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**CMA Part 2 Financial Decision Making Study Unit 3**

Profitability Analysis Patricia Burnett, CMA

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**Categories of Financial Ratios**

Our next studies will focus on the following types of Financial Ratios Activity: how efficiently a company performs day-to-day tasks such as collection of receivables and management of inventory Liquidity: company’s ability to meet its short-term obligations Solvency: ability to meet long-term obligations Profitability: company’s ability to generate profitable sales from its resources (assets) Valuation: quantity of an asset or flow (earnings) associated with ownership of a specified claim (Share)

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**Profitability Analysis**

Profitability is a firm’s ability to generate earnings over a period of time with a given set of resources. It is analyzed by examining the elements of revenues, the cost of sales, and operating and other expenses. There are a number of ways an investor can look at return on his or her investment. Some returns involve the price of the stock as it trades in the securities markets. Although there are actions a company can take to make its stock more attractive to investors, return on market price depends on when each investor purchases and sells the stock. Thus, the analyst of a company’s financial and operating performance cannot make this calculation for the individual investor. An analyst, can, however, examine how the investor’s contribution to the company performed on a per-share basis. This can be done by measuring earnings per share and the dividend yield.

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**Profitability Analysis**

The numerator of the return ratio is some measure of earnings or profits. The measure selected for the numerator should match the investment base in the denominator. For example, if total assets are used in the denominator, the income to all providers of the capital ought to be included in the numerator, which includes interest. Thus, interest usually is added back to the net income when computing the ROA. This leads to a popular measure known as earnings before interest, taxes, depreciation, and amortization (EBITDA). When return on common equity capital is computed, net income after deductions for interest and preferred dividends is used. The final ROI always must reflect all applicable costs and expenses, including income taxes, particularly when the return on shareholders’ equity is computed. Profit, or “the profit motive,” is realized when an organization is generating more resources than it consumes during the course of a year. That is, profit is the amount by which revenue from sales exceeds the costs required to achieve those sales. And the profit margin is the percentage of revenues represented by that excess of revenues over costs. Revenues and costs, however, are measured by diverse criteria.

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**Profitability Analysis**

Profit margins commonly are calculated using one of three different profit measures: 1. Gross profit , which equals net sales revenue minus the cost of goods sold (COGS). 2. Operating income , which equals gross profit minus various administrative expenses, not including interest or taxes (because they are not part of operations). Operating income is sometimes called earnings before interest and taxes (EBIT). 3. Net income , which reduces revenues by all expenses—cost of goods, operating expenses, and interest and taxes. 4. EBITDA, earnings before interest, taxes, depreciation, and amortization, is a performance measure that approximates cash-basis profits.

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**Profitability Analysis**

Gross profit margin is what percentage of gross revenues remains with the firm after paying for merchandise. Revenue – COGS = GP As with all financial ratios, the gross margin derives its meaning by comparison to performance of the company in past years as well as by comparison to industry averages. One of the things an analyst looks for is the trend of the gross profit margin: Is it increasing, decreasing, or remaining steady? Key – That the percentage of GP remains or increases with sales. GP – SG&A = Operating Profit

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**Profitability Analysis**

Gross Profit Margin = Gross Profit / Net Sales = Net Sales – COGS / Net Sales Profit Margin = Net Income / Net Sales = Net Sales – COGS – G&A – Fixed costs – Tax – Interest What is left to be reinvested or distributed? Net Profit Margin and Profit Margin are the same Difference between Operating Income and EBIT OTHER Other Income Other Loss

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**Profitability considerations**

Financial analyst must also look for reasons that explain changes. Here are some reasons that gross profit margin may change: Sales prices have not increased at the same rate as the change in inventory costs. Sales prices have declined due to competition. The mix of products sold has changed to more products with lower profit margins. Inventory is being stolen. (If this is the case, the cost of goods will be higher against the same sales.)

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**Profitability Analysis**

EBITDA performance measure that approximates accrual-basis profits from ongoing operations EBITDA / Net Sales adding back 2 major noncash expenses to EBIT ROI: what is Return and what is Investment? ROA: how well Management is deploying the firm’s assets in the pursuit of a profit NET INCOME / AVG TOTAL Assets That ratio will be very low in High Assets industry (Manufacturing) ROE: measures the return per owner dollar invested NET INCOME / AVG TOTAL Equity The difference between the two are Liabilities, which is why ROE is always larger than ROA

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Key Take-Away CMA are expected to be able to determine the profitability of a business by calculating ROA / ROE using the DuPont Model and explain how it helps analysis Demonstrate: That you know the formulas That you are able to properly apply and analyze and evaluate Discussion on inconsistent definitions and what factors contribute to inconsistency

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**Return on Assets: ROA ROA = Net Income / Sales X Sales / Total Assets**

