Financial Statement

Analysis
CHARLES H. GIBSON

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Chapter
8

Profitability

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use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.

Profitability Measures
The primary financial analysis of profit ratios
should include only those items of income
arising from normal operations
Excludes
Discontinued operations
Extraordinary items

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Net Profit Margin

Also referred to as return on sales
Reflects net income dollars generated by each
dollar of sales
Potential distortion can be caused by other
income and other expense items from net
income, as these do not relate to net sales
Net Income Before Noncontrolling Interest,
Net Profit Margin =

Equity Income, and Nonrecurring Items

Net Sales

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Total Asset Turnover

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
Total Asset Turnover =

Net Sales
Average Total Assets

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Return on Assets
Measures the ability to utilize assets to create
profits
Average total assets
For internal analysis use month-end amounts
For external analysis use beginning and ending
amounts
If necessary, consistent use of end-of-year amounts,
instead of averages
Net Income Before Noncontrolling
Return on Assets =

Interest and Nonrecurring Items

Average Total Assets

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product or service or otherwise on a password-protected website for classroom use.

DuPont Return on Assets

DuPont analysis separates return on assets into
net profit margin and total asset turnover
Separating the ratio into the two elements allows
for improved analysis of the causes for the
change in the percentage of return on assets
Return on Assets = Net Profit Margin Total Asset Turnover

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DuPont Return on AssetsContinued

Net Income Before

Net Income Before

Noncontrolling Interest

Noncontrolling Interest

and Nonrecurring Items

and Nonrecurring Items

Average Total Assets

Net sales

Net Sales
Average Total Assets

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product or service or otherwise on a password-protected website for classroom use.

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 less the cost of sales
Operating expenses

May give significantly different results

Reflective of ROA from primary business
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Operating Income Margin

Includes only operating income in the numerator

Operating Income Margin =

Operating Income
Net Sales

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Operating Asset Turnover

Measures the ability of operating assets to
generate sales dollars

Operating Asset Turnover =

Net Sales
Average Operating Assets

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Return on Operating Assets

Measures the ability of operating assets to
generate operating income
Operating Income
Return on Operating assets =
Average Operating Assets

DuPont analysis of the return on operating

assets:

DuPont Return Operating

Operating

= Income

On
Asset

Margin Turnover

Operating Assets

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product or service or otherwise on a password-protected website for classroom use.

Sales to Fixed Assets

Measures the ability to make productive use of
property, plant, and equipment by generating
sales dollars
Exclude construction in progress from net fixed assets

Possible distortions
Old fixed assets
Labor-intensive industry
Sales to Fixed Assets =

Net Sales
Average Net Fixed Assets
(Exclude Construction in Progress)

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Return on Investment (ROI)

Measures income earned on invested capital
and how well the firm utilizes its asset base
Evaluates enterprise performance without regard
to financing sources
Net Income Before Noncontrolling
Interest and Nonrecurring Items +
[(Interest Expense) (1 Tax Rate)]
Return on Investment =
Average (Long-Term Liabilities + Equity)

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Return on Total Equity

Measures the return to common and preferred
stockholders
Net Income Before Nonrecurring Items
Return on Equity =

Dividends on Redeemable Preferred Stock

Average Total Equity

Adjustments for redeemable preferred stock

Deduct dividends from net income (numerator)
Deduct stock value from total equity (denominator)

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Return on Common Equity

Measures the return to the common stockholder
Net income Before Nonrecurring
Return on Common Equity =

Items Preferred Dividends

Average Common Equity

Common equity = Total Stockholders Equity

Preferred Capital

Noncontrolling Interest

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Return on Total Asset Variation

Includes the return to all suppliers of funds, both
long- and short-term, by both creditors and
investors
Net Income + Interest Expense
Return on Total Asset Variation =
Average Total Assets

Differs from the return on assets ratio and return

on investment
It does not lend itself to DuPont Analysis

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The Relationship Between Profitability

Ratios
Rate of
return on

Measures
return to
providers of

Assets

All funds

Investment
Total equity

Typical result
Lowest (includes all assets)

Long-term funds Higher than ROA (relative small

amount of short-term funds)
Equity

Higher than ROI (measures return

only to shareholders)

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The Relationship Between Profitability

RatiosContinued
Rate of
return on
Common
equity

Measures
return to
providers of
Common equity

Typical result
Highest
Common shareholders absorb
greatest degree of risk
Requires that return to preferred
shareholders exceed funds paid to
preferred shareholders

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Gross Profit Margin

Comparing gross profit with net sales is termed
the gross profit margin
Net Sales Revenue
Cost of Goods Sold
= Gross Profit
Gross Profit Margin =

Beginning Inventory
+ Purchases of Inventory
Ending Inventory

Gross Profit
Net Sales

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Gross Profit Margin Analysis

Analysis helps the following ways:
Managers budget gross profit levels into their
predictions of profitability
Used in cost control
Estimate inventory levels for interim financial
statements and insured losses in merchandising
industries
Used by auditor and Internal Revenue Service to
judge accuracy of accounting systems

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Segment Reporting
Operating segments
Separate financial information is available
Evaluated by the chief operating decision maker
Requires information about
Countries in which the firm earns revenues and holds assets
Major customers

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Segment ReportingContinued
Disclosures
The way the operating segments are determined
Products and services by the operating segments
Differences between the measurements used in
reporting segment and firms general-purpose
financial information

Profitability trends can also be shown as

revenues by major product lines

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Gains and Losses from Prior Period

Adjustments
Charged directly to retained earnings
Changes in accounting principles
Realization of income tax benefits of preacquisition
operating loss carryforwards of purchased
subsidiaries
Changes in accounting entity
Correction of errors in prior periods

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Comprehensive Income
Items not included in net income
Reported as a separate component of
shareholders equity
Foreign currency translation adjustments
Unrealized holding gains and losses from availablefor-sale marketable securities
Changes to stockholders equity resulting from
additional minimum pension liability adjustments
Unrealized gains and losses from derivative
instruments
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Comprehensive IncomeContinued
Traditional profitability analysis includes items
related to 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

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Pro-Forma Financial Information

It is a hypothetical or projected amount
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

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Interim Reports
Unaudited financial reports covering fiscal
periods of less than one year
SEC requires limited financial data be provided on
Form 10-Q
Certain quarterly information is disclosed in notes to
the annual report
Interim reports are an integral part of the annual
report

Less reliable than annual reports as contain

more estimates
2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain
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