Accounting: The Language of Business - Vol. 2 (Intermediate: Part 62)

What we take anything to be profoundly affects how we go about describing it, and how we describe something profoundly affects how we go about explaining, accounting for, or understanding what is what we are, in a sense, defining, by our description.

R. D. Laing

Statements of Net Income and Comprehensive Income (Part Q)

By

Charles Lamson

Profitability Analysis

Ratio analysis is one of the most common financial statement analysis tools. Ratios compute meaningful relationships between financial statement items useful in:

• Understanding a company over time.

• Comparing one company to another company.

• Benchmarking a company to an industry standard.

In this section, we introduce the most common ratios for profitability analyses. We will expand our coverage of ratios as we cover additional topics in later posts. In management's discussion and analysis of financial condition and results of operations, companies will often comment on the profitability using the ratios we discuss below. We present commonly used ratio definitions and computations are presented. It is important to understand how each company defines its ratios because companies could vary.

Profitability 

Profitability is a company’s ability to generate a return for its shareholders based on the revenues or resources available. the "bottom line" return to the shareholders is the company's net income. Profitability analysis allows a financial statement user to assess how well a company has performed and how much return it has generated relative to its revenues or resources. Common measures of profitability are:

1. Profit margin

2. Return on assets

3. Return on equity

Profit Margin

Firms measure profitability as the percent of each dollar of sales that is available for distribution. The profit margin indicates the percent of each dollar of sales remaining after covering cost of sales and other business expenses. The profit margin is computed as net income divided by sales revenue:

Profit Margin = Net income / Sales Revenue       (5B.1)

 A higher profit margin indicates a higher return to shareholders.

Return on Assets

Firms also assess profitability based on how well a company is using its resources. The return on assets ratio measures the income generated for shareholders from each dollar of average total assets.

Return on Assets = Net Income / Average Total Assets        (5B.2) 

Average total assets is used as the base and the denominator. A firm earns income over a period of time. However, total assets are measured at a point in time, the balance sheet date. To obtain a measure of the assets in use over the period in which income is earned, we take the average of total assets at the beginning and ending of the period. The assumption is that the firm earns net income evenly over the year on assets it employs. Average total assets is computed as:

Average Total Assets = Beginning Total Assets + Ending Total Assets / 2    (5B.3)

 

   Return on Equity Ratio

The return on equity ratio measures the return on shareholders' investment in the company. Return on equity is the amount of net income the company generates by using the equity provided by shareholders:

Return on Equity = Net Income / Average Stockholders' Equity       (5B.4)

Similar to using average total assets and return on assets, we use the average shareholders' equity as the base in the denominator. Again, the assumption is that the firm earns net income evenly over the year. Average shareholders' equity is computed as:

Average Stockholders' Equity = Beginning Stockholders' Equity + Ending Stockholders' Equity / 2

The various return ratios address the question of how well a company is using its resources. In contrast to the return on assets ratio, the return on equity is an indicator of a company's return to its shareholders. 

When analyzing ratios based on net income, it is important to assess whether the income items are recurring or non-recurring. Recurring income items are better indicators of future performance and profitability than non-recurring items. For example, a loss on discontinued operations is not expected to recur. In example 5A.1 Johnson & Johnson reported losses on the restructuring of $491 million and $509 million in 2016 and 2015, respectively. Whereas a large company like Johnson & Johnson is expected to have these types of losses and expenses, the amounts can vary each year and may not recur. 

EXAMPLE 5B.1 Profitability Analysis of Johnson & Johnson's 2015 and 2016

PROBLEM: Use the following information provided from the 2016 Johnson & Johnson annual report to compute the profit margin, return on assets, and return on equity for 2015 and 2016. What does each measure indicate about Johnson & Johnson's profitability? What do the measures taken together indicate about Johnson & Johnson's profitability?

SOLUTION: The table below provides the computations of the profit margin, return on assets, and return on equity for 2015 and 2016.

*Click to enlarge*

Johnson & Johnson reported profit margins of 23% and 22% in 2016 and 2015, respectively. The results indicate that Johnson & Johnson is able to return 23.0 and 22.0 cents of each dollar of sales to its stockholders in 2016 and 2015, respectively. Its return on assets of 12% and 11.7% in 2016 and 2015, respectively, suggests that for each dollar invested in assets the return is about $0.12 and $0.12 in 2016 and 2015, respectively. The return on equity of 23.6% and 21.9% in 2016 and 2015, respectively, indicates that for each dollar of equity invested, the return is about $0.24 and $0.22 in 2016 and 2015, respectively.

All profitability ratios are positive. All three ratios increased from 2015 to 2016. One reason for the increase is higher income in 2016; however, further analysis is required to determine the contributing factors. For example, an analyst could examine the income statement line items for any changes or unusual items. In this case, part of the increase in net income in 2016 is due to the lower selling, marketing, and administrative expenses. In addition, the denominator in two of the ratios is increasing, suggesting that Johnson & Johnson is able to increase overall profitability as a percentage of sales and total assets. 

Exhibit 5B.1 summarizes profitability ratios, computations, desirable characteristics, and potential problems.

EXHIBIT 5B.1 Profitability Ratios

*Click to enlarge*

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 232-234*

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