Gibson 11e Ch08

Chapter 8
Profitability
COPYRIGHT 2009 South-Western, a part of Cengage Learning.

Profitability Measures
Exclude items of income not arising from

normal operations
Discontinued operations
Extraordinary items
Copyright 2009 by South-Western, a part of Cengage Learning. All rights reserved. Chapter 8, Slide #2
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
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
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
DuPont Return on Assets
Return on Assets = Net Profit Margin Total Asset Turnover
Net Income Before Net Income Before

Minority Share of Minority Share of
Earnings and Earnings and
Nonrecurring Items Nonrecurring Items Net Sales
=
Average Total Assets Net Sales Average Total Assets
DuPont Return on Assets (contd)
DuPont analysis separates return on assets

into net profit margin and total asset turnover
Return on Net Profit Total Asset
Assets = Margin Turnover
Firm A
Year 1 10% = 4.0% 2.5
Year 2 8% = 4.0% 2.0
FIRM B
Year 1 10% = 4.0% 2.5
Year 2 8% = 3.2% 2.5
Separating the ratio into the two elements

allows evaluation of the causes for the change
in return on assets
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
Operating Income Margin
Operating Income
Net Sales
Use operating income in the numerator
Operating Asset Turnover
Net Sales
Average Operating Assets
Measures the ability of operating assets to

generate sales dollars
Return on Operating Assets
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
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
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
Return on Investment (ROI) (contd)
Measures ability to reward investors and to

attract providers of future funds
Evaluates the earnings performance without
regard to financing sources
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)
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
The Relationship Between Profitability
Ratios
Measures
Rate of return to
return on 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
Gross Profit Margin
Gross Profit
Net Sales
Sales
Beginning Inventory
Cost of Goods Sold + Purchases of Inventory
Ending Inventory
= Gross Profit
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
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
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
Comprehensive Income (contd)
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
Pro Forma Financial Information
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
Interim Reports
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

Gibson 11e Ch08

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Chapter 8

COPYRIGHT 2009 South-Western, a part of Cengage Learning.

Exclude items of income not arising from

Net Income Before Minority Share of Earnings,

Also referred to as return on sales

Measures the activity of the assets and the

Net Income Before Minority Share

Measures the ability to utilize assets to create

Return on Assets = Net Profit Margin Total Asset Turnover

Net Income Before Net Income Before

DuPont analysis separates return on assets

Separating the ratio into the two elements

Consider only operating assets and income

Use operating income in the numerator

Measures the ability of operating assets to

Measures the ability of operating assets to

Measures the ability to make productive use of

Net Income Before Minority Share of

Measures the earnings on investment and

Measures ability to reward investors and to

Net Income Before Nonrecurring Items

Measures the return to common and preferred

Net Income Before Nonrecurring Items

Measures the return to the common

Charged directly to retained earnings

Items not included in net income

Traditional profitability analysis utilizes net

Non-GAAP-based financial information

Unaudited financial reports covering fiscal

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