TOPIC 3

Profitability Analysis

P rofitability is a firm’s ability to generate earnings over

a period of time with a given set of resources. It is analyzed by examining the
elements of revenues, the cost of sales, and operating and other expenses.
There are a number of ways an investor can look at return on his or her invest-
ment. Some returns involve the price of the stock as it trades in the securities
markets. Although there are actions a company can take to make its stock more
attractive to investors, return on market price depends on when each investor pur-
chases and sells the stock. Thus, the analyst of a company’s financial and operating
performance cannot make this calculation for the individual investor. An analyst,
can, however, examine how the investor’s contribution to the company performed
on a per-share basis. This can be done by measuring earnings per share and the
dividend yield.

READ the Learning Outcome Statements (LOS) for this topic as found in
Appendix B and then study the concepts and calculations presented here
to be sure you understan​​d the content you could be tested on in the
CMA exam.

This topic is the logical extension of the previous two topics. The analysis in
the previous two topics is at a more detailed level. For example, you might confirm
from a calculation of inventory turnover that there is a problem with more dollars
being lodged in inventory than is warranted by the current levels of sales. Therefore,
action should be taken before slow-moving inventory becomes obsolete inventory
or before code-dated items go past their expiration dates and have to be discarded
rather than being sold.
The analysis described in this topic might first alert you to a degradation in
return on investment (ROI). An analysis of the decomposition of ROI might lead
you to the conclusion that the firm’s assets are being underutilized, and you could
use various turnover ratios introduced in the previous topic to determine whether
the problem might be with investments in inventory or accounts receivable or fixed
assets. Thus, this chapter discusses analysis at a very high level.

51

LS-Part2-c03.indd 51 7/9/2019 11:52:39 AM

 52 CMAexcel Self-Study Part 2: Strategic Financial Management

Return on Investment
The principal objective of for-profit businesses is to invest funds into resources like
inventory and fixed assets so that the business might earn profits for its owners
to adequately compensate them for the risk they expose themselves to with their
investment. Thus, several of the measures to be discussed might be characterized
generically as a return on investment.
Recall from the previous topic, Financial Ratios, that the return on invest-
ments ratios in their various forms may be performed by analysts that sub-
stitute book value of certain assets for fair values (such as market values or
replacement cost). Specifically, analysts who use the modified investment basis
to calculate ROI or ROA believe that some components can skew the results.
These analysts remove elements from total assets or make determinations of
whether to use book value or market value for certain assets. On the exam, you
will be given book value or fair value to solve this equation. If given both, use
the book value.

Income of Business Unit

Return on Investment (ROI) =
Assets of Business Unit

Two very specific types of return on investment are described: return on assets
(ROA) and return on equity (ROE).
We approach these return metrics through a group of concepts referred to as the
DuPont model or DuPont analysis. It was conceived by managers in the DuPont
Corporation almost a century ago. That makes it one of the most enduring concepts
in the business world.

Return on Assets
Calculation of ROA in its simplest form, as shown next, uses net income and the
value of all assets.

Net Income
Return on Assets (ROA) =
Average Total Assets

The genius of the DuPont model is that the managers realized that management
must manage profitability and the investment in and utilization of assets. In other
words, ROA can be driven by increasing margins and/or increasing asset turnover
depending on the strategy of the company. Excellence in both of these areas should
result in an excellent ROA. Therefore, the DuPont managers deconstructed ROA
in this way:

LS-Part2-c03.indd 52 7/9/2019 11:52:40 AM

 Section A, Topic 3—Profitability Analysis 53

Net Income Net Income Sales

ROA = = ×
Average Total Assets Sales Average Total Assets

Profit margin or net profit margin is the term used to describe Net Income/
Sales. In its simplest terms it describes how many cents are left out of a dollar of
sales after all expenses have been covered.
Total asset turnover or asset turn is the term used to describe Sales/Average
Total Assets. It says how many dollars of sales can be generated from a dollar invested
in the assets a firm uses in its business. As discussed in Topic 2, when a ratio involves
one account that measures something over a period of time and another account that
measures something at a point in time, the latter account value should be represented
by the average of latter account’s values at the beginning and end of the period. This
is especially important for firms that are growing or shrinking rapidly. People taking
the CMA exam are expected to average beginning and ending values of such accounts.
Many analysts offer variations on the above definitions. Some advocate omit-
LOS
§2.A.3.a ting investments in assets that are not being used in the business. Some advocate
using original cost of plant, property, and equipment rather than book value. Some
may even advocate using replacement values.

