Ch.8 Evaluating performance: profitability

What is analysing Accounting reports?

Examining financial reports in detail to identify changes or differences in performance.

What is interpreting Accounting reports?

Examining relationships between items in financial reports to explain the causes and effects of changes or differences in performance.

What are profitability, liquidity, efficiency and stability?

Profitability = ability to earn profit relative to a base; liquidity = ability to meet short-term debts as they fall due; efficiency = ability to manage assets and liabilities; stability = ability to meet debts and continue operations in the long term.

Why is profitability a relative measure rather than simply Net Profit?

Profit must be compared with a base such as Sales, assets or owner's equity because differences in business size, Sales or investment affect the amount of profit that can be earned.

What are the two basic factors determining profitability?

The ability to earn revenue and control expenses.

What tools can be used to assess profitability?

Trends, variances, benchmarks and profitability indicators.

What is horizontal analysis?

Comparing reports from one Period to the next and identifying increases or decreases in specific items, usually in both dollar and percentage terms. Percentage change = difference ÷ previous Period's figure × 100.

What benchmarks can be used to assess profitability?

Previous Periods, budgeted performance and similar businesses/industry averages.

What are the five main profitability-related indicators?

Return on Owner's Investment (ROI), Return on Assets (ROA), Asset Turnover (ATO), Net Profit Margin (NPM) and Gross Profit Margin (GPM).

What does Return on Owner's Investment (ROI) measure and how is it calculated?

It measures how effectively the business has used the owner's capital to earn profit. ROI = Net Profit ÷ Average Capital × 100.

How is Average Capital calculated and why is it used for ROI?

Average Capital = (Capital at start + Capital at end) ÷ 2. It is used because Net Profit is earned over a Period whereas Capital is measured at a point in time.

How can ROI increase even if Net Profit decreases?

If Average Capital decreases proportionately more than Net Profit, the business earns more profit per dollar of owner's capital, causing ROI to increase.

What does the Debt Ratio measure and how is it calculated?

It measures the percentage of assets financed by liabilities and therefore the firm's reliance on debt. Debt Ratio = Total Liabilities ÷ Total Assets × 100.

What is the relationship between Debt Ratio, risk and ROI?

A higher Debt Ratio can increase ROI because less owner's capital is used to finance assets, but it also increases risk because the business has greater debt and interest obligations.

What does Return on Assets (ROA) measure and how is it calculated?

It measures how effectively the business has used its assets to earn profit. ROA = Net Profit ÷ Average Total Assets × 100.

How should changes in ROA be interpreted?

ROA improves when Net Profit increases proportionately more than assets, indicating assets are being used more effectively to earn profit; it falls when assets increase proportionately more than Net Profit.

Why is ROI normally higher than ROA?

Owner's equity is normally lower than Total Assets because some assets are financed by liabilities. The size of the gap between ROI and ROA therefore depends on the Debt Ratio.

What does Asset Turnover (ATO) measure and how is it calculated?

It measures how productively the business uses its assets to generate Sales revenue. ATO = Net Sales ÷ Average Total Assets, expressed in times.

What can the relationship between ATO and ROA reveal?

ATO assesses the ability to use assets to earn revenue, while ROA assesses the ability to use assets to earn profit. If ATO improves but ROA worsens, expense control has deteriorated.

What is expense control?

The ability to manage expenses so they decrease or, for variable expenses, increase no faster than Sales revenue.

What does Net Profit Margin (NPM) measure and how is it calculated?

It measures the percentage of Net Sales retained as Net Profit and therefore overall expense control. NPM = Net Profit ÷ Net Sales × 100.

What is the relationship between ATO, NPM and ROA?

ROA = ATO × NPM. Therefore, profitability depends on both the ability to use assets to earn Sales revenue and the ability to control expenses and retain that revenue as Net Profit.

What does Gross Profit Margin (GPM) measure and how is it calculated?

It measures the percentage of Net Sales retained as Gross Profit and assesses the average mark-up and control of Cost of Goods Sold. GPM = Gross Profit ÷ Net Sales × 100.

What can cause GPM to increase?

A higher average mark-up caused by selling prices increasing relative to cost prices or cost prices decreasing relative to selling prices.

Why might increasing the mark-up not increase Gross Profit?

Higher selling prices may reduce sales volume, while using a cheaper supplier may reduce inventory quality and increase sales returns or inventory losses.

What is vertical analysis of the Income Statement?

Expressing each Income Statement item as a percentage of Net Sales, allowing the owner to assess how much of each Sales dollar is consumed by each expense and retained as profit.

Why should financial information not be used alone when assessing profitability?

It is historical, indicators may rely on averages that conceal details, different Accounting methods can reduce Comparability, and financial reports contain limited information. Relevant non-financial information should also be considered.

What non-financial information may be useful when assessing profitability?

Customer satisfaction and complaints, repeat sales and sales returns, employee performance and turnover, suitability of inventory, economic conditions, competitors and relevant social, environmental or seasonal factors.

What strategies can improve profitability?

Increase revenue by changing selling prices, improving advertising, inventory mix, location or customer service; control expenses through cheaper/better suppliers, improved inventory procedures, staff rostering/training and more efficient non-current assets.