Profitability Analysis
9
CHAPTER
Analyzing Profitability
Focus 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 Profitability
Focus 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 Profitability
Measuring 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 Profitability
Measuring 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 Profitability
Measuring Income--Estimation Issues
Management discretion is part of income measurement
Estimates of skilled and experienced professionals 
Some consensus (less variability)
Analyzing Profitability
Measuring Income--Accounting Methods
Professional
experience
Regulatory
agendas
Business
happenings
Social
Influences
Accounting
standards
governing
income
measurement
Political
pressures
Academic
research
Analyzing Profitability
Measuring 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 Profitability
Measuring 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
Analyzing Profitability
Measuring 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
Analyzing Profitability
Measuring Income--Incentives for Disclosure
Result:
“Acceptable” methods, not necessarily
“appropriate” methods
Analyzing Profitability
Measuring 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 income
measurement consistent with one’s objectives
Analyzing Revenues
Two-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
Analyzing Revenues
Revenue 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?
Analyzing Revenues
Revenue 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
Analyzing Revenues
Revenue 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
Analyzing Revenues
Revenue 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
Analyzing Revenues
Revenue Sources
Reporting requirements exist for:
• Industry segments
• International activities
• Export sales
• Major customers
GAAP
Analyzing Revenues
Revenue 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 sales
Ten segments is viewed as a practical limit on the
number of segments reported
GAAP
Analyzing Revenues
Revenue 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
Analyzing Revenues
Revenue Sources
Limitations of segment data:
• Difficult to define segments
• Arbitrary allocations of costs
across segments
Analyzing Revenues
Revenue Sources
Useful applications of segment data include:
 Analysis of sales growth
 Analysis of asset growth
 Analysis of profitability
Analyzing Revenues
Persistence of Revenues
Persistence (stability and trend)
important to profitability analysis
of
revenues
is
Analysis tools for assessing persistence in revenues
include:
(1) trend percent analysis
(2) evaluation of Management’s Discussion and
Analysis
Analyzing Revenues
Persistence of Revenues--Trend Percent Analysis
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:
Correlated
Compared to industry norms
Compared to competitors
Analyzing Revenues
Persistence 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
Analyzing Revenues
Persistence of Revenues--MD&A
Management’s Discussion and Analysis (MD&A) is often
useful in analysis of persistence in revenues
• Aids in understanding and evaluating period-to-period
changes
• 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 Revenues
Key Revenue Relations
Revenues and Accounts Receivable Relation
Bears on:
Earnings quality
Collectibility of receivables
Analyzing Revenues
Key Revenue Relations
Revenues and Inventories Relation
Bears on:
Future revenues
Analysis of operations
Analyzing Revenues
Revenues Recognition
Profitability analysis must adjust for different
revenue recognition methods in:
• Comparative analysis—both
cross-sectional
• Forecasting revenues
temporal
and
Chapter 6 discusses revenue recognition criteria
and measurement
Analyzing Costs of Revenues
Measuring 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
Analyzing Costs of Revenues
Measuring Gross Profit
Gross profits vary across industries depending on
factors such as:
•
Competition
•
Capital investment
•
Level of costs that must be
recovered 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 sales
Step 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
Item
Year Ended December 31
Year-to-Year Change
Year 1
Year 2
Increase
$ 687.5
245.3
$ 442.2
231.5
$
1. Sales ($ millions)
$
2.Cost of sales ($ millions)
3.Gross profit ($ millions) $
4.Units sold (in millions)
5.Sales price per unit
(1 ÷ 4)
$
6.Cost per unit (2 ÷ 4)
657.6
237.3
420.3
215.6
3.05
1.10
$
2.97
1.06
$
Decrease
29.9
8.0
21.9
15.9
$
0.08
0.04
Analyzing Costs of Revenues
Analyzing Gross Profit
Analysis Statement of Changes in Gross Profit
Year 2 versus Year 1
Analysis of Variation in Sales
1. Change in volume of products sold:
Change in volume (15.9)  Year 1 unit selling price ($3.05)
2..Change in selling price:
Change in selling price ($0.08)  Year 1 sales volume (215.6)
$
48.5
$
3. Combined change in sales volume (15.9) and unit price ($0.08)
Increase in net sales
$
17.2
31.3
1.3
30.0*
Analysis of Variation in Cost of Sales
1. Change in volume of products sold:
Change in volume (15.9)  Year 1 cost per unit ($1.10)
2. Change in cost per unit sold:
Change in cost per unit ($0.04)  Year 1 sales volume (215.6)
$
17.5
$
3. Combined change in volume (15.9) and cost per unit ($0.04)
Increse in cost of sales
Net variation in gross profit
* Differences are due to rounding.
$
$
8.6
8.9
0.6
8.3*
21.7*
Analyzing Costs of Revenues
Interpreting Changes in Gross Profit
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
Analyzing Costs of Revenues
Interpreting Changes in Gross Profit
• Identification of factors driving gross profit yields
• Improved business strategies
• Better assessment of future performance
Analyzing Expenses
Tools for Analysis of 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 analysis
Index number analysis of income statements expresses income and its components
in an index number related to a base period
Highlights relative changes across time
Changes 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
Analyzing Expenses
Selling 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
Analyzing Expenses
Depreciation Expense
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:
Depreciation expense
Depreciable assets
It is often useful to compute this ratio by asset categories
Analyzing Expenses
Maintenance and Repairs Expense
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
Analyzing Expenses
Maintenance and Repairs Expense
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
Analyzing Expenses
Amortization of Special Costs
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
Analyzing Expenses
Amortization of Special Costs
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
Analyzing Expenses
General and Administrative Expenses
Most are fixed—such as rent and salary
Tendency for increases, especially in
prosperous times
Analyzing Expenses
General and Administrative Expenses
Analysis of G&A should focus on:
•
Trend in these expenses
•
Percent of revenues they consume
Analyzing Expenses
Financing 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
Analyzing Expenses
Financing Expenses
Average effective interest rate:
Total interest incurred
Average interest-bearing indebtedness
Useful tool for:
• Analysis of the cost of borrowed money
• Credit standing
• Comparisons across years and companies
• Assessing sensitivity to interest rate changes
Analyzing Expenses
Income Tax 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
Analyzing Expenses
Income Tax Expenses
Effective Tax Rate (ETR)
Income tax expense
Income before income taxes
ETR (also called tax ratio) reflects
relation between the income tax
accrual and pre-tax income
Analyzing Expenses
Income Tax 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
Analyzing Expenses
Income Tax 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