profitability analysis is a technique or tool for using application analysis for running

Chapter 9
Profitability Analysis

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

Focus of Profitability Analysis
Profitability analysis helps address questions such as:
 What is a company’s 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 company’s earning power?

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

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

Measuring Income - Estimation Issues
Management discretion is part of income measurement
Estimates of skilled and experienced professionals 
Some consensus (less variability)

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

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

Measuring Income - Incentives for Disclosure
Ideally:
 Financial statements fairly present transactions and
events
 Accounting is neutral—not affecting how transactions
and events are perceived
 Methods chosen that are most applicable to the
circumstances
 Relevant information is disclosed—favorable and
unfavorable

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

Result:
“Acceptable” methods, not necessarily
“appropriate” methods

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 one’s 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 objectives—such 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
 Management’s 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 company’s 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:
 Sales - both intersegment and to unaffiliated customers
 Operating income - revenues less operating expenses
 Identifiable assets
 Capital expenditures
 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:
 trend percent analysis
 evaluation of Management’s 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 analysis—concentration, 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

Management’s 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 analysis—both 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 Gross Profit
Analysis of gross profit directs attention at the
factors explaining variations in:
 Sales
 Costs of sales

Analysis Statement of Changes in Gross Profit
Step 1. Focus on year-to-year change in volume assuming unit
selling price is unchanged—Volume 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.

Analysis Statement of Changes in Gross Profit—Illustration
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

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.

Interpreting Changes in Gross Profit
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
 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

Tools for Analysis of Expenses
Analyzing 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
depreciation—this 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:
 Revenues
 Net property and equipment
Amortization of special costs can be related to and
expressed as a percent of:
 Revenues
 Unamortized special costs
 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 fixed—such 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 fixed - exception 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 company’s
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

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