Profitability Analysis

9
CHAPTER
 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
 Analyzing Profitability
Focus of Profitability Analysis
Profitability analysis helps address questions such as:
What is a companys 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 companys earning power?
 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
 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
 Analyzing Profitability
Measuring Income--Estimation Issues

Management discretion is part of income

measurement

Estimates of skilled and experienced professionals

Some consensus (less variability)
 Analyzing Profitability
Measuring Income--Accounting Methods

Professional Social
experience Influences

Accounting
standards
Regulatory governing Political
agendas income pressures
measurement

Business Academic
happenings research
 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
 Analyzing Profitability
Measuring Income--Incentives for Disclosure

Ideally:
Ideally:
Financial
Financial statements
statements fairly
fairly present
present transactions
transactions andand
events
events
Accounting
Accounting isis neutralnot
neutralnot affecting
affecting how
how
transactions
transactions and
and events
events are
are perceived
perceived
Methods
Methods chosen
chosen that
that are
are most
most applicable
applicable to
to the
the
circumstances
circumstances
Relevant
Relevant information
information isis disclosedfavorable
disclosedfavorable and and
unfavorable
unfavorable
 Analyzing Profitability
Measuring Income--Incentives for Disclosure

Reality:
Reality:

Each
Each of
of us
us possess
possess opinions--we
opinions--we see
see the
the world
world from
from different
different
perspectives
perspectives

Managers
Managersbring
bringstrong
strongviews
viewstotothe
thetable
table

Managers
Managersfeelfeelpressures
pressuresof of competition
competitionandandsociety
society

Directors
Directorsexpect
expect results
results
Shareholders
Shareholdersconcentrate
concentrateon onthe
thebottom
bottomline
line
Creditors
Creditorswant
wantsafeguards
safeguards
Financial
Financialanalysts
analystsdislike
dislikesurprises
surprises
Accounting
Accounting preparers
preparers andand auditors
auditors demand
demand acceptable
acceptable
practices
practices
 Analyzing Profitability
Measuring Income--Incentives for Disclosure

Result:
Result:

Acceptable
Acceptable methods,
methods, not
not necessarily
necessarily
appropriate
appropriate methods
methods
 Analyzing Profitability
Measuring Income--Diversity Across Users

Financial
Financial statements
statements are
are generalpurpose
generalpurpose reports
reports
serving
serving diverse
diverse needs
needs of
of many
many users
users

Diversity
Diversity ofof views
views implies
implies an
an analysis
analysis uses
uses income
income
as
as an
an initial
initial measure
measure ofof profitability
profitability

Use
Use available
available information
information adjust
adjust income
income
measurement
measurement consistent
consistent with
with ones
ones objectives
objectives
 Analyzing Revenues
Two-Phase Analysis of Income

Analysis
Analysisof
ofincome
incomeand
andits
itscomponents
componentsinvolves
involvestwo
twophases
phases

1.
1.Analysis
Analysisof
ofaccounting
accountingand
andits
itsmeasurements
measurements

Purpose:
Purpose: To
To apply
apply knowledge
knowledge of
of accounting
accounting to
to yield
yield aa measure
measure ofof
income,
income,and
andits
itscomponents,
components,consistent
consistentwith
withthe
theanalysis
analysisobjectives
objectives

2.
2. Applying
Applying analysis
analysis tools
tools to
to income
income (and
(and its
its components)
components) and
and
interpreting
interpretingthe
theanalytical
analyticalresults
results

Purpose:
Purpose:ToToapply
applyanalysis
analysistools
toolsto
toaid
aidachieve
achievethe
theanalysis
analysis
objectivessuch
objectivessuchas asincome
incomeforecasting
forecastingand
andestimating
estimatingearning
earning
power
power
 Analyzing Revenues
Revenue Sources

Analysis
Analysis of
of revenues
revenues (sales)
(sales) helps
helps address
address questions
questions
such
such as:
as:

What
What are
arethe
themajor
majorsources
sourcesofof revenue?
revenue?
How
How persistent
persistentare
arerevenue
revenuesources?
sources?
How
How areare revenues,
revenues, receivables,
receivables, and
and inventories
inventories
related?
related?
When
Whenis isrevenue
revenuerecorded?
recorded?
How
How isisrevenue
revenuemeasured?
measured?
 Analyzing Revenues
Revenue Sources

Knowledge
Knowledge of of major
major sources
sources of
of revenues
revenues is
is important
important
to
toprofitability
profitabilityanalysis
analysis

Each
Each market
market and
and product
product line
line often
often has
has its
its own
own growth
growth
pattern,
pattern, profitability,
profitability,and
and future
future potential
potential

Common-size
Common-size analysis
analysis of
of revenues
revenues shows
shows the
the percent
percent
of
of each
eachmajor
major class
classof
of revenue
revenue to
to its
its total
total

Graphical
Graphicalanalysis
analysisis
isaauseful
usefultool
tool to
tointerpret
interpretthe
the
sources
sourcesof
ofrevenues
revenues
 Analyzing Revenues
Revenue Sources

Diversified
Diversified Companies
Companies present
present special
special challenges
challenges
Different
Different segments
segments usually
usually experience
experience varying
varying rates
rates ofof
profitability,
profitability,risk,
risk,and
andgrowth
growth
Asset
Asset composition
composition and and financing
financing requirements
requirements of of segments
segments
often
oftenvary
vary
Evaluation,
Evaluation, projection,
projection, and
and valuation
valuation ofof income
income isis aided
aided by
by
segment
segmentanalysis
analysis
Segments
Segmentsshare
sharecharacteristics
characteristicsofofvariability,
variability,growth,
growth,andandrisk
risk
Income
Incomeforecasting
forecastingbenefits
benefitsfrom
fromforecasts
forecastsby bysegments
segments
Must
Mustseparate
separateand andinterpret
interpretthe
theimpact
impactof ofindividual
individualsegments
segments
 Analyzing Revenues
Revenue Sources

Full
Full disclosure
disclosureby
bysegments
segmentsis
israre
rarebecause
becauseof:
of:

Difficulties
Difficultiesin
inseparating
separating segments
segments

Managements
Managementsreluctance
reluctanceto
torelease
releaseinformation
information
that
thatcan
canharm
harmits
itscompetitive
competitiveposition
position
 Analyzing Revenues
Revenue Sources

Reporting
Reporting requirements
requirements exist
exist for:
for:

Industry
Industry segments
segments
International
International activities
activities
Export
Export sales
sales
Major
Major customers
customers

GAAP
 Analyzing Revenues
Revenue Sources

Reporting
Reporting requirements
requirements consider
consider aa segment
segment
significant
significant ifif its
its sales,
sales, operating
operating income,
income, oror
identifiable
identifiable assets
assets comprise
comprise 10
10 percent
percent or
or more
more of
of
their
theirrelevant
relevant totals
totals

Notes:
Notes:
Combined
Combined sales
sales of
of all
all segments
segments reported
reported must
must be
be at
at
least
least75
75percent
percent of
of the
thecompanys
companystotal
total sales
sales
Ten
Ten segments
segments is
isviewed
viewedas asaapractical
practicallimit
limit on
onthe
the
number
number of
ofsegments
segments reported
reported

GAAP
 Analyzing Revenues
Revenue Sources
Information
Informationdisclosed
disclosedfor
foreach
eachsegment:
segment:
(1)
(1) salesboth
salesboth intersegment
intersegment and
and to
to unaffiliated
unaffiliated
customers
customers
(2) operating
(2) operating incomerevenues
incomerevenues lessless operating
operating
expenses
expenses
(3)
(3) identifiable
identifiableassets
assets
(4)
(4) capital
capitalexpenditures
expenditures
(5)
(5) depreciation,
depreciation,depletion,
depletion,and
andamortization
amortization

Similar
Similar disclosures
disclosures are
are required
required for
for international
international operations
operations
and
and export
export sales
sales (except
(except capital
capital expenditures
expenditures andand
depreciation)
depreciation)