How effectively assets are used? It measures the combine effects of profit margins and asset turnover

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**Return on Equity: ROE ROE = Net Profit / Equity**

= Net Profit / Pre-tax Profit X Pre-tax Profit / EBIT ROE = Tax burden X Interest burden X Margin X Turnover X Leverage ROE = Tax burden X ROA X Compound Leverage factor Tax Burden Interest Burden

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**Statement of Income and Retained Earnings**

SU 3.1 Practice Question 1 Balance Sheet Statement of Income and Retained Earnings Cash $100 Sales $ 3,000 Accounts receivable 200 Cost of goods sold -1,600 Inventory 50 Gross profit $ 1,400 Net fixed assets 600 Total $950 Operations expenses -970 Operating income $ 430 Accounts payable $140 Interest expense -30 Long-term debt 300 Capital stock 260 Income before tax $ 400 Retained earnings 250 Income tax -200 Net income $ 200 Dividendosaurus has return on assets of Add: Jan. 1 retained earnings 150 A 21.10% Less: dividends -100 B 39.20% Dec. 31 retained earnings $ 250 C 42.10% D 45.30%

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**SU 3.1 Practice Question 1 Answer**

Correct Answer: A The return on assets is the ratio of net income to total assets. For Dividendosaurus, it equals 21.1% ($200 net income ÷ $950 total assets). Incorrect Answers: B The ratio of net income to common equity is 39.2%. C The ratio of income before tax to total assets is 42.1%. D The ratio of income before interest and tax to total assets is 45.3%.

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SU 3.1 Practice Question 2 In the current year, Griffin, Inc., had $15 million in sales, while total fixed costs were held to $6 million. The firm’s total assets averaged $20 million and the debt-to-equity ratio was calculated at If the firm’s EBIT is $3 million, the interest on all debt is 9%, and the tax rate is 40%, what is the firm’s return on equity? A 11.16% B 14.4% C 18.6% D 24.0%

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**SU 3.1 Practice Question 2 Answer**

Correct Answer: A The first step is to determine the amount of equity. If the debt-to-equity ratio is .6, the calculation is .6E + E = $20 million. Thus, E (equity) equals $12.5 million. Debt is therefore $7.5 million. At 9%, interest on $7.5 million of debt is $675,000. Earnings before taxes are $2,325,000 ($3,000,000 EBIT – $675,000 interest). At a 40% tax rate, taxes are $930,000, which leaves a net income of $1,395,000. Return on equity is calculated by dividing the $1,395,000 by the $12,500,000 of equity capital, giving an ROE of 11.16%.

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SU 3.1 Practice Question 3 White Knight Enterprises is experiencing a growth rate of 9% with a return on assets of 12%. If the debt ratio is 36% and the market price of the stock is $38 per share, what is the return on equity? A 7.68% B 9.0% C 12.0% D 18.75%

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**SU 3.1 Practice Question 3 Answer**

Correct Answer: D Assume that the firm has $100 in assets, with debt of $36 and equity of $64. Income (return) is $12. The $12 return on assets equates to an 18.75% return on equity ($12 ÷ $64). Incorrect Answers: A The figure of 7.68% is based on 64% of the ROA. B The figure of 9.0% is the growth rate, not a return. C The figure of 12.0% is the return on assets, not return on equity.

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**SU 3.2 Profitability Analysis**

Inconsistent Definitions Adjustments of the RETURNS Subtracting Preferred Dividends IACS (Income available to Common Stockholders) Adding minority interest in the income of a consolidated Subsidiary Adding back interest expense Adding back both interest and taxes = EBIT Basic Earning Power ratio

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**SU 3.2 Profitability Analysis**

Inconsistent Definitions (Cont.) Adjustments of the ASSETS / EQUITY Excluding non-operating Assets (investments, intangibles) Excluding unproductive Assets (idle plant, obsolete inventory) Excluding current Liabilities to emphasize on long-term capital Excluding debt and PS to arrive at equity capital Stating invested capital at market value

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DUPONT Analysis Developed in 1919 as a way to better understand return ratios and why they change over time. The bases for this approach are the linkages made through financial ratios between the Balance Sheet and the I/S Breaking returns into their components

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DuPont Model

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**Dupont Triangle ROE ROA Financial Leverage Net Profit Margin**

Total Assets Turnover Financial Leverage Tax Burden Interest Burden EBIT Margin Total Assets Turnover Financial Leverage

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**Dupont Model: Deep Dive**

ROE = Profit Margin X Asset Turnover X Equity Multiplier High Turnover Industries = retail, groceries volume High Margin Industries = fashion, luxury rare, customized High Leverage Industries = financial sector, real estate Profitability Operating Efficiency Financial Leverage

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SU 3.1 Practice Question 1 White Knight Enterprises is experiencing a growth rate of 9% with a return on assets of 12%. If the debt ratio is 36% and the market price of the stock is $38 per share, what is the return on equity? A. 7.68% B. 9.0% C. 12.0% D. 18.75%

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**SU 3.1 Practice Question 1 Answer**

Correct Answer: D Assume that the firm has $100 in assets, with debt of $36 and equity of $64. Income (return) is $12. The $12 return on assets equates to an 18.75% return on equity ($12 ÷ $64). Incorrect Answers: A: This percentage is based on 64% of the ROA. B: This percentage is the growth rate, not a return. C: This percentage is the return on assets, not return on equity.

