Chapter 6: Analysis of Profitability

Chapter 6: Analysis of Profitability

• Profitability analysis focuses on income generated from normal operations.
• Discontinued operations and extraordinary items are excluded. These are removed from the analysis because they are not representative of ongoing business activities or revenue streams.
• Profitability ratios represent the percentage of sales converted into profit.

1/ Net Profit Margin

• Also known as return on sales.
• Reflects the net income dollars generated by each dollar of sales.
• This ratio shows the percentage of sales that are converted into profit.
• Potential distortion from "other income" and "other expenses," which do not relate to primary sales activities, is possible.
• Formula: Net Income (Before Noncontrolling Interest, Equity Income, and Nonrecurring Items) / Net Sales.
• Firms prefer higher ratios, signifying better profitability.

2/ Total Asset Turnover

• Measures the activity of assets and ability to generate sales through asset utilization.
• Indicates the efficiency of asset use.
• Example: With sales of €1,000,000 and assets of €10,000,000, the firm generates this profit through asset use.
• Formula: Net Sales / Average Total Assets.
• Potential distortion from investments can occur.

3/ Return on Assets

• Measures the ability to utilize assets to create profits.
• Similar to previous return measures, but uses net profit.
• Formula: Net Income (Before Noncontrolling Interest and Nonrecurring Items) / Average Total Assets.

DuPont Return on Assets

• Separates return on assets into net profit margin and total asset turnover.
• Separating this way improves the analysis of causes for return changes.
• Formula: Net Profit Margin × Total Asset Turnover

DuPont Return on Assets—Continued

• Analysis showing profitability variations (using specific examples).

There is the decrease in ROA for both firms—but not for the same reason.

• Firm A's decrease in ROA is due to efficiency problems (using assets to maximize sales).
• Firm B's decrease in ROA is due to profitability problems (not enough sales).

DuPont Analysis Variation

• Considers only operating assets and income instead of total assets and net income.
• Excludes construction in progress, long-term investments, intangibles, and "other" assets.
• Operating income includes only net sales less the cost of sales and operating expenses.
• Might give significantly different results.
• More conservative and reflective of ROA from primary business than previous ratios.

4/ Operating Income Margin.

• Includes only operating income in the numerator.
• Formula: Operating Income / Net Sales.

5/ Operating Asset Turnover

• Measures the ability of operating assets to generate sales dollars.
• Formula: Net Sales / Average Operating Assets.

6/ Return on Operating Assets

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

7/ Sales to Fixed Assets

• Measures the ability to make productive use of property, plant, and equipment (fixed assets) by generating sales dollars.
• Excludes construction in progress from net fixed assets.
• Example: With €1,000 net sales and €10,000 fixed assets, this means that for every €10 of fixed assets, €1 of sales is generated.

8/ Return on Investment (ROI)

• Measures the income earned on invested capital and the firm's ability to utilize its asset base.
• Evaluates enterprise performance without considering financing sources.
• Example: With an ROI of 10%, the investor earns €0.10 for every €1 invested

ROI Calculations (example)

• ROI formula, and example calculations using provided data.

9/ Return on Total Equity (ROE)

• Measures return to common and preferred stockholders, considering only equity.
• Formula: Net Income Before Nonrecurring Items - Dividends on Redeemable Preferred Stock / Average Total Equity.

10/ Return on Common Equity

• Measures return to common stockholders (similar to previous ROE but for common equity).
• Formula: Net income Before Nonrecurring Items – Preferred Dividends / Average Common Equity.

11/ Gross Profit Margin.

• Compares gross profit with net sales, termed as a gross profit margin.
• Formula: Gross Profit / Net Sales.

Gross Profit Margin Analysis

• Helps managers budget gross profit levels into their profitability predictions.
• Used in cost control.
• Estimates inventory levels for interim financial statements and insured losses in merchandising industries.
• Used by auditors and Internal Revenue Service to judge accounting system accuracy.