Return on Equity and Return on Common Equity

Return on Equity (ROE) measures the return to shareholders. Its definition is:

Net Income
ROE =
Average Stockholders’ Equity

However, a special case occurs when a firm has preferred stock in its capital
structure. Two metrics are appropriate in this case. ROE (as defined in the previ-
ous key box) is still meaningful. It measures the book return to shareholders—both
preferred and common. The second metric is Return on Common Equity (ROCE).
It measures the book return to common shareholders. Its definition is:

(Net Income − Preferred Dividends)

ROCE =
(Average Equity − Average Preferred Equity)

“Preferred Equity” is the amount expected to be paid to preferred shareholders

in the event of the firm’s liquidation. It includes both the par value of outstanding
preferred shares and any premium to be paid in liquidation. Note that par value of
the preferred shares excludes any additional paid-in capital arising from preferred
stock issued at a price above par value.

LS-Part2-c03.indd 53 7/9/2019 11:52:41 AM

 54 CMAexcel Self-Study Part 2: Strategic Financial Management

ROCE may be meaningfully compared to both ROA and ROE. Use of preferred
stock in the capital structure is really a different form of leverage. If leverage is work-
ing as intended, then ROCE>ROA and ROCE>ROE.
The DuPont model expands the ROE equation as follows:

Net Income Average Assets

ROE = × = ROA × Financial Leverage Ratio
Average Assets Average Equity

Average Assets/Average Equity is the definition of the financial leverage ratio,

which is also frequently referred to as the equity multiplier.

Average Assets
Financial Leverage Ratio =
Average Equity

The CMA Exam Ratio Definitions document excludes the word “average” in both
numerator and denominator. We recommend that candidates use the information
provided in the exam question. If the exam data set permits using average figures
then use them.

Illustrations of DuPont Model for ROA and ROE

The hypothetical financial statements and ratios in Figure 2A-5 illustrate how
DuPont analysis might be used as a starting point for analyzing results and
­diagnosing possible problems. Note that the DuPont model may also be useful in
high-level planning. The year headings are explained in detail at the end of t­his
figure.
The base case in the illustration is Alpha Co. for Year 1. Assume that Alpha
is a retailing company, an industry with which many people are familiar. As you
can see from the balance sheet, Alpha chooses to leverage its capital structure;
this is evidenced by Notes Payable in the balance sheet and by Interest Expense in
the income statement. Also, the balance sheet for Year 0 and Year 1 are identical.
Assume that Alpha is not growing. Therefore, it can afford to pay out 100% of its
net income in dividends to its shareholders. DuPont analysis shows a profit mar-
gin of 4.5% and an asset turnover of 2.0, resulting in an ROA of 9%. These results
could be compared to other companies in the industry, and the comparisons may
be valid or they may not be. For example, some of the comparisons to a retailer
that chooses not to leverage its capital structure may be flawed. Or another retailer
that does not have its own credit program would not provide a good comparative.
Next, we can see that the equity multiplier has a value of 1.667, and the resulting
ROE is 15%.

LS-Part2-c03.indd 54 7/9/2019 11:52:41 AM

 Section A, Topic 3—Profitability Analysis 55

Figure 2A-5 DuPont Analysis—3 Companies Contrasted

Alpha Co. Beta Co. Gamma Co.
Yr. 0 Yr. 1 Yr. 2a Yr. 2b Yr. 0 Yr. 1 Yr. 0 Yr. 1
Cash $50 $50 $50 $50 $50 $50 $50 $50
A/R 200 200 200 240 200 200 200 200
Inventory 150 150 150 150 150 150 150 150
Net PP&E 100 100 100 100 100 100 100 100
Assets $500 $500 $500 $540 $500 $500 $500 $500

A/P $100 $100 $100 $100 $100 $100 $100 $100

Accr. Rent 100 100
N/P 100 100 100 110 75 75
Liabilities $200 $200 $200 $210 $100 $100 $275 $275
Comm. Stk. $100 $100 $100 $100 $200 $200 $100 $100
Ret. Earnings 200 200 200 230 200 200 125 125
Equity $300 $300 $300 $330 $400 $400 $225 $225
Total $500 $500 $500 $540 $500 $500 $500 $500

Sales $1,000.00 $1,000.00 $1,000.00 $1,000.00 $1,000.00

COGS 600.00 600.00 600.00 600.00 600.00
Gross Profit $400.00 $400.00 $400.00 $400.00 $400.00
SG&A 314.00 319.00 314.00 314.00 314.00
Operating Inc. $86.00 $81.00 $86.00 $86.00 $86.00
Interest Exp.   11.00   11.00   11.55 8.25
Inc. before Tax $75.00 $70.00 $74.45 $86.00 $77.75
Inc. Tax Expense 30.00 28.00 29.78 34.40   31.10
Net Income $45.00 $42.00 $44.67 $51.60 $46.65

