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Profitability Analysis
9CHAPTER
Analyzing ProfitabilityFocus 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 ProfitabilityFocus of Profitability Analysis
Profitability analysis helps address questions such as:
What is a company’s 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 company’s earning power?
Analyzing ProfitabilityMeasuring 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 ProfitabilityMeasuring 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 ProfitabilityMeasuring Income--Estimation Issues
Management discretion is part of income measurement
Estimates of skilled and experienced professionals Some consensus (less variability)
Analyzing ProfitabilityMeasuring Income--Accounting Methods
Professional experience
Regulatory agendas
Businesshappenings
Academicresearch
SocialInfluences
Politicalpressures
Accounting standards governing
income measurement
Analyzing ProfitabilityMeasuring 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 ProfitabilityMeasuring Income--Incentives for Disclosure
Ideally: Financial statements fairly present transactions and
events Accounting is neutral—not affecting how
transactions and events are perceived Methods chosen that are most applicable to the
circumstances Relevant information is disclosed—favorable and
unfavorable
Ideally: Financial statements fairly present transactions and
events Accounting is neutral—not affecting how
transactions and events are perceived Methods chosen that are most applicable to the
circumstances Relevant information is disclosed—favorable and
unfavorable
Analyzing ProfitabilityMeasuring Income--Incentives for Disclosure
Reality: Each of us possess opinions--we see the world from different
perspectives Managers bring strong views to the table Managers feel pressures of competition and society Directors expect results Shareholders concentrate on the bottom line Creditors want safeguards Financial analysts dislike surprises Accounting preparers and auditors demand acceptable
practices
Reality: Each of us possess opinions--we see the world from different
perspectives Managers bring strong views to the table Managers feel pressures of competition and society Directors expect results Shareholders concentrate on the bottom line Creditors want safeguards Financial analysts dislike surprises Accounting preparers and auditors demand acceptable
practices
Analyzing ProfitabilityMeasuring Income--Incentives for Disclosure
Result:
“Acceptable” methods, not necessarily “appropriate” methods
Result:
“Acceptable” methods, not necessarily “appropriate” methods
Analyzing ProfitabilityMeasuring Income--Diversity Across Users
• Financial statements are general‑purpose reports serving diverse needs of many users
• Diversity of views implies an analysis uses income as an initial measure of profitability
• Use available information adjust incomemeasurement consistent with one’s objectives
• Financial statements are general‑purpose reports serving diverse needs of many users
• Diversity of views implies an analysis uses income as an initial measure of profitability
• Use available information adjust incomemeasurement consistent with one’s objectives
Analyzing RevenuesTwo-Phase Analysis of Income
Analysis of income and its components involves two phases
1. Analysis of accounting and its measurements
Purpose: To apply knowledge of accounting to yield a measure of income, and its components, consistent with the analysis objectives
2. Applying analysis tools to income (and its components) and interpreting the analytical results
Purpose: To apply analysis tools to aid achieve the analysis objectives—such as income forecasting and estimating earning power
Analysis of income and its components involves two phases
1. Analysis of accounting and its measurements
Purpose: To apply knowledge of accounting to yield a measure of income, and its components, consistent with the analysis objectives
2. Applying analysis tools to income (and its components) and interpreting the analytical results
Purpose: To apply analysis tools to aid achieve the analysis objectives—such as income forecasting and estimating earning power
Analyzing RevenuesRevenue Sources
Analysis of revenues (sales) helps address questions such as:
What are the major sources of revenue? How persistent are revenue sources? How are revenues, receivables, and inventories
related? When is revenue recorded? How is revenue measured?
Analysis of revenues (sales) helps address questions such as:
What are the major sources of revenue? How persistent are revenue sources? How are revenues, receivables, and inventories
related? When is revenue recorded? How is revenue measured?
