Financial Statement Analysis

Profitability Analysis

The purpose of a profitability analysis is to evaluate overall business efficiency and performance. Dupont analysis and several common measures of profitability are frequently used to evaluate overall business efficiency and performance.

The ultimate goal of any business is to generate a sustainable profit. Thus, owners and managers pay special attention to a business's performance and efficiency. Profitability analysis provides an opportunity for both business owners and managers to evaluate the ability of a business to generate profit in the future. To successfully analyze business profitability, both the income statement and the balance sheet are required. In addition to Dupont analysis, there are six common profitability measures used to assess a business's profitability and ability to return profits to investors: asset turnover, return on total assets, return on stockholders' equity, earnings per share (EPS), price-earnings (P/E) ratio, and dividends per share.

Dupont analysis breaks down return on equity (ROE) into three basic areas to better understand organizational performance: asset usage, financial leverage, and operational efficiency. ROE is calculated using metrics from each of the three areas: ROE=Asset Turnover×Profit Margin×Financial Leverage\text{ROE}=\text{Asset Turnover}\times\text{Profit Margin}\times\text{Financial Leverage}. By breaking down ROE into smaller sections, it can be easier to identify which elements of organizational performance are driving changes in ROE over time. Asset turnover measures how well the organization is utilizing assets to generate sales. Profit margin, or return on sales (ROS), measures how much of each sales dollar results in profit after all expenses are covered. Finally, financial leverage measures how much of an organization's assets come from equity versus debt. Combining three areas into one analysis helps give investors a well-rounded view of factors that impact an organization's overall return on equity.

Created to measure the effectiveness of a business's asset utilization to generate revenue, the asset turnover ratio can be computed by dividing the net sales by the average total assets. To compute the asset turnover ratio, both the comparative balance sheet and the income statement are needed. The comparative balance sheet provides a 2-year comparison of assets, liabilities, and equity. Net sales are the total sales less any sales discounts or sales returns and allowances, which is the same as net sales or net revenue that is reported on the income statement. The average total assets can be computed by adding the assets for the past 2 years and dividing by two. To illustrate the computation of the asset turnover ratio for 2017, Greenfield Gates Company has provided information from its income statement and balance sheet: 2017 net sales at $905,000 and total assets at $780,000, 2016 net sales at $900,000 and total assets at $650,000. Their asset turnover is 1.27 which means that on average, their net sales would pay for or replace their total assets 1.27 times per year.

Income Statement and Balance Sheet Information

2017 2016
Net sales $905,000 $900,000
Total assets $780,000 $650,000

Asset Turnover=Net SalesAverage Total Assets=$905,000($780,000+$650,000)/2=$905,000$715,000=1.27\begin{aligned}\text{Asset Turnover}&=\frac{\text{Net Sales}}{\text{Average Total Assets}}\\\\&=\frac{\$905{,}000}{(\$780{,}000+\$650{,}000)/2}\\\\&=\frac{\$905{,}000}{\$715{,}000}\\\\&=1.27\end{aligned}
Designed to measure the efficiency of a business to utilize assets to generate profits, the return on total assets is often referred to as the return on assets (ROA) and aids in comparing business entities in the same or similar industries. ROA can be computed by dividing the net income by the average total assets. (ROA is also computed as profit margin times asset turnover.) The return of total assets computation uses the information for 2017 from Greenfield Gates Company. Greenfield Gates Company has a return on total assets of 0.49. This means that each dollar of assets they own helps them generate 49 cents of net income.

Information to Compute Return on Total Assets

2017 2016
Net income $350,000 $365,000
Total assets $780,000 $650,000

Return on Total Assets=Net IncomeAverage Total Assets=$350,000($780,000+$650,000)/2=0.49\begin{aligned}\text{Return on Total Assets}&=\frac{\text{Net Income}}{\text{Average Total Assets}}\\\\&=\frac{\$350{,}000}{(\$780{,}000+\$650{,}000)/2}\\\\&=0.49\end{aligned}
Return on stockholders' equity measures the profit generated using the funds stockholders have invested. An increase in return on stockholders' equity indicates management's improved operational efficiency. Return on stockholders' equity is also known as return on equity (ROE) and should not be the sole deciding factor when investors are deciding whether to invest in an entity's stock. Both the balance sheet and the income statement are required to compute the return on stockholders' equity for Greenfield Gates Company.

