Chapter 4
Profitability
Analysis
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Overview of Profitability Analysis
 Evaluates whether managers are
effectively executing a firm’s strategy.
 Helps to develop an understanding of a
firm’s performance to enable forecasts of
future performance.
 Approaches to understanding firm’s net
income:
Overview of Profitability Analysis (Contd.)
 Alternative transformations of measured net
income:
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Earnings per share analysis
Common-size analysis
Percentage change analysis
Alternative definitions of profits
 Rate of Return Metrics:
 Return on total assets
 Return on common equity
Alternative Approaches to Analyzing Net
Income
Earnings Per Share
 One of the most frequently used measures of
profitability.
 The only financial ratio that GAAP requires firms
to disclose on the face of the income statement.
 Covered explicitly by the opinion of the
independent auditor.
 Types of EPS:
 Basic EPS (Simple Capital Structure)
 Diluted EPS (Complex Capital Structure)
Calculating EPS
Basic EPS (Simple Capital Structure)
 For the firms do not have:
 Outstanding convertible bonds or convertible
preferred stock that can be exchanged for shares of
common stock.
 Options or warrants that holders can use to acquire
common stock.
 Basic EPS is calculated as:
Net Income Preferred Stock Dividends
Weighted Average Number of
Common Shares Outstandin g
Calculating EPS (Contd.)
Diluted EPS (Complex Capital Structure)
 For the firms that have Convertible securities and/or
stock options or warrants outstanding.
 Presents two EPS amounts: Basic EPS & Diluted EPS
 Diluted EPS reflects the dilution potential of
convertible securities, options, and warrants.
 Diluted EPS is calculated as:
Net Income - Preferred Stock Dividends  Adjustmen ts for Dilutive Securities
W eighted Average
Weig hted Average Number
Number of Common  of Shares Issuable from
Shares Outstandin g
Dilutive Securities
Criticisms of EPS
 It does not consider the amount of assets or
capital required to generate a particular level of
earnings.
 Two firms with the same earnings and EPS are
not necessarily equally profitable.
 The number of shares of common stock
outstanding serves as a poor measure of the
amount of capital in use.
Despite the above criticisms of EPS as a measure of profitability, it
remains one of the focal points of announcements and is frequently
used valuing firms.
Common-Size Analysis
 Simple way of creating greater comparability
across firms and for same firm through time.
 Most frequently utilized in:
 Income statement: by expressing all line items scaled
by revenues.
 Balance sheet: by expressing all line items scaled by
total assets.
 Common scaling enables figures across firms
and across time to be more comparable.
Percentage Change Analysis
 Computes percentage changes in
individual line items.
 Can be compared across firms or across
time.
 Focus is not on the financial data
themselves, but on the changes in
individual line items through time.
Alternative Definitions Of Profits
 Analysts use measures of past profitability
to forecast the firm’s future profitability.
 These may include:
 Comprehensive Income
 Operating Income, EBIT, EBITDA, and Other
Profit Measures
 Segment Profitability
 Pro Forma, Adjusted, or Street Earning
Return On Assets
 Independent of firm’s financing decisions.
 Measures ongoing profitability.
 Unusual or nonrecurring items (such as
restructuring charges), may be removed,
net of tax.
 Return on Assets is calculated as:
Net Income  (1 - Tax Rate)(Inte rest Expense)  Minority Interest in Earnings
Average Total Assets
Disaggregating ROA
ROA can be further disaggregated into:
ROA  Profit Margin for ROA x Asse ts Turnover
Where :
Profit Margin 
Adjusted Net Income
Assets Turnover 
Sales
Sales
Average Total Assets
Realized ROA versus Expected ROA
 Realized ROA is derived from financial statement
data for a particular period and will not
necessarily correlate perfectly with expected
returns.
 Reasons for this may be:
 Faulty assumptions were used in deriving expected
ROAs.
 Changes in the environment.
