Profitability: The Star Logo, and South-Western Are Trademarks Used Herein Under License

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.
Profitability Measures
• Exclude items of income not arising from

normal operations
– Discontinued operations
– Extraordinary items
Chapter 8, Slide #2
Copyright 2007 by Thomson South-Western, a part of The Thomson Corporation. All rights reserved.
Net Profit Margin
Net Income Before Minority Share of Earnings,

Equity Income, and Nonrecurring Items
Net Sales
• Also referred to as return on sales

• Reflects net income dollars generated by each
dollar of sales
• Potential distortion
– Net “other” income or loss
Chapter 8, Slide #3
Total Asset Turnover
Net Sales
Average Total Assets
• 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
Chapter 8, Slide #4
Return on Assets
Net Income Before Minority Share

of Earnings and Nonrecurring Items
Average Total 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
Chapter 8, Slide #5
Operating Income Margin
Operating Income
Net Sales
• Use operating income in the numerator
Chapter 8, Slide #6
Operating Asset Turnover
Net Sales
Average Operating Assets
• Measures the ability of operating assets to

generate sales dollars
Chapter 8, Slide #7
Return on Operating Assets
Operating Income
Average Operating Assets
• Measures the ability of operating assets to

generate operating income
Chapter 8, Slide #8
Sales to Fixed Assets
Net Sales
Average Net 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
Chapter 8, Slide #9
Return on Investment (ROI)
Net Income Before Minority Share of

Earnings and Nonrecurring Items
+ Interest Expense   1-Tax Rate  
Average Long-Term Liabilities + Equity 
• Measures the earnings on investment and

indicates how well the firm utilizes its asset
base
• Evaluates enterprise performance
Chapter 8, Slide #10

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

Return on Total Equity
Net Income Before Nonrecurring Items

- Dividends on Redeemable Preferred Stock
Average 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)

Return on Common Equity
Net Income Before Nonrecurring Items

- Preferred Dividends
Average Common Equity
• Measures the return to the common

stockholder
• Common equity:
Total stockholders’ equity
less preferred capital
less minority interest reported as equity

The Relationship Between Profitability
Ratios
Measures
Rate of return to
return on providers of Typical result
Assets All funds Lowest (includes all assets)
Investment Long-term funds Higher than ROA (relative small
amount of short-term funds)
Total equity Equity Higher than ROI (measures return only
to shareholders)
Common equity Common equity Highest
• Common shareholders absorb
greatest degree of risk
• Requires that return to preferred
shareholders exceed funds paid to
preferred shareholders
Gross Profit Margin
Gross Profit
Net Sales
Sales
Beginning Inventory
– Cost of Goods Sold + Purchases of Inventory
– Ending Inventory
= Gross Profit

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

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

Pro Forma Financial Information
• Non-GAAP-based financial information

• “What if” Financial Statements

Interim Reports
• Unaudited financial reports covering fiscal

periods of less than one year
• SEC requires quarterly information be filed on
Form 10-Q
• Produced quickly; rely on more estimates


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Chapter 8

COPYRIGHT ©2007 Thomson South-Western, a part of the Thomson Corporation. Thomson,

• Exclude items of income not arising from

Net Income Before Minority Share of Earnings,

• Also referred to as return on sales

• Measures the activity of the assets and the

Net Income Before Minority Share

• Measures the ability to utilize assets to create

• Use operating income in the numerator

• Measures the ability of operating assets to

• Measures the ability of operating assets to

• Measures the ability to make productive use of

Net Income Before Minority Share of

• Measures the earnings on investment and

Chapter 8, Slide #10

• Measures ability to reward investors and to

Chapter 8, Slide #11

Net Income Before Nonrecurring Items

• Measures the return to common and preferred

Chapter 8, Slide #12

Net Income Before Nonrecurring Items

• Measures the return to the common

Chapter 8, Slide #13

Chapter 8, Slide #15

Chapter 8, Slide #16

• Charged directly to retained earnings

Chapter 8, Slide #17

• Non-GAAP-based financial information

Chapter 8, Slide #18

• Unaudited financial reports covering fiscal

Chapter 8, Slide #19

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