Chapter 4 Profitability Analysis

• Chapter 4

• Profitability Analysis

Overview of Profitability Analysis

• Evaluates whether managers are effectively executing a firm’s strategy.
• Helps to develop an understanding of a firm’s performance to enable forecasts of future performance.
• Approaches to understanding firm’s net income:

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Overview of Profitability Analysis (Contd.)

• Alternative transformations of measured net income:
• Earnings per share analysis
• Common-size analysis
• Percentage change analysis
• Alternative definitions of profits
• Rate of Return Metrics:
• Return on total assets
• Return on common equity

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Alternative Approaches to Analyzing Net Income

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Earnings Per Share

• One of the most frequently used measures of profitability.
• The only financial ratio that GAAP requires firms to disclose on the face of the income statement.
• Covered explicitly by the opinion of the independent auditor.
• Types of EPS:
• Basic EPS (Simple Capital Structure)
• Diluted EPS (Complex Capital Structure)

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Calculating EPS

• Basic EPS (Simple Capital Structure)
• For firms that do not have:
• Outstanding convertible bonds or convertible preferred stock that can be exchanged for shares of common stock.
• Options or warrants that holders can use to acquire common stock.
• Basic EPS is calculated as:

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Calculating EPS (Contd.)

• Diluted EPS (Complex Capital Structure)
• For the firms that have Convertible securities and/or stock options or warrants outstanding.
• Presents two EPS amounts: Basic EPS & Diluted EPS
• Diluted EPS reflects the dilution potential of convertible securities, options, and warrants.
• Diluted EPS is calculated as:

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