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May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or
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 Chapter
8

Profitability

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use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for
classroom use.
Profitability Measures
• The primary financial analysis of profit ratios
should include only those items of income
arising from normal operations
• Excludes
– Discontinued operations
– Extraordinary items

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Net Profit Margin
• Also referred to as return on sales
• Reflects net income dollars generated by each
dollar of sales
• Potential distortion can be caused by “other
income” and “other expense” items from net
income, as these do not relate to net sales

¿ Net Income ( Before Noncontrolling Interest ,

Net Profit Margin = ¿Equity Income, and Nonrecurring Items ¿
Net Sales
¿

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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

Net Sales
Total Asset Turnover =
Average Total Assets

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product or service or otherwise on a password-protected website for classroom use.
Return on Assets
• Measures the ability to utilize assets to create
profits

¿Net Income (Before Noncontrolling

Return on Assets = ¿Interest and Nonrecurring Items ¿
Average Total Assets
¿

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DuPont Return on Assets
• DuPont analysis separates return on assets into
net profit margin and total asset turnover
• Separating the ratio into the two elements allows
for improved analysis of the causes for the
change in the percentage of return on assets
Return on Assets = Net Profit Margin  Total Asset Turnover

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DuPont Return on Assets—Continued

Net Income Before Net Income Before

Noncontrolling Interest Noncontrolling Interest
and Nonrecurring Items and Nonrecurring Items Net Sales
= ×
Average Total Assets Net sales Average Total Assets

Return on Net Profit Total Asset

Assets = Margin × Turnover
Firm A
Year 1 10% = 4.0% × 2.5
Year 2 8% = 4.0% × 2.0

Firm B
Year 1 10% = 4.0% × 2.5
Year 2 8% = 3.2% × 2.5

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DuPont 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 less the cost of sales
• Operating expenses
• May give significantly different results
• Reflective of ROA from primary business
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Operating Income Margin
• Includes only operating income in the numerator

Operating Income
Operating Income Margin =
Net Sales

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Operating Asset Turnover
• Measures the ability of operating assets to
generate sales dollars

Net Sales
Operating Asset Turnover =
Average Operating Assets

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product or service or otherwise on a password-protected website for classroom use.
Return on Operating Assets
• Measures the ability of operating assets to
generate operating income
Operating Income
Return on Operating assets =
Average Operating Assets

• DuPont analysis of the return on operating

assets:
 DuPont Return   Operating   Operating 
 On  =  Income  ×  Asset 
     
 Operating Assets   Margin   Turnover 
     

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Sales to Fixed Assets
• Measures the ability to make productive use of
property, plant, and equipment by generating
sales dollars
– Exclude construction in progress from net fixed assets

Net Sales
Sales to Fixed Assets =
Average Net Fixed Assets
(Exclude Construction in Progress)

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Return on Investment (ROI)
• Measures income earned on invested capital
and how well the firm utilizes its asset base
• Evaluates enterprise performance without regard
to financing sources

Net Income Before Noncontrolling

Interest and Nonrecurring Items +
[(Interest Expense) × (1  Tax Rate)]
Return on Investment =
Average (Long-Term Liabilities + Equity)

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Return on Total Equity
• Measures the return to common and preferred
stockholders
Net Income Before Nonrecurring Items 
Dividends on Redeemable Preferred Stock
Return on Equity =
Average Total Equity

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Return on Common Equity
• Measures the return to the common stockholder
Net income Before Nonrecurring
Items  Preferred Dividends
Return on Common Equity =
Average Common Equity

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Gross Profit Margin
• Comparing gross profit with net sales is termed
the gross profit margin

Net Sales Revenue Beginning Inventory

− Cost of Goods Sold + Purchases of Inventory
− Ending Inventory
= Gross Profit

Gross Profit
Gross Profit Margin =
Net Sales

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Gross Profit Margin Analysis
• Analysis helps the following ways:
– Managers budget gross profit levels into their
predictions of profitability
– Used in cost control
– Estimate inventory levels for interim financial
statements and insured losses in merchandising
industries
– Used by auditor and Internal Revenue Service to
judge accuracy of accounting systems

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product or service or otherwise on a password-protected website for classroom use.