Profitability

Analysis
Prashanti Kumar
 Overview

• Profitability
– Ability of the firm to generate profits
• Analyzing profit is an important part of
financial statement analysis
 Analysis of Revenue
• What are the major sources of revenue
• How persistent are the revenue sources
• How are revenues, receivables & inventories
related
• When is revenue recorded & how is it
measured
13/07/2016
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 Sources of Revenue
• Information is important if the firm is a
diversified one
• ITC Revenue Sources:
– FMCG: (64%)
– Agri Business (21%)
– Paper Boards, Paper & Packaging (12%)
– Hotel Business (3%)
 Sources of Revenue
• ITC FMCG Revenue
• Sources:
– Cigarettes (65%)
– Others (35%)
• An excellent means to analyze sources
of revenue is common-size analysis
• Common size shows the percent of
each major class of revenue to its total
 Profitability Ratios
• Attempt to measure the ability of a firm
to generate funds from operations
– Sustain itself
– Provide an acceptable return to its
shareholders
• Ratios seek to associate the amount
of profit earned either
– Amount of resources used OR
– Amount of activity undertaken
 Profitability Ratios
• Why should a company generate
profits in the long run
– Replace fixed assets that are worn out
– Purchase new assets as revenue
increases
– Service debts
– Provide for cash needs associated with
the growth
• Investors expectation for a return on
the funds
PROFITABILITY RATIOS
Profit Return on
Margin Common
Stockholders’
Equity

Gross Return on
Margin Total Assets
 General Profitability
• Expenses/Sales
–COGS/Sales
–OPEX/Sales
–Depreciation/Sales
–Interest/Sales
–Tax/Sales
 Return on Investment
• Profit Generating Ability:
– Return on total assets(ROTA):
• Net Income or PAT /Average Total Assets
Profit Distributing Ability
• Return on Shareholders Equity (ROE):
– Net Income or PAT/ Avg.Share holders
Equity
• Earning Per Share
– Net Income or PAT/No. of shares
 General Profitability Ratios
• Profit Margin
– Gives a rate of return on sales
– Relates two items of the income statement
– Measures how much of each dollar in
revenue received ultimately becomes net
income

Net Income
Profit Margin =
Sales or Revenue
 Profit Margin
• Profit Margins tend to vary from industry to
industry
• Firms dealing in commodities
– Tend to have low profit margin
– High volume of sales relative to assets
– Ability to turn inventory over many times
• Firms dealing in capital intensive
– Higher profit margin
– Sales volume relative to fixed assets tends to
be lower than firms dealing in commodities
 Profit Margin
Year Walmart Costco Target

2015 3.37 2.03 -2.25

2014 3.36 1.8 2.72

2013 3.62 1.94 4.09

2012 3.51 1.72 4.19

2011 3.89 1.64 4.33

General Profitability Ratios
• Gross Margin
– Measure of profitability before the
inclusion of operating expenses, admin
exp, finance exp & taxes
– Relates two items of the income statement

Gross Income/Profit
Gross Margin =
Sales Revenue
 Gross Margin

Year Walmart Costco Target

2015 24.83 13.03 29.39

2014 24.82 12.60 29.50

2013 24.83 12.60 30.40

2012 25.02 12.40 30.90

2011 25.26 12.60 30.90

General Profitability Ratios
• Operating or PBIT/EBIT Margin
– Measure of profitability before the
inclusion of finance exp & taxes
– Relates two items of the income statement

EBIT/PBIT
Operating Margin =
Sales Revenue
 Operating Margin
Year Walmart Costco Target

2015 5.59 3.11 6.25

2014 5.64 2.81 5.80

2013 5.92 2.90 7.30

2012 5.94 2.78 7.60

2011 6.05 2.74 7.80

 Profit Generating Ability
• Basic Earning Power
– Measures the relationship between profits
and investment
– Key ratio used by analyst
– It highlights the efficiency of management of
using its total assets before considering
finance & taxes
– Measures the earning power of the assets
and is not influenced by how the assets are
financed
– Formula: EBIT/Total Assets
 Return on Asset

• Measures the ability of a firm to use its

assets to earn profit
• This ratio factors in the expenses
incurred by the business

Net Income
Return on Asset =
Total Assets
 Return on Assets
• Capital intensive industries like
railroads/thermal power/telecommunication
providers need a lot of assets to turn a
profit
– so will have a lower return on assets.
• In contrast, software companies/advertising
agencies/personnel services tend to use
lesser amount of assets
– will have a higher ROA
 Return on Assets
Year Walmart Costco Target

2015 8.03 6.46 -3.81

2014 7.83 6.31 4.25

2013 8.37 7.10 6.33

2012 8.39 6.34 6.48

2011 9.33 5.78 6.62

 Return on Asset
• The return on assets is a function of both
– Profit Margin
– Asset Turnover or Utilization
• Decomposition of the formula
• Net Income x Net Sales = Net Income
Net Sales Total Assets Total Assets
• If the firm is not able to obtain a sufficient
high return on assets it will find difficult to
sustain
 Return on Assets

2015 Profit Margin Asset Return on

Turnover Assets

Walmart 3.37 2.38 8.01

Costco 2.03 3.18 6.46

Target -2.25 1.69 -3.81

 Return on Equity
• Return on equity is the overall measure
of performance of a company
• It is shown as a percent
• Higher the better

Net Income/PAT-Pref.Dividend
Return on Equity =
Shareholders Equity/Net worth
 Return on Equity

Year Walmart Costco Target

2015 20.10 20.22 -10.82

2014 21.01 17.75 12.02

2013 22.27 17.58 18.52

2012 22.45 14.03 18.71

2011 23.53 12.81 18.94