Ratios
Profit Margin 4.50% 4.20% 4.47% 5.16% 4.67%
Asset Turnover 2.000 2.000 1.923 2.000 2.000
Return on Assets 9.00% 8.40% 8.59% 10.32% 9.33%
Equity Multiplier 1.667 1.667 1.651 1.250 2.222
Return on Equity 15.00% 14.00% 14.18% 12.90% 20.73%

Now let’s compare Year 2a to the first year’s results . In the second year, assume
LOS
§2.A.3.b the increase in operating expenses is to increase the number of salespeople on the
floor. This would be signaled immediately by the decrease in the profit margin from
4.5% to 4.2%.
Next, we’d be likely to compare the gross profit percentage and see that it had
not changed. That finding rules out a decrease in pricing power or increased costs
from suppliers that could not be passed along to customers.

LS-Part2-c03.indd 55 7/9/2019 11:52:42 AM

 56 CMAexcel Self-Study Part 2: Strategic Financial Management

The gross profit margin percentage is a measurement of gross profit (sales minus
LOS
§2.A.3.g cost of sales) as a percentage of sales:

Gross Profit = Sales − Cost of Sales

Gross Profit Margin = Gross Profit/Sales

Possible reasons for changes in the gross profit margin percentage include:
• Sales prices not changing at the same rate as unit costs
• Sales prices increasing/decreasing due to the intensity of competition
• Mix of products sold shifting to products with lower or higher margins
• Changes in inventory shrinkage (disappearance of inventory)
Next, the operating profit margin would be examined. The operating profit
LOS
§2.A.3.h margin is the ratio of operating profit (EBIT, as noted) to sales.

Operating Income
Operating Profit Margin Percentage =
Sales

In this case, the operating profit margin has declined from 8.6% to 8.1%;
additional vertical income statement analysis would show the change to be in the
­relationship of sales salaries to sales. And, of course, there is no evidence of any
increase in sales, which suggests that the strategy of trying to provide an improved
shopping experience for the customer has not produced the hoped-for increase in
sales. Any differences in the behavior of the operating profit margin percentage and
the net profit percentage would, of course, be due either to interest expense and/or
to income tax expense. In this case, the erosion of the profit margin is due entirely
to the change in the relationship between sales salaries and sales and the related
impact on income taxes. Also, there is no change in the equity multiplier, so the
decrease in ROE from 15% to 14% is completely attributable to the decreased profit
margin coming from the increase in sales salaries.

Net Income
Net Profit Margin Percentage =
Sales

Next, let’s look at Year 2b, and assume those were the results for the second year. In
this version of the second year, the profit margin remained nearly constant. However,
there was a decrease in the asset turnover. Using ratios such as days of sales outstand-
ing, inventory turnover, and fixed asset turnover, it’s easy to ascertain that the problem
is a significant increase in accounts receivable at year-end without a corresponding
increase in the level of sales. Almost all of the decrease in ROA from 9% to about 8.6%

LS-Part2-c03.indd 56 7/9/2019 11:52:42 AM

 Section A, Topic 3—Profitability Analysis 57

was attributable to a decrease in the collection of accounts receivable. Again, there was
hardly any change in the equity multiplier. Therefore, the decrease in ROE from 15%
to about 14.2% was the consequence of the receivables collection problem.
Now let’s do a comparison of Alpha’s first year in relation to that of competitor
Beta. At first blush, Beta may appear to be the better performer of the two com-
panies because it has the higher profit margin (almost 5.2% compared to 4.5% for
Alpha). However, comparing the gross profit margin percentages and the oper-
ating margin percentages shows the two companies to be operating identically.
The real difference is in how the two managements choose to finance their com-
panies. Alpha has used leverage, and Beta has not. Therefore, Alpha has interest
expense in its income statement and Beta does not. That is the real difference in
the profit margins of the two companies and in their ROAs. The asset turnovers
are identical. Beta, of course, must maintain additional equity in its balance sheet
to make up for the absence of borrowed money. However, when we direct our
attention to the ROEs, the tables are turned. Beta has the smaller equity multiplier
and the smaller ROE (12.9% versus 15%).
Both companies have been illustrated as having the same level of sales and
assets. If they were not the same, the ratio comparisons of companies of different
scale would be valid because the ratios make them comparable by removing the
effect of scale differences. The illustrations use companies of the same sales lev-
els simply to make it easier to immediately identify the source of the problem. It
should also be pointed out that the weighted average cost of capital (WACC) for
Alpha is likely lower than that for Beta. Prudent use of debt in the capital structure
usually reduces the cost of capital due to the tax deductibility of interest expense.
In some sense, you can think of it as the U.S. Government subsidizing a firm’s
borrowings. However, remember that the party that holds that debt is being taxed
on its interest income. The lower cost of capital makes it likely that Alpha does a
better job of creating shareholder value.
Finally, consider one other competitor of Alpha, Gamma Co. Gamma’s profit
margin is a tiny bit better than Alpha’s. With the same value of the asset turnover,
Gamma’s ROA is also a tiny bit better than Alpha’s. However, the real difference
comes from the equity multiplier (2.222 for Gamma versus 1.667 for Alpha). That
results in a 20.7% versus 15% ROE advantage for Gamma over Alpha. What accounts
for this large difference? There is an item called “Accrued Rent Payable” on Gamma’s
balance sheet that does not appear on Alpha’s. Gamma has negotiated lower front-
end rent payments and higher back-end rent payments to its landlords for stores
leased under operating leases. The ASC requires that uneven rental payments in an
operating lease should be recognized on a straight-line basis unless some other basis
is more appropriate. Gamma needs to accrue rental expense in excess of its lower
front-end rental payments in order to even out the payments on a straight-line basis.
When the lower payment provision expires and higher rents are required, the accrued
rent payable amounts will be released as an offset to the higher latter-year lease pay-
ments. This has exactly the same effect as accounts payable (A/P). Every dollar of
either A/P or accrued rent payable is a dollar of “free” financing; it will reduce the
amount of “expensive” financing the company would have to get from either credi-
tors or shareholders.