Analyzing RevenuesRevenue Sources
Knowledge of major sources of revenues is important to profitability analysis
Each market and product line often has its own growth pattern, profitability, and future potential
Common-size analysis of revenues shows the percent of each major class of revenue to its total
Graphical analysis is a useful tool to interpret the sources of revenues
Knowledge of major sources of revenues is important to profitability analysis
Each market and product line often has its own growth pattern, profitability, and future potential
Common-size analysis of revenues shows the percent of each major class of revenue to its total
Graphical analysis is a useful tool to interpret the sources of revenues
Analyzing RevenuesRevenue Sources
Diversified Companies present special challenges
• Different segments usually experience varying rates of profitability, risk, and growth
• Asset composition and financing requirements of segments often vary
• Evaluation, projection, and valuation of income is aided by segment analysis
• Segments share characteristics of variability, growth, and risk• Income forecasting benefits from forecasts by segments• Must separate and interpret the impact of individual segments
Diversified Companies present special challenges
• Different segments usually experience varying rates of profitability, risk, and growth
• Asset composition and financing requirements of segments often vary
• Evaluation, projection, and valuation of income is aided by segment analysis
• Segments share characteristics of variability, growth, and risk• Income forecasting benefits from forecasts by segments• Must separate and interpret the impact of individual segments
Analyzing RevenuesRevenue Sources
Full disclosure by segments is rare because of:
• Difficulties in separating segments
• Management’s reluctance to release information that can harm its competitive position
Full disclosure by segments is rare because of:
• Difficulties in separating segments
• Management’s reluctance to release information that can harm its competitive position
Analyzing RevenuesRevenue Sources
Reporting requirements exist for:
• Industry segments• International activities• Export sales• Major customers
Reporting requirements exist for:
• Industry segments• International activities• Export sales• Major customers
GAAP
Analyzing RevenuesRevenue Sources
Reporting requirements consider a segment significant if its sales, operating income, or identifiable assets comprise 10 percent or more of their relevant totals
Notes:Combined sales of all segments reported must be at least 75 percent of the company’s total salesTen segments is viewed as a practical limit on the number of segments reported
Reporting requirements consider a segment significant if its sales, operating income, or identifiable assets comprise 10 percent or more of their relevant totals
Notes:Combined sales of all segments reported must be at least 75 percent of the company’s total salesTen segments is viewed as a practical limit on the number of segments reported
GAAP
Analyzing RevenuesRevenue Sources
Information disclosed for each segment:(1) sales—both intersegment and to unaffiliated
customers(2) operating income—revenues less operating
expenses(3) identifiable assets(4) capital expenditures(5) depreciation, depletion, and amortization
Similar disclosures are required for international operations and export sales (except capital expenditures and depreciation) Revenues from a single customer are disclosed if they comprise 10 percent or more of total revenues
Information disclosed for each segment:(1) sales—both intersegment and to unaffiliated
customers(2) operating income—revenues less operating
expenses(3) identifiable assets(4) capital expenditures(5) depreciation, depletion, and amortization
Similar disclosures are required for international operations and export sales (except capital expenditures and depreciation) Revenues from a single customer are disclosed if they comprise 10 percent or more of total revenues
Analyzing RevenuesRevenue Sources
Limitations of segment data:
• Difficult to define segments• Arbitrary allocations of costs
across segments
Limitations of segment data:
• Difficult to define segments• Arbitrary allocations of costs
across segments
Analyzing RevenuesRevenue Sources
Useful applications of segment data include:
Analysis of sales growth
Analysis of asset growth
Analysis of profitability
Persistence (stability and trend) of revenues is important to profitability analysis
Analysis tools for assessing persistence in revenues include:(1) trend percent analysis(2) evaluation of Management’s Discussion and
Analysis
Persistence (stability and trend) of revenues is important to profitability analysis
Analysis tools for assessing persistence in revenues include:(1) trend percent analysis(2) evaluation of Management’s Discussion and
Analysis
Analyzing RevenuesPersistence of Revenues
Revenues for a prior period are set equal to 100 percent
