Chapter 8 Profitability COPYRIGHT 2007 Thomson SouthWestern a

Chapter 8 Profitability COPYRIGHT © 2007 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Profitability Measures • Exclude items of income not arising from normal operations – Discontinued operations – Extraordinary items 2 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Net Profit Margin • Also referred to as return on sales • Reflects net income dollars generated by each dollar of sales • Potential distortion – Net “other” income or loss 3 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

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 4 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Return on Assets • Measures the ability to utilize assets to create profits • Average total assets – Internal analysis: month-end amounts – External analysis: beginning and ending amounts – If necessary, consistent use of end-of-year amounts 5 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Du. Pont Return on Assets 6 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Du. Pont Return on Assets (cont’d) • Du. Pont analysis separates return on assets into net profit margin and total asset turnover • Separating the ratio into the two elements allows evaluation of the causes for the change in return on assets 7 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Du. Pont 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 • Operating expenses • May give significantly different results • Reflective of ROA from primary business 8 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Operating Income Margin • Use operating income in the numerator 9 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Operating Asset Turnover • Measures the ability of operating assets to generate sales dollars 10 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Return on Operating Assets • Measures the ability of operating assets to generate operating income • Du. Pont analysis of the return on operating assets: 11 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Sales to Fixed Assets • Measures the ability to make productive use of property, plant, and equipment by generating sales dollars – Exclude construction in progress • Possible distortions – Old fixed assets – Labor-intensive industry 12 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Return on Investment (ROI) • Measures the earnings on investment and indicates how well the firm utilizes its asset base • Evaluates enterprise performance 13 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Return on Investment (ROI) (cont’d) • Measures ability to reward investors and to attract providers of future funds • Evaluates the earnings performance without regard to financing sources 14 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Return on Total Equity • Measures the return to common and preferred stockholders • Adjustments for redeemable preferred stock – Deduct dividends from net income (numerator) – Deduct stock value from total equity (denominator) 15 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Return on Common Equity • Measures the return to the common stockholder • Common equity: Total stockholders’ equity less preferred capital less minority interest reported as equity 16 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

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) Common equity Highest • Common shareholders absorb greatest degree of risk • Requires that return to preferred shareholders exceed funds paid to preferred shareholders 17 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Gross Profit Margin Sales – Cost of Goods Sold = Gross Profit Beginning Inventory + Purchases of Inventory – Ending Inventory 18 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Segment Reporting • Operating segments – Separate financial information is available – Evaluated by the chief decision making officer • Geographical information – Revenues earned – Asset concentration • Major customers • Products and services 19 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Gains and Losses from Prior Period Adjustments • Charged directly to retained earnings – Changes in accounting principles – Realization of net operating loss carryforward tax benefits from purchased subsidiaries – Changes in accounting entity – Correction of errors originating in prior periods 20 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Comprehensive Income • Items not included in net income • Reported as a separate component of stockholders’ 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 21 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Comprehensive Income (cont’d) • Traditional profitability analysis utilizes 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 22 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Pro Forma Financial Information • Non-GAAP-based financial information • 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 – Pro forma data is not misleading or untrue 23 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.

Interim Reports • Unaudited financial reports covering fiscal periods of less than one year – Interim reports are an integral part of the annual report – Quarterly information is disclosed in the annual report • SEC requires quarterly information be filed on Form 10 -Q • Produced quickly; rely on more estimates 24 Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.