CHAPTER 8

Profitability
 After studying this chapter you should be
able to understand
• Profitability Measures
• Net Profit Margin
• Total Asset Turnover
• Return on Assets
 CHAPTER 8
Profitability
Profitability is the ability of the firm to generate
earnings. Analysis of profit is of vital concern to
stockholders since they derive revenue in the form
of dividends. Further, increased profits can cause a
rise in market price, leading to capital gains.
Profits are also important to creditors because
profits are one source of funds for debt coverage.
 Profitability Measures
 The income statement contains several figures that
might be used in profitability analysis. In general,
the primary financial analysis of profit ratios should
include only the types of income arising from the
normal operations of the business. This excludes the
following:
1. Discontinued operations
2. Extraordinary items
3. Cumulative effects of changes in accounting
principles
 Net Profit Margin
 A commonly used profit measure is return on sales, often
termed net profit margin. If a company reports that it earned
6% last year, this statistic usually means that its profit was 6%
of sales. Calculate net profit margin as follows:

Net Profit Margin = Net Income/

Net Sales
Net Profit Margin = 72,700
$980,000
Net Profit Margin = 0.074 or 7.42%
 Profitability Ratios
 Net profit margin: Net profit margin
meanwhile indicates what percentage of a
company’s sales revenue would remain after
all costs have been taken into account.
Net Income
Net Profit Margin  X100
Sales
 Net Profit Margin
• A "good" profit margin depends on various
factors, including industry norms, business
size, and economic conditions. However, in
general, a higher profit margin is usually
considered favorable, as it indicates that a
company is effectively managing its costs and
generating stronger profits relative to its
revenue.
 Total Asset Turnover
 Total asset turnover measures the activity of the assets and the
ability of the firm to generate sales through the use of the
assets. Compute total asset turnover as follows:
 Net Sales = 980, 000
 Average Total Assets
 Beginning of year = $859,000 Ending of Year = $860,000

 Total Asset Turnover = Net Sales

Average Total Assets
 Total Asset Turnover = $980,000
($859,000 + $860,000)/2
 Total Asset Turnover = 1.14 times per year
 Return on Assets
 Return on assets measures the firm’s ability to utilize
its assets to create profits by comparing profits with
the assets that generate the profits. Compute the
return on assets as follows:

Return on Assets = Net Income

Average Total Assets
Return on Assets = $72,700
($859,000 + $860,000)/2
Return on Assets = 8.46%
 DuPont Return on Assets
 The net profit margin, the total asset turnover, and the
return on assets are usually reviewed together because
of the direct influence that the net profit margin and the
total asset turnover have on return on assets. When
these ratios are reviewed together, it is called the
DuPont return on assets. This method of performance
measurement was started by the DuPont Corporation in
the 1920s.
 Compute the DuPont return on assets as follows:

 Return on Assets = Net Profit Margin x Total Asset Turnover

8.46% = 7.42% x 1.14 times
 Variation in Computation of DuPont Ratios
Considering Only Operating Accounts
 Operating assets exclude construction in progress, long-
term investments, intangibles, and the other assets
category from total assets.

 operating income is the profit generated by

manufacturing, merchandising, or service functions that
equals net sales less the cost of sales.
 Operating Income and Operating Assets Years Ended May 31,
2014 and 2013 and operating assets for 2014, 2013, and 2012
2013 2012
Operating income:
Net sales [A] $87,769 $95,531
Operating expenses:
Cost of products sold $54,935 $60,655
Selling, general and administrative 24,266 26,238
Total operating expenses [B] $79,201 $86,893
Operating income [A−B] $ 8,568 $ 8,638
Operating assets: 2013 2012 2011
Total assets [A] $52,477 $53,974 $53,612
Less: Intangibles, deferred income 7170 7117 6,079
taxes and other assets [B]
Operating assets [A−B] $45,307 $46,857 $47,533
 Operating Income Margin
 The operating income margin includes only operating income
in the numerator. Compute the operating income margin as
follows:

 Operating Income Margin = Operating Income

Net Sales
 Operating Income Margin = $115, 000
$980,000
 Operating Income Margin = 11.73%
 Operating Asset Turnover
 This ratio measures the ability of operating assets to
generate sales dollars. Compute operating asset
turnover as follows:
 Operating Asset Turnover = Net Sales
Average Operating Assets

 Operating Asset Turnover = $980,000

($859,000- $80,000 + $861,000-
$85,000)/2
 Operating Asset Turnover = 1.26 times per year
 Return on Operating Assets
 Adjusting for non-operating items results in the following
formula for return on operating assets:

 Return on Operating Assets = Operating Income

Average Operating Assets
 Return on Operating Assets = $355,000- $240,000
($ 779, 000 + $776 000)/2
 Return on Operating Assets = 14.79%
 Sales to Fixed Assets
 This ratio measures the firm’s ability to make productive use of
its property, plant, and equipment by generating sales. Since
construction in progress does not contribute to current sales, it
should be excluded from net fixed assets. Compute the sales to
fixed assets as follows:
 Sales to Fixed Assets = Net Sale
Average Net Fixed Asset
(Exclude Construction in Progress)
Sales to Fixed Assets = $980,000
($500,000 + $491,000)/2

Sales to Fixed Assets = 1.98 times per year

 Return on Total Equity
 The return on total equity measures the return to both common
and preferred stockholders. Compute the return on total equity
as follows:
 Net Income = $72,700, Dividends = $6,400
 Average Total Equity = Beginning of year = $520,000
 End of year = $518,000
Net Income –
 Return on Total Equity = Dividends on Redeemable Preferred Stock
Average Total Equity
 Return on Total Equity = $72,700- $6,400
($520,000 + $518,000)/2
 Return on Total Equity = 12.77%
 Return on Common Equity
 This ratio measures the return to the common stockholder, the
residual owner. Compute the return on common equity as
follows:
Net Income −
 Return on Common Equity = Preferred Dividends
Average Common Equity
 Return on Common Equity = $72,700- $12,700
($450,000 + $448,000)/2
 Return on Common Equity = 13.36
 Gross Profit Margin
 Gross profit equals the difference between net sales revenue and
the cost of goods sold. The cost of goods sold is the beginning
inventory plus purchases minus the ending inventory. It is the cost
of the product sold during the period. Changes in the cost of goods
sold, which represents such a large expense for merchandising and
manufacturing firms, can have a substantial impact on the profit
for the period. Comparing gross profit to net sales is termed the
gross profit margin. Compute the gross profit margin as follows:
Gross Profit
 Gross Profit Margin = Net Sales
 Gross Profit Margin = $1,500,000
$5,000,000
30.00%
 Trends in Profitability
A profitability trend is the evolution of profit
within a business. An upward trend means that
profit has generally increased over time in the
short or long run. A downward profitability trend
means profits are declining.