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SU 3.1 Practice Question 2 According to the DuPont formula, which one of the following will not increase a profitable firm’s return on equity? A Increasing total asset turnover. B Increasing net profit margin. C Lowering corporate income taxes. D Lowering equity multiplier.

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**SU 3.1 Practice Question 2 Answer**

Correct Answer: D Lowering the equity multiplier would not increase a profitable firm’s return on equity.The DuPont model depicts return on assets as total asset turnover (sales divided by average total assets) times the profit margin (net income divided by sales). Incorrect Answers: A Increasing total asset turnover would increase a profitable firm’s return on equity. B Increasing net profit margin would increase a profitable firm’s return on equity. C Lowering corporate income taxes would increase a profitable firm’s return on equity.

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SU 3.1 Practice Question 3 The DuPont formula involves which combination of financial elements in its computation? A Net profit margin, total asset turnover, and equity multiplier. B Total asset turnover and sales turnover profitability. C Profit margin, sales turnover, and asset-use efficiency. D Total asset turnover, sales turnover, and equity multiplier.

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**SU 3.1 Practice Question 2 Answer**

Correct Answer: A The DuPont model begins with the standard equation for return on equity (ROE) and breaks it down into three different efficiency components. ROE = Net profit margin × Asset turnover × Equity multiplier Incorrect Answers: B The DuPont model also involves net profit margin and equity multiplier. C The DuPont model also involves total asset turnover and equity multiplier. D The DuPont model also involves net profit margin.

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ROCE Return on Common Equity = Net Income – Preferred Dividends / AVG Common Equity ROCE = IACS / Net Sales X Net Sales / AVG Ttl Assets X Leverage The equity multiplier measures a company’s financial leverage High financial leverage means that the company relies more on debt to finance its assets Raising capital with debt, the company can increase its equity multiplier and improve its ROE However, on the other hand, taking on additional debt may worsen the company’s solvency and increase the risk of going bankrupt

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Other measures Sustainable Equity Growth rate = ROCE x (1 – Dividend Payout) Plowback rate = Net Income not distributed = reinvested in RE Net Profit Margin on Sales = Net Income / Sales Question 7 page 126 Plowback rate

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**Sustainable Equity Growth**

Although some companies fail because of ever-declining revenues, companies also fail by attempting to grow too fast. Many small businesses, in particular, go under because they take on a contract with deadlines that cannot be met with their current staff , equipment, capital, and expertise. The sustainable growth ratio indicates the maximum earnings growth a firm can have without resorting to other means of financing. The key to sustainable growth is retaining sufficient earnings to reinvest in growth rather than paying out too much in earnings as dividends. This can be calculated as 1 minus the dividend payout ratio multiplied by return on equity (ROE).

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SU 3.2 Practice Question 1 If Company A has a higher rate of return on assets than Company B, the reason may be that Company A has a <List A> profit margin on sales, a <List B> asset turnover ratio, or both. List A List B A. Higher B. Lower C. D.

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**SU 3.2 Practice Question 1 Answer**

Correct Answer: A The DuPont model treats the return on assets as the product of the profit margin and the asset turnover: Return on Assets = Profit Margin X Asset Turnover If one company has a higher return on assets than another, it may have a higher profit margin, a higher asset turnover, or both.

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SU 3.2 Practice Question 2 Transnational Motors has decided to make an additional investment in its operating assets, which are financed by debt. Assuming all other factors remain constant, this increase in investment will have which of the following effects? Operating Profit Margin Total Asset Turnover Return on Assets A. Increase No Change B. Decrease C. D.

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**SU 3.2 Practice Question 2 Answer**

Correct Answer: B An additional investment in operating assets that are financed by debt will cause assets and liabilities to increase proportionally. This transaction would have no effect on income statement balances. Therefore, there will be no change in operating profit margin (operating income ÷ sales). Both the total asset turnover (net sales ÷ average total assets) and the return on assets (net income ÷ average total assets) will decrease as the denominator for both of these ratios will increase, but the numerator remains constant. Incorrect Answers: A: Operating profit margin will not be affected by the purchase of assets because this transaction will have no effect on the income statement. However, the total asset turnover and the return on assets will both decrease, not remain constant and increase. C: The total asset turnover will decrease, not increase. The denominator in this ratio is increasing while the numerator is staying constant, causing a decrease in the total ratio. D: Operating profit margin will not be affected as the purchase of assets financed by debt will not affect any income statement amounts.

