Chapter 4: Profitability Analysis

Liquidity Analysis

Pay short- term liabilities

Profitability Analysis is for

Income generated

Solvency Analysis

long- term viability

Financial Ratio Analysis

Why do we complete financial statement analysis?

Ratio analysis is an integral part of the analysis of a company's financial statement.

Financial ratios help standardize companies' results, allowing for greater comparability across time (trend) and across companies and industries (peer).

Ratios must be consistently defined and calculated to allow for comparability.

A single ratio or a small set of ratios rarely allows one to make a definitive judgement about any specific asset of a company's financial health.

Assessment of a ratio should NOT be done in isolation - away from other ratios or without a solid understanding of accounting underlying the financial statements. Ratios are a performance measure ... not a goal!

Characteristics of Net Income

Net income (earnings) can be described in terms of the sufficiency, sustainability, and quality:

Earnings sufficiency

Earnings sustainability

Earnings quality

Earnings sufficiency

Earnings sufficiency describes the amount of income necessary to maintain and grow a business

Earnings sustainability

Earnings sustainability describes the income amounts that an entity can reproduce in the future - "bottom line earnings" Nonrecurring gains and losses

Earnings quality

Earnings quality consider both sufficiency and sustainability

Reports restructuring expenses

Reports restructuring expenses - which occurs when an organization significantly changes operations, usually as a result of a shift in business strategy

Reports the gain on the sale of equipment

Reports the gain on the sale of equipment - selling equipment at an amount in excess of its book value is not an activity performed as part of its core business

Reports losses from a discontinued operation

Reports losses from a discontinued operation - the elimination of a major business segment (i.e. product line). Reported on an net-of-tax basis

Extraordinary items

Extraordinary items - rare events that are both unusual in nature and infrequent in occurrence

Profitability Analysis - Net Income

For companies that consist of more than one segment, GAAP and IFRS both require measures of profitability be provided for each segment.

Financial statement users generally analyze net income as the bottom-line measure of performance. GAAP and IFRS require the inclusion of 'Comprehensive Income', which includes changes in equity of a business from non-owner sources (i.e. foreign exchanges losses, pension benefit adjustment ...). These items impact net income, but are not likely to persist.

Profitability Analysis - EPS

Earnings per share (EPS) is one of the most widely used measures of profitability.

EPS is the only financial ratio that U.S. GAAP and IFRS require firms to disclose on the face of the income statement; it is covered explicitly by the opinion of the independent auditor.

If a firm has a simple capital structure (no convertible bonds or convertible preferred stock and no options or warrants holders can use to acquire common stock) then EPS is calculated as:

Basic EPS= Net income to common Shareholders / weighted average number of common shares outstanding

Profitability Analysis - Diluted EPS

Firms that have complex capital structures have convertible securities and/or stock options or warrants outstanding. Diluted EPS is calculated, which reflects the dilution POTENTIAL of convertible securities, options, and warrants:

A convertible security is a security that can be converted into another security. Convertible securities may be convertible bonds or preferred stocks that pay regular interest and can be converted into shares of common stock

A stock option is a privilege, sold by one party to another, that gives the buyer the right, but not the obligation, to buy or sell a stock at an agreed- upon price within a certain period of time.

A stock warrant is a certificate is issued by a company and that gives the holder the right but not the obligation to buy an underlying security at a certain price, quantity and future time.

Profitability Analysis - EPS 2

Come financial analyst claim that EPS is not the best measure of a firm's profitability.

EPS does not consider the amount of assets or capital required to generate the achieved level of earnings.

Equal Profits (Net Income)

The number of shares of common stock in a firm's capital structure does not fully represent the amount of capital used by a firm.A stock split could double the amount of shares of common stock without raising additional capital

Profitability Analysis -Alternative Methods

Instead of focusing solely on net income, a firm might consider other types of analysis:

Common-Size (Vertical) Analysis

Percentage Change Analysis

Common-Size (Vertical) Analysis

Common-Size (Vertical) Analysis - the profitability of two firms can be compared by scaling net income and the individual income statement line items by a common denominator (total revenues for the income statement)

Percentage Change Analysis

this technique focuses on the change in individual line items through time. This is different than the relative horizontal common-size statement analysis (which was a ratio of new value/old value) ... this is a percentage change.