Revenues for other periods are compared to it
Revenue trends by segments are often:
CorrelatedCompared to industry normsCompared to competitors
Revenues for a prior period are set equal to 100 percent
Revenues for other periods are compared to it
Revenue trends by segments are often:
CorrelatedCompared to industry normsCompared to competitors
Analyzing RevenuesPersistence of Revenues--Trend Percent Analysis
Other related measures:
(Auto)correlations of revenues across periods
Assess sensitivity of revenues to
business conditions Customer analysis—concentration,
dependence, and stability Revenues’ concentration or dependence on one
segment Revenues’ reliance on sales staff
Geographical diversification of markets
Other related measures:
(Auto)correlations of revenues across periods
Assess sensitivity of revenues to
business conditions Customer analysis—concentration,
dependence, and stability Revenues’ concentration or dependence on one
segment Revenues’ reliance on sales staff
Geographical diversification of markets
Analyzing RevenuesPersistence of Revenues--Trend Percent Analysis
Management’s Discussion and Analysis (MD&A) is often useful in analysis of persistence in revenues
• Aids in understanding and evaluating period-to-periodchanges
• Report on changes in revenue components• Discloses uncertainties affecting or likely to affect
revenues• Explains growth in revenues to prices, volume,
inflation, or new product introduction• Reports some forward‑looking information• Discusses trends and forces not evident from financial statements
Management’s Discussion and Analysis (MD&A) is often useful in analysis of persistence in revenues
• Aids in understanding and evaluating period-to-periodchanges
• Report on changes in revenue components• Discloses uncertainties affecting or likely to affect
revenues• Explains growth in revenues to prices, volume,
inflation, or new product introduction• Reports some forward‑looking information• Discusses trends and forces not evident from financial statements
Analyzing RevenuesPersistence of Revenues--MD&A
Revenues and Accounts Receivable Relation
Bears on:
Earnings qualityCollectibility of receivables
Revenues and Accounts Receivable Relation
Bears on:
Earnings qualityCollectibility of receivables
Analyzing RevenuesKey Revenue Relations
Revenues and Inventories Relation
Bears on:
Future revenuesAnalysis of operations
Revenues and Inventories Relation
Bears on:
Future revenuesAnalysis of operations
Analyzing RevenuesKey Revenue Relations
Profitability analysis must adjust for different revenue recognition methods in:
• Comparative analysis—both temporal and cross-sectional• Forecasting revenues
Chapter 6 discusses revenue recognition criteria and measurement
Profitability analysis must adjust for different revenue recognition methods in:
• Comparative analysis—both temporal and cross-sectional• Forecasting revenues
Chapter 6 discusses revenue recognition criteria and measurement
Analyzing RevenuesRevenues Recognition
Analyzing Costs of RevenuesMeasuring 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 future‑directed discretionary expenditures
Measuring Gross Profit
Gross profits vary across industries depending on factors such as:
• Competition
• Capital investment
• Level of costs that must berecovered 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 year‑to‑year change in volume assuming unit
selling price is unchanged—Volume change is
multiplied by the constant unit selling price to yield
change in salesStep 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 Profit—Illustration
Year Ended December 31 Year-to-Year Change
Item Year 1 Year 2 Increase Decrease
1. Sales ($ millions) $ 657.6 $ 687.5 $ 29.92.Cost of sales ($ millions) 237.3 245.3 8.03.Gross profit ($ millions) $ 420.3 $ 442.2 $ 21.94.Units sold (in millions) 215.6 231.5 15.95.Sales price per unit
(1 ÷ 4) $ 3.05 $ 2.97 $ 0.086.Cost per unit (2 ÷ 4) 1.10 1.06 0.04
Analyzing Costs of Revenues
Analyzing Gross Profit
Analysis Statement of Changes in Gross ProfitYear 2 versus Year 1
Analysis of Variation in Sales1. Change in volume of products sold:
Change in volume (15.9) Year 1 unit selling price ($3.05) $ 48.52..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) 1.3Increase in net sales $ 30.0*
Analysis of Variation in Cost of Sales1. Change in volume of products sold:
Change in volume (15.9) Year 1 cost per unit ($1.10) $ 17.52. 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) 0.6Increse 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
Analyzing Costs of Revenues
Changes in gross profit are often driven by one or more of the following factors:
Increase in sales volume Decrease in sales volume Increase in unit selling price Decrease in unit selling price Increase in cost per unit
Decrease in cost per unit
Changes in gross profit are often driven by one or more of the following factors:
Increase in sales volume Decrease in sales volume Increase in unit selling price Decrease in unit selling price Increase in cost per unit
