Chapter03

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Unformatted text preview: fficiently the firm manages its operations. The focus in this group is on the bottom line—net income. PROFIT MARGIN Companies pay a great deal of attention to their profit margin: Profit margin Net income _____________ Sales $363 ________ $2,311 15.7% [3.14] CHAPTER 3 Financial Statements Analysis and Long-Term Planning 53 ros82361_ch03.indd 53 5/27/08 10:14:59 AM Confirming Pages This tells us that Prufrock, in an accounting sense, generates a little less than 16 cents in profit for every dollar in sales. All other things being equal, a relatively high profit margin is obviously desirable. This situation corresponds to low expense ratios relative to sales. However, we hasten to add that other things are often not equal. For example, lowering our sales price will usually increase unit volume, but will normally cause profit margins to shrink. Total profit (or, more importantly, operating cash flow) may go up or down, so the fact that margins are smaller isn’t necessarily bad. After all, isn’t it possible that, as the saying goes, “Our prices are so low that we lose money on everything we sell, but we make it up in volume!”? 3 Profit margins are very different for different industries. For example, grocery stores have a notoriously low profit margin, generally around 2 percent. In contrast, the profit margin for the pharmaceutical industry is about 18 percent. RETURN ON ASSETS Return on assets (ROA) is a measure of profit per dollar of assets. It can be defined several ways, but the most common is: Return on assets Net income _____________ Total assets $363 ________ $3,588 10.12% [3.15] RETURN ON EQUITY Return on equity (ROE) is a measure of how the stockholders fared during the year. Since benefiting shareholders is our goal, ROE is, in an accounting sense, the true bottom-line measure of performance. ROE is usually measured as: Return on equity Net income _____________ Total equity $363 ________ $2,591 14% [3.16] Therefore, for every dollar in equity, Prufrock generated 14 cents in profit, but, again, this is only correct in accounting terms. Because ROA and ROE are such commonly cited numbers, we stress that it is important to remember they are accounting rates of return. For this reason, these measures should properly be called return on book assets and return on book equity. In addition, ROE is sometimes called return on net worth. Whatever it’s called, it would be inappropriate to compare the result to, for example, an interest rate observed in the financial markets. The fact that ROE exceeds ROA reflects Prufrock’s use of financial leverage. We will examine the relationship between these two measures in more detail below. Market Value Measures Our final group of measures is based, in part, on information not necessarily contained in financial statements—the market price per share of the stock. Obviously, these measures can be calculated directly only for publicly traded companies. We assume that Prufrock has 33 million shares outstanding and...
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This note was uploaded on 10/28/2009 for the course FINA 505 taught by Professor Deborahcernauskas during the Summer '09 term at Northern Illinois University.

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