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SU 3.2 Practice Question 3 Zoron Corporation experienced the following year-over-year changes. Net profit margin Increased 25% Total asset turnover 40% Total assets Decreased 10% Total equity Using DuPont analysis, what is the year-over-year change in Zoron’s return on equity (ROE)? A. Increased 95.0%. B. Increased 63.0%. C. Increased 12.5%. D. Increased 10.0%.

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**SU 3.2 Practice Question 3 Answer**

Correct Answer: C The ROE using the DuPont analysis is calculated as follows: Net profit margin × Total asset turnover × Equity multiplier (Total assets ÷ Total equity) The best way to solve this problem is to use actual numbers for the return on equity comparison of this year to last year. Assuming that last year Zoron had a net profit margin of .025, total asset turnover of 1.05, total assets of $500,000, and total equity of $200,000, last year’s ROE is equal to 6.56% [.025 × 1.05 × ($500,000 ÷ $200,000)]. By using the information given in the problem, Zoron’s current-year amounts can be calculated, resulting in a net profit margin of (increased by 25%), total asset turnover of 1.47 (increased by 40%), total assets of $450,000 (decreased by 10%), and total equity of $280,000 (increased by 40%). Therefore, this year’s ROE is equal to 7.38% [ × 1.47 × (450,000 ÷ 280,000)]. The increase in ROE from last year to this year can now be calculated as 12.5% [(7.38 – 6.56) ÷ 6.56].

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**SU 3.3 - Market Valuation Measures**

Book Value per Share = Ttl Equity - liquidation value of PS / Common Shares outstanding Book Value is based on historical cost and may differ from fair market value Market / Book Ratio = Market Price per Share / BV per Share A high ratio reflects stock market’s positive assessment of the firm’s performance / management How much an investor must spend to own a dollar of net assets Price/Earnings Ratio = Market Price per Share / Diluted Earnings per Share Measures how much an investor must spend to buy a dollar of Earnings

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**SU 3.3 - Market Valuation Measures**

Price / EBITDA Ratio = Market Price per Share / EBITDA Why EBITDA is a good measure and what are the limitations? High Tech Companies producing little net income Comparability for Companies with and without Debt Investment Bankers wanted to compare operating earnings before deducting non-cash expenses (Depreciation/Amortization) Disadvantages of using EBITDA: Distorts reality: investors interested in Net Income after Tax and Interest and Depreciations Companies can have high EBITDA but Working Capital issues

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Remember Profit, as an economic term, is the measure of the resources generated by the firm in excess of the resources consumed over the life of the fi rm. At any given time, the economic profits of the firm are the net present value of its earnings over its lifetime. However, this is not what gets measured as accounting income or accounting profit. The measurement of accounting profit is based on accrual accounting. The measurement of resources generated and consumed follow the rules set by generally accepted accounting principles (GAAP). The need to report on a periodic and ongoing basis, even though the business is continuing, leads to the need to make such approximations, causing the economic profit to be different from the accounting profit. The objective of financial accounting is not to make the accounting profit close to the economic profit but to provide a reasonable basis to infer the economic profit from the reported accounting profits.

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Remember Users of financial statements often place too much emphasis on summary indicators and key ratios, such as the current ratio or the EPS amount. No single ratio, or measure, is capable of capturing all relevant or important information about a particular company. The calculation of various ratios is merely the starting point. Analysis requires thinking about these ratios, forming expectations, and understanding the reasons of variances from those expectations. There is no overarching rule of what a ratio ought to be, and it depends on the particular industry as well as the business model.

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Also Additionally, many financial statements contain information on nonoperating items, such as extraordinary losses or effects of discontinued operations. Ratios mean nothing without some means of comparison: past ratios of the same business, a predetermined standard, or ratios of other companies in the same industry. Numbers within the financial statements must be interpreted based on an understanding of the accounting principles employed by the business. For a ratio to make sense, there must be a relationship between the two accounts used in the ratio—for example, there is no relationship between shipping costs and marketable securities. The validity of ratios also depends on the validity of the numbers used in the calculations. If the business’s accounting system cannot be relied on to produce reliable figures, ratios are also unreliable.

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$$ Entrepreneurial Finance, 5th Edition Adelman and Marks Pearson Higher Education ©2010 by Pearson Education, Inc. Upper Saddle River, NJ 07458 4-1 Chapter.

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