ISL459U-FINANCIAL STATEMENT ANALYSIS
Chapter 8: Profitability Analysis
Introduction
The companies may have different financial objectives. Among those objectives making profit settles on the top of the list. Investors are particularly interested in financial performances. There may be different aspects of successful financial performance like sustainability. Regardless of these aspects, “profit” which is presented in income statement is seen as a must characteristic.
Profitability analysis is used to compare the current performance of a company with its past performance, performance of competitors and industry averages. Calculation of profit ratios is relatively easy and interpretation of them do not require much detailed conclusions. Usually higher rates are preferred by the analysts. However, care should be given to company and industry related conditions.
Profitability Concept and Profitability Measures
A company’s income or loss has a direct effect on its ability to obtain debt and equity financing, its liquidity and its growth performance. Analysts use profitability as a test of management’s operating effectiveness.
Both investors and creditors analyze the financial statements in order to find some information that is needed for their decision-making purposes. The information provided in the income statement is essential to understand and analyze the company’s historical profitability and estimate the future profitability.
Profitability analysis deals with relationships of profits with some operational and financial aspects of a company. This analysis requires “profit (or loss)” in order to calculate some ratios. That raises a need for understanding the profit concept. Simply, profit can be defined as a surplus of income over expenses. When an accounting income is greater than expenses a profit is produced, when expenses are greater it results in a loss.
While the profit is a result of incomes and expenses, we should understand nature, content, and presentation of the income statements which provide information about incomes and expenses of a company.
Income Statement and its Presentation
The conceptual framework issued by the International Accounting Standards Board defines income as; “increases in assets or decreases in liabilities that result in increases in equity other than relating to contributions from holders of equity claim” (IFRS Conceptual Framework).
This definition covers both revenues and other income items. Revenues are income generated from ordinary business activities like sale of goods or services. Revenues are stated on the top line of the income statement and are the major contributor of the net income (profit) of the company.
Income statement provides information about the financial performance of the company consequently revenues, incomes, and expenses of the company. However, financial reporting standards do not allow disclosure of all net asset increases in income statements. The remaining net asset increases are covered under other comprehensive income (OCI).
If we select to use one statement approach, we start this statement with income statement items and find a profit or loss of the period. Then to present the total comprehensive income, other comprehensive income items are added to profit or loss amount.
If we select to use separate statements approach, then initially a separate income statement is prepared. Afterwards a separate other comprehensive income statement, beginning with net profit/loss amount, is prepared.
Components of Income Statement
As you can notice from income statements of Anadolu Efes and Otokar, (Table 8.2, p.159) there are some components of the income statement. Relationships among profitability measures are important. In this part we will discuss three of them;
• Gross Profit • Operating Profit (Profit/Loss from Operating Activities) • Net Income (Profit)
Gross Profit Revenue is the income that an entity earned during its ordinary course of business. Cost of sales on the other hand measures the total directly attributable cost of a product or service sold to the customer. Their difference makes the gross profit.
Changes in gross profit are more limited than changes in other profit measures.
There are some factors we have to consider:
• Gross profit is affected by the industries. In some industries gross profit can be relatively high, in some industries it could be low. We must compare the gross profit with the relevant industry averages. • Gross profit is affected by management policy. Some companies set lower prices and try to maximize the total amount of units sold, some set higher prices which may lead to fewer sales. • Operational efficiency. Cost of sales is said to be the measure of all directly attributable costs for the products or services sold to the customers. Especially in production company’s inefficiency will raise the total amount of inputs consumed. That will increase the production cost of products thus decreasing the gross profit.
Operating Profit
An important type of expense in businesses is operating expenses. Operating expenses consist of marketing expenses, general administrative expenses, and research and development expenses. Operating profit is computed by deducting operating expenses from gross profit.
Operating profit = Gross Profit - Operating Expenses
There are also some other operating income and expenses incurring in the business. Those amounts should be taken into consideration in computing the operating profit. In Table 8.1 the operating profit of Anadolu Efes for the year 2019 is 2.233.745 TL. Anadolu Efes does not present any research and development expenses. The reason for this is that the business does not have research and development expenses or is not material enough to require a separate classification.
Otokar, on the other hand, as presented in Table 8.2 have some research and development expenses. In analyzing the operating profit margin, analysts should look for the potential effect of other operating activities.
Net Profit
Net profit/loss represents the final outcome of the company’s performance which was the net of all revenues and expenses of the company for the given period. It is accepted by many financial statement users as a measure of a company’s success.
Failure of companies to generate sufficient net profit may increase the need for external financing for businesses. Failure to meet investors’ profitability expectations will reduce the business’s potential to attract new investments.
Profitability Ratios
Profit and profitability are closely related terms, but they are not the same. Profit is an absolute amount that shows the net difference between its revenue and expenses during a period. Profitability on the other hand is a relative one. It is a measure that determines the company’s profit in relation to a base. That base can be total assets, net sales or another related item.
Calculation and interpretation of profitability ratios is relatively easy. Profitability ratios disclose information whether the company earned sufficient profit in the analysis period. Financial statements solely do not answer this question. The analyst should gather data that show the relationship of some profit elements with some accounts in order to respond to sufficiency questions regarding the profit. Profitability ratios could be classified into two; margin ratios and return ratios.
Margin ratios represent the relationship of income (profit) elements with sales. Income statement is the only source needed to calculate these ratios. However, return ratios also require some information presented in the statement of financial position (balance sheet). Return ratios present
how the company effectively and efficiently used its economic resources.