 ROA is an incomplete measure of economic rates of
return.
Elements of risk - differences in ROAs
 Three elements of risk help in
understanding differences across firms
and changes over time in ROAs:
 Operating leverage: Refers to proportion of
fixed costs relative to variable costs.
 Cyclicality of Sales: Are sales sensitive to
economic conditions.
 Product Life Cycle: Relates to the stage and
length of firm’s product life.
Trade-Offs between Profit Margin and
Assets Turnover
 Important to examine the differences
between the relative mix of profit margin
and assets turnover.
 Differences in ROA due to relative mix of
profit margin and assets turnover can be
explained by:
 Microeconomic Theory
 Business Strategy
Microeconomic Theory
 Capacity Constraint
 Heavy fixed capacity costs and lengthy periods
required to add new capacity.
 There is an upper limit on the size of assets
turnover achievable.
 Only way to increase ROA is to increase profit
margin.
 The firms usually achieve the high profit
margin through some form of entry barrier.
Microeconomic Theory (Contd.)
 Competitive Constraint
 For firms whose products are commodity- like.
 Few entry barriers and intense competition.
 There is an upper limit on the achievable level
of profit margin for ROA.
 Only way to improve ROA is to achieve high
asset turnover.
 Firms achieve the high assets turnovers by
controlling costs with aggressively low prices
to gain market share.
Business Strategy
 Two generic alternative strategies for a
particular product are:
 Product differentiation strategy Differentiate a product to obtain market power over
revenues and, therefore, profit margins.
 Low-cost leadership strategy Enabling the firm to charge the lowest prices and to
achieve higher sales volumes.
Analyzing the Profit Margin for ROA
 Sales
 Individual expenses
 Cost of goods sold
 Selling, General, and Administrative Expenses
 Income taxes
 Profit margin
 Segment data: Permits the analyst to examine
ROA, profit margin, and assets turnover at an
additional level of depth.
Analyzing Total Assets Turnover
 Captures how efficiently assets are being utilized
to generate revenues.
 Provides insight into changes in the total assets
turnover by examining turnover ratios:
 Accounts receivable turnover- Indicates the average
time until firms collect accounts receivable in cash.
 Inventory turnover- Indicates the length of time needed
to produce, hold, and sell inventories.
 Fixed assets turnover- Measures the relation between
sales and the investment in property, plant, and
equipment.
Return on Common Equity
 Measures the return to common stock holders
after subtracting operating expenses and costs
of debt financing and preferred stock.
 It should adjust net income for nonrecurring
charges, as in ROA.
 Explicitly accounts for the cost of debt and
preferred stock financing.
 ROCE is calculated as:
Net Income – Preferred Stock Dividends
Average Common Stockholde rs’ Equity
Relating ROA to ROCE
 ROA measures operating performance
independent of financing.
 ROCE considers the cost of debt and
preferred stock financing.
Disaggregating ROCE
ROCE can be further disintegrated into:
ROCE =
Profit Margin for ROCE x Assets Turnover x Capital Structure Leverage
Average
Net Income to Common
Sales
Total Assets
x
x
Sales
Averag e
Average Common
Total Assets Shareholde rs’ Equity
 Leverage refers to use of debt to increase return to
common stockholders
 ROCE > ROA
 When ROA > Cost of debt and Preferred stock financing.
Interpreting Financial Statement Ratios
 Comparing with Earlier Periods
 Raise the following questions:
 Has the firm made a significant change in its product,
geographic, or customer mix?
 Has the firm made a major acquisition or divestiture?
 Has the firm changed its methods of accounting over
time?
 Are there any unusual or nonrecurring amounts that
impair a comparable analysis of financial results
across?
Interpreting Financial Statement Ratios
(Contd.)
 Comparing with Other Firms
 Consider the following:
 Definition of the industry
 Calculation of industry average
 Distribution of ratios around the mean
 Definition of financial statement ratios