Profitability Analysis

9
CHAPTER
Analyzing Profitability
Focus of Profitability Analysis
Profitability analysis is a key part of
financial statement analysis
All financial statements are pertinent to
profitability analysis
Emphasis of profitability analysis is on the
income statement
Analyzing Profitability
Focus of Profitability Analysis
Profitability analysis helps address questions such as:
What is a companys relevant income measure?
What is the quality of income?
What income components are important for
forecasting?
How persistent are income and its components?
What is a companys earning power?
Analyzing Profitability
Measuring Income

Income is defined as revenues less expenses over a
reporting period

This definition does not yield a unique amount because
of:
+ Estimation Issues
+ Accounting Methods
+ Incentives for Disclosure
+ Diversity across Users

Analyzing Profitability
Measuring Income--Estimation Issues

Income measurement depends on estimates of future
events

These estimates require:

Use of judgment and probabilities
Allocations of revenues and expenses across periods
Prediction of the future usefulness of many assets
Forecasts of future obligations


Analyzing Profitability
Measuring Income--Estimation Issues

Management discretion is part of income measurement


Estimates of skilled and experienced professionals
Some consensus (less variability)

Analyzing Profitability
Measuring Income--Accounting Methods
Professional
experience
Regulatory
agendas
Business
happenings
Academic
research
Social
Influences
Political
pressures
Accounting
standards
governing
income
measurement
Analyzing Profitability
Measuring Income--Accounting Methods

Methods reflect the outcome of numerous factors,
including compromises

Discretion is permitted to accommodate different
business circumstances

Methods geared toward general-purpose
financial statements

Analyzing Profitability
Measuring Income--Incentives for Disclosure

Ideally:
O Financial statements fairly present transactions and
events
O Accounting is neutralnot affecting how
transactions and events are perceived
O Methods chosen that are most applicable to the
circumstances
O Relevant information is disclosedfavorable and
unfavorable

Analyzing Profitability
Measuring Income--Incentives for Disclosure

Reality:
O Each of us possess opinions--we see the world from different
perspectives
O Managers bring strong views to the table
O Managers feel pressures of competition and society
O Directors expect results
O Shareholders concentrate on the bottom line
O Creditors want safeguards
O Financial analysts dislike surprises
O Accounting preparers and auditors demand acceptable
practices

Analyzing Profitability
Measuring Income--Incentives for Disclosure

Result:

Acceptable methods, not necessarily
appropriate methods


Analyzing Profitability
Measuring Income--Diversity Across Users

Financial statements are general-purpose reports
serving diverse needs of many users

Diversity of views implies an analysis uses income
as an initial measure of profitability

Use available information adjust income
measurement consistent with ones objectives

Analyzing Revenues
Two-Phase Analysis of Income

Analysis of income and its components involves two phases

1. Analysis of accounting and its measurements

Purpose: To apply knowledge of accounting to yield a measure of
income, and its components, consistent with the analysis objectives

2. Applying analysis tools to income (and its components) and
interpreting the analytical results

Purpose: To apply analysis tools to aid achieve the analysis
objectivessuch as income forecasting and estimating earning
power

Analyzing Revenues
Revenue Sources

Analysis of revenues (sales) helps address questions
such as:

What are the major sources of revenue?
How persistent are revenue sources?
How are revenues, receivables, and inventories
related?
When is revenue recorded?
How is revenue measured?

Analyzing Revenues
Revenue Sources

Knowledge of major sources of revenues is important
to profitability analysis

Each market and product line often has its own growth
pattern, profitability, and future potential

Common-size analysis of revenues shows the percent
of each major class of revenue to its total

Graphical analysis is a useful tool to interpret the
sources of revenues

Analyzing Revenues
Revenue Sources

Diversified Companies present special challenges

Different segments usually experience varying rates of
profitability, risk, and growth
Asset composition and financing requirements of segments
often vary
Evaluation, projection, and valuation of income is aided by
segment analysis
Segments share characteristics of variability, growth, and risk
Income forecasting benefits from forecasts by segments
Must separate and interpret the impact of individual segments

Analyzing Revenues
Revenue Sources

Full disclosure by segments is rare because of:

Difficulties in separating segments

Managements reluctance to release information
that can harm its competitive position

Analyzing Revenues
Revenue Sources

Reporting requirements exist for:

Industry segments
International activities
Export sales
Major customers

GAAP
Analyzing Revenues
Revenue Sources

Reporting requirements consider a segment
significant if its sales, operating income, or
identifiable assets comprise 10 percent or more of
their relevant totals

Notes:
Combined sales of all segments reported must be at
least 75 percent of the companys total sales
Ten segments is viewed as a practical limit on the
number of segments reported

GAAP
Analyzing Revenues
Revenue Sources
Information disclosed for each segment:
(1) salesboth intersegment and to unaffiliated
customers
(2) operating incomerevenues less operating
expenses
(3) identifiable assets
(4) capital expenditures
(5) depreciation, depletion, and amortization

