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ACCT820 Chapter 4[1] - Overview of Profitability Analysis...

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Overview of Profitability Analysis Profitability analysis evaluates whether managers are effectively executing a firm’s strategy; with this in mind, we view financial statement analysis as a form of hypothesis testing Although firms must report comprehensive income, net income, or earnings, remains the key measure of profitability o Dhaliwal, Subramanyam, & Trezevant examined the association b/w stock returns & comprehensive income & its components With the exception of firms in the financial industry, net income is more strongly associated w/stock returns than comprehensive income o Our purpose in analyzing profitability is to generate an understanding of a firm’s performance to enable forecasts of future performance OCI amounts exhibit a very low level of persistence; thus, we focus on NI as our primary measure of profitability, w/the caveat that components of OCI for certain firms should not be automatically dismissed o Different approaches to analyzing a firm’s profitability are aimed at generating a deeper understanding of net income o In addition, accounting method choices will affect the financial statements & the measurement of net income Diagram of the approaches to analyzing net income: o Diagram beings w/NI, which is the summary measure of profits from the IS; from NI, 2 branches represent alternative approaches to better understanding firms’ NI On the left, the approach is to analyze alternative transformations of measured NI, which include the following approaches: EPS analysis, common-size analysis, percentage change analysis, & alternative definitions of profits These are straightforward approaches to understand The right side of the diagram frames profitability in terms of rate of return metrics Rates of return integrate info from the IS & the BS to compute various profitability metrics, the most common being ROA & ROCE (return on common equity) o These are key metrics in the discussions of accounting quality & forecasting & valuation ROA & ROCE can be decomposed into measures of margin, turnover, & leverage, which facilitate a deeper understanding of how a firm is generating wealth for its shareholders o The dashed lines for the decomposition of ROCE into margin (& leverage) highlight that there are differences in the decompositions for ROA & ROCE The primary difference is that profit margins for ROA & ROCE are computed based on different measures of income in the numerator o Finally, the measures of margin, turnover, & leverage can be further dissected by means of various financial ratios prepared from different line items in the financial statements
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o Note that the 2 branches of analysis of NI are interrelated, especially in the use of common size analysis & alternative definitions of profits Both of these can be incorporated into rate of return analysis Earnings per Share (EPS) One of the most frequently used measures of profitability is EPS (earnings per common share) o
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