Profitability Analysis 9 CHAPTER Analyzing Profitability analysis is
Profitability Analysis 9 CHAPTER
Analyzing Profitability analysis is a key part of financial statement analysis ØEmphasis of profitability analysis is on the income statement ØRelationship between revenues and expenses ØExtent to which a business generates a profit from the use of labor, management and capital ØFocus on level of profits in relation to the amount of investment
Focus of Profitability Analysis Profitability analysis helps address questions such as: What is a company’s relevant income measure? What is the quality of income? What income components are important forecasting?
Analyzing Profitability Income is defined as revenues less expenses over a reporting period This definition does not yield a unique amount because of: v Estimates of future events v. Prediction of the future usefulness of many assets v. Allocations of revenues and expenses across periods v Accounting Methods v Depreciation mehods v Incentives for Disclosure: v Directors and mangers expect results v Shareholders concentrate on the bottom line v “Acceptable” methods, not necessarily “appropriate” methods v Diversity across Users
Capitol Tour Bus (Bought Bus for $ 50000) Income Statement ( Two methods of depreciation) Y 1 Y 2 Y 3 Y 4 Net income before 30000 Depreciation and Repair 1. Straight Line Method of Depreciation ( Rate 20%) Depreciation 10000 Repair 0 2500 5000 7500 Net income 20000 17500 15000 12500 2. Double Decline Method of Depreciation Rate 30% 25% Depreciation 15000 12500 Repair 0 2500 Net income 15000 20% 10000 5000 15% 7500 15000 Y 5 30000 10000 10% 5000 10000 15000 Which method of depreciation is better and Why?
Analyzing Revenues Analysis of revenues (sales) helps address questions such as: What are the major sources of revenue? How persistent are revenue sources? When is revenue recorded? ØHow is revenue measured? Knowledge of major sources of revenues is important to profitability analysis Ø Each market and product line often has its own growth pattern, profitability, and future potential Ø Analysis of sales growth Ø Analysis of profitability Ø Persistence (stability and trend) of revenues
Analyzing Revenues Revenue Sources Earnings Contribution and Growth Rates by Segments Earnings Contributions ($ thousands) Leisure goods: Camping equipment $ Fishing equipment Boats and accessories Sporting goods $ Clothing apparel: Dress $ Casual Sports $ Education: Textbook publishing $ Papers and supplies $ Total $ Growth Rate of Contribution for Past Three Years 100 50 72 12 234 11% 2 15 3 85 72 12 169 2 8 15 40 17 57 460 3 6
Analyzing Revenues Revenue Sources Segmented Earnings Contribution Matrix Growth Rate (in percent) Segment 0– 5 Total Leisure goods $ 62 Clothing apparel 85 Education 40 Total $187 5– 1010– 15 $ 0 72 17 $ 89 $ 172 12 0 $ 184 $ 234 169 57 $ 460
Lucky Super Market Earnings Contribution and Growth Rates by Segments Earnings Contributions for Past Three Years (in $ 000) Growth Rate of Earning Cosmetics & Toiletries 120 20% Bakery & milk products 80 5% Baby Food 150 15% Fruits, Vege & Meat 70 7% Home products 200 12% Apparel 170 5% Total 790 q. Is it easy to collect such information? How? q. If you are manager of lucky Super market, q. Will you show this segment information in the Annual Report? Why
Revenue Sources Full disclosure by segments is rare because of: • Difficulties in separating segments • Management’s reluctance to release information that can harm its competitive position Reporting requirements exist for: • Industry segments • International activities • Export sales • Major customers
Analyzing Revenues: Other related measures q Correlations of revenues across periods: Relationship between revenue and time q Assess sensitivity of revenues to business conditions q If Price decreases, what will happen to Revenue? q Customer analysis— q Are our customer concentrated in few industry? q Are we dependent on few customer? q. Cambodian Garment Factory export main Customer q Is revenue from cutomers stable? q. Lucky Super Market main customer q Revenues’ reliance on sales staff q. Sales Person A 15% Sales Person B 25% q. Sales Person C 40% Sales Person D 20%
Analyzing Costs of Revenues Measuring Gross Profit Gross profit, or gross margin, is measured as revenues less cost of sales All other costs must be recovered from gross profit Any income earned is the balance remaining after these costs Gross profit must finance essential future‑directed discretionary expenditures
Measuring Gross Profit Gross profits vary across industries depending on factors such as: Industries Gross Profit Example Margin High Competition Low Cold Drink, Toiletries and cosmetics High Capital investment (Machine Intensive) High Car, Electricity, Oil, More Fixed Cost High Tele communication, University More Variable Cost Low Retail Business Analysis of gross profit directs attention at the factors explaining variations in: • Sales • Costs of sales
Analyzing Costs of Revenues Analyzing Gross Profit Analysis Statement of Changes in Gross Profit—Illustration Item Year Ended December 31 Year 2 1. Sales ($ millions) $ 2. Cost of sales ($ millions) 3. Gross profit ($ millions) $ 4. Units sold (in millions) 5. Sales price per unit (1 ÷ 4) $ 0. 08 6. Cost per unit (2 ÷ 4) 0. 04 657. 6 237. 3 420. 3 215. 6 3. 05 1. 10 $ 687. 5 245. 3 $ 442. 2 231. 5 $ Year-to-Year Change Increase Decrease $ $ 29. 9 8. 0 21. 9 15. 9 2. 97 1. 06 Calculate Gross Profit Margin Ratio. $
Interpreting Changes in Gross Profit Changes in gross profit are often driven by one or more of the following factors: Factors Total Gross Profit Increase in sales volume Increase Decrease in sales volume Decrease Increase in unit selling price Elastic Demand Inelastic Demand Decrease Increase Decrease in unit selling price Elastic Demand Inelastic Demand Increase Decrease Increase in cost per unit Decrease in cost per unit Increase By Identification of factors driving gross profit, Business can • Improved business strategies • Better assessment of future performance
Analyzing Expenses Tools for Analysis of Expenses Common-size analysis § Common‑size income statements express expenses in terms of their percent relation with revenues § Traced over several periods or compared with competitors Operating ratio analysis § Operating ratio measures the relation between operating expenses (or its components) and revenues § Equals cost of goods sold plus other operating expenses divided by net revenues § Interest and taxes are normally excluded from this measure due to its focus on operating efficiency (expense control) and not financing and tax management § Useful for analysis of expenses within and across companies
Analyzing Expenses Selling Expenses Analysis of selling expenses focuses on three areas: Evaluating the relation between key selling expenses and revenues Assessing bad debts expense Evaluating the trend and productivity of future‑directed marketing expenses
Analyzing Expenses Maintenance and Repairs Expense Relation of sales to maintenance and repairs expense, both across companies and time, must be interpreted with care • Bear on productivity and earnings quality assessments • Impacts asset valuations Analysis and interpretation using this ratio • Is enhanced if we can distinguish between variable and fixed portions of these expenses • Must recognize the discretionary nature of these expenses
Analyzing Expenses General and Administrative Expenses Analysis of G&A should focus on: • Trend in these expenses • Percent of revenues they consume • Most are fixed—such as rent and salary • Tendency for increases, especially in prosperous times
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