Decrease in cost per unit
Interpreting Changes in Gross Profit
Analyzing Costs of Revenues
• Identification of factors driving gross profit yields
• Improved business strategies
• Better assessment of future performance
• Identification of factors driving gross profit yields
• Improved business strategies
• Better assessment of future performance
Tools for Analysis of Expenses
Analyzing Expenses
Common-size analysis
Common‑size income statements express expenses in terms of their percent relation with revenues
Traced over several periods or compared with competitors
Index number analysisIndex number analysis of income statements expresses income and its components in an index number related to a base periodHighlights relative changes across timeChanges 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
Common-size analysis
Common‑size income statements express expenses in terms of their percent relation with revenues
Traced over several periods or compared with competitors
Index number analysisIndex number analysis of income statements expresses income and its components in an index number related to a base periodHighlights relative changes across timeChanges 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
Selling Expenses
Analyzing 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 future‑directed marketing 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 future‑directed marketing expenses
Depreciation Expense
Analyzing Expenses
Relation of depreciation to gross plant and equipment helps reveal changes in the composite rate of depreciation—this is useful in evaluating depreciation levels and in detecting adjustments (smoothing) to income:
It is often useful to compute this ratio by asset categories
Relation of depreciation to gross plant and equipment helps reveal changes in the composite rate of depreciation—this is useful in evaluating depreciation levels and in detecting adjustments (smoothing) to income:
It is often useful to compute this ratio by asset categories
assets eDepreciabl
expense onDepreciati
Maintenance and Repairs Expense
Analyzing Expenses
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
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
Maintenance and Repairs Expense
Analyzing Expenses
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
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
Amortization of Special Costs
Analyzing Expenses
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
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
Amortization of Special Costs
Analyzing Expenses
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
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
General and Administrative Expenses
Analyzing Expenses
Most are fixed—such as rent and salary
Tendency for increases, especially in prosperous times
Most are fixed—such as rent and salary
Tendency for increases, especially in prosperous times
General and Administrative Expenses
Analyzing Expenses
Analysis of G&A should focus on:
• Trend in these expenses
• Percent of revenues they consume
Analysis of G&A should focus on:
• Trend in these expenses
• Percent of revenues they consume
Financing Expenses
Analyzing Expenses
Most are fixed—exception is variable-rate interest
Most creditor financing is eventually refinanced and not removed
Interest expense often includes amortization of a premium or
discount
Most are fixed—exception is variable-rate interest
Most creditor financing is eventually refinanced and not removed
Interest expense often includes amortization of a premium or
discount
Average effective interest rate:
Useful tool for:
• Analysis of the cost of borrowed money• Credit standing• Comparisons across years and companies• Assessing sensitivity to interest rate changes
Financing Expenses
Analyzing Expenses
ssindebtedne bearing-interest Average
incurredinterest Total
Income Tax Expenses
Analyzing Expenses
Income tax expenses:
Reflect a distribution of profits between a company and governmental agencies
Usually comprise a substantial portion of a company’s pre-tax income
Income tax expenses:
Reflect a distribution of profits between a company and governmental agencies
Usually comprise a substantial portion of a company’s pre-tax income
Income Tax Expenses
Analyzing Expenses
Effective Tax Rate (ETR)
ETR (also called tax ratio) reflects relation between the income tax accrual and pre‑tax income
Effective Tax Rate (ETR)
ETR (also called tax ratio) reflects relation between the income tax accrual and pre‑tax income
taxes income before Income
expense tax Income
Income Tax Expenses
Analyzing 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
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
Income Tax Expenses
Analyzing 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
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
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