LS-Part2-c03.indd 57 7/9/2019 11:52:42 AM

 58 CMAexcel Self-Study Part 2: Strategic Financial Management

To summarize the discussion to this point, when Alpha uses DuPont analysis
to analyze its results over time, the analysis seems to work well. However, when a
firm uses DuPont analysis to make comparisons against other firms in the industry,
the analysis may not be as revealing and may even be misleading.

NOTE: The IMA’s CMA LOS and Ratio Definitions documents do not
directly address the information that follows. However we feel that
this information is important in understanding this variation in DuPont
analysis.

Is there a way to remedy some of the deficiencies of DuPont analysis? Yes!

One useful ratio to measure profitability is the NOPAT margin. NOPAT stands
for net operating profit after tax. It can be calculated most simply as Operating
Income (1 − Tax Rate). It calculates how much income would remain after
income taxes if the company were taxed on all its operating income. Next,
NOPAT should be divided by sales to turn it into a margin (%). By this measure,
all three companies—Alpha, Beta, and Gamma—would have the same mea-
sure of profitability in Year 1 at 5.16%. In other words, this measure of operat-
ing profitability is not affected by differences in how the companies choose to
finance themselves.
Another helpful ratio is called invested capital turnover. Invested capital
can be defined as either (assets less operating liabilities) or (stockholders’ equity
plus interest-bearing liabilities). The former is the net resources financed by
expensive sources of capital, and the latter is the sources of financing for those
resources. They must produce the same value, given that the balance sheet
must balance. If you divide average invested capital into sales, you have deter-
mined the value of the invested capital turnover. In the earlier illustrations,
Alpha and Beta had invested capital turnover values of 2.5; Gamma had a much
higher value of 3.33 due to its advantageous lease payment arrangements with
its landlords.
Finally, the product of the NOPAT margin and the invested capital turnover
is the return on invested capital (ROIC). This ratio has an important attribute.
If a firm’s ROIC is greater than the firm’s WACC, the firm should be creat-
ing shareholder value; conversely, a firm earning a ROIC that is lower than its
WACC is likely to be destroying shareholder value. (A quick calculation of ROIC
demonstrates that Gamma’s ROIC is significantly higher than Alpha’s or Beta’s
ROIC.) This one attribute could make the ROIC ratio the most important of
all; it is the primary responsibility of for-profit business organizations to create
shareholder value. Please note that the ROA does not have such a “standard” to
be compared to.

LS-Part2-c03.indd 58 7/9/2019 11:52:43 AM

 Section A, Topic 3—Profitability Analysis 59

LOS Sustainable Growth Rate

§2.A.3.j

Although some companies fail because of ever-declining revenues, companies also

fail by attempting to grow too fast. Many small businesses, in particular, go under
because they take on a contract with deadlines that cannot be met with their cur-
rent staff, equipment, capital, and expertise. The sustainable growth ratio (SGR)
indicates the maximum earnings growth a firm can achieve without resorting to
other means of financing.
The sustainable growth rate discussed in this section might be confused
with the sustainability movement that has evolved in recent years. In fact there
exists the Sustainability Accounting Standards Board that has issued a number of
sustainability standards that have already found their way into U.S. SEC disclosure
requirements. As you read the following information on sustainable growth rate,
remind yourself that this rate has little to do with the environmentally charged
sustainability movement.
The key to sustainable growth is to retain sufficient earnings to reinvest in
growth, rather than paying out too much of earnings as dividends.
A reason for believing the ROE is an important ratio is that a firm’s maximum
sustainable growth rate is a function of the firm’s ROE. The calculation is as follows:

