Chapter 8:

Profitability
 Learning Outcomes:

At the end of this module, the students will be able to:

1. Identify what are the different profitability measures.
2. Understand what is segment reporting.
3. Define the Pro Forma Financial Information and
Interim Reports.

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 1.
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. Further,
increased profits can
cause a rise in market
price, leading to capital
gains.
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 Profitability Measures

✘ The income statement contains several figures that

might be used in profitability analysis. In general, the
primary financial analysis of profit ratios should
include only the types of income arising from the
normal operations of the business. This excludes the
following:
✗ Discontinued operations

✗ Extraordinary items

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 2.
Trend Analysis
  is a technique used in
technical analysis that
attempts to predict future
stock price movements
based on recently
observed trend data. Trend
analysis uses historical
data, such as price
movements and trade
volume, to forecast the
long-term direction of
market sentiment.
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 3.
Net Profit Margin
 A commonly used profit
measure is return on sales,
often termed net profit
margin. If a company
reports that it earned 6%
last year, this statistic
usually means that its
profit was 6% of sales
Net Profit Margin = Net Income Before Minority Share of Earnings, Equity Income and Nonrecurring Items
Net Sales

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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.

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 4.
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 Assets Turnover= Net Sales

Average Total Assets

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A picture is worth a thousand words

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 5.
Return on Asset
 measures the firm’s ability
to utilize its assets to
create profits by
comparing profits with the
assets that generate the
profits.
Return on Assets = Net Income Before Minority Share of Earnings and Nonrecurring Items
Average Total Assets

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However, even a simple average based on beginning and ending amounts requires two
figures. Ratios for two years require three years of balance sheet data. Since an annual
report only contains two balance sheets, obtaining the data for averages may be a
problem. If so, ending balance sheet figures may be used consistently instead of
averages for ratio analysis.

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 6.
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.
Net Income Before Net Income Before
Minority Share of Earnings Minority Share of
and Nonrecurring Items = Earnings and Nonrecurring Items × Net Sales
Average Total Assets Net Sales Average Total Assets

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INTERPRETATION THROUGH DUPONT ANALYSIS

The following examples help to illustrate the use of this analysis:

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VARIATION IN COMPUTATION OF DUPONT RATIOS
CONSIDERING ONLY OPERATING ACCOUNTS

It is often argued that only operating assets should be

considered in the return on asset calculation. Operating
assets exclude construction in progress, long-term
investments, intangibles, and the other assets category from
total assets. Similarly, operating income the profit generated
by manufacturing, merchandising, or service functions that
equals net sales less the cost of sales and operating expenses
should also be used instead of net income.

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 6.
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

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 7.
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

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 8.
Return on
Operating Assets
 RETURN ON OPERATING
ASSETS
 Return on operating assets
(ROOA) is an efficiency
financial ratio that calculates the
percentage return a company
earns from investing money in
assets used in its operating
activities. 
 A typical result of this
measurement is an ongoing
campaign to eliminate
unnecessary assets.

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Return on Operating Assets

Exhibit 8-9 shows the

return on operating
assets for Nike for
2007 and 2006. It
indicates a decrease
in the return on
operating assets from
2006 to 2007.

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DuPont Return on Operating Assets= Operating Income
Margin X Operating Asset Turnover

Exhibit 8-10 indicates the

DuPont return on operating
assets for Nike for 2007 and
2006. This figure supports
the conclusion that a
substantial decrease in
operating income margin and
a slight decrease in operating
asset turnover resulted in a
substantial decrease in return
on operating assets.

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 EXAMPLE: ROOA
Suppose A to Z Distributors has just wrapped up its first fiscal year with a new business segment.
Management wants to determine if the assets that were purchased for this new business venture were
profitable. To start, the management team decides to calculate the ROOA to help narrow it down.
Net income for the A to Z Distributors was $ 1,725,000. Total assets on the company’s balance
sheet were $ 10,000,000 of which $ 7,500,000 was classified as operating assets.

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 9.
Sales to Fixed
Assets
 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. Since construction in progress does not
contribute to current sales, it should be excluded from net
fixed assets.

✘ Is an asset utilization measure that allows analysts to

understand if a company requires a large investment in
property, plant, and equipment in order to generate
revenue.

✘ In some industries, a key barrier to entry is the large

amount of assets required to produce revenues. By using
the sales to fixed assets ratio, this is a particularly effective
measure when compared to the same ratio for other
companies in the same industry.
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Sales to Fixed Assets

Exhibit 8-11 shows the

sales to fixed assets for
Nike for 2007 and 2006.
It increased substantially
between 2006 and 2007.
Sales increases more
than kept up with net
fixed assets increases.

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 10.
Return on
Investment (ROI)
 RETURN ON INVESTMENT
(ROI)
✘ The return on investment (ROI)
applies to ratios measuring the
income earned on the invested
capital.
✘ Is a popular profitability metric
used to evaluate how well an
investment has performed.

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Return on Investment

Exhibit 8-12 shows the

return on investment for
Nike for 2007 and
2006. This ratio
decreased slightly
between 2006 and
2007.

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Return on Investment

Exhibit 8-12 shows the

return on investment for
Nike for 2007 and
2006. This ratio
decreased slightly
between 2006 and
2007.

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Other formula for Return on Investment

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 EXAMPLE: ROI

Pedro purchases a home for $ 250,000 in 2019. 5 years later, he sells it for
$325,000. What is Pedro’s return on investment?

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 EXAMPLE: ROI

Karen purchases 500 shares of stock at $ 20. The stock rises to $ 27 in 3 months. What is
Karen’s return on investment?

