HUANGHUAI UNIVERSITY & BANGOR UNIVERSITY Lecture 7 Profitability DR. AZIZ JAAFAR

1. HUANGHUAI UNIVERSITY & BANGOR UNIVERSITY Lecture 7 Profitability DR. AZIZ JAAFAR

2. Profitability Measures • The ability of the firm to generate earnings • Analysis of profit is of vital concern to stockholders since they derive revenue in the form of dividends. • Also important to creditors because profits are one source of funds for debt coverage. • Exclude items of income not arising from normal operations • Discontinued operations • Extraordinary items

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

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

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

6. DuPont Return on Assets

7. DuPont Return on Assets (cont’d) • DuPont analysis separates return on assets into net profit margin and total asset turnover • Separating the ratio into the two elements allows evaluation of the causes for the change in return on assets

8. DuPont Analysis Variation • Consider only operating assets and income • Operating assets exclude • Construction in progress • Long-term investments • Intangibles • ‘Other’ assets • Operating income includes only • Net sales • Operating expenses • May give significantly different results • Reflective of ROA from primary business

9. Operating Income Margin • Use operating income in the numerator

10. Operating Asset Turnover • Measures the ability of operating assets to generate sales dollars

11. Return on Operating Assets • Measures the ability of operating assets to generate operating income • DuPont analysis of the return on operating assets:

12. 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

13. Return on Investment (ROI) • Measures the earnings on investment and indicates how well the firm utilizes its asset base • Evaluates enterprise performance

14. 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

15. 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)

16. Return on Common Equity • Measures the return to the common stockholder • Common equity: Total stockholders’ equity less preferred capital less minority interest reported as equity

17. The Relationship Between Profitability Ratios

18. Gross Profit Margin Beginning Inventory + Purchases of Inventory – Ending Inventory Sales – Cost of Goods Sold = Gross Profit

19. 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

20. 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

21. Comprehensive Income • Items not included in net income • Reported as a separate component of stockholders’ equity • Foreign currency translation adjustments • Unrealized holding gains and losses from available-for-sale marketable securities • Changes to stockholders’ equity resulting from additional minimum pension liability adjustments • Unrealized gains and losses from derivative instruments

22. Comprehensive Income (cont’d) • Traditional profitability analysis utilizes net income • Items of accumulated other comprehensive income are excluded from analysis • Consider supplemental analysis including other comprehensive income items for • Return on assets • Return on investment • Return on total equity • Return on common equity