Sustainable Growth Rate = (1 − Dividend Payout Ratio) × ROE

If the firm pays out dividends at a rate of 30% of earnings, for example, it retains
the other 70% (1 − 30% = 70%). The resulting increase in shareholders’ equity will
also earn a rate of return and can continue to generate growth in earnings. The
ability to take on debt grows as shareholders’ equity grows, allowing for more bor-
rowing without dangerous changes to the ratio of debt to total assets or debt to
equity. If a firm grows at a rate greater than its sustainable growth rate, it will need
additional capital from debt or equity. Unfortunately, not all firms can access the
money needed to survive in that situation.
To see why this is true, another illustration may be helpful. In this instance, we
have chosen not to use the average value of equity but the beginning-of-the-year
value for the sake of simplicity.
The firm in Figure 2A-6 earns about a 14% return on equity and pays out one-
third of its income as dividends, retaining two-thirds. This means the firm will
increase its stockholders’ equity by 10% year over year. It can “afford” to grow its
debt by 10% as well, because the ratio of total debt to equity will be 2:3 at the end of
year 1, just as it was at the beginning of year (end of year 0). This enables all assets

LS-Part2-c03.indd 59 7/9/2019 11:52:43 AM

 60 CMAexcel Self-Study Part 2: Strategic Financial Management

Figure 2A-6 Illustration of Sustainable Growth

Year 1 Year 2

Year 0 10% Incr. 13% Incr.

Cash $55.00 $60.50 $68.37
A/R 220.00 242.00 273.46
Inventory 165.00 181.50 205.10
Net PP&E 110.00   121.00 136.73
$550.00 $605.00 $683.65

A/P $110.00 $121.00 $136.73

N/P 110.00 121.00 136.73
Liabilities $220.00 $242.00 $273.46
Comm. Stock 100.00 100.00 100.00
Ret. Earnings 230.00 263.00 300.29
Equity $330.00 $363.00 $400.29
Total $550.00 $605.00 $673.75
Capital shortfall $9.90
Sales $1,100.00 $1,243.00
COGS 660.00 745.80
Gross Profit $440.00 $497.20
SG&A 345.40 390.30
Operating Inc. $94.60 $106.90
Interest Exp. 12.10 13.67
Inc. before Tax $82.50 $93.22
Inc. Tax Expense 33.00 37.29
Net Income $49.50 $55.93

Note: Some numbers are slightly off due to rounding.

(cash, accounts receivable, inventory, and fixed assets) to grow by 10% and assumes
that A/P, an operating liability or a spontaneous liability, also grows by 10%. This
can be confirmed by preparing a statement of retained earnings:

Beginning Retained Earnings $230.00

+ Net Income 49.50
− Dividends 16.50
Ending Retained Earnings $263.00

Now consider that the firm has market opportunities that would permit its
sales to grow by 13% in the next year and remain equally profitable. All of the asset

LS-Part2-c03.indd 60 7/9/2019 11:52:43 AM

 Section A, Topic 3—Profitability Analysis 61

accounts must grow by 13% to support the increased sales. A/P will also grow by
13%. Assume also that we allow notes payable to increase by 13%. Common stock
will not increase because the firm’s management does not want to issue new shares
of common stock. In fact, not issuing new shares is a part of the definition of the
sustainable growth rate. The retained earnings is calculated as follows:

Beginning Retained Earnings $263.00

+ Net Income 55.93
− Dividends   18.64
Ending Retained Earnings $300.29

This results in a capital shortfall of $9.90 in year 2, given all the above assump-
tions. How can the capital shortfall be solved? There are three methods:
1. Borrow additional money. Such borrowing would increase the principal
amount of the note payable, which in turn would increase interest expense.
However, the ratio of debt to equity would also increase; likely that could cause
an increase in the interest rate, which would be another reason for interest
expense to increase. The increase in interest expense needs to “feed back” into
the income statement, which would cause net income to fall and, in turn, cause
both the dividend to fall and the amount available for reinvestment to fall. This
would necessitate another round of changes to both the balance sheet and the
income statement.
2. Issue additional shares of common stock. However, many firms are reluctant
to do this, either because of the high costs of floating new common stock or
because their management fears that doing so sends a negative signal to the
capital markets.
3. Cut the dividend. This solution is very obvious from the formula for sustain-
able growth.

