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• Exclude items of income not arising from normal operations
– Discontinued operations
– Extraordinary items
Chapter 8, Slide #2
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Net Income Before Minority Share of Earnings,
Equity Income, and Nonrecurring Items
Net Sales
• Also referred to as return on sales
• Reflects net income dollars generated by each dollar of sales
• Potential distortion
– Net “other” income or loss
Chapter 8, Slide #3
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Net Sales
Average Total Assets
• 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
Chapter 8, Slide #4
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Net Income Before Minority Share of Earnings and Nonrecurring Items
Average Total 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
Chapter 8, Slide #5
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Net Income Before
Minority Share of
Earnings and
Nonrecurring Items
Average Total Assets
=
Net Income Before
Minority Share of
Earnings and
Nonrecur ring Items
Net Sales

Net Sales
Average Total Assets
Chapter 8, Slide #6
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

• DuPont analysis separates return on assets into net profit margin and total asset turnover
Firm A
Year 1
Year 2
FIRM B
Year 1
Year 2
Return on Net Profit Total Asset
Assets = Margin × Turnover
10%
8%
10%
8%
=
=
=
=
4.0% ×
4.0% ×
4.0% ×
3.2% ×
2.5
2.0
2.5
2.5
• Separating the ratio into the two elements allows evaluation of the causes for the change in return on assets
Chapter 8, Slide #7
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

• 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
Chapter 8, Slide #8
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Operating Income
Net Sales
• Use operating income in the numerator
Chapter 8, Slide #9
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Net Sales
Average Operating Assets
• Measures the ability of operating assets to generate sales dollars
Chapter 8, Slide #10
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Operating Income
Average Operating Assets
• Measures the ability of operating assets to generate operating income
• DuPont analysis of the return on operating assets:
DuPont Return Operating Operating on = Income × Asset
Operating Assets Margin Turnover
Chapter 8, Slide #11
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Net Sales
Average Net 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
Chapter 8, Slide #12
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.



   

• Measures the earnings on investment and indicates how well the firm utilizes its asset base
• Evaluates enterprise performance
Chapter 8, Slide #13
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

• Measures ability to reward investors and to attract providers of future funds
• Evaluates the earnings performance without regard to financing sources
Chapter 8, Slide #14
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

• 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)
Chapter 8, Slide #15
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

• Measures the return to the common stockholder
• Common equity:
Total stockholders’ equity less preferred capital less minority interest reported as equity
Chapter 8, Slide #16
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Rate of return on
Measures return to providers of Typical result
Assets 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
Chapter 8, Slide #17
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Gross Profit
Net Sales
Sales
– Cost of Goods Sold
= Gross Profit
Beginning Inventory
+ Purchases of Inventory
– Ending Inventory
Chapter 8, Slide #18
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

• 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
Chapter 8, Slide #19
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

• 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
Chapter 8, Slide #20
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

• Items not included in net income
• Reported as a separate component of stockholders’ equity
– Foreign currency translation adjustments
– Unrealized holding gains and losses from availablefor-sale marketable securities
– Changes to stockholders’ equity resulting from additional minimum pension liability adjustments
– Unrealized gains and losses from derivative instruments
Chapter 8, Slide #21
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

• 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
Chapter 8, Slide #22
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

• Non-GAAP-based financial information
• Release timed to coincide with release of
GAAP financial results
• Sarbanes-Oxley Act of 2002 requires
– Reconciling of pro forma data to GAAP financial condition and results of operations
– Pro forma data is not misleading or untrue
Chapter 8, Slide #23
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

• Unaudited financial reports covering fiscal periods of less than one year
– Interim reports are an integral part of the annual report
– Quarterly information is disclosed in the annual report
• SEC requires quarterly information be filed on
Form 10-Q
• Produced quickly; rely on more estimates
Chapter 8, Slide #24
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.