1. Chapter 10 Profitability and Return on Investment

2. Financial Information Analysis2 Copyright 2006 John Wiley & Sons Ltd Profitability and Return on Investment Investments are made with a view to: earnings capital appreciation Investors will assess investment under: profitability return on investment dividend policy capital appreciation Ratios, etc. developed to assess these

3. Financial Information Analysis3 Copyright 2006 John Wiley & Sons Ltd Profitability Critical for long-term viability Gross Profit rate (Gross Profit / Revenue) x 100% focus on trading activity inter-company comparison Operating Profit rate (Operating Profit / Revenue) x 100% Net Profit rate (PBIT / Revenue) x 100%

4. Financial Information Analysis4 Copyright 2006 John Wiley & Sons Ltd Return on Investment Relationship between investment & earnings Numerator (Earnings) must be consistent with denominator (Investment) Return on Capital Employed (ROCE): (PBIT / Capital Employed) x 100% Capital Employed usually long-term funding Denominator can also include short-term debt ROCE = Net Profit Rate x Asset Turnover

5. Financial Information Analysis5 Copyright 2006 John Wiley & Sons Ltd Return on Investment ctd. Return on Equity (ROE) focus on return enjoyed by owners i.e. denominator is Equity (Shareholders Funds) numerator changes to reflect this, i.e., profit after interest, tax and preference dividends ROE = Profit after interest, tax and preference dividends. Equity (Shareholders Funds)

6. Financial Information Analysis6 Copyright 2006 John Wiley & Sons Ltd Earnings Per Share (EPS) Widely used and closely regulated EPS = Earnings / Equity shares in issue Must be provided at end of Income Statement with workings in Notes IAS 33: Basic and Diluted EPS Calculation of denominator complicated by: new issues share options

7. Financial Information Analysis7 Copyright 2006 John Wiley & Sons Ltd Market ratios Price/Earnings Ratio (PER) relationship between earnings and market price important benchmark - industry averages available = market price per share / EPS Earnings yield inverts this ratio = EPS / market price per share measures earnings generated in relation to market price Widely used by investors: Higher PER = expectation of EPS growth PEG = PER/Prospective growth in EPS Prospective growth based on various assumptions

8. Financial Information Analysis8 Copyright 2006 John Wiley & Sons Ltd Payouts Investors invest to earn a return Total Shareholder Return: = Share price appreciation + Dividends Increasingly companies also engaged in Share Buybacks Involves company acquiring own shares in market Benefits for both shareholder and company Occasionally used to favourably impact ratios Attractive to companies with cash surplus

9. Financial Information Analysis9 Copyright 2006 John Wiley & Sons Ltd Dividend Policy Company dividend policy depends on: previous policy availability of profits and cash market expectations Dividend Yield (Dividend per share/Market Price per share) x 100% Dividend Cover Profit after Tax and Pref Dividend / Ordinary Dividend Dividend Payout Ordinary Dividend/ Profit after Tax and Pref Dividend

10. Financial Information Analysis10 Copyright 2006 John Wiley & Sons Ltd Summary Businesses must generate returns profits capital appreciation Ratios developed to assess earnings/return relate earnings to investment being assessed Profitability ratios assess success of firm in generating profits Earnings ratios assess performance of firm from perspective of investors