Chapter 4 Profitability Analysis

Business Strategy

• Two generic alternative strategies for a particular product are:
• Product differentiation strategy-
• Differentiate a product to obtain market power over revenues and, therefore, profit margins.
• Low-cost leadership strategy-
• Enabling the firm to charge the lowest prices and to achieve higher sales volumes.

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Analyzing the Profit Margin for ROA

• Sales
• Individual expenses
• Cost of goods sold
• Selling, General, and Administrative Expenses
• Income taxes
• Profit margin
• Segment data: Permits the analyst to examine ROA, profit margin, and assets turnover at an additional level of depth.

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Analyzing Total Assets Turnover

• Captures how efficiently assets are being utilized to generate revenues.
• Provides insight into changes in the total assets turnover by examining turnover ratios:
• Accounts receivable turnover- Indicates the average time until firms collect accounts receivable in cash.
• Inventory turnover- Indicates the length of time needed to produce, hold, and sell inventories.
• Fixed assets turnover- Measures the relation between sales and the investment in property, plant, and equipment.

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Return on Common Equity

• Measures the return to common stock holders after subtracting operating expenses and costs of debt financing and preferred stock.
• It should adjust net income for nonrecurring charges, as in ROA.
• Explicitly accounts for the cost of debt and preferred stock financing.
• ROCE is calculated as:

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Relating ROA to ROCE

• ROA measures operating performance independent of financing.
• ROCE considers the cost of debt and preferred stock financing.

• Chapter: 04