Chapter 4 - Profitability Analysis

Which ratios are related to profitability analysis?

1. Activity ratios 2. Profitability ratios

What is the formula for average days in inventory?

365 / inventory turnover ratio

What is the formula for the average collection period?

365 / receivables turnover ratio

What does an activity ratio measure?

A company's efficiency in managing and utilizing its assets

What are the most frequently calculated activity ratios?

Asset turnover ratio Receivables turnover ratio Inventory turnover ratio

What type of activity ratios are preferred and why?

High turnover ratios usually are preferred because the greater the number of times an assets turns over, the fewer assets that are required to maintain a given level of activity (revenue)

What are the most frequently calculated profitability ratios?

Profit margin on sales Return on assets Return on equity

What are the three key components of return on equity under the DuPont framework?

Profitability Activity Financial Leverage

How can profitability be achieved in relation to ROA?

Return on assets = profit margin * asset turnover profitability can be achieved by a high profit margin, high asset turnover or a combination of the two

What is the equation form of the DuPont framework?

Return on equity = profit margin X asset turnover X equity multiplier OR Return on equity = return on assets X equity multiplier

What does a higher profit margin indicate?

a company generates more profit from each dollar of sales

What does a higher asset turnover indicate?

a company uses its assets efficiently to generate more sales from each dollar of assets

What do profitability ratios attempt to measure?

a company's ability to earn an adequate return relative to sales or resources devoted to operations

What does the receivables turnover ratio indicate?

a company's efficiency in collecting cash from customers shows the number of times during a period that the average accounts receivable balance is collected

What does the DuPont framework provide?

a convenient basis for analysis of how an investor's return can be improved that breaks return on equity into three key components

What kind of inventory turnover ratio usually is desirable and why?

a relatively high ratio indicates comparative strength could be caused by a company's superior sales force or a relatively low inventory level (efficient)

What kind of inventory turnover ratio usually is unfavorable and why?

a relatively low ratio or a decrease in the ratio over time too much capital may b tied up in inventory, or there could be overstocking, the presence of obsolete items or poor marketing/sales efforts

What will an equity multiplier greater than 1 produce?

a return on equity that is higher than return on assets

What effect would a decline in the receivables turnover ratio have on the average collection period? What could this indicate?

an increase in the average collection period could indicate that sales are declining because of customer dissatisfaction with the product or the company is granting extended credit terms in order to maintain customers - both signal a future increase in bad debts

How is activity measured in relation to the DuPont framework?

asset turnover

What are the tradeoffs associated with profitability?

at some point, the benefits of a higher equity multiplier are offset by a lower profit margin if the leverage is too high, creditors become concerned about the potential for default on the company's debt and require higher interest rates

What is an extension of the inventory turnover ratio?

average days in inventory

What is the equity multiplier?

average total assets / average total equity

What is the formula for inventory turnover ratio?

cost of goods sold / average inventory

How do analysts adjust net income for any temporary income effects?

first separating temporary earnings from permanent earnings with income from continuing operations adjustments are then made for any unusual, one-time gains or losses included in income from continuing operations

What does the asset turnover ratio indicate?

how efficiently a company utilizes all of its assets to generate revenue

What are shareholders concerned with in regards to profitability and what captures this concern?

how well management uses their equity to generate a profit return on equity is a closely watched measure that captures this concern

What does return on assets express and measure?

income as a percentage of average total assets available to generate that income measures the return generated by a company's assets

How do you evaluate the inventory turnover ratio of a specific company?

industry comparison

What is the formula for return on equity?

net income / average shareholders' equity

What is the formula for return on assets?

net income / average total assets

What is the formula for profit margin on sales?

net income / net sales

When calculating profitability ratios, analysis often adjust what?

net income for any temporary income effects

What is the formula for receivables turnover ratio?

net sales / average accounts receivable (net)

What is the formula for asset turnover ratio?

net sales / average total assets

What is return on assets an inclusive way of doing and why?

of measuring earning power that ignores specific sources of financing because total assets are partially financed with debt and partially by equity funds

How is profitability measured in relation to the DuPont framework?

profit margin

What is a company's return on assets related to?

profit margin and asset turnover

What is an important dimension of a company's profitability?

profit margin on sales

What does a high equity multiplier indicate?

relatively more of the company's assets have been financed with debt the company is more leveraged which can provide additional return to the company's equity holders

What is ROA?

return on assets

What is ROE?

return on equity

What should be included when calculating return on equity and how?

shareholders' equity only includes common shareholders deduct preferred stock from shareholders equity AND deduct preferred dividends from net income

The higher the receivables turnover ratio, the ...

shorter the average time between sales and cash collection

What is an extension of the receivables turnover ratio?

the average collection period

What does management of a company need to identify?

the combination of profitability, activity and leverage that produces the highest return for equity holders

How is financial leverage measured in relation to the DuPont framework?

the equity multiplier

What is a leverage ratio?

the equity multiplier

What is an important activity measure for a merchandising (retail, wholesale or manufacturing) company?

the inventory turnover ratio

The more frequently a business is able to sell/turn over its inventory, ....

the lower its investment in inventory must be for a given level of sales

What does the average days in inventory indicate?

the number of days it normally takes to sell inventory

What does the inventory turnover ratio indicate?

the number of times the average inventory balance is sold during a reporting period indicates how quickly inventory is sold

What does profit margin indicate?

the portion of each dollar of revenue that is available after all expenses have been covered offers a measure of the company's ability to withstand either higher expenses or lower revenues

What is considered to be a desirable profit margin?

this is highly sensitive to the nature of the business activity a low profit margin can be compensated for by a high asset turnover rate and vice versa

What is net accounts receivable?

total accounts receivable less allowance for uncollectible accounts

What are resources devoted to operations?

total assets or only those assets provided by owners

What is another name for activity ratios?

turnover ratios