Chapter 8
Profitability
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Profitability Measures
• 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 Profit Margin
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.
Total Asset Turnover
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.
Return on Assets
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.
Operating Income Margin
Operating Income
Net Sales
• Use operating income in the numerator
Chapter 8, Slide #6
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Operating Asset Turnover
Net Sales
Average Operating Assets
• Measures the ability of operating assets to
generate sales dollars
Chapter 8, Slide #7
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Return on Operating Assets
Operating Income
Average Operating Assets
• Measures the ability of operating assets to
generate operating income
Chapter 8, Slide #8
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Sales to Fixed Assets
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 #9
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Return on Investment (ROI)
Net Income Before Minority Share of
Earnings and Nonrecurring Items
+ Interest Expense   1-Tax Rate  
Average Long-Term Liabilities + Equity 
• Measures the earnings on investment and
indicates how well the firm utilizes its asset
base
• Evaluates enterprise performance
Chapter 8, Slide #10
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 8, Slide #11
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Return on Total Equity
Net Income Before Nonrecurring Items
- Dividends on Redeemable Preferred Stock
Average 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)
Chapter 8, Slide #12
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Return on Common Equity
Net Income Before Nonrecurring Items
- Preferred Dividends
Average Common Equity
• Measures the return to the common
stockholder
• Common equity:
Total stockholders’ equity
less preferred capital
less minority interest reported as equity
Chapter 8, Slide #13
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
The Relationship Between Profitability
Ratios
Rate of
return on
Measures
return to
providers of
Assets
All funds
Investment
Total equity
Typical result
Lowest (includes all assets)
Long-term funds Higher than ROA (relative small
amount of short-term funds)
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 #14
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Gross Profit Margin
Gross Profit
Net Sales
Sales
– Cost of Goods Sold
= Gross Profit
Beginning Inventory
+ Purchases of Inventory
– Ending Inventory
Chapter 8, Slide #15
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 8, Slide #16
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 8, Slide #17
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Pro Forma Financial Information
• Non-GAAP-based financial information
• “What if” Financial Statements
Chapter 8, Slide #18
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
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
Chapter 8, Slide #19
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.