Try this simulation with other growth rates, and you’ll become convinced that
the product of ROE and the complement of the payout ratio (known as the reten-
tion ratio) is the highest rate at which sales can grow while:
1. Not changing the capital structure
2. Not issuing new common stock

Given that:
1. Profitability (as measured by the NOPAT margin) doesn’t improve
2. Asset intensity (as measured by the earlier mentioned invested capital turn-
over) doesn’t improve
Because firms that are creating shareholder value will want to grow as rapidly
as possible, ROE is a very important performance metric.

LS-Part2-c03.indd 61 7/9/2019 11:52:43 AM

 62 CMAexcel Self-Study Part 2: Strategic Financial Management

LOS Revenue Analysis

§2.A.3.d

Revenue is an indicator of resources generated by a business from its customers

through its operations. Fundamentally, a company exists to provide goods or services
to a customer and generate more resources than it expends in providing the good
or service. Lenders and owners provide capital to the business because they believe
in the business model that the firm would be able to provide some good/service to
customers at a price higher than what is required to provide that service in the long
run. Accountants must be careful to accurately recognize revenue as it is one of the
fundamental measures in the financial statement. Remember that revenue is used as
the base for common-sizing the income statement.
The FASB and IASB have already issued new revenue recognition standards
with effective dates of 2018. The new revenue recognition standards will be tested
beginning with the January 2019 exam.
While many revenue transactions are recognized at a point in time without
complications, the new revenue recognition standard imposes additional require-
ments on the timing and amount of revenue recognition. This is particularly impor-
tant for contracts with customers that transfer control of the good or service over
time. These requirements are examined on the current CMA exams.
The FASB created the new Accounting Standards Update (ASU) 2014-09,
Revenue from Contracts with Customers (Topic 606) that was issued on May 28,
2014. The core principle of the guidance is that an entity should recognize reve-
nue for the transfer of promised goods or services to customers in an amount that
reflects the consideration the entity expects to receive for the goods or services. To
achieve this, the entity applies the following steps:

1. Identify the contract(s) with a customer

2. Identify the performance obligations in the contract
3. Determine the transaction price
4. Allocate the transaction price to the performance obligations in the contract
5. Recognize revenue as the entity satisfies a performance obligation

Under current revenue recognition guidance enhanced by the US SEC, r­ evenue

should not be recognized until it is realized or realizable and earned. The two
­conditions (being realized or realizable and being earned) are usually met by the
time product or merchandise is delivered or services are rendered to customers, and
revenues from manufacturing and selling activities and gains and losses from sales
of other assets are commonly recognized at time of sale (usually meaning delivery.)
If services are rendered or rights to use assets extend continuously over time (for
example, interest or rent), reliable measures based on contractual transaction prices
established in advance are commonly available, and revenues may be recognized
as earned as time passes.
The following table summarizes the former criteria and the new criteria for
revenue recognition:

LS-Part2-c03.indd 62 7/9/2019 11:52:43 AM

 Section A, Topic 3—Profitability Analysis 63

Former Criteria & Terminology New Criteria & Terminology

Persuasive evidence of an arrangement exists Parties to the contract have an approved
contract
Delivery has occurred or services have been Entity can identify each party’s rights
rendered regarding the goods or services
Seller’s price to the buyer is fixed or Entity can identify the payment terms for the
determinable goods or services
Contract has commercial substance
Collectability is reasonably assured It is probable that the entity will collect the
consideration, based on the customer’s
ability and intention to pay the amount due

An analyst must evaluate carefully whether the timing of revenue recogni-

LOS
§2.A.3.f tion is appropriate, given the nature of the business. Early recognition of revenue
would lead to higher reported income and better profitability as well as liquidity
ratios. In order to ascertain whether revenue recognition policies are acceptable,
the analysis must consider how the company “earns” revenue—that is, what con-
stitutes the “earnings” process. The definition will vary across firms depending on
their business models.

Revenue Trends and Stability

Analysts, investors, and creditors all need to determine whether revenue represents
the stable trend of a growing business or an unusual or one-time event. Sales indexes
of various product lines can be correlated and compared to composite industry
figures or to product sales trends of specific competitors. Important considerations
bearing on the quality and stability of the sales and revenues trend include those
listed next.

