PROFITABILITY

chapter 8
 PROFITABILITY

• PROFITABILITY IS THE ABILITY OF THE

FIRM TO generate earnings.
• Analysis of profit is of vital concern to
stockholders since they derive revenue in
the form of dividends.
 PROFITABILITY MEASURES
• A commonly used profit measure is return on sales, often termed net profit
margin
• Net Profit Margin = Net Income Before Minority Share of Earnings,
Equity Income and Nonrecurring Items /Net Sales
• This ratio gives a measure of net income dollars generated by each
dollar of sales.
• While it is desirable for this ratio to be high, competitive forces
within an industry, economic conditions, use of debt financing, and
operating characteristics such as high fixed costs will cause the
net profit margin to vary between and within industries.
 Total Asset Turnover

• Total asset turnover measures the activity of the

assets and the ability of the firm to generate sales
through the use of the assets.
• Compute total asset turnover as follows:
• Total Asset Turnover = Net Sales / Average
Total Assets
 Return on Assets
• Return on assets measures the firm’s ability to utilize
its assets to create profits by comparing profits with
the assets that generate the profits.
• Compute the return on assets as follows:
• Return on Assets = Net Income Before Minority
Share of Earnings and Nonrecurring Items
/Average Total Assets
 DuPont Return on Assets
• The net profit margin, the total asset turnover, and the return on assets
are usually reviewed together because of the direct influence that the net
profit margin and the total asset turnover have on return on assets.
• The rate of return on assets can be broken down into two component
ratios: the net profit margin and the total asset turnover. These ratios
allow for improved analysis of changes in the return on assets percentage.
• Net Income Before Minority Share of Earnings and Nonrecurring Items
/Average Total Assets
• Net Income Before Minority Share of Earnings and Nonrecurring Items Net
Sales
= Net Sales × Average Total Assets
 Operating Income Margin

• The operating income margin includes

only operating income in the numerator.
Compute the operating income margin as
follows:
• Operating Income Margin = Operating
Income / Net Sales
 Operating Asset Turnover

• This ratio measures the ability of operating

assets to generate sales dollars.
• Compute operating asset turnover as follows:
• Operating Asset Turnover = Net Sales
/Average Operating Assets
 Return on Operating Assets

• Adjusting for non-operating items results in

the following formula for return on
operating assets:
• Return on Operating Assets =
Operating Income / Average Operating
Assets
 DuPont Analysis
• The return on operating assets can be viewed
in terms of the DuPont analysis that follows:
• Operating DuPont Return =
• Income on Operating Assets Margin ×
Operating Asset Turnover
 Sales to Fixed Assets

• This ratio measures the firm’s ability to

make productive use of its property, plant,
and equipment by generating sales dollars.
• Sales to Fixed Assets = Net Sales
/Average Net Fixed Assets (Exclude
Construction in Progress)
 Return on Investment (ROI)
• The return on investment applies to ratios measuring the income
earned on the invested capital.
• These types of measures are widely used to evaluate enterprise
performance. Since return on investment is a type of return on
capital, this ratio measures the ability of the firm to reward those
who provide long-term funds and to attract providers of future funds.
• Compute the return on investment as follows:
• Return on Investment = Net Income Before Minority Share of
Earnings and Nonrecurring Items + [(Interest Expense) × (1 −
Tax Rate)] / Average (Long-Term Liabilities + Equity)
 Return on Total Equity

• The return on total equity measures the

return to both common and preferred stock-
holders.
• Compute the return on total equity as
follows:
• Return on Total Equity = Net Income
Before Nonrecurring Items – Dividends
on Redeemable Preferred Stock /
 Return on Common Equity

• This ratio measures the return to the common

stockholder, the residual owner.
• Compute the return on common equity as
follows:
• Net Income Before Nonrecurring Items –
Preferred Dividends / Average Common Equity
 The Relationship Between
Profitability Ratios…1)

• Frequently used measure is a variation of the return on total assets. Compute this
return on total assets variation as follows:
• Return on Total Assets Variation = Net Income + Interest Expense
/Average Total Assets
• This ratio includes the return to all suppliers of funds, both long- and short-term,
by both creditors and investors. It differs from the return on assets ratio
previously discussed because it adds back the interest. It differs from the return
on investment in that it does not adjust interest for the income tax effect, it
includes short-term funds, and it uses the average investment. It will not be
discussed or utilized further here because it does not lend itself to DuPont
analysis.
 The Relationship Between
Profitability Ratios…2)
• Rates of return have been calculated on a variety of bases. The
interrelationship between these ratios is of importance in understanding
the return to the suppliers of funds.
• The return on assets measures the return to all providers of funds since
total assets equal total liabilities and equity. This ratio will usually be
the lowest since it includes all of the assets. The return on investment
measures the return to long-term suppliers of funds, and it is usually
higher than the return on assets because of the relatively low amount
paid for short-term funds. This is especially true of accounts payable.
 The Relationship Between
Profitability Ratios…3)
• The rate of return on total equity will usually be higher than the return
on investment because the rate of return on equity measures return only
to the stockholders. A profitable use of long-term sources of funds from
creditors provides a higher return to stockholders than the return on
investment. In other words, the profits made on long-term funds from
creditors were greater than the interest paid for the use of the funds.
• Common stockholders absorb the greatest degree of risk and, therefore,
usually earn the highest return. For the return on common equity to be
the highest, the return on funds obtained from preferred stockholders
must be more than the funds paid to the preferred stockholders.
 Gross Profit Margin

• Gross profit equals the difference between net sales revenue and the cost of goods
sold.
• The cost of goods sold is the beginning inventory plus purchases minus the ending
inventory. It is the cost of the product sold during the period.
• Changes in the cost of goods sold, which represents such a large expense for
merchandising and manufacturing firms, can have a substantial impact on the
profit for the period. Comparing gross profit to net sales is termed the gross profit
margin.
• Compute the gross profit margin as follows:
• Gross Profit Margin = Gross Profit / Net Sales