Similar disclosures are required for international operations
and export sales (except capital expenditures and
depreciation)

Revenues from a single customer are disclosed if they
comprise 10 percent or more of total revenues
Analyzing Revenues
Revenue Sources

Limitations of segment data:

Difficult to define segments
Arbitrary allocations of costs
across segments

Analyzing Revenues
Revenue Sources
Useful applications of segment data include:

Analysis of sales growth

Analysis of asset growth

Analysis of profitability

Persistence (stability and trend) of revenues is
important to profitability analysis

Analysis tools for assessing persistence in revenues
include:
(1) trend percent analysis
(2) evaluation of Managements Discussion and
Analysis



Analyzing Revenues
Persistence of Revenues

Revenues for a prior period are
set equal to 100 percent

Revenues for other periods are
compared to it

Revenue trends by segments are often:

Correlated
Compared to industry norms
Compared to competitors

Analyzing Revenues
Persistence of Revenues--Trend Percent Analysis
Other related measures:

(Auto)correlations of revenues
across periods
Assess sensitivity of revenues to
business conditions
Customer analysisconcentration, dependence,
and stability
Revenues concentration or dependence on one
segment
Revenues reliance on sales staff
Geographical diversification of markets

Analyzing Revenues
Persistence of Revenues--Trend Percent Analysis
Managements Discussion and Analysis (MD&A) is often
useful in analysis of persistence in revenues

Aids in understanding and evaluating period-to-period
changes
Report on changes in revenue components
Discloses uncertainties affecting or likely to affect
revenues
Explains growth in revenues to prices, volume,
inflation, or new product introduction
Reports some forward-looking information
Discusses trends and forces not evident from financial
statements
Analyzing Revenues
Persistence of Revenues--MD&A

Revenues and Accounts Receivable Relation

Bears on:

Earnings quality
Collectibility of receivables

Analyzing Revenues
Key Revenue Relations

Revenues and Inventories Relation

Bears on:

Future revenues
Analysis of operations

Analyzing Revenues
Key Revenue Relations

Profitability analysis must adjust for different
revenue recognition methods in:

Comparative analysisboth temporal and
cross-sectional
Forecasting revenues

Chapter 6 discusses revenue recognition criteria
and measurement

Analyzing Revenues
Revenues Recognition
Analyzing Costs of Revenues
Measuring Gross Profit
Gross profit, or gross margin, is measured as
revenues less cost of sales

All other costs must be recovered from gross profit

Any income earned is the
balance remaining after these costs

Gross profit must finance essential future-directed
discretionary expenditures
Measuring Gross Profit

Gross profits vary across industries depending on
factors such as:

Competition

Capital investment

Level of costs that must be
recovered from gross profit

Analyzing Costs of Revenues
Analyzing Gross Profit

Analysis of gross profit directs attention at the
factors explaining variations in:

Sales

Costs of sales

Analyzing Costs of Revenues
Analyzing Gross Profit
Analysis Statement of Changes in Gross Profit

Step 1. Focus on year-to-year change in volume assuming unit
selling price is unchangedVolume change is
multiplied by the constant unit selling price to yield
change in sales
Step 2. Focus on year-to-year change in selling price
assuming volume is constant--Change in selling price
is multiplied by the constant volume to yield change in
sales
Step 3. Focus on joint changes in volume and unit price
Volume change is multiplied by the change in unit
selling price to yield net change in sales
Step 4. Steps 1 to 3 explain the net change in sales.

Analyzing Costs of Revenues
Analyzing Gross Profit

Analysis Statement of Changes in Gross ProfitIllustration

Year Ended December 31 Year-to-Year Change
Item Year 1 Year 2 Increase Decrease

1. Sales ($ millions) $ 657.6 $ 687.5 $ 29.9
2.Cost of sales ($ millions) 237.3 245.3 8.0
3.Gross profit ($ millions) $ 420.3 $ 442.2 $ 21.9
4.Units sold (in millions) 215.6 231.5 15.9
5.Sales price per unit
(1 4) $ 3.05 $ 2.97 $ 0.08
6.Cost per unit (2 4) 1.10 1.06 0.04

Analyzing Costs of Revenues
Analyzing Gross Profit

Analysis Statement of Changes in Gross Profit
Year 2 versus Year 1

Analysis of Variation in Sales
1. Change in volume of products sold:
Change in volume (15.9) Year 1 unit selling price ($3.05) $ 48.5
2.. Change in selling price:
Change in selling price ($0.08) Year 1 sales volume (215.6) 17.2
$ 31.3
3. Combined change in sales volume (15.9) and unit price ($0.08) 1.3
Increase in net sales $ 30.0*