Information to Compute Return on Stockholders’ Equity

2017 2016
Net income $350,000 $365,000
Total stockholders' equity $400,000 $450,000

The return on stockholders’ equity for Greenfield Gates Company for 2017 would be 0.82. This means that the business has earned 82 cents for every dollar invested in stockholders’ equity.
Return on Stockholders’ Equity=Net IncomeAverage Total Stockholders’ Equity=$350,000($400,000+$450,000)/2=0.82\begin{aligned}\text{Return on Stockholders' Equity}&=\frac{\text{Net Income}}{\text{Average Total Stockholders' Equity}}\\\\&=\frac{\$350{,}000}{(\$400{,}000+\$450{,}000)/2}\\\\&=0.82\end{aligned}
As a profitability measure, earnings per share (EPS) is the amount of net income per share allocated to outstanding common shares. EPS also serves as an indicator of profitability on a per-share basis and is required to be disclosed at the bottom of the income statement. EPS can be computed by subtracting preferred dividends from net income and dividing by the average outstanding shares. The average outstanding shares is derived by adding the beginning balance of the common shares outstanding with the ending balance of the common shares outstanding and dividing by two. The comparative balance sheet and the income statement are needed to compute the earnings per share. Data from the balance sheet and the income statement are required to compute the EPS and P/E ratio for Greenfield Gates Company for 2017. The company has an EPS of $11.82 which means that it earned $11.82 of net income for every outstanding share of common stock.

Information to Compute EPS and P/E Ratio

2017 2016
Net income $350,000 $365,000
Dividends on preferred stock $25,000 $25,000
Shares of common stock outstanding 30,000 25,000
Market price per share of common stock $37.45 $44

Earnings Per Share (EPS)=(Net IncomeDividends on Preferred Stock)Average Outstanding Shares=$350,000$25,000(30,000+25,000)/2=$325,00027,500=$11.82Per Share\begin{aligned}\text{Earnings Per Share (EPS})&=\frac{({\text{Net Income}}-{\text{Dividends on Preferred Stock}})}{\text{Average Outstanding Shares}}\\\\&=\frac{\$350{,}000-\$25{,}000}{(30{,}000+25{,}000)/2} \\\\&=\frac{\$325{,}000}{27{,}500}\\\\&=\$11.82\;\text{Per Share}\end{aligned}
The price-earnings (P/E) ratio measures the market price of a common stock at a certain date compared to the earnings per share. Essentially measuring future earnings, the higher price-earnings ratio provides investors with an expectation of higher future earnings on their investments. A higher P/E ratio is indicative of a business entity's strength in the market or market overpricing. The P/E ratio can be computed by dividing the market price per share by the earnings per share (EPS). For example, with a market price per share of $37.45 and an EPS of $11.82 per share, Greenfield Gates Company has a P/E ratio of 3.17.
P/E Ratio=Market Price Per ShareEarnings Per Share (EPS)=$37.45$11.82=3.17\begin{aligned}\text{P/E Ratio}&=\frac{\text{Market Price Per Share}}{\text{Earnings Per Share (EPS)}}\\\\&=\frac{\$37.45}{\$11.82\;}\\\\&=3.17\end{aligned}
Dividends per share measures the extent of earnings being distributed to shareholders and provides investors a way to estimate possible future dividend payments, the amount of income transferred to shareholders. Dividends are the yield (cash return) feature of a stock, as sought by some investors. Some industries' stocks, such as in the consumer industry, are depended upon to have a consistent yield. Other industries' stocks, such as in technology, are not. Dividends are typically paid quarterly, if funds are available. To calculate dividends per share of common stock outstanding, divide the total dividends paid in a year by the number of shares outstanding. Consistent and increasing dividends are a signal to both shareholders and potential investors of the business's strong ability to return capital to equity holders. Data from the balance sheet and statement of cash flows are required to compute dividends per share for Greenfield Gates Company. They have dividends per share of $0.83 which means that when declared, stockholders will receive $0.83 for each share of common stock they own.

Information to Compute Dividends per Share

Dividends on common stock $50,000
Shares of common stock outstanding 60,000

Dividends Per Share=DividendsNumber of Shares Outstanding=$50,00060,000=$0.83Per Share\begin{aligned}\text{Dividends Per Share}&=\frac{\text{Dividends}}{\text{Number of Shares Outstanding}}\\\\&=\frac{\$50{,}000}{60{,}000}\\\\&=\$0.83\;\text{Per Share}\end{aligned}
Using financial ratios for financial statement analysis provides insight about past, current, and future performance of a business entity.