FSA Ch. 4: Profitability Analysis

Earnings Per Share

one of the most widely used measures of profitability.; require firms to disclose on the face of the income statement

Limitations:

Critics of EPS as a measure of profitability point out that 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 equally profitable if one firm requires twice the amount of assets or capital to generate those earnings compared to the other firm. Also, the number of shares of common stock outstanding serves as a poor measure of the amount of capital in use

• change in EPS is an ambiguous measure of the change in profitability over time because a change in shares outstanding over time can have a disproportionate effect on the numerator and denominator.

Common-Size Analysis

Common-size analysis converts financial statement line items into percentages of either total sales (for line items on the income statement) or total assets (for those on the balance sheet). Through the use of a common denominator, common-size analysis enables you to compare financial statements across firms and across time for the same firm.

ROA

ROA measures a firm’s success in using assets to generate earnings independent of the financing of those assets. This means that a properly calculated ROA will be unaffected by the proportion of debt versus equity financing and the costs of those types of capital. To ensure that financing does not affect the calculation

• independent of the way in which a firm finances its assets

• Can disaggregate into PM for ROA and totall assets turnover

PM for ROA

indicates the ability of a firm to utilize its assets to generate earnings for a particular level of sales

• indicates the firm’s ability to use sales to generate profits

• captures the overall profitability of a firm’s operations and is measured as the amount of after-tax profit generated (before financing costs) as a percentage of sales

To examine profit margin for ROA, we use common-size analysis, expressing individual income statement amounts as percentages of sales to identify reasons for changes in the profit margin for ROA

• Analyze…

  • COGS

  • Selling & Admin exp

  • Income Tax Exp

  • Segmented Data

Asset Turnover

indicates the firm’s ability to generate sales from a particular level of investment in assets. The assets turnover ratio indicates the firm’s ability to use assets to generate sales

• captures how efficiently the firm utilizes assets to generate revenues

• gain greater insight into changes in total assets turnover by examining turnover ratios for individual classes of assets:

  Accounts receivable turnover

  Inventory turnover

  Fixed assets turnover

ROCE

Return on common equity (ROCE), on the other hand, measures the return to common shareholders after subtracting from revenues not only operating expenses but also the costs of financing debt and preferred stock, and after subtracting income attributable to noncontrolling shareholders (if any). Costs of financing debt and preferred stock include interest expense on debt and lease obligations as well as required dividends on preferred stock (if any). Thus, ROCE is a more complete measure of firm performance because it incorporates the results of a firm’s operating, investing, and financing decisions

• Disaggregated components…

  • PM ROCE

  • Asset Turnover

  • Capital Structure Leverage

Financial Leverage

using lower-cost creditor and preferred stock capital to increase the return to common shareholders

• ROCE will exceed ROA whenever ROA exceeds the cost of capital provided by creditors, lessors and preferred shareholders. If common equity holders can rely on lower-cost financing by creditors, lessors, and preferred shareholders, and use that capital to invest in assets that generate higher rates of return, then they have leveraged such financing for assets that produce a return sufficiently high to pay interest and preferred stock dividends and yield an excess return, which then belongs to the common shareholders

Capital Structure Leverage Ratio

measures the degree to which a firm strategically utilizes financial leverage to finance assets

A/ R Turnover

average time until firms collect credit sales in cash. You calculate accounts receivable turnover by dividing net sales on account by average accounts receivable

• consider a firm’s credit strategy and policies when interpreting

Inventory Turnover

The length of time needed to produce and sell inventories

• dividing cost of goods sold by the average inventory during the period

• examining the changes in relation to changes in the cost of goods sold to sales percentage.

Fixed Asset Turnover

measures the relation between sales and the investment in property, plant, and equipment. Fixed assets turnover equals sales divided by average fixed assets (net of accumulated depreciation) during the year

• Increase = indicates greater efficiency in the use of existing fixed assets to generate sales