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