Profitability Analysis - Operating Performance

When comparing firms of different structures, it is often helpful to 'move up the income statement' and analyze different levels of profitability

gross margin= gross profit / sales revenue

operating profit= EBIT/sales revenue

profit margin = Net income/ sales revenue

Return on Investment - ROA

Return on Assets (ROA) is traditionally calculated as:

ROA = Net Income / Average Total Assets

However, ROA should measure a firm's success in using assets to generate earning independent of the financing of those assets. ROA should be unaffected by the capital structure of an entity - the proportion of debt versus equity financing and those cost of associated with each type of capital.

DEBT: To remove the effect of financing from the ROA equation, we need to examine net income before financing costs. However, interest is subtracted from operating income (EBIT), and impacts taxable income (EBT). The interest needs to be added back to Net Income on a tax-adjusted basis.

EQUITY: Because common and preferred dividends are not subtracted from net income, calculating ROA requires no adjustment for dividends.

Any noncontrolling interest in earnings is also added back to net income. Make adjustment to net income (gain/losses) that are not likely to persist

Return on Assets

ROA can be disaggregated in Profit margin (for ROA) x Total Asset Turnover:

=

The profit margin for ROA indicates the firm's ability to utilize its assets to generate earnings for a particular level of sales.

Asset turnover ratio indicates the firm's ability to generate sales from a particular level of investment in assets.

The Return on Assets (ROA), the product of the two ratios, indicates the firm's ability to use assets to generate profitability

Return on Equity

ROA should measure a firm's success in using assets to generate earning independent of the financing of those assets.

Return on Common Equity (ROCE) measures the return to common shareholders AFTER subtracting not only the operating expenses, but also subtracting the cost of financing debt and preferred stock. The ROCE incorporates the results of a firm's operating, investing, and financing decisions

The numerator requires no further adjustment for creditors' claims for interest expense ... do not adjust by after-tax interest expense

Adjustments are still made to net income for non-recurring items

The denominator is the average amount of total common shareholder's equity; the par value of preferred stock is subtracted

Profitability Ratios

Where ROA measures profitability before considering a firm's capital structure, Return on Common Equity (ROCE) measures the return to common shareholders.

ROE is the basic formulasubtracting preferred stock dividends calculates returns to common stock specificallyROCE

Net income to common shareholders-preferred stock div / average common shareholders' equity

After-Tax Cost of Capital

This calculation can demonstrate the cost and benefit of raising capital through debt financing.

Comparing this cost to the ROA can determine the return earned to shareholders by funding assets with debt.

Financial leverage is beneficial only if ROA exceeds the cost of non- common equity financing.

After - Tax cost of capital= (1- Statutory tax rate)*interest expense / average (assets-total equity)

What accounts comprise total assets?

Current assetscash, accounts receivable, and inventory Long-term assetsfixed assets

A change in total assets can be caused by a change in any (or all) of these accounts. We can decompose total assets and examine each of these accounts separately:

Accounts receivable turnover Inventory turnover Fixed asset turnover Cash turnover

Profitability Analysis - Accounts Receivable Turnover

The rate at which accounts receivable turn over indicate the average time until firms collect credit sales as cash

How can we determine credit sales (sales on account)?

Most sales transactions between businesses are on account

Except for retailers and restaurants that deal directly with consumers, the assumption that all sales are on account is usually reasonable.

IS THIS A SAFE ASSUMPTION FOR A COMPANY LIKE STARBUCKS?

Profitability Analysis - Inventory Turnover

The rate at which inventories turn over indicates the length of time needed to produce and sell inventories.

The interpretation of inventory turnover involves two opposing considerations:

A firm would like to sell as many goods as possible with a minimum of capital investment in inventoryinventory is subject to obsolescence or spoilagewould like to see a higher inventory turnover rate

A firm does not want to have so little inventory on hand that shortages result in missed sales opportunities

Can divided into 365 to calculate the Days Inventory Held ratio

Profitability Analysis - Fixed Asset Turnover

The fixed asset turnover ratio measures the relation between sales and the investment in property, plant and equipment.

An increasing fixed asset turnover ratio generally indicates greater efficiency in the use of existing assets to generate sales (lower turnover ratio suggests the opposite).

The fixed asset turnover is affected by acquisitions and divestitures of fixed assets

Firms invest in fixed assets in anticipation of higher production and sales in FUTURE periods ... may temporarily decrease turnover

Profitability Analysis - Cash Turnover

Although turnover ratios are more common for receivables, inventory, and fixed assets, the cash turnover ratio can be calculated to help measure the efficiency with which cash is managed.

Interpreting Financial Statement Ratio

ROA and ROCE differ across industries depending on the industry's economic characteristics.

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?