Chapter 8 Profitability P rofitability is the ability of the firm are one source of funds for debt coverage. to generate earnings. Analysis of Management uses profit as a performance profit is of vital concern to stock- measure. holders since they derive revenue in In profitability analysis, absolute figures are the form of dividends.
Further, less meaningful than earnings measured as a per- increased profits can cause a rise in centage of a number of bases: the productive market price, leading to capital gains. Profits assets, the owners’ and creditors’ capital employed, are also important to creditors because profits and sales. Profitability Measures The income statement contains several figures that might be used in profitability analysis. In general, the primary financial analysis of profit ratios should include only the types of income arising from the normal operations of the business.
This excludes the following: 1. Extraordinary items Exhibit 4-3 in Chapter 4 illustrates an income statement with these items. Review this section on special income statement items in Chapter 4 before continuing with the discussion of profitability. Equity in earnings of nonconsolidated subsidiaries and the minority share of earnings are also important to the analysis of profitability.
Chapter 4 covers these items, and Exhibits 4-5 and 4-9 illustrate the concepts. Trend analysis should also consider only income arising from the normal operations of the business. An illustration will help justify this reasoning. XYZ Corporation had net income of $100,000 in Year 1 and $150,000 in Year 2.
Year 2, however, included an extraordinary gain of $60,000. In reality, XYZ suffered a drop in profit from operating income. NET PROFIT MARGIN A commonly used profit measure is return on sales, often termed net profit margin. If a company reports that it earned 6% last year, this statistic usually means that its profit was 6% of sales.
Calculate net profit margin as follows: Net Income Before Minority Share of Earnings, Equity Income and Nonrecurring Items Net Profit Margin = Net Sales 298 Chapter 8 Profitability This ratio gives a measure of net income dollars generated by each dollar of sales. While it is desirable for this ratio to be high, competitive forces within an industry, economic condi- tions, use of debt financing, and operating characteristics such as high fixed costs will cause the net profit margin to vary between and within industries. Exhibit 8-1 shows the net profit margin using the 2007 and 2006 figures for Nike. This analysis shows that Nike’s net profit margin declined moderately, but would still be consid- ered high.
Exhibit 8-1 NIKE, INC. Net Profit Margin Years Ended May 31, 2007 and 2006 (In millions) 2007 2006 Net income [A] $ 1,491.9 Net profit margin [A B] 9.31% Several refinements to the net profit margin ratio can make it more accurate than the ratio computation in this book. Numerator refinements include removing “other income” and “other expense” items from net income. These items do not relate to net sales (denominator).
Therefore, they can cause a distortion in the net profit margin. This book does not adjust the net profit margin ratio for these items because this often requires an advanced understanding of financial statements beyond the level intended. Also, this chapter covers operating income margin, operating asset turnover, and return on operating assets. These ratios provide a look at the firm’s operations.
When working the problems in this book, do not remove “other income” or “other expense” when computing the net profit margin unless otherwise instructed by the problem. In other analyses, if you elect to refine a net profit margin computation by removing “other income” or “other expense” items from net income, remove them net of the firm’s tax rate. This is a reasonable approximation of the tax effect. If you do not refine a net profit margin computation for “other income” and “other expense” items, at least observe whether the company has a net “other income” or a net “other expense.” A net “other income” distorts the net profit margin on the high side, while a net “other expense” distorts the profit margin on the low side.
The Nike statement can be used to illustrate the removal of items that do not relate to net sales. Exhibit 8-2 shows the net profit margin computed with these items removed for 2007 and 2006. The adjusted computation results in the 2007 net profit margin being decreased by 0.29% and the 2006 net profit margin being decreased by 0. Both of these decreases are likely to be considered immaterial, but the 2007 decrease was over twice the 2006 decrease.
The trend between 2006 and 2007 was negative, and this negative trend increased with the revised computation. TOTAL ASSET TURNOVER Total asset turnover measures the activity of the assets and the ability of the firm to generate sales through the use of the assets. Compute total asset turnover as follows: Net Sales Total Asset Turnover = Average Total Assets Exhibit 8-3 shows total asset turnover for Nike for 2007 and 2006. The total asset turnover decreased from 1.
This decrease would be considered to be immaterial. The total asset turnover computation has refinements that relate to assets (denominator) but do not relate to net sales (numerator). Examples would be the exclusion of investments Chapter 8 Profitability 299 Exhibit 8-2 NIKE, INC. Net Profit Margin (Revised Computation) Years Ended May 31, 2007 and 2006 (In millions) 2007 2006 Net income $1,491.0 Tax rate: Provision for income taxes [A] 708.6 Income before income taxes [B] 2,199.00% Items not related to net sales: Interest (income) expense, net (67.8) Other (income) expense, net (0.4 Net (income) expense not related to net sales (68.06) Net income minus net of tax items not related to net sales [C] 1,445.9 Adjusted net profit margin [C ÷ D] 8.17% ∗ The tax rate could also be determined from the income tax note.
Exhibit 8-3 NIKE, INC. Total Asset Turnover Years Ended May 31, 2007 and 2006 (In millions) 2007 2006 Net sales [A] $16,325.9 Average total assets: Beginning of year $ 9,869.6 End of year 10,688.6 Total asset turnover [A B] 1.60 times and construction in progress. This book does not make these refinements. This chapter covers operating income margin, operating asset turnover, and return on operating assets.
If the refinements are not made, observe the investment account, Construction in Progress, and other assets that do not relate to net sales. The presence of these accounts distorts the total asset turnover on the low side. (Actual turnover is better than the computation indicates.) RETURN ON ASSETS Return on assets measures the firm’s ability to utilize its assets to create profits by comparing profits with the assets that generate the profits. Compute the return on assets as follows: Net Income Before Minority Share of Earnings and Nonrecurring Items Return on Assets = Average Total Assets Exhibit 8-4 shows the 2007 and 2006 return on assets for Nike.
The return on total assets for Nike decreased moderately in 2007. Theoretically, the best average would be based on month-end figures, which are not avail- able to the outside user. Computing an average based on beginning and ending figures provides 300 Chapter 8 Profitability Exhibit 8-4 NIKE, INC. Return on Assets Years Ended May 31, 2007 and 2006 (In millions) 2007 2006 Net income [A] $ 1,491.0 Average total assets [B] $10,279.6 Return on assets [A B] 14.92% a rough approximation that does not consider the timing of interim changes in assets.
Such changes might be related to seasonal factors. However, even a simple average based on beginning and ending amounts requires two fig- ures. Ratios for two years require three years of balance sheet data. Since an annual report only contains two balance sheets, obtaining the data for averages may be a problem.
If so, ending balance sheet figures may be used consistently instead of averages for ratio analysis. Similar comments could be made about other ratios that utilize balance sheet figures. DUPONT RETURN ON ASSETS The net profit margin, the total asset turnover, and the return on assets are usually reviewed together because of the direct influence that the net profit margin and the total asset turnover have on return on assets. This book reviews these ratios together.
When these ratios are reviewed together, it is called the DuPont return on assets. The rate of return on assets can be broken down into two component ratios: the net profit margin and the total asset turnover. These ratios allow for improved analysis of changes in the return on assets percentage. DuPont de Nemours and Company developed this method of separating the rate of return ratio into its component parts.
Compute the DuPont return on assets as follows: Net Income Before Net Income Before Minority Share of Earnings Minority Share of and Nonrecurring Items Earnings and Nonrecurring Items Net Sales = × Average Total Assets Net Sales Average Total Assets Exhibit 8-5 shows the DuPont return on assets for Nike for 2007 and 2006. Separating the ratio into the two elements allows for discussion of the causes for the increase in the percent- age of return on assets. Exhibit 8-5 indicates that Nike’s return on assets decreased primarily because of a decrease in net profit margin. The decrease in return on assets was slightly caused by the very slight decrease in total asset turnover.
Exhibit 8-5 NIKE, INC. DuPont Return on Assets Years Ended May 31, 2007 and 2006 Return on Net Profit Total Asset Assets∗ ⴝ Margin ⴛ Turnover 2007 14.60 ∗ There are some minor differences due to rounding. Chapter 8 Profitability 301 INTERPRETATION THROUGH DUPONT ANALYSIS The following examples help to illustrate the use of this analysis: Example 1 Return on Net Profit Total Asset Assets ⴝ Margin ⴛ Turnover Year 1 10% = 5% × 2.5 Example 1 shows how a more efficient use of assets can offset rising costs such as labor or materials. Example 2 Return on Net Profit Total Asset Assets ⴝ Margin ⴛ Turnover Firm A Year 1 10% = 4.5 Example 2 shows how a trend in return on assets can be better explained through the breakdown into two ratios.
The two firms have identical returns on assets. Further analysis shows that Firm A suffers from a slowdown in asset turnover. It is generating fewer sales for the assets invested. Firm B suffers from a reduction in the net profit margin.
It is generating less profit per dollar of sales. VARIATION IN COMPUTATION OF DUPONT RATIOS CONSIDERING ONLY OPERATING ACCOUNTS It is often argued that only operating assets should be considered in the return on asset cal- culation. Operating assets exclude construction in progress, long-term investments, intangi- bles, and the other assets category from total assets. Similarly, operating income—the profit generated by manufacturing, merchandising, or service functions—that equals net sales less the cost of sales and operating expenses should also be used instead of net income.
The DuPont analysis, considering only operating accounts, requires a computation of oper- ating income and operating assets. Exhibit 8-6 shows the computations of operating income and operating assets for Nike. This includes operating income for 2007 and 2006 and oper- ating assets for 2007, 2006, and 2005. The operating ratios may give significantly different results from net earnings ratios if a firm has large amounts of nonoperating assets.
For example, if a firm has heavy investments in uncon- solidated subsidiaries, and if these subsidiaries pay large dividends, then other income may be a large portion of net earnings. The profit picture may not be as good if these earnings from other sources are eliminated by analyzing operating ratios. Since earnings from investments are not derived from the primary business, the lower profit figures that represent normal earnings will typically be more meaningful. OPERATING INCOME MARGIN The operating income margin includes only operating income in the numerator.