Overview

The bottom line. That's what many business people look at to gauge the profitability of a company. While important, the bottom line doesn't always provide the entire picture, and using it as the sole barometer of company performance could have serious fiscal repercussions.

This discussion provides some simple profitability ratios and analytical procedures that can help determine your company's present and future financial standing. With your findings, you can identify company trends and compare current figures to your business's historical performance. Once this essential data is in hand, you will be able to evaluate your business in relation to your competition and industry norms.

The following ratios and analytical procedures described here will provide you with a quick reference guide to how your business is performing:

For more information on financial ratios, see Financial Ratio Analysis.

Ratios

• Gross Profit on Net Sales
• Net Profit on Net Sales
• Management Rate of Return
• Net Profit to Tangible Net Worth
• Rate of Return on Common Stock Equity

Analytical Procedures

• Comparative Statements
• Index-Number Trend Series
• Common-Size Statements
• Analysis of Financial Statement Components

This discussion also provides you with a detailed example of a common-size income statement and other procedures you can use to examine your company's profitability.

Outline:

1. Purpose of Profitability Analysis
2. Profitability Ratios
3. Analytical Procedures
4. Commonly Used Analytical Procedures
5. Comparative Statements
6. Index-Number Trend Series
7. Common-Size Statements
8. Analysis of Financial Statement Components
9. Vertical Analysis
10. Resources

I. Purpose of Profitability Analysis

A properly conducted profitability analysis provides invaluable evidence concerning the earnings potential of a company and the effectiveness of management.

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II. Profitability Ratios

Profitability ratios are the most significant - and telling - of financial ratios. Similar to income ratios, profitability ratios provide a definitive evaluation of the overall effectiveness of management based on the returns generated on sales and investment.

The adequacy of your company's earnings can be measured in terms of (1) the rate earned on sales; (2) the rate earned on average total assets; (3) the rate earned on average common stockholders' equity; and (4) the availability of earnings to common stockholders. The most widely used profitability measurements are profit margin on sales, return-on-investment ratios, and earnings per share.

Gross Profit on Net Sales

You can use the following ratio to determine the percentage of gross profit on net sales:  

Net Sales - Cost of Goods Sold	= Gross Profit Rate
Net Sales

Your gross profit rate helps you determine whether your average markup on goods will consistently cover your expenses, therefore resulting in the desired profit. If your gross profit rate is continually lower than your average margin, something is wrong! Be on the lookout for downward trends in your gross profit rate. This is a sign of future problems for your bottom line.

Note: This percentage rate can - and will - vary greatly from business to business, even those within the same industry. Sales, location, size of operations, and intensity of competition are all factors that can affect the gross profit rate.

Net Profit on Net Sales  

Earnings after Taxes	= Net Profit Rate
Net Sales

This ratio provides a primary appraisal of net profits related to investment. Once your basic expenses are covered, profits will rise disproportionately greater than sales above the break-even point of operations.

Note: Sales expenses may be substituted out of profits for other costs to generate even more sales and profits.

Management Rate of Return

This profitability ratio compares operating income to operating assets, which are defined as the sum of tangible fixed assets and net working capital.  

Operating Income	= Rate of Return
Fixed Assets + Net Working Capital

This rate determines whether you have made efficient use of your assets. You can calculate for your entire company or for each of its divisions or operations, determines whether you have made efficient use of your assets. The percentage should be compared with a target rate of return that you have set for the business.

Net Sales to Tangible Net Worth  

Net Sales	= Net Sales to Tangible Net Worth Ratio
Tangible Net Worth*

This ratio indicates whether your investment in the business is adequately proportionate to your sales volume. It may also uncover potential credit or management problems, usually called overtrading and undertrading.

Overtrading, or excessive sales volume transacted on a thin margin of investment, presents a potential problem with creditors. Overtrading can come from considerable management skill, but outside creditors must furnish more funds to carry on daily operations.

Undertrading is usually caused by management's poor use of investment money and their general lack of ingenuity, skill or aggressiveness.

*Tangible Net Worth = owners' equity - intangible assets

Rate of Return on Common Stock Equity

Instead of focusing on total assets, this ratio takes a reading on the rate of return on stockholders' equity.  

Earnings after Taxes	= Rate of Return
Tangible Net Worth

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III. Analytical Procedures

Procedures you can use to analyze your business's profitability are generally broken up into two categories: (1) those based upon financial data from two or more fiscal periods, or (2) financial data from only the current fiscal period. To complete a thorough review of your company's financial standing, we recommend you utilize both types of analytical procedures.

