MEASURES OF PROFITABILITY’ Accounting Help

Measures of a company’s profitability are of interest primarily to equity investors and management, and are drawn from the income statement. The measures that we discuss’ in this chapter include percentage changes in key measurements, gross profit rates, operating income, net income as a percentage of sales, earnings per share, return on assets, and return on equity.

Public opinion polls show that many people believe that most businesses earn a profit equal to 30% or more of the sales price of their merchandise, Actually, this is far from true. Most successful companies earn a net income of between 5% and, perhaps, 15%  of sales revenue.one time America’s “flagship” airline-ceased operations/Many American corporations had some bad years in the early 1990s: Each of the “Big Three” American automakers reported huge losses. So did most of the nation’s major airlines. Even IBM sustained a net loss-the. first in the company’s SO-year history. The oil companies have been particularly subject to criticism for so-called excessive profits, so let us briefly look at the profits of Exxon, the world’s largest oil company.

A recent annual report of Exxon (audited by Price Waterhouse) shows that profits amounted – to a little over $4,7 billion. Standing alone, that figure seems enormous-but we need to look a little farther. The total revenue of Exxon was over $115 billion, so net income amounted to about 4% of sales. On the other hand, income taxes, excise taxes, and other taxes and duties levied on Exxon amounted to more than $36 billion, or about 7Y2times ,as much as the company’s profit.

Thus taxation represents a far greater portion of the cost of a gall~ of gasoline than does the. oil company’s profit. . Multiple-Step Income Statements’

A multiple-step income statement draws its name from the series of steps in which costs and expenses are deducted from revenue. As a first step, the cost of goods sold is deducted from net sales to determine the subtotal gross profit. As asecond step, operating expenses are deducted to obtain a subtotal called operating income (or, income from operations).

As a fmal step, income taxes expense and other nonoperating items are taken into consideration to arrive at net income. . Notice that the income statement is divided into four major sections: (1) reVenue,· (2) cost of goods sold, (3) operating expenses, and (4) nonoperating items. Multiple-step income statements are noted for their numerous sections and the development of significant subtotals. ‘

The Revenue Section In a merchandising company, the revenue section of the income statement usually contains only one line, ‘entitled net sales. (Other types of revenue, if any, appear in the final section of the statement.) Investors and managers are vitally interested in the trend in net sales. As one means of evaluating this trend, they often compute the percentage change in net sales from year to year.

A percentage change is the dollar amount of the change in a financial measurement, expressed as a percentage. It is computed by dividing the dollar amount of increase or decrease by the dollar amount of the measurement before the change occurred. (Dollar changes.canner be expressed as percentages if the financial statement amount in the earlier period is zero or has changed from a negative amount to a positive amount.) In our economy, most prices increase over time.

The average increase in prices during the year is called the rate of inflation. Because of inflation, a company’s net sales may increase slightly from year to year even if the company is not selling greater amounts of merchandise. if a company’s physical sales volume is increasing, net sales usua y will grow faster than the rate of inflation.a company’s sales grow faster than the industry average, the company increases its market share-that is, its share of total industry sales.

Publicly owned corporations include in their annual reports schedules summarizing operating data=-sucli as net sales-for a period of 5 or 10 years. This information is also readily available through several on-line databases

The Cost of Goods Sold Section The second section of a merchandising company’s income statement shows cost of goods sold·for the period.

Cost of goods sold usually appears as a single dollar amount,which includes such incidental items as transportationin and normal shrinkage losses.Gross ‘Proflt: A Key Subtotal In a multiple-step income statement. gross profit appears as II subtotal.

This makes it easy for users of the Incomestatement to compute lhepany’s gross profit rate (or profit margin)In evaluating the gross profit rate ofa particular company, the analyst should consider the rates earned in prierperiods, as well as the rates earned by other companies. in the same industry,

For most merchandising companies, gross profit rates usually lie,between 20% and 50%, depending on the types of products they sell. These rates usually are lowest on fast-moving merchandise. such as groceries, andhighest on specialty and novelty products. . ‘Under normal circumstances. a company’s gross profit rate tends to remain reasonably stable fromone period to the next.

Significant changes in this rate may provide’ investors with an early indication of changing consumer demand for the company’s products. the Expectation Overestimating .expenses are in producing revenue. These expenses often are subdivided into the classifications of sellingexpenses and general and administrative expenses. Subdividing operating expenses into functional Classifications aids managementand other users of the statements in separately evaluating different aspects of the company’s operations. For example, selling expenses often rise and fall in concert with changes in net sales, Administrative expenses, on’ the other hand,usually remain more constant from one period to the next. Operating Income:

Another Key Subtotal’ Some of the revenues and expenses of a business result from activities other than the-company’s basic business operations. Common examples include interest earned on investments and income taxes expense,

Operating income (Qr income from; operations) shows the relationship between revenue earned from customers and expenses incurred in producing this revenue, In effect. operating income measures, the probability of a company’s basic or core.business operations and leaves out other types of revenue and expenses.

Nimoperatlng Items Revenue and expenses that are not directly related to the company’s primary business activities are listed in a final section of the -income statement following the determination of operating income

Posted on November 23, 2015 in Financial Statement Analysis

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