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 EXAMPLE: ROI
You purchase a Condo property in Alabang Muntinlupa City Philippines, Studio Unit 24 sqm
for Php. 1,600,000.
Assuming:
 Real Property Tax, Insurance, and others ( all expense applic.) = Php. 18,000.00 
 Monthly Rental Php. 15,000 x 12 months = Php. 180,000.00 

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 11.
Return on Total
Equity
 RETURN ON TOTAL EQUITY

✘ The return on total equity measures the return to both

common and preferred stockholders

✘ Expresses the percentage of net income relative to

stockholders’ equity, or the rate of return on the
money that equity investors have put into the
business.

✘ The higher the ROTE, the more efficient the company

is able to generate profits fro shareholders.

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Return on Total Equity

Exhibit 8-13 shows

the return on total
equity for Nike for
2007 and 2006. It
decreased
moderately from
23.34% to 22.41%.

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Other formula for Return on Total Equity

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 EXAMPLE:ROTE
Company A generated a net income of $300 M in the past 12 months. This
company has $ 800 M in shareholders equity. What is the ROE for this company?

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 EXAMPLE:ROTE

A company declares an annual return of 10 million pesos. Its book value is

declared 100 million pesos.

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 12.
RETURN ON
COMMON
EQUITY
 This ratio measures the
return to the common
stockholder, the residual
owner. Compute the
return on common equity
as follows:

Return on Common Equity = Net Income Before Nonrecurring Items − Preferred Dividends
Average Common Equity

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Exhibit 8-14 shows the return on common equity for Nike for 2007 and
2006. Nike’s return on common equity is the same as its return on total
equity.

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 13.
The Relationship
between
Profitability Ratio
 Another 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

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Exhibit 8-15 displays a comparison of profitability measures for Nike

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 14.
Gross Profit
Margin
 Gross profit margin is a
metric analysts use to assess
a company's financial health
 by calculating the amount of
money left over from product
sales after subtracting the 
cost of goods sold (COGS).

Gross Profit Margin = Gross Profit

Net Sales

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 Factors?

1. The cost of buying inventory has increased more rapidly than have
selling prices.
2. Selling prices have declined due to competition.
3. The mix of goods has changed to include more products with lower
margins.
4. Theft is occurring. If sales are not recorded, the cost of goods sold
figure in relation to the sales figure is very high. If inventory is being
stolen, the ending inventory will be low and the cost of goods sold will
be high.

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Exhibit 8-17 presents Nike’s gross profit margin, which decreased
between 2005 and 2006 and between 2006 and 2007.

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 15.
Trends in
Profitability
A profitability trend is the
evolution of profit within a
business. An upward trend
means that profit has
generally increased over
time in the short or long
run. A downward
profitability trend means
profits are declining.
Recognizing problems
early in profitability trends
gives you a better chance
to address revenue and
cost issues in play.
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Example:
Assume that a company that has net profits of $200 in the year
2010, $250 in 2011, $350 in 2012 and $450 in 2013. In this
example, the net profit of $200 in 2010 will be used as a
benchmark since it is the earliest year. Subtracting each year’s
net profit from the benchmark figure, dividing the difference
by the benchmark amount and multiplying the result by 100
will yield the following percentage changes: 25 percent (250 -
200 ÷ 200) increase in 2011, 75 percent (350 - 200 ÷ 200)
increase in 2012 and 125 percent (450 - 200) increase in 2013.

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Net Profit Trend= (Net Profit-Benchmark) x100
Benchmark
2011 2012

(250-200) (350-200) x100

x100
200 200

50 X100= 25% 150 X100= 75%

200 200
2013
(450-200) x100
200
250
X100= 125%
200

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 Trend Chart

Trend charts are graphical representations of data

arranged in a time sequence. It shows a trend line that displays
the general pattern of change. Using the chart to observe net
profit trends over a given period of time allows you to identify
favorable and unfavorable trend changes. To maintain
uniformity and accuracy of comparison, the net profit figures
used must have similar time periods, such as months to
months, quarters to quarters and years to years.

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 16.
Segment
Reporting
A public business enterprise
reports financial and
descriptive information about
reportable operating segments.
Operating segments are
segments about which separate
financial information is
available that is evaluated by
the chief operating decision
maker in deciding how to
allocate resources and in
assessing performance

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 17.
Comprehensive
Income
Chapter 4 explained that the categories
within accumulated other income are:
✘ (1) foreign currency translation
adjustments,
✘ (2) unrealized holding gains and
losses on available-for-sale
marketable securities,
✘ (3) changes to stockholders’
equity resulting from additional
minimum pension liability
adjustments, and
✘ (4) unrealized gains and losses
from derivative instruments.

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 18.
Pro Forma
Financial
Information
Pro forma financial
information is a hypothetical
or projected amount.
Synonymous with “what if”
analysis, pro forma data
indicate what would have
happened under specified
circumstances.

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 19.
Interim Reports
Interim reports are an
additional source of
information on
profitability. These are
reports that cover fiscal
periods of less than one
year.

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For interim financial reports, timeliness of data offsets lack of detail. Some data
included are:
1. Income statement amounts:
a. Sales or gross revenues
b. Provision for income taxes
c. Extraordinary items and tax effect
d. Cumulative effect of an accounting change
e. Net income

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2. Earnings per share
3. Seasonal information
4. Significant changes in income tax provision or estimate
5. Disposal of segments of business and unusual items material to the period
6. Contingent items
7. Changes in accounting principles or estimates
8. Significant changes in financial position

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