Chapter 4

Profitability Analysis
 Overview of Profitability Analysis
(Screen 1 of 2)
• Evaluates whether managers are effectively
executing a firm’s strategy.
• Helps to develop an understanding of a firm’s
performance to enable forecasts of future
performance.

Chapter: 04 2
 Overview of Profitability Analysis
(Screen 2 of 2)
Approaches to understanding firm’s net income:
– Alternative transformations of measured net
income:
• Earnings per share analysis
• Common-size analysis
• Percentage change analysis
• Alternative definitions of profits
– Rate of Return Metrics:
• Return on total assets
• Return on common equity
Chapter: 04 3
Alternative Approaches to Analyzing Net
Income

Chapter: 04 4
 Earnings Per Share
• One of the most frequently used measures of
profitability.
• The only financial ratio that GAAP requires firms
to disclose on the face of the income statement.
• Covered explicitly by the opinion of the
independent auditor.
• Types of EPS:
– Basic EPS (Simple Capital Structure)
– Diluted EPS (Complex Capital Structure)

Chapter: 04 5
 Calculating EPS (Screen 1 of 2)
Basic EPS (Simple Capital Structure)
• For firms that do not have:
– Outstanding convertible bonds or convertible
preferred stock that can be exchanged for shares of
common stock.
– Options or warrants that holders can use to acquire
common stock.
• Basic EPS is calculated as:
Net Income - Preferred Stock Dividends
Weighted Average Number of
Common Shares Outstanding
Chapter: 04 6
 Calculating EPS (Screen 2 of 2)
Diluted EPS (Complex Capital Structure)
– For the firms that have Convertible securities and/or
stock options or warrants outstanding.
– Presents two EPS amounts: Basic EPS & Diluted EPS.
– Diluted EPS reflects the dilution potential of
convertible securities, options, and warrants.
– Diluted EPS is calculated as:
Net Income - Preferred Stock Dividends + Adjustment s for Dilutive Securities
Weighted Average Weig hted Average Number
Number of Common + of Shares Issuable from
Shares Outstandin g Dilutive Securities
Chapter: 04 7
 Criticisms of EPS
• It does not consider the amount of assets or
capital required to generate a particular level
of earnings.
• Two firms with the same earnings and EPS are
not necessarily equally profitable.
• The number of shares of common stock
outstanding serves as a poor measure of the
amount of capital in use.
Despite the above criticisms of EPS as a measure of profitability, it
remains one of the focal points of announcements and is frequently used
valuing firms.
Chapter: 04 8
 Common-Size Analysis
• Simple way of creating greater comparability
across firms and for same firm through time.
• Most frequently utilized in:
– Income statement: by expressing all line items
scaled by revenues.
– Balance sheet: by expressing all line items scaled
by total assets.
• Common scaling enables figures across firms
and across time to be more comparable.
Chapter: 04 9
 Percentage Change Analysis
• Computes percentage changes in individual
line items.
• Can be compared across firms or across time.
• Focus is not on the financial data themselves,
but on the changes in individual line items
through time.

Chapter: 04 10
Common-Size Analysis

Chapter: 04 11
Percentage Change Analysis

Chapter: 04 12
 Alternative Definitions of Profits
• Analysts use measures of past profitability to
forecast the firm’s future profitability.
• These may include:
– Comprehensive Income
– Operating Income, EBIT, EBITDA, and Other Profit
Measures
– Segment Profitability
– Pro Forma, Adjusted, or Street Earning
Chapter: 04 13
 Return on Assets
• Independent of firm’s financing decisions.
• Measures ongoing profitability.
• Unusual or nonrecurring items (such as
restructuring charges) may be removed, net of
tax.
• Return on Assets is calculated as:

Net Income + (1 - Tax Rate)(Interest Expense) + Noncontrolling Interest in Earnings

Average Total Assets

Chapter: 04 14
 Disaggregating ROA
ROA can be further disaggregated into:

ROA = Profit Margin for ROA x Asse ts Turnover

Where :
Adjusted Net Income
Profit Margin =
Sales
Sales
Assets Turnover =
Average Total Assets

Chapter: 04 15
 Return on Common Equity
 Measures the return to common stockholders
after subtracting operating expenses and costs
of debt financing and preferred stock.
 It should adjust net income for nonrecurring
charges, as in ROA.
 Explicitly accounts for the cost of debt and
preferred stock financing.
 ROCE is calculated as:
Net Income – Preferred Stock Dividends
Average Common Stockholde rs’ Equity
Chapter: 04 16
 Relating ROA to ROCE
• ROA measures operating performance
independent of financing.
• ROCE considers the cost of debt and preferred
stock financing.

