Lecture 6: Analysis of Profitability PDF

Chapter 6 Analysis of the profitability Profitability Measures The primary financial analysis of profit ratios should include only those items of income arising from normal operations Excludes Discontinued operations Extraordinary items ==]= remove the exceptio...

Chapter 6 Analysis of the profitability Profitability Measures The primary financial analysis of profit ratios should include only those items of income arising from normal operations Excludes Discontinued operations Extraordinary items ==]= remove the exceptional revenues and expenses froM the analysis. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 1/ Net Profit Margin Also referred to as return on sales Reflects net income dollars generated by each dollar of sales ===== Percentage of sales that are converted into profit Potential distortion can be caused by “other income” and “other expense” items from net income, as these do not relate to net sales ¿Net Income (Before Noncontrolling Interest , Net Profit Margin = ¿Equity Income, and Nonrecurring Items ¿ Net Sales ¿ Firms prefer HIGHER ratios indicating a better profitability. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2/ Total Asset Turnover Measures the activity of the assets and the ability of the firm to generate sales through the use of the assets ==== Indicates the efficiency when using the assets Eg ; Sales €1,000,000 and assets 10,000,000 The firm is able to generate this profit by Net Sales using assets Total Asset Turnover = Average Total Assets Potential distortion Investments © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3/ Return on Assets Measures the ability to utilize assets to create profits === similar to previous one but uses net profit ¿Net Income (Before Noncontrolling Return on Assets = ¿Interest and Nonrecurring Items ¿ Average Total Assets ¿ © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. DuPont 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 Return on Assets = Net Profit Margin  Total Asset Turnover on assets © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. DuPont Return on Assets—Continued Net Income Before Net Income Before Noncontrolling Interest Noncontrolling Interest and Nonrecurring Items and Nonrecurring Items Net Sales = × Average Total Assets Net sales Average Total 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. There is the decrease in ROA for both firms but not for the same reason. For firm A, it is a problem of efficiency (how to use the assets to maximize sales) For firm B , it is a problem of profitability (sales are not enough profitable) === So the DuPont Analysis can explain why ROA is decreasing. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. DuPont Analysis Variation Consider only operating assets and income (instead of total assets and net 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 More conservative than the previous ratios ( will give lower value) © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4/ Operating Income Margin= other version of ratio 1 Includes only operating income in the numerator Operating Income Operating Income Margin = Net Sales © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 5/ Operating Asset Turnover Measures the ability of operating assets to generate sales dollars Net Sales Operating Asset Turnover = Average Operating Assets © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 6/ Return on Operating Assets Measures the ability of operating assets to generate operating income Operating Income Return on Operating assets = Average Operating Assets DuPont analysis of the return on operating assets:  DuPont Return   Operating   Operating   On  =  Income  ×  Asset         Operating Assets   Margin   Turnover        © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 7/ Sales to Fixed Assets Measures the ability to make productive use of property, plant, and equipment (Fixed assets) by generating sales dollars Exclude construction in progress from net fixed assets Eg ; Net sales are €1000 and fixed assets are €10,000 = Sales to FA = 10% = it means that for every €10 of fixed assets, 1 euro of sales will be generated Net Sales Sales to Fixed Assets = In SERVICE Companies, this Average ratio Net FixedisAssets always very high because the amount of fixed assets is low (Exclude Construction in Progress) © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 8/ Return on Investment (ROI) Measures income earned on invested capital and how well the firm utilizes its asset base Evaluates enterprise performance without regard to financing sources EG: if ROI = 10%, it means that for every euro invested, the investor is earning 0.1 euro Net Income Before Noncontrolling Interest and Nonrecurring Items + [(Interest Expense) × (1  Tax Rate)] Return on Investment = Average (Long-Term Liabilities + Equity) © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Eg ; Common stock at the beginning of the year = 1200 Common stock at the END of the year = 1400 Bank loan at the beginning of the year = 400 Bank loan at the END of the year = 300 Interest expenses = 50 Net income = 100 Tax rate = 25% = Calculate the ROI Average equity = (1200+1400)/ 2 = 1300 Average long term liability = (400+300)/2 = 350 ROI = (100 + (50*0.75)) / (1300+350) = 8.3% === Investors prefer higher ROI © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 9/ Return on Total Equity (ROE) Measures the return to common and preferred stockholders === It takes into account only equity Net Income Before Nonrecurring Items  Dividends on Redeemable Preferred Stock Return on Equity = Average Total Equity © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 11/ Return on Common Equity == similar to the previous one, but with common equity Measures the return to the common stockholder Net income Before Nonrecurring Items  Preferred Dividends Return on Common Equity = Average Common Equity © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 12/ Gross Profit Margin == similar to the first ratio but uses GROSS PROFIT (Gross profit = sales – COGS) Comparing gross profit with net sales is termed the gross profit margin Net Sales Beginning Inventory Revenue + Purchases of Inventory − Ending Inventory − Cost of Goods Sold = Gross Profit Gross Profit Gross Profit Margin = Net Sales © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Gross Profit Margin Analysis 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.