PROFITABILITY

Chapter 5

Net Profit Margin

Measures net income generated each dollar
Net Profit Margin = Net
income
Net
Sales

Total Asset Turnover

Measures the activity of the assets and the
ability of the firm to generate sales
Net Sales
through
the use of the assets
Total Asset Turnover =

Average Total Assets

Return on Assets

Measures the ability to utilize assets to

create profits

Net Income Before Noncontrolling

Interest and Nonrecurring Items
Return on Assets =
Average Total Assets

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
Return on Assets = Net Profit Margin Total Asset Turnover
percentage of return on assets

DuPont Return on Assets

Continued
Net Income Before

Net Income Before

Noncontrolling Interest

Noncontrolling Interest

and Nonrecurring Items

Average Total Assets

and Nonrecurring Items

Net sales

Net Sales
Average Total Assets

DuPont Analysis
Variation
Consider only operating assets and income
Operating assets exclude
Construction in progress
Long-term investments
Intangibles

Operating income includes only

Net sales less the cost of sales
Operating expenses

Operating Income Margin

Includes only operating income in the
numerator

Operating Income
Operating Income Margin =
Net Sales

Operating Asset Turnover

Measures the ability of operating
assets to generate sales dollars

Net Sales
Operating Asset Turnover =
Average Operating Assets

Return on Operating Assets

Measures the ability of operating assets to
generate operating income
Return on Operating assets =

Operating Income
Average Operating Assets

DuPont analysis of the return on operating

assets:

DuPont Return Operating

Operating

= Income

On
Asset

Operating Assets
Margin
Turnover

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

Possible distortions
Old fixed assets
Labor-intensive industry
Sales to Fixed Assets =

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

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)

Return on Total Equity

Measures the return to common and
preferred stockholders
Redeemable preferred stock is excluded from
total equity and considered part of debts.
Net Income Before Nonrecurring Items
Dividends on Redeemable Preferred Stock
Return on Equity =
Average Total Equity

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 = Common Capital Stock

+ Retained Earnings - Common Treasury
Stock

Return on Total Asset

Variation
Includes the return to all suppliers of
funds, both long- and short-term, by both
creditors and investors
Return on Total Asset Variation =

Net Income + Interest Expense

Average Total Assets

Differs from the return on assets ratio and return on investment

It does not lend itself to DuPont Analysis

13. Gross profit margin

Exhibit 8-16 illustrates trend analysis and the

gross profit margin has declined and this could be
attributable to a number of factors:

1.The cost of buying inventory increased more

rapidly than selling prices.

2. Selling prices declined due to competition.

Other Considerations for

Profitability
1.Trends in Profitability
2.Segment Reporting
3.Revenues by Major Product Line
4.Gains and Losses from Prior Period Adjustment
5.Interim Reports

1. Trends in Profitability
-An upward trend means that profit has
generally increased over time.

-A downward profitability trend means profits

are declining.

2. Segment Reporting
Operating segments
Separate financial information is available
Evaluated by the chief decision making
officer

Geographical information
Major customers
Products and services

3. Revenues by Major Product

Lines

4. Gains and Losses from Prior

Period Adjustments
Charged directly to retained earnings
Changes in accounting principles
Changes in accounting entity
Correction of errors in prior periods

5. Interim Reports
Interim reports are an additional source
of information on profitability.

These are reports that cover fiscal

periods of less than one year.

Interim reports contain more estimates

in the financial data than in the annual
reports.