• Elasticity of demand for products (how consumers respond to a change in the

price of a product)
• Ability of the business to anticipate demand trends by the introduction of new
products and services
• Level of competition
• Degree of customer concentration and dependence on a single industry or a
single customer, such as for government contractors
• Degree of dependence on relatively few leading sales associates
• Degree of geographical diversification of markets

LOS Interrelationships Among Revenue, Inventory, and Receivables

§2.A.3.e
Noncash revenue (sales) is recorded as accounts receivable. Thus, the implicit
assumption behind accounts receivable is that revenue must have been earned to
be recognized. If a company inappropriately recognizes revenue early, net income

LS-Part2-c03.indd 63 7/9/2019 11:52:43 AM

 64 CMAexcel Self-Study Part 2: Strategic Financial Management

is overstated and current assets on the balance sheet are overstated. Inappropriately
recognizing revenues after they are earned will understate net income and current
assets. Further, an increase in receivables without a corresponding increase in sales
may signal problems with collections from customers.
Because merchandising and manufacturing primarily earn revenue through
sales of merchandise, the increase in revenue should correspond to an increase
in inventory. However, an increase in inventory balance without a correspond-
ing increase in sales may signal problems with inventory management. Again, the
application of ratios, such as inventory turnover, may highlight potential problems.

LOS Income Measurement Analysis

§2.A.3.c

There is no absolute measure of “real earnings.” The income and expenses ­presented in
the income statement are subject to a variety of judgments and accounting methods.
The FASB holds that the entities should prepare general purpose financial
statements for external users. This requirement is necessary to keep the burden of
financial reporting costs approximately in line with costs of producing the infor-
mation those reports contain. Furthermore, financial accounting and reporting
contains considerable need for estimations. Of course, estimations can change.
Additionally companies in some circumstances may appropriately wish to change
between two or more acceptable accounting and reporting methods for a particular
type of transaction. Also the FASB from time to time issues new accounting and
reporting requirements to be integrated into the ASC (the new revenue standards,
for example). Where there is a change in accounting the usual method of presenting
the new information is via retrospective application net of income taxes. Finally,
financial reporting includes not only the four basic financial statements but myri-
ads of required disclosures that further explain accounting policies and complex
transactions. For all of these reasons, income measurement is complicated.
These factors need to be considered in measuring income:
1. Estimates
2. Accounting methods
3. Disclosure
4. Different needs of users

1. Estimates
The determination of income depends on estimates regarding future events and
their outcomes. For publicly traded companies, management makes the estimates,
which the auditors verify for reasonableness. The estimates and assumptions could
affect the measurement of income significantly. For example, the estimate of useful
life for depreciable assets affects the depreciation expense and thereby the reported
income. A generous estimate of longer useful life reduces depreciation expense,
thereby increasing income.

LS-Part2-c03.indd 64 7/9/2019 11:52:43 AM

 Section A, Topic 3—Profitability Analysis 65

2. Accounting Methods
It is important to understand and assess the implications that the use of one accounting
principle as opposed to another (such as straight-line versus accelerated depreciation)
has on the firm’s measurement of income as well as how it compares to other businesses.
The accounting methods are chosen at the discretion of management, and the auditor’s
role is to ensure that the method selected is one of the many generally accepted account-
ing methods and that its use has been consistent over years. Auditors are responsible
for understanding the effect of these methods on reported income and other financial
statement measures, including how they affect the computation of ratios.
For example, two commonly used methods of inventory valuation are first-in,
first-out (FIFO) and last-in, first-out (LIFO). For the same underlying economic event,
use of LIFO, under certain assumptions of increasing inventory units and prices,
yields lower income than the FIFO inventory valuation method. Thus, a firm using
LIFO would report lower income and lower inventory value than a similar firm using
FIFO inventory valuation method. Lower income and lower assets both affect the
computation of the return of asset ratio. An analyst is required to consider such effects
of accounting policy choices on various financial ratios. The CMA exam tests the abil-
ity to evaluate and deduce the effects of various accounting choices on common ratios.

3. Disclosure
The ASC includes requirements for specific disclosures. The SEC often adds
­disclosure requirements for issuers. In practice it is not unusual for companies,
­including issuers, to draft disclosures that only nominally meet the ASC
requirements. In other instances companies have been known to draft disclosures
that are so dense and detailed that readers of the financial statements may be unable
to determine exactly what has been said in the disclosure.
The degree of informative disclosure about the results of operations and the
asset base of segments of a business can vary widely. Full disclosure would call for
providing detailed income statements for each significant segment. This is rarely
found in practice because of the difficulty of obtaining such breakdowns internally
and management’s reluctance to divulge information that could harm the business’s
competitive position.
The more relevant information a company discloses, the better its position will
be understood, and as a result, the stock price will more correctly reflect its fair
value. However, because it is not always in the best interest of management to dis-
close information that might be used by competitors, the level of disclosure may be
tempered, even at the expense of undervaluation in the equity market.