Chapter: 04 17
 Disaggregating ROCE
ROCE can be further disintegrated into:
ROCE =
Profit Margin for ROCE x Assets Turnover x Capital Structure Leverage

Average
Net Income to Common Sales Total Assets
x x
Sales Average Average Common
Total Assets Shareholde rs’ Equity
 Leverage refers to use of debt to increase return to
common stockholders
 ROCE > ROA
 When ROA > Cost of debt and Preferred stock financing.
Chapter: 04 18
 Realized ROA versus Expected ROA
• Realized ROA is derived from financial
statement data for a particular period and will
not necessarily correlate perfectly with
expected returns.
• Reasons for this may be:
– Faulty assumptions were used in deriving
expected ROAs.
– Changes in the environment.
– ROA is an incomplete measure of economic rates
of return.
Chapter: 04 19
 Elements of risk - differences in ROAs
• Three elements of risk help in understanding
differences across firms and changes over
time in ROAs:
– Operating leverage: Refers to proportion of fixed
costs relative to variable costs.
– Cyclicality of Sales: Are sales sensitive to
economic conditions?
– Product Life Cycle: Relates to the stage and length
of firm’s product life.
Chapter: 04 20
 Trade-Offs between Profit Margin and Assets
Turnover
• Important to examine the differences
between the relative mix of profit margin and
assets turnover.
• Differences in ROA due to relative mix of
profit margin and assets turnover can be
explained by:
– Microeconomic Theory
– Business Strategy
Chapter: 04 21
Microeconomic Theory (Screen 1 of 2)
• Capacity Constraint
– Heavy fixed capacity costs and lengthy periods
required to add new capacity.
– There is an upper limit on the size of assets
turnover achievable.
– Only way to increase ROA is to increase profit
margin.
– The firms usually achieve the high profit margin
through some form of entry barrier.
Chapter: 04 22
Microeconomic Theory (Screen 2 of 2)
• Competitive Constraint
– For firms whose products are commodity-like.
– Few entry barriers and intense competition.
– There is an upper limit on the achievable level of
profit margin for ROA.
– Only way to improve ROA is to achieve high asset
turnover.
– Firms achieve the high assets turnovers by
controlling costs with aggressively low prices to
gain market share.
Chapter: 04 23
 Business Strategy
• Two generic alternative strategies for a
particular product are:
– Product differentiation strategy-
• Differentiate a product to obtain market power over
revenues and, therefore, profit margins.
– Low-cost leadership strategy-
• Enabling the firm to charge the lowest prices and to
achieve higher sales volumes.

Chapter: 04 24
Analyzing the Profit Margin for ROA
• Sales
• Individual expenses
– Cost of goods sold
– Selling, General, and Administrative Expenses
– Income taxes
• Profit margin
• Segment data: Permits the analyst to
examine ROA, profit margin, and assets
turnover at an additional level of depth.
Chapter: 04 25
 Analyzing Total Assets Turnover
 Captures how efficiently assets are being utilized
to generate revenues.
 Provides insight into changes in the total assets
turnover by examining turnover ratios:
 Accounts receivable turnover- Indicates the average
time until firms collect accounts receivable in cash.
 Inventory turnover- Indicates the length of time
needed to produce, hold, and sell inventories.
 Fixed assets turnover- Measures the relation between
sales and the investment in property, plant, and
equipment.
Chapter: 04 26
 Interpreting Financial Statement Ratios
(Screen 1 of 2)
• Comparing with Earlier Periods
• Raise the following questions:
 Has the firm made a significant change in its product,
geographic, or customer mix?
 Has the firm made a major acquisition or divestiture?
 Has the firm changed its methods of accounting over
time?
 Are there any unusual or nonrecurring amounts that
impair a comparable analysis of financial results
across?
Chapter: 04 27
 Interpreting Financial Statement Ratios
(Screen 2 of 2)

• Comparing with Other Firms

• Consider the following:
 Definition of the industry
 Calculation of industry average
 Distribution of ratios around the mean
 Definition of financial statement ratios

Chapter: 04 28