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IV. Commonly Used Analytical Procedures

The most common types of analytical procedures are: (1) comparative statements; (2) index-number trend series; (3) common-size statements;  (4) analysis of financial statement components; and (5) vertical analysis.

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V. Comparative Statements

A first look at your business's current financial figures can be quite overwhelming and, more often than not, a little confusing. But, if you were to compare that data to your business's historical performance, it becomes significantly more meaningful. Compare your company's current financial numbers with monthly, quarterly, or annual data from previous fiscal years. You should notice some trends that will help you map out the future of your business.

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VI. Index-Number Trend Series

If you are trying to analyze financial data that span a long period of time, simply trying to compare financial statements can turn into quite a cumbersome task. If you find yourself in this boat, try to create an index-number trend series to alleviate some of your confusion.

First, choose a base year to which all other financial data will be compared. Usually, the base year is the earliest year in the group being analyzed, or it can be another year you consider particularly appropriate.

Next, express all base year amounts as 100 percent. Then state corresponding figures from following years as a percentage of the base year amounts. Keep in mind that index-numbers can be computed only when amounts are positive.

Example  

The index-number trend series technique is a type of horizontal analysis that can provide you with a long range view of your firm's financial position, earnings, and cash flow. It is important to remember, however, that long-range trend series are particularly sensitive to changing price levels. For instance, between 1975 and 1985 the price level in the United States doubled. A horizontal analysis that ignored such a significant change might suggest that your sales or net income increased dramatically during the period when, in fact, little or no real growth occurred.

Data expressed in terms of a base year can be very useful when comparing your company's figures to those from government agencies and sources within your industry or the business world in general, because they will often use an index-number trend series as well. When making comparisons, be sure the samples you use are in the same base period. If they aren't, simply change one so they match.

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VII. Common-Size Statements

When performing a ratio analysis of financial statements, it is often helpful to adjust the figures to common-size numbers. To do this, change each line item on a statement to a percentage of the total. For example, on a balance sheet, each figure is shown as a percentage of total assets, and on an income statement, each item is expressed as a percentage of sales.

This technique is quite useful when you are comparing your business to other businesses or to averages from an entire industry, because differences in size are neutralized by reducing all figures to common-size ratios. Industry statistics are frequently published in common-size form.

When comparing your company with industry figures, make sure that the financial data for each company reflect comparable price levels, and that it was developed using comparable accounting methods, classification procedures, and valuation bases.

Such comparisons should be limited to companies engaged in similar business activities. When the financial policies of two companies differ, these differences should be recognized in the evaluation of comparative reports. For example, one company leases its properties while the other purchases such items; one company finances its operations using long-term borrowing while the other relies primarily on funds supplied by stockholders and by earnings. Financial statements for two companies under these circumstances are not wholly comparable.

Example Common-Size Income Statement  

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VIII. Analysis of Financial Statement Components

The preceding analytical procedures have been selected because they will prove to be the most beneficial for you, the small business owner and operator. There are other, more specific, techniques that are used by people and agencies with special interests in certain components of financial statements.

Creditors, for example, are concerned with the ability of a company to pay its current obligations and, therefore, seek information about the relationship of current assets to current liabilities. Stockholders are concerned with dividends. Management is concerned with the activity of the merchandise inventory. All parties, it seems, are vitally interested in profitability.

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IX. Vertical Analysis

Vertical analysis is the computation of percentages, ratios, turnovers, and other measures of financial position and operating results for one fiscal period. When these figures are compared with those from other periods, it becomes horizontal analysis.

Note: It should be emphasized that sound conclusions on a company's profitability cannot be reached from an individual measurement. However, many computations, together with adequate investigation and study, can lead to a satisfactory evaluation of financial data.

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X. Resources

Books

Peter Atrill and  Eddie McLaney, "Accounting and Finance for Non-Specialists" (Prentice Hall, 1997)

Leopold Bernstein and John Wild, "Analysis of Financial Statements" (McGraw-Hill, 2000)

Daniel L. Jensen, "Advanced Accounting" (McGraw-Hill College Publishing, 1997)

Martin Mellman et. al, "Accounting for Effective Decision Making" (Irwin Professional Press, 1994)

Eric Press, "Analyzing Financial Statements" (Lebahar-Friedman, 1999)

Gerald I. White, "The Analysis and Use of Financial Statements" (John Wiley & Sons, 1997)

Magazines

Journal of Accountancy

The Practical Accountant

Web Sites

AICPA - Avenue of the Americas, New York, NY

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