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Profitability
COPYRIGHT ©2007 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.
Chapter 8
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 8, Slide #2
Profitability Measures
• Exclude items of income not arising from normal operations– Discontinued operations– Extraordinary items
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 8, Slide #3
Net Profit Margin
• Also referred to as return on sales• Reflects net income dollars generated by each dollar of sales• Potential distortion
– Net “other” income or loss
Net Income Before Minority Share of Earnings,Equity Income, and Nonrecurring Items
Net Sales
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 8, Slide #4
Total Asset Turnover
• Measures the activity of the assets and the ability of the firm to generate sales through the use of the assets
• Potential distortion– Investments– Construction in progress– Other assets that do not relate to net sales
Net Sales
Average Total Assets
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 8, Slide #5
Return on Assets
• Measures the ability to utilize assets to create profits
• Average total assets– Internal analysis: month-end amounts– External analysis: beginning and ending amounts– If necessary, consistent use of end-of-year amounts
Net Income Before Minority Shareof Earnings and Nonrecurring Items
Average Total Assets
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 8, Slide #6
Operating Income Margin
• Use operating income in the numerator
Operating Income
Net Sales
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 8, Slide #7
Operating Asset Turnover
• Measures the ability of operating assets to generate sales dollars
Net Sales
Average Operating Assets
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 8, Slide #8
Return on Operating Assets
• Measures the ability of operating assets to generate operating income
Operating Income
Average Operating Assets
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 8, Slide #9
Sales to Fixed Assets
• Measures the ability to make productive use of property, plant, and equipment by generating sales dollars– Exclude construction in progress
• Possible distortions– Old fixed assets– Labor-intensive industry
Net Sales
Average Net Fixed Assets
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 8, Slide #10
Return on Investment (ROI)
• Measures the earnings on investment and indicates how well the firm utilizes its asset base
• Evaluates enterprise performance
Net Income Before Minority Share ofEarnings and Nonrecurring Items
+ Interest Expense 1-Tax Rate
Average Long-Term Liabilities + Equity
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 8, Slide #11
Return on Investment (ROI) (cont’d)
• Measures ability to reward investors and to attract providers of future funds
• Evaluates the earnings performance without regard to financing sources
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 8, Slide #12
Return on Total Equity
• Measures the return to common and preferred stockholders
• Adjustments for redeemable preferred stock– Deduct dividends from net income (numerator)– Deduct stock value from total equity (denominator)
Net Income Before Nonrecurring Items- Dividends on Redeemable Preferred Stock
Average Total Equity
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 8, Slide #13
Return on Common Equity
• Measures the return to the common stockholder
• Common equity: Total stockholders’ equityless preferred capitalless minority interest reported as equity
Net Income Before Nonrecurring Items- Preferred Dividends
Average Common Equity
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 8, Slide #14
The Relationship Between Profitability Ratios
Rate ofreturn on
Measuresreturn to
providers of Typical resultAssets All funds Lowest (includes all assets)
Investment Long-term funds Higher than ROA (relative small amount of short-term funds)
Total equity Equity Higher than ROI (measures return only to shareholders)
Common equity Common equity Highest• Common shareholders absorb
greatest degree of risk• Requires that return to preferred
shareholders exceed funds paid to preferred shareholders
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 8, Slide #15
Gross Profit Margin
Sales
– Cost of Goods Sold
= Gross Profit
Beginning Inventory+ Purchases of Inventory– Ending Inventory
Gross Profit
Net Sales
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 8, Slide #16
Segment Reporting
• Operating segments– Separate financial information is available– Evaluated by the chief decision making officer
• Geographical information– Revenues earned– Asset concentration
• Major customers• Products and services
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 8, Slide #17
Gains and Losses from Prior Period Adjustments
• Charged directly to retained earnings– Changes in accounting principles– Realization of net operating loss carryforward tax
benefits from purchased subsidiaries– Changes in accounting entity– Correction of errors originating in prior periods
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 8, Slide #18
Pro Forma Financial Information
• Non-GAAP-based financial information• “What if” Financial Statements
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.Chapter 8, Slide #19
Interim Reports
• Unaudited financial reports covering fiscal periods of less than one year
• SEC requires quarterly information be filed on Form 10-Q
• Produced quickly; rely on more estimates