4. Different Needs of Users

Users of financial statement analysis often have different needs. For example, the
investing public is interested in analysis of the financial position of the business

LS-Part2-c03.indd 65 7/9/2019 11:52:43 AM

 66 CMAexcel Self-Study Part 2: Strategic Financial Management

and its ability to earn future profits. Investors use an analysis of past trends and the
current position to project the future prospects of the business.
Creditors obtain limited return from extending credit and tend to judge con-
servatively. Creditors risk loss of capital loaned and so look for the firm’s ability to
repay both short- and long-term debt. Suppliers extend credit and must weigh their
risk of loss of income if not paid for merchandise. If, for example, a supplier sells a
product with a 10% markup, it would need to sell ten of the product items to make
up for the loss on one not paid for.
Management analyzes data from the viewpoints of both investors and credi-
tors. Management is concerned about the current position to meet obligations and
future earnings prospects. Union representatives analyze financial statements for
the firm’s ability to grant increases in wages and fringe benefits. Government is
interested in financial statements and the health of businesses for tax and regula-
tory purposes.

LS-Part2-c03.indd 66 7/9/2019 11:52:43 AM

 Section A, Topic 3—Profitability Analysis 67

Topic Questions:
Profitability Analysis

Directions: Answer each question in the space provided. Correct answers and
explanations follow these topic questions.
1. A corporation has a return on equity of 20%, a return on assets of 15%, and
a dividend payout ratio of 30%. The corporation’s sustainable equity growth
rate is:
◻ a. 50.0%.
◻ b. 14.0%.
◻ c. 6.0%.
◻ d. 4.5%.
2. A financial analyst has calculated gross profit margin and net profit margin for
a company. Economists are forecasting a reduction in the corporate income
tax rate. This would:
◻ a. increase the gross profit margin and increase the net profit margin.
◻ b. decrease the gross profit margin and increase the net profit margin.
◻ c. not change the gross profit margin and increase the net profit
margin.
◻ d. increase the gross profit margin and not change the net profit
margin.
3. Two companies have identical return on assets. Company X purchased most
of its assets many years ago when prices were relatively low. Company Y pur-
chased most of its assets in recent years when prices were relatively high.
Both companies have identical debt levels and record their assets at histori-
cal cost. The return on assets ratio is most likely:
◻ a. overstated for both companies.
◻ b. overstated for Company X.
◻ c. overstated for Company Y.
◻ d. accurate for both companies.

LS-Part2-c03.indd 67 7/9/2019 11:52:43 AM

 68 CMAexcel Self-Study Part 2: Strategic Financial Management

Topic Question Answers:

Profitability Analysis

1. A corporation has a return on equity of 20%, a return on assets of 15%, and

a dividend payout ratio of 30%. The corporation’s sustainable equity growth
rate is:
◻ a. 50.0%.
b. 14.0%.
◻ c. 6.0%.
◻ d. 4.5%.
A corporation’s sustainable equity growth rate represents the maximum rate that
a firm can grow using its own revenue. The sustainable equity growth rate is cal-
culated as return on equity × (1− dividend payout ratio); therefore, the sustainable
equity growth rate for the company in this example is 14.0% (20% × (1 − 30%)).
2. A financial analyst has calculated gross profit margin and net profit margin for
a company. Economists are forecasting a reduction in the corporate income
tax rate. This would:
◻ a. increase the gross profit margin and increase the net profit margin.
◻ b. decrease the gross profit margin and increase the net profit margin.
c. not change the gross profit margin and increase the net profit
margin.
◻ d. increase the gross profit margin and not change the net profit
margin.
A company’s gross profit margin is calculated as Gross Profit ÷ Sales. The com-
pany’s net profit margin is calculated as Net Income ÷ Sales. A reduction in the
corporate tax rate will not impact gross profit or sales, so this reduction will not
affect the gross profit margin. This reduction will increase the company’s net
income because the tax expense will be reduced; therefore, it will increase the
net profit margin.
3. Two companies have identical return on assets. Company X purchased most
of its assets many years ago when prices were relatively low. Company Y pur-
chased most of its assets in recent years when prices were relatively high.
Both companies have identical debt levels and record their assets at histori-
cal cost. The return on assets ratio is most likely:
◻ a. overstated for both companies.
b. overstated for Company X.
◻ c. overstated for Company Y.
◻ d. accurate for both companies.

LS-Part2-c03.indd 68 7/9/2019 11:52:43 AM

 Section A, Topic 3—Profitability Analysis 69

Company X’s assets likely have a much lower balance sheet valuation than do
Company Y’s assets. This valuation is likely not very accurate since the prices are
from a long time ago. Since assets are the denominator in the ROA calculation,
the lower valuation for X’s assets means its ROA is likely overstated.

LS-Part2-c03.indd 69 7/9/2019 11:52:43 AM

LS-Part2-c03.indd 70 7/9/2019 11:52:43 AM