Revenues
Revenuesfrom
fromaasingle
singlecustomer
customerare
aredisclosed
disclosedififthey
they
comprise
comprise10
10percent
percentor
ormore
moreof
oftotal
totalrevenues
revenues
Analyzing Revenues
Revenue Sources

Limitations
Limitations of
of segment
segment data:
data:

Difficult
Difficult to
to define
define segments
segments
Arbitrary
Arbitrary allocations
allocations of
of costs
costs
across
across segments
segments
 Analyzing Revenues
Revenue Sources

Useful applications of segment data include:

Analysis of sales growth

Analysis of asset growth

Analysis of profitability
 Analyzing Revenues
Persistence of Revenues

Persistence
Persistence (stability
(stability and
and trend)
trend) of
of revenues
revenues is
is
important
importantto
toprofitability
profitabilityanalysis
analysis

Analysis
Analysis tools
tools for
for assessing
assessing persistence
persistence in
in revenues
revenues
include:
include:
(1)
(1) trend
trendpercent
percent analysis
analysis
(2)
(2) evaluation
evaluationof of Managements
ManagementsDiscussion
Discussionand
and
Analysis
Analysis
 Analyzing Revenues
Persistence of Revenues--Trend Percent Analysis

Revenues
Revenuesfor foraaprior
priorperiod
period are
are
set
setequal
equal to
to100
100percent
percent

Revenues
Revenuesfor
forother
other periods
periods are
are
compared
comparedto
toitit

Revenue
Revenuetrends
trendsby
bysegments
segmentsare
areoften:
often:

Correlated
Correlated
Compared
Comparedto toindustry
industrynorms
norms
Compared
Comparedto tocompetitors
competitors
 Analyzing Revenues
Persistence of Revenues--Trend Percent Analysis

Other
Otherrelated
relatedmeasures:
measures:

(Auto)correlations
(Auto)correlations ofof revenues
revenues
across
acrossperiods
periods

Assess
Assesssensitivity
sensitivityof ofrevenues
revenuestoto
business
businessconditions
conditions

Customer
Customer analysisconcentration,
analysisconcentration, dependence,
dependence,
and
andstability
stability

Revenues
Revenues concentration
concentration or or dependence
dependence on
on one
one
segment
segment

Revenues
Revenuesreliance
relianceononsales
sales staff
staff

Geographical
Geographical diversification
diversificationofofmarkets
markets
 Analyzing Revenues
Persistence of Revenues--MD&A

Managements
Managements Discussion
Discussion and
and Analysis
Analysis (MD&A)
(MD&A) is
is often
often
useful
usefulin
inanalysis
analysisof
of persistence
persistencein
in revenues
revenues

Aids
Aidsininunderstanding
understandingand andevaluating
evaluatingperiod-to-period
period-to-period
changes
changes
Report
Reportononchanges
changesin in revenue
revenuecomponents
components
Discloses
Discloses uncertainties
uncertainties affecting
affecting or
or likely
likely to
to affect
affect
revenues
revenues
Explains
Explains growth
growth in in revenues
revenues to to prices,
prices, volume,
volume,
inflation,
inflation, or
ornew
new product
productintroduction
introduction
Reports
Reportssome
someforward
forward looking
lookinginformation
information
Discusses
Discussestrends
trends and
andforces
forcesnot not evident
evident from
from financial
financial
statements
statements
 Analyzing Revenues
Key Revenue Relations

Revenues
Revenuesand
andAccounts
AccountsReceivable
ReceivableRelation
Relation

Bears
Bearson:
on:

Earnings
Earningsquality
quality
Collectibility
Collectibilityof
of receivables
receivables
 Analyzing Revenues
Key Revenue Relations

Revenues
Revenuesand
andInventories
InventoriesRelation
Relation

Bears
Bearson:
on:

Future
Futurerevenues
revenues
Analysis
Analysisof
ofoperations
operations
 Analyzing Revenues
Revenues Recognition

Profitability
Profitability analysis
analysis must
must adjust
adjust for
for different
different
revenue
revenuerecognition
recognition methods
methodsin:
in:

Comparative
Comparative analysisboth
analysisboth temporal
temporal and
and
cross-sectional
cross-sectional
Forecasting
Forecastingrevenues
revenues

