Profitability

- Is the state or condition of yielding a financial profit or gain.

- It is ability of a company to use its resources to generate revenues in excess
of its expenses. In other words, this is a company’s capability of generating
profits from its operations.

Profit vs. Profitability

Profit is an absolute number determined by the amount of income or revenue above

and beyond the costs or expenses a company incurs. It is calculated as total
revenue minus total expenses and appears on a company's income statement.

Profitability is a measurement of efficiency – and ultimately its success or failure.

Profitability can further be defined as the ability of a business to produce a return
on an investment based on its resources in comparison with an alternative
investment. While profit is an absolute amount, profitability is a relative one.

Reasons for Computing Profitability

- Profitability represents final performance of company i.e. how profitable
company. It also represents how profitable owner’s funds have been utilized
in the company.

- Increasing profitability is one of the most important tasks of the business

managers. Managers constantly look for ways to change the business to
improve profitability.

- Profitability represents final performance of company i.e. how profitable

company. It also represents how profitable owner’s funds have been utilized
in the company.

 Profitability Ratios
A variety of Profitability Ratios (Decision Tool) can be used to assess the financial
health of a business. Profitability ratios are a class of financial metrics that are used
to assess a business's ability to generate earnings relative to its associated
expenses.
1. Rate of Return on sales (ROS)

 Return on sales indicates the amount of net income per peso of sales or the
profitability based on sales.

Formula:

For example:

Company A has a Net Income of 30, 000 and Net Sales of 100, 000.

This means for every peso earned, the company gets to keep 30% as profit. The
higher the ROS, the better. A high percentage means that the company did well in
managing its expenses.

2. Rate of Return on asset (ROA)

• Return on assets (ROA) is an indicator of how profitable a company is

relative to its total assets or total capital, both borrowed and invested.

• The higher the return, the more productive and efficient management is in
utilizing economic resources.

Formula:

or
Equation for Average Total Assets:

Example: Company A has a Net Income of 30,000, beginning asset of 100,000 and
an ending asset of 200,000

This means that the company was able to convert 20% of its assets into profit.

3. Asset Turnover

The asset turnover ratio measures the value of a company's sales relative to the
value of its assets.

Formula:

Differentiating Return on Assets and Asset turnover

vs.
The difference is that ROA shows the return in profit of each dollar invested in
assets. On the other hand, asset turnover ratio shows how much sales the firm
generates for every dollar invested on total assets.

Formula:

This means that for every peso of the Company’s assets, they generated 0.66 in
revenue.

4. Gross Profit Ratio

• Gross Profit Ratio indicates the gross margin per peso of sales. It is used in
determining the adequacy of gross margin to cover operating expenses and
provide desired profit.

Formula:

Example:

A company has Net sales of 100,000 and Gross Profit of 40,000

The gross profit margin percentage tells us that the company has 40% of its
revenues left over after it pays the direct costs associated with its cost of goods
sold (COGS).
5. Operating Ratio

Indicates what portion of sales is absorbed by operating costs.

Formula:

6. Rate of Return on Current Asset

Indicates the profitability in the use of current asset.

Formula:

7. Current Asset Turnover

Indicates the rate at which current assets are being used.

Formula:

8. Rate of Return per Current Asset Turnover

Indicates the percentage profit every time current assets are used.

Formula:
Given:Cost of sales= 40,000

Operating expenses= 10,000

Net Income= 30, 000

Current Asset, 2017= 45,000

Current Asset, 2018= 30,000

Solution:

Return on current assets: (0.80)

Net Income= 30,000

Average Current Assets= 37,500

Current Asset turnover (1.33)

Operating expenses= 10,000

Cost of Sales= 40,000

Average Current assets=37,500

Answer:

 The company generates 0.60 or 60% of sales in their current assets.

9. Rate of Return on Working Capital

Indicates the profitability in the use of working capital.

Formula:
Working Capital

• Working capital is the amount of cash and other assets a business has
available after all its current liabilities are accounted for.

Formula for Working Capital

Working Capital= Current Asset - Current Liabilities

Formula for Average Working Capital

Average Working Capital= working capital current year + working capital prior
year ÷ 2

10. Working Capital Turnover

Indicate the rate which working capital is being used.

Formula:

11. Rate of Return per Working Capital Turnover

Indicates the percentage of profit earned every time working capital is used.

Formula:

12. Invested Capital Turnover

Indicates the rate at which owner’s capital is being used or the rate at which assets
provided by owner’s are being used.
Formula:

13. Rate of Return on Owner’s Equity

Indicates the profitability in the use of invested capital or the amount of return per
peso of owner’s equity

Formula:

or
Return on sales X Invested capital turnover

Formula:
For Example: Company A has a Net Income of 10, 000 and
Shareholder’s Equity of 20, 000.

This means that the company generated .50 or 50% of profit for every 1
peso of shareholder’s equity.
A rising ROE suggests that a company is increasing its ability to
generate profit without needing as much capital. It also indicates how
well a company's management is deploying the shareholders' capital. In
other words, the higher the ROE the better

14. Earnings per share

Indicates the amount of returns on each share of common stock and the ability to
pay dividends.

It is how much each shareholder would get if the company paid its income in form
of dividends. It is how much a common shareholder earned per share.

Formula:

Preferred Stock Dividends- A preferred stock dividend is a payment made to

the holders of an issuing entity's preferred shares.

Calculating Average No.of Common Shares Outstanding:

Average No.of Common Shares Outstanding is a number of shares of the Company

after incorporating changes in the shares during the year

Example 1 – No new shares issued

Let there be a Company A which has 100 000 shares outstanding at the start of the
year 1 January. The Company did not issue any new shares.
  Thus, weighted average shares outstanding = (100 000 X 12)/ 12 = 100 000

Example 2 – The company issues new shares once during the period

Now, the Company A issued 12,000 new shares on 1 April.

 Thus, the Company had 100, 000 shares for the first 3 months and 112, 000
shares for the rest of the 9 months.

 Thus, weighted average shares outstanding in this case = (100000*3 +

112000*9)/12 = 1308000/12 = 109000

 Thus, weighted average shares outstanding in this case, the Company has
109,000 shares outstanding at the end of the year.

Example 3 – Company issues new shares twice during the year

The Company A issued another 12, 000 shares on 1 October during the
year. Let us seen how the weighted average number of shares
outstanding will change.

 Thus, the Company has 100,000 shares during the first 3 months,
112, 000 shares during the next 6 months and 124, 000 shares
during the last 3 months of the year

 Thus, weighted average shares outstanding in this case =

(100000*3 + 112000*6 + 124000*3)/12 = 1344000/12 = 112000

 Thus, weighted average shares outstanding in this case, the

Company has 112,000 shares outstanding at the end of the year.
Calculating EPS:
Company A has:
Net Income- 150, 000
Preferred Stock Dividends- 10,000
No.of Common Shares Outstanding- 112,000

It has been reported that the company’s shareholders have 1.25 earnings
per share. A high EPS is good because it mean it has more earning for
shareholders and if your company has higher EPS than last year’s it
means it is more profitable than before.

15. Price Earnings Ratio

Measures the relationship between market price and earnings on each share

Formula:

Example: ABC’s company have market price per share of 100,000 and