AGibson 13E Ch08

Chapter
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
• Profitability is the ability of a firm to generate earnings.
• Analysis of profit is of vital concern to Stockholders
because they derive revenue in the form of dividends, and
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.
• Management uses profit as a performance measure.
• The primary financial analysis of profit ratios should include
only those items of income arising from normal operations
• This excludes Discontinued operations and Extraordinary
items
© 2013 Cengage Learning. All Rights Reserved. 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 otherwise on a password-protected website for classroom use.
1. Net Profit Margin (return on
sales) %
• Reflects net income dollars generated by each
dollar of sales.
• If a company reports that it earned 6% last year,
this means that its profit was 6% of sales.
• It is desirable for this ratio to be high.
Net Income Before Noncontrolling Interest,
Equity Income, and Nonrecurring Items
Net Profit Margin =
Net Sales
2. Total Asset Turnover (times)
• Measures the activity of the assets and the
ability of the firm to generate sales through the
use of the assets
Net Sales
Total Asset Turnover =
Average Total Assets
3. 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.
• Average total assets
– For internal analysis use month-end amounts
– For external analysis use beginning and ending
amounts
Net Income Before Noncontrolling
Interest and Nonrecurring Items
Return on Assets =
4. 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
Common equity includes common capital stock and

retained earnings less common treasury stock.
Pr. 8-2, P. 343
PROBLEM 8-2
Net Profit Margin = (Net Income Before Minority Share of

Earnings and Nonrecurring Items) ÷ Net Sales
2011 2010
$52,500 = 5.00% $40,000 = = 4.00%
$1,050,000 $1,000,000
Return on Assets = (Net Income Before Minority Share of
Earnings and Nonrecurring Items) ÷ Average Total Assets
2011 2010
$52,500 = 22.83% $40,000 = 20.00%
$230,000 $200,000
Total Asset Turnover = Net Sales ÷ Average Total Assets
2011 2010
$1,050,000 =4.57 times $1,000,000 =5.00 times
$230,000 per year $200,000 per year
Return on Common Equity = (Net Income Before Nonrecurring Items –
Preferred Dividends) ÷ Average Common Equity
2011 2010
$52,500 = 30.88% $40,000 = 25.00%
$170,000 $160,000
• Ahl Enterprise has had a substantial rise in profit to sales. This is
somewhat tempered by a reduction in asset turnover. Given a slight
rise in common equity, there is a substantial rise in return in
common equity.
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
DuPont Analysis Definition
• The DuPont analysis is a framework for analyzing
fundamental performance popularized by the DuPont
Corporation.
• DuPont analysis is a useful technique used to decompose
the different drivers of return on equity (ROE).
• The name comes from the DuPont Corporation that started
using this formula in the 1920s. DuPont explosives
salesman Donaldson Brown invented this formula in an
internal efficiency report in 1912.
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
• The above example shows how a trend in return
on assets can be better explained through the
breakdown into two ratios.
• The two firms have identical returns on assets.
• Firm A suffers from a slowdown in asset
turnover. It is generating fewer sales for the
assets invested.
• Firm B suffers from a reduction in the net profit
margin. It is generating less profit per dollar of
sales.
DuPont Analysis Variation
• Considers only operating assets and operating income
– Operating assets exclude Construction in progress,
Long-term investments, Intangibles, and ‘Other’ assets
from total assets.
– Similarly Operating income that equals Net sales less
the cost of sales and Operating expenses should also
be used instead of net income.
• The operating ratios May give significantly different results
from net earnings ratios if a firm has large amounts of
nonoperating assets.
• For example, if a firm has heavy investments in
unconsolidated subsidiaries.
5. Operating Income Margin (%)
• Reflects operating income dollars generated by
each dollar of sales
• Includes only operating income in the numerator
• Operating income equals Net sales less the cost
of sales and Operating expenses.
Operating Income
Operating Income Margin =
Net Sales
6. Operating Asset Turnover (times)
• Measures the ability of operating assets to
generate sales dollars
• Operating assets = Total assets
• less: Construction in progress, Long term
investments, Intangible assets net, and other
assets.
Net Sales
Operating Asset Turnover =
Average Operating Assets
7. 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 
     
8. Sales to Fixed Assets (times)
• Measures the firm’ s ability to make productive use of
property, plant, and equipment by generating sales dollars.
– Exclude construction in progress from net fixed assets,
because it does contribute to current sales
Net Sales
Sales to Fixed Assets =
Average Net Fixed Assets
(Exclude Construction in Progress)
This ratio may not be meaningful because of old fixed

assets or a labor-intensive industry. In this case, the
ratio is substantially higher because of the low fixed
assets base.
9. Return on Investment (ROI) %
‫العائد على االستثمار‬
• Measures income earned on invested capital, and the
ability of the firm to reward those who provide long-term
funds and to attract providers(Creditors + Owners) of
future funds.
Net Income Before Noncontrolling
Interest and Nonrecurring Items +
[(Interest Expense) × (1  Tax Rate)]
Return on Investment =
Average (Long-Term Liabilities + Equity)
This ratio evaluates the earnings performance of

the firm without regard to the way the investment
is financed.
10. 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
• Preferred stock subject to mandatory redemption is termed
redeemable preferred stock considered part of debt.
• Adjustments for redeemable preferred stock
– Deduct dividends from net income (numerator)
– Deduct stock value from total equity (denominator)
– The redeemable preferred stock is excluded from total
equity and considered part of debt)Liability).
11. Return on Common Equity %
• Measures the return to the common stockholder
Net income Before Nonrecurring
Items  Preferred Dividends
Return on Common Equity =
Common equity includes common capital stock and

retained earnings less common treasury stock.
This amount equals Total Stockholders’ Equity
minus Preferred Capital and any Noncontrolling
Interest included in the equity section.
12. Return on Total Asset Variation
• Includes the return to all suppliers of funds, both
long- and short-term, by both creditors and
investors
Net Income + Interest Expense
Return on Total Asset Variation =
• Differs from the return on assets ratio because it adds back
the interest. It differs from the return on investment in that it
does not adjust interest for the income tax effect, and it
includes short term funds.
• Technically, a ratio with a profit figure in the numerator and
some type of supplier of funds figure in the denominator is a
type of return on investment (ROI).
The Relationship Between
Profitability Ratios
Technically, a ratio with a profit figure in the numerator
and some type of supplier of funds figure in the
denominator is a type of return on investment (ROI).
Measures
Rate of
return to Typical result
return on
providers of
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)
The Relationship Between
Profitability Ratios—Continued
Measures
Rate of
return to Typical result
return on
providers of
Common Common equity Highest
equity • Common shareholders absorb
greatest degree of risk
• Requires that return to preferred
shareholders exceed funds paid to
preferred shareholders
13. 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
The ratio should be compared with industry data or analyzed by trend analysis.
Pr. 8 – 6. Page 348.
Earnings before interest and tax $ 245,000
- Interest (750,000 x 6%) 45,000
= Earnings before tax $ 200,000
- Tax 80,000
= Net income $ 120,000
- Preferred dividends 15,000
= Income available to common $ 105,000
Pr. 8-6 continued.
a. Return on Assets = (Net Income Before Minority
Share of Earnings, Equity Income and
Nonrecurring Items) ÷ Average Total Assets =
$120,000 ÷ $3,000,000 = 4.00 %.
b. Return on Total Equity = (Net Income Before
Nonrecurring Items – Dividends on Redeemable
Preferred Stock) ÷ Average Total Equity =
$120,000 ÷ $1,800,000 = 6.67%
Pr. 8-6 continued.
c. Return on Common Equity = (Net Income Before
Nonrecurring Items – Preferred dividends) ÷
= ($120,000 – $15,000) ÷ $1,500,000 = 7.00%
d. Times Interest Earned = (Recurring Earnings,
Excluding Interest Expense, Tax Expense, Equity
Earnings, and Noncontrolling Interest) ÷ Interest
Expense, Including Capitalized Interest
= $245,000 ÷ $45,000 = 5.44 times per year
Pr. 8-5, P. 346
1. Net Profit Margin = net income ÷ net sales
2011: = $72,700÷ $980,000 = 7.42%
2. Total Asset Turnover = Net Sales ÷ Average Total Assets
2011: = $980,000 ÷ ($859,000 + $861,000)/2 =
1.14 times per year
3. Return On Assets = Net income ÷ Average Total Assets
2011: = $72,700 ÷ ($859,000 + $861,000)/2 = 8.45%
4. DuPont Return on Assets = Net Profit Margin x Total Asset

Turnover
2011: = 7.42% X 1.14 times = 8.45%
5. Operating Income Margin = Operating Income ÷ Net Sales
2011: = ($355,000 - $240,000) ÷ $980,000 = 11.73%
6. Operating Asset Turnover = Net Sales ÷ Average Operating
Assets
2011: $980,000 ÷ ($859,000 – $80,000 + $861,000 –
$85,000)/2 = 1.26 times per year
7. Return on Operating Assets = Operating Income ÷ Average

Operating Assets
2011: ($355,000 – $240,000 )÷ ($859,000 – $80,000 +
$861,000 – $85,000)/2 = 14.79%
8. DuPont Return on Operating Assets = Operating Income
Margin x Operating Asset Turnover
2011: = 11.73% X 1.26 = 14.78%
9. Sales to Fixed Assets = Net Sales ÷ Average Net Fixed Assets

2011: = $980,000) ÷ ($500,000 + $491,000)/2 = 1.98
10. Return On Investment

2011: ($72,700 + $6,500(1 – 0.33)) ÷ ($859,000 –
$194,000 + $861,000 – $195,500)/2 = 11.58%
11. Return on total equity
2011: = ($72,700 – $6,400) ÷ ($520,000 +
518,000)/2 = 12.77%
12. Return On Common Equity
2011: = ($72,700 – $6,400 – $6,300) ÷
($520,000 – $70,000 + $518,000 –
$70,000)/2 = 13.36%
13. Gross Profit Margin = Gross Profit ÷ Net Sales
2011: = $355,000 ÷ $980,000 = = 36.22%
b. In general, the profitability appears to be very good and
the trend is positive.

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AGibson 13E Ch08

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Chapter

Common equity includes common capital stock and

Net Profit Margin = (Net Income Before Minority Share of

Return on Net Profit Total Asset

• DuPont analysis of the return on operating

This ratio may not be meaningful because of old fixed

This ratio evaluates the earnings performance of

Common equity includes common capital stock and

Net Sales Revenue Beginning Inventory

4. DuPont Return on Assets = Net Profit Margin x Total Asset

7. Return on Operating Assets = Operating Income ÷ Average

9. Sales to Fixed Assets = Net Sales ÷ Average Net Fixed Assets

10. Return On Investment

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