Chapter
Chapter66discusses
discussesrevenue
revenuerecognition
recognitioncriteria
criteria
and
andmeasurement
measurement
 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 futuredirected

discretionary expenditures
 Analyzing Costs of
Revenues
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
Analyzing Gross Profit

Analysis of gross profit directs attention at the

factors explaining variations in:

Sales

Costs of sales
 Analyzing Costs of
Revenues
Analyzing Gross Profit
Analysis Statement of Changes in Gross Profit

Step 1. Focus on yeartoyear change in volume assuming unit

selling price is unchangedVolume change is
multiplied by the constant unit selling price to yield
change in sales
Step 2. 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
Step 3. 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
Analyzing Gross Profit

Analysis Statement of Changes in Gross ProfitIllustration

Year Ended December 31 Year-to-Year Change

Item Year 1 Year 2 Increase Decrease

1. Sales ($ millions) $ 657.6 $ 687.5 $ 29.9

2.Cost of sales ($ millions) 237.3 245.3 8.0
3.Gross profit ($ millions) $ 420.3 $ 442.2 $ 21.9
4.Units sold (in millions) 215.6 231.5 15.9
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
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
Interpreting Changes in Gross Profit

Changes
Changesin ingross
grossprofit
profitare
areoften
oftendriven
drivenby
byone
oneor
ormore
more
of
ofthe
thefollowing
followingfactors:
factors:

Increase
Increase in
insales
salesvolume
volume

Decrease
Decreasein insales
salesvolume
volume

Increase
Increase in
inunit
unitselling
sellingprice
price

Decrease
Decreasein inunit
unit selling
selling price
price

Increase
Increase in
incost
cost per
perunit
unit

Decrease
Decreasein incost
cost per
perunit
unit
 Analyzing Costs of
Revenues
Interpreting Changes in Gross Profit

Identification
Identification of
of factors
factorsdriving
driving gross
grossprofit
profit yields
yields

Improved
Improved business
businessstrategies
strategies

Better
Betterassessment
assessment of
of future
futureperformance
performance
 Analyzing Expenses
Tools for Analysis of Expenses
Common-size analysis
Commonsize 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
 Analyzing Expenses
Selling 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

futuredirected marketing expenses
 Analyzing Expenses
Depreciation Expense

Relation of depreciation to gross plant and equipment

helps reveal changes in the composite rate of
depreciationthis is useful in evaluating depreciation
levels and in detecting adjustments (smoothing) to
income:
Depreciation expense
Depreciable assets

It is often useful to compute this ratio by asset

categories
 Analyzing Expenses
Maintenance and Repairs Expense

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

 Analyzing Expenses
Maintenance and Repairs Expense
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
 Analyzing Expenses
Amortization of Special Costs

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
 Analyzing Expenses
Amortization of Special Costs

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

 Analyzing Expenses
General and Administrative Expenses

Most are fixedsuch as rent and salary

Tendency for increases, especially in

prosperous times
 Analyzing Expenses
General and Administrative Expenses

Analysis of G&A should focus on:

Trend in these expenses

Percent of revenues they consume

 Analyzing Expenses
Financing Expenses

Most are fixedexception is variable-rate interest

Most creditor financing is eventually refinanced and

not removed

Interest expense often includes amortization of a

premium or discount
 Analyzing Expenses
Financing Expenses

Average effective interest rate:

Total interest incurred
Average interest-bearing indebtedness

Useful tool for:

Analysis of the cost of borrowed money

Credit standing
Comparisons across years and companies
Assessing sensitivity to interest rate changes
 Analyzing Expenses
Income Tax Expenses

Income tax expenses:

Reflect a distribution of profits between a company

and governmental agencies

Usually comprise a substantial portion of a

companys pre-tax income
 Analyzing Expenses
Income Tax Expenses

Effective Tax Rate (ETR)

Income tax expense

Income before income taxes

ETR (also called tax ratio) reflects

relation between the income tax
accrual and pretax income
 Analyzing Expenses
Income Tax 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
 Analyzing Expenses
Income Tax 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