Profitability Ratios

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There are many measures of profitability. As a group, these measures enable analysts to evaluate the firm's profits with respect to a given level of sales, a certain level of assets, or the owners' investment. Without profits, a firm could not attract outside capital. Owners, creditors, and management pay close attention to boosting profits because of the great importance the market places on earnings.

14. Although preferred stock dividends, which are stated at the time of issue, can be "passed" (not paid) at the option of the firm's directors, it is generally believed that the payment of such dividends is necessary. This text therefore treats the preferred stock dividend as a contractual obligation, to be paid as a fixed amount, as scheduled.

Common-Size Income Statements cotnsnon-saze income staiement

An income statement in which each item is expressed as a percentage of sales.

A popular tool for evaluating profitability in relation to sales is the common-size income statement.15 Each item on this statement is expressed as a percentage of sales. Common-size income statements are especially useful In comparing performance across years. Three frequently cited ratios of profitability that can be read directly from the common-size income statement are (1) the gross profit margin, (2) the operating profit margin, and (3) the net profit margin.

Common-size income statements for 2009 and 2008 for Bartlett Company are presented and evaluated in Table 2.7. These statements reveal that the firm's cost of goods sold increased from 66.7 percent of sales in 2008 to 67.9 percent in 2009, resulting in a worsening gross profit margin. However thanks to a decrease in total operating expenses, the firm's net profit margin rose from 5.4 percent of sales in 2008 to 7.2 percent in 2009. The decrease in expenses more than com-

Bartlett Company Common-Size Income Statements

For the years ended

December 31 Evaluation'1

2009 2003 2008-2009

Sales revenue Less; Cost of goods sold (1} Gross profit margin Less: Operating expenses Selling expense

General and administrative expenses Lease expense Depreciation expense Total operating expense

(2) Operating profit margin Less: Interest expense Net profits before taxes Less: Taxes

Net profits after taxes Less: Preferred stock dividends

(3) Net profit margin

67.9 66.7 worse

6.8 6.7 better

1.1 1.3 better

7.3 9.3 better

3.1 2.5 worse* 7.5% 5.8% better 0.3 0.4 better 7.2% 5.4% better

"Subjecrivc assessments based on data provided.

'Taxes as a percentage of sales increased noticeably between 2008 and 2009 because of differing costs and expenses, whereas the average tax rates {taxes ■+■ net profits before taxes) for 200S and 2009 remained about the same—30% and 29%, respectively.

15. This statement is sometimes called a percent income statement. The same treatment is often applied to the firm's balance sheet to make it easier to evaluate changes in the asset and financial structures of the firm. In additioa to measuring profitability, these statements in effect can be used as an alternative or supplement to liquidity, activity, and debt-ratio analysis.

pensated for the increase in the cost of goods sold: A decrease in the firm's 2009 interest expense (3.0 percent of sales versus 3.5 percent in 2008) added to the increase in 2009 profits.

gross profit margin Measures the percentage of each sales dollar remaining after the firm has paid for its goods.

Gross Profit Margin

The gross profit margin measures the percentage of each sales dollar remaining after the firm has paid for its goods. The higher the gross profit margin, the better (that is, the lower the relative cost of merchandise sold). The gross profit margin is calculated as follows:

Gross profit margin =

Sales - Cost of goods sold Gross profits

Sales

Sales

This is a very significant ratio for small retailers, especially during rimes of inflationary prices. If tie owner of the firm does not raise prices when the cost of sales is rising, the gross profit margin will erode.

Bartlett Company's gross profit margin for 2009 is

This value is labeled (1) on the common-size income statement in Table 2.7.

operating profit margin Measures the percentage-of -each sales dollar remaining after all costs and expenses other than interest, taxes, and preferred stock dividends are deducted; the "pure profits" earned on each sales dollar.

Operating Profit Margin

The operating profit margin measures the percentage of each sales dollar remaining after all costs and expenses other than interest, taxes, and preferred stock dividends are deducted. It represents the "pure profits" earned on each sales dollar. Operating profits are "pure" because they measure only the profits earned on operations and ignore interest, taxes, and preferred stock dividends. A high operating profit margin is preferred. The operating profit margin is calculated as follows:

Operating profit margin =

Operating profits Sales

Bartlett Company's operating profit margin for 2009 is

$418,000

$3,074,000 /o This value is labeled (2) on the common-size income statement in Table 2.7.

net profit margin Measures the percentage of each sales dollar remaining after all costs and expenses, including interest, taxes, and preferred stock dividends, have been deducted.

Net Profit Margin

The net profit margin measures the percentage of each sales dollar remaining after all costs and expenses, including interest, taxes, and preferred stock dividends, have been deducted. The higher the firm's net profit margin, the better. The net profit margin is calculated as follows:

Net profit margin =

Earnings available for common stockholders Sales

The net profit margin is sometimes defined as net profits after taxes divided by sales. The formula used here places greater emphasis on the common stockholders.

Barriett Company's net profit margin for 2009 is

$221,000

$3,074,000

This value is labeled (3) on the common-size income statement in Table 2.7.

The net profit margin is a commonly cited measure of the firm's success with respect to earnings on sales. "Good" net profit margins differ considerably across industries. A net profit margin of 1 percent or less would not be unusual for a grocery store, whereas a net profit margin of 10 percent would be low for a retail jewelry store.

EPS represents the dollar amount earned on behalf of cach outstanding share of common stock—not the amount of earnings actually distributed to shareholders.

Earnings per Share (EPS)

The firm's earnings per share (EPS) is generally of interest to present or prospective stockholders and management. As we noted earlier; EPS represents the number of dollars earned during the period on behalf of each outstanding share of common stock. Earnings per share is calculated as follows:

Earnings per share =

Earnings available for common stockholders Number of shares of common stock outstanding

Bartlett Company's earnings per share in 2009 is

$221,000

76,262

This figure represents the dollar amount earned on behalf of each outstanding share of common stock. The dollar amount of cash actually distributed to each shareholder is the dividend per share (DPS), which, as noted in Bartiett Company's income statement (Table 2.1), rose to $1.29 in 2009 from $0.75 in 2008. EPS is closely watched by the investing public and is considered an important indicator of corporate success.

return on total! assets (RCA) Measures the overall effectiveness of management in generating profits with its available assets; also called the return on investment (ROQ.

IwfiCTi Some firms use this measure as a simple decision technique for evaluating proposed fixed-asset investments.

Return on Total Assets (ROA)

The return on total assets (ROA), often called the return on investment (ROI), measures the overall effectiveness of management in generating profits with its available assets. The higher the firm's return on total assets, the better. The return on total assets is calculated as follows:

Return on total assets =

Earnings available for common stockholders Total assets

Bartlett Company's return on total assets in 2009 is

$221,000

$3,597,000

This value indicates that the company earned 6.1 cents on each dollar of asset investment.

return on common equity (ROE)

Measures the return earned on the common stockholders' investment in the firm.

Return on Common Equity (ROE)

The return on common equity (ROE) measures the return earned on the common stockholders' investment in the firm. Generally, the higher this return, the better off are the owners. Return on common equity is calculated as follows:

Return on common equity =

Earnings available for common stockholders

Common stock equity

This ratio for Bartlett Company in 2009 is

$221,000

$1,754,000

Note that the value for common stock equity ($1,754,000) was found by subtracting the $200,000 of preferred stock equity from the total stockholders' equity of $1,954,000 (see Bartlett Company's 2009 balance sheet in Table 2.2). The calculated ROE of 12.6 percent indicates that during 2009 Bartlett earned 12.6 cents on each dollar of common stock equity.

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