Analysis of Variation in Cost of Sales
1. Change in volume of products sold:
Change in volume (15.9) Year 1 cost per unit ($1.10) $ 17.5
2. Change in cost per unit sold:
Change in cost per unit ($0.04) Year 1 sales volume (215.6) 8.6
$ 8.9
3. Combined change in volume (15.9) and cost per unit ($0.04) 0.6
Increse in cost of sales $ 8.3*
Net variation in gross profit $ 21.7*
* Differences are due to rounding.
Analyzing Costs of Revenues
Interpreting Changes in Gross Profit
Analyzing Costs of Revenues

Changes in gross profit are often driven by one or more
of the following factors:

Increase in sales volume
Decrease in sales volume
Increase in unit selling price
Decrease in unit selling price
Increase in cost per unit
Decrease in cost per unit


Interpreting Changes in Gross Profit
Analyzing Costs of Revenues

Identification of factors driving gross profit yields

Improved business strategies

Better assessment of future performance



Tools for Analysis of Expenses
Analyzing Expenses
Common-size analysis
Common-size income statements express expenses in terms of their percent relation
with revenues
Traced over several periods or compared with competitors

Index number analysis
Index number analysis of income statements expresses income and its components
in an index number related to a base period
Highlights relative changes across time
Changes in expenses are readily compared with changes in both revenues and related
expenses

Operating ratio analysis
Operating ratio measures the relation between operating expenses (or its
components) and revenues
Equals cost of goods sold plus other operating expenses divided by net revenues
Interest and taxes are normally excluded from this measure due to its focus on
operating efficiency (expense control) and not financing and tax management
Useful for analysis of expenses within and across companies
Selling Expenses
Analyzing Expenses

Analysis of selling expenses focuses on three areas:

Evaluating the relation between key selling
expenses and revenues

Assessing bad debts expense

Evaluating the trend and productivity of
future-directed marketing expenses

Depreciation Expense
Analyzing Expenses

Relation of depreciation to gross plant and equipment
helps reveal changes in the composite rate of
depreciationthis is useful in evaluating depreciation
levels and in detecting adjustments (smoothing) to
income:


It is often useful to compute this ratio by asset categories

assets e Depreciabl
expense on Depreciati
Maintenance and Repairs Expense
Analyzing Expenses

Maintenance and repairs expense:

Varies with investment in plant and equipment and
with the level of productive activity

Affect costs of sales and other expenses

Comprise both variable and fixed costs

Do not vary directly with sales

Maintenance and Repairs Expense
Analyzing Expenses
Relation of sales to maintenance and repairs expense,
both across companies and time, must be interpreted
with care

Analysis and interpretation using this ratio
Is enhanced if we can distinguish between variable
and fixed portions of these expenses
Must recognize the discretionary nature of these
expenses
Bear on productivity and earnings quality
assessments
Impacts asset valuations

Amortization of Special Costs
Analyzing Expenses

Expenditure for special costs can be related to and
expressed as a percent of:

(1) revenues
(2) net property and equipment

Amortization of special costs can be related to and
expressed as a percent of:

(1) revenues
(2) unamortized special costs
(3) net property and equipment

Amortization of Special Costs
Analyzing Expenses

Ratios involving special costs are useful in:

Comparison of annual trends in these relations

Analysis of consistency in income reporting

Evaluation of income for two or more competitors



General and Administrative Expenses
Analyzing Expenses


Most are fixedsuch as rent and salary

Tendency for increases, especially in
prosperous times


General and Administrative Expenses
Analyzing Expenses


Analysis of G&A should focus on:

Trend in these expenses

Percent of revenues they consume


Financing Expenses
Analyzing Expenses


Most are fixedexception is variable-rate interest

Most creditor financing is eventually refinanced and
not removed

Interest expense often includes amortization of a
premium or discount



Average effective interest rate:




Useful tool for:

Analysis of the cost of borrowed money
Credit standing
Comparisons across years and companies
Assessing sensitivity to interest rate changes

Financing Expenses
Analyzing Expenses
ss indebtedne bearing - interest Average
incurred interest Total
Income Tax Expenses
Analyzing Expenses

Income tax expenses:

+ Reflect a distribution of profits between a company
and governmental agencies

+ Usually comprise a substantial portion of a
companys pre-tax income





Income Tax Expenses
Analyzing Expenses

Effective Tax Rate (ETR)





ETR (also called tax ratio) reflects
relation between the income tax
accrual and pre-tax income


taxes income before Income
expense tax Income
Income Tax Expenses
Analyzing Expenses

Differences in ETR from normal or expected rate affects
assessments of income

Level
Trend
Forecasts

Small changes in ETR can yield major
changes in income


Income Tax Expenses
Analyzing Expenses

Analysis of income tax disclosures aims to:

Assess tax implications for income, assets,
liabilities, and cash sources and uses
Evaluate tax effects for future income and cash
flows
Appraise the effectiveness of tax management
Identify unusual gains or losses only revealed in tax
disclosures
Signal areas of concern requiring further analysis or
management inquiry