Financial Accounting Profitability Ratios Lecture Notes

Profitability = a firms ability to generate money.

  1. A big concern to shareholders for both dividend payments and price of their stock in the financial markets
  2. Absolute earnings are meaningless unless compared to something. What does it mean if you made $1,000,000? If for example it is compared for $1,000,000 in assets the OK but $100,000,000,000 in assets then your assets are not producing income.
  3. Allows use to look at performance in relationship to our equity
  4. The efficiency in which we use our assets
  5. Identify areas that need to be corrected or promoted
  6. Like all ratio analysis we are concerned with recurring events to get an accurate picture of our earning potential. So we dismiss (footnote):

a)Discontinued Operations

b)Extraordinary Items

c)Effects of Accounting Practices Changes

  1. Trend Analysis is critical in drawing conclusions and fixing problems

NET PROFIT MARGIN

  1. ‘A company made 6% last year’ usually means that profits were 6% of sales
  1. From Net Income, Minority Share Earning, Equity Income and Nonrecurring items are taken out of Net Income
  1. Math = Net Income minus #2/Net Sales
  1. Tells you how much a RBM in sales ends up in your pocket so to speak.
  1. A higher percentage is better and if high compared to the industry shows either more effective sales expenses or operating expenses.

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TOTAL ASSET TURNOVER

  1. Measures how efficiently assets are used to generate money.
  1. Math = Net Sales/Average Total Assets
  1. Turnover again means how many times you use something
  1. Look for “material” changes

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RETURN ON ASSETS

  1. Measures a firms ability to use assets to generate money
  1. Math = Net Income minus Minority Income and Nonrecurring items/ Average Total Assets.

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FINDING TRENDS AND MIXING RATIOS

  1. We often compare ratios to understand trends and identify problems/successes so we can make better decisions.
  1. For example Return on Assets = Net Profit Margin x Total Asset Turnover
  1. By looking at these together we can better understand a situation

View Excel Sheet 2 for this lecture

SAME RATIOS ONLY CONSIDERING ONLY OPERATING ACCOUNTS

  1. It is often argued that ONLY operating assets should be considered in return on assets – assets used for the primary business
  1. Operating Assets EXCLUDE:

a)construction in progress

b)long-term investments (held to maturity)

c)intangibles

d)others

  1. Operating Income – similarly this figure just includes net sales minus cost of sales and operational expenses
  1. Only operating accounts considered.

SALES TO FIXED ASSETS

  1. Measures a firms ability to use its property and plants,
  1. Math – Net Sales/Average Net Fixed Assets
  1. Value dependent on book value of assets which depend on depreciation methods changing values as opposed to replacement cost.

RETURN ON INVESTMENT (ROI)

  1. Measures Return on money put into the company

a)long-term debt is $ in

b)Equity = $ in

  1. Math is Net Earning Before Minority Share of Earnings + (Interest expense) x (1-Tax rate) / Average (long-Term Liabilities + Equity)

Do Excel Sheet 3