogspot.com/ Chapter 8, Slide #21
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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
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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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
http://iiqtisad.blogspot.com/ Chapter 8, Slide #23
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
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
http://iiqtisad.blogspot.com/ Chapter 8, Slide #24
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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
http://iiqtisad.blogspot.com/ Chapter 8, Slide #25
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

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
http://iiqtisad.blogspot.com/ Chapter 8, Slide #26
Net Profit Margin

Net Income Before Noncontrolling Interest,


Equity Income, and Nonrecurring Items
Net Sales

• Also referred to as return on sales


• Reflects net income dollars generated by each
dollar of sales
• Potential distortion
– Net “other” income or loss

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly accessible website, in whole or in part.
http://iiqtisad.blogspot.com/ Chapter 8, Slide #27

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