Accounting: The Language of Business - Vol. 1 (Part 105)

"Mark-to-market accounting is like crack. Don`t do it." 

- Andrew Fastow 

Financial Statement Analysis (Part D)

by

Charles Lamson

Profitability Analysis

The ability of a business to earn profits depends on the effectiveness and efficiency of its operations as well as the resources available to it. Profitability analysis, therefore, focuses primarily on the relationship between operating results as reported in the income statement and resources available to the business as reported in the balance sheet. Major analyses used in assessing profitability include the following:

1. Ratio of net sales to assets

2. Rate earned on total assets

3. Rate earned on stockholders' equity

4. Rate earned on common stockholders' equity

5. Earnings per share on common stock

6. Price-earnings ratio

7. Dividends per share

8. Dividend yield 

Ratio of Net Sales to Assets

The ratio of net sales to assets is the profitability measure that shows how effectively a firm utilizes its assets. For example, two competing businesses have equal amounts of assets. If the sales of one are twice the sales of the other, the business with the higher sales is making better use of its assets.

In computing the ratio of net sales to assets, any long-term investments are excluded from total assets, because such investments are unrelated to normal operations involving the sale of goods or services. Assets may be measured as the total at the end of the year, the average at the beginning and end of the year, or the average of monthly totals. The basic data and the computation of this ratio for Lincoln Company are as follows:

This ratio improved during 2023, primarily due to an increase in sales volume. A comparison with similar companies or industry averages would be helpful in assessing the effectiveness of Lincoln Company's use of its assets.

Rate Earned on Total Assets

The rate earned on total assets measures the profitability of total assets, without considering how the assets are financed. This rate is therefore not affected by whether the assets are financed primarily by creditors or stockholders.

The rate earned on total assets is computed by adding interest expense to net income and dividing this sum by the average total assets. Adding interest expense to net income eliminates the effect of whether the assets are financed by debt or equity. The rate earned by Lincoln Company on total assets is computed as follows:

The rate earned on total assets of Lincoln Company during 2023 improved over that of 2022. A comparison with similar companies and industry averages would be useful in evaluating the Lincoln Company's profitability on total assets.

Sometimes it may be desirable to compute the rate of income from operations to total assets. This is especially true if significant amounts of nonoperating income and expense are reported on the income statement. In this case, any assets related to the nonoperating income and expense items should be excluded from total assets in computing the rate. In addition, using income from operations (which is before tax) has the advantage of eliminating the effects of any changes in the tax structure on the rate of earnings. When evaluating published data on rates earned on assets, you should be careful to determine the exact nature of the measure that is reported.

Rate Earned on Stockholders' Equity

Another measure of profitability is the rate on earned stockholders' equity. It is computed by dividing net income by average total stockholders' equity. In contrast to the rate turned on total assets, this measure emphasizes the rate of income earned on the amount invested by the stockholders.

The total stockholders' equity may vary throughout a period. For example, a business may issue or retire stock, pay dividends, and earn net income. If monthly amounts are not available, the average of the stockholders' equity at the beginning and the end of the year is normally used to compute this rate. For Lincoln Company, the rate earned on stockholders' equity is computed as follows:

The rate earned by a business on the equity of its stockholders is usually higher than the rate earned on total assets. This occurs when the amount earned on assets acquired with creditors' funds is more than the interest paid to creditors. This difference in the rate on stockholders' equity and the rate on total assets is called leverage.

Lincoln Company's rate earned on stockholders' equity for 2023, 11.3%, is greater than the rate of 8.2% earned on total assets. The leverage of 3.1% (11.3% - 8.2%) for 2023 compares favorably with the 2.7% (10% - 7.3%) leverage for 2022. Exhibit 8 shows the 2023 and 2022 leverages for Lincoln Company. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 704-706*

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