Margin Ratios
Margin ratios can be classified as gross profit margin, operating profit margin and net profit margin.
The Gross Profit Margin
Gross profit represents the income that company makes from its main activity. Gross profit should be relatively high to cover its operating and other expenses. The gross profit margin is calculated as:
Gross Profit Margin = Gross Profit Divided by Net Sales
Gross profit indicates the margin on products sold and services rendered. A low gross profit margin may cause financial problems for the company. Thus, if this ratio is lower than industry averages, it will be an indicator of a financial distress. Higher gross profit margin is preferable for the analysts.
As the competitiveness increases the gross profit rate declines.
The Operating Profit Margin
In the income statement there is more than one profit element. The operating income or profit presents the income remained after the company paid all its operating expenses. If the company has any additional operating income, that amount is also included in operating profit. Operating profit margin is calculated as follows:
Operating Profit Margin = Operating Income divided by NetSales
Higher operating profit margin is preferable. Higher margin shows that all operating expenses are covered and it is a sign of a higher net profit margin. Usually gross profit is a more controllable profit element than the operating profit. That makes operating profit more prone to external effects.
The Net Profit Margin
Net profit is the bottom line of the income statement, and usually investors first look at this amount. Net profit is the amount that is attributable to the shareholders. Net profit margins vary among industries. Net profit margin is calculated as follows:
Net Profit Margin = Net Profit divided by Net Sales
Sometimes total expenses of the company exceed total income. That results in a loss which causes a negative profit margin.
Net profit margin shows if the revenues and income cover all the expenses and losses. The revenues and expenses among industries are identical that lead approximate net profit margin in an industry. However, net profit margins vary among industries. Some industries may have high net profit margins and some industries may have low ones.
But that does not mean a company will have the same industry average net profit margin.
Return Ratios
Return ratios aim to find how resources efficiently used to earn profit. Two main return ratios are return on total assets and return on equity.
Return on Total Assets
Total assets represent all the resources to generate income. Then it is important at the end to indicate how much income generated with these resources. Return on total assets shows how much income generated by one monetary unit of asset. This ratio is calculated as follows:
Return on Assets = Net Income divided by Total Assets
Return on Equity
Another important ratio is return on equity. This ratio shows the net income earned for one unit of investment made by the shareholders. ROE is calculated as follows:
Return on Equity = Net Income divided by Total Equity
ROE highlights the company’s performance from investors’ view. Equity represents the rights of the shareholders on the company. As the ROE increases, the return from the total rights increases. However, that may also indicate that the company largely finances its assets with debt. That may lead to some default or bankruptcy risk in negative economic conditions.
A constantly and regularly rising ROE is the preferred alternative for investment.
Earnings Per Share (EPS)
Earnings per Share (EPS) is the ratio of the net income to the average number of common shares outstanding during the year. It is calculated as follows:
Earnings per Share (EPS) = Net Income divided by Average Outstanding Common Shares
If the company has any preferred stock, the dividends for these preferred stocks must be deducted from the net income. In financial analysis, analysts make inter firm comparisons to better understand the financial position and performance of a business. However, EPS comparisons across companies do not provide meaningful information. That is due to the wide variations in the number of outstanding shares of companies. On the other hand, observing the EPS trend of a company gives insight to investors about the relative earning performance of the business.
Another interesting point for EPS is that you do not need to calculate it for public companies. EPS is computed by companies and they disclose it in the income statement.
DuPont Analysis
DuPont analysis was initially developed by DuPont Corporation’s management in the 1920s. They noticed that
the product of two often-computed ratios, net profit margin and total asset turnover, equals return on assets (ROA). In the 1970’s, emphasis in financial analysis shifted from ROA to return on equity (ROE), and the DuPont model was modified to include the ratio of total assets to equity.
DuPont analysis helps analysts better understand the profitability and how effectively it is made. Simply this analysis decomposes Return on Equity (ROE) into subcomponents; net profit margin, total assets turnover, and financial leverage.
DuPont analysis shows that as all ratios increase, ROE increases. Increases in both net profit margin and asset turnover are positive news for the business. However, for the financial leverage ratio the analysts should be cautious. Higher financial leverage ratio does not lead to positive results. In a case of loss, higher financial leverage multiplies the amount of the loss. Businesses should look for an optimal level of financial leverage. Companies with relatively high financial leverages bear more financial risks to the businesses, investors and creditors.
Interpretation of Profitability Analysis Results
Calculating and understanding the profitability ratios are easy. However, to interpret the profitability ratios correctly needs some attention. Stand alone profitability ratios may give some insights about the company. Nevertheless, for a more correct picture we must understand the company operations and management policy that may have different effects on operations other than the industry.
In profitability analysis it is essential to compare the profitability ratios with the industry averages or a competitor’s profitability ratios. Also, in order to understand the trend and make future estimates the historical ones must be compared.
Discussion on Profitability Analysis
Profitability shows the company’s competitive position, and by extension, the quality of its management. That is why profitability analysis attracts the attention of many financial statement users. Profitability analysis requires a profit/loss figure which was disclosed in the profit or loss statement.
Calculating profitability ratios are easy and interpretation of them usually do not require much knowledge. While interpreting the profitability measures, the details of the profit/loss must be understood. The analyst should understand the main source of income and should be able to compare the similarities and differences of the company’s operations with the competitors and industry. Profitability ratios based on the financial statements present the historical performance. These ratios in normal economic conditions serve as an indicator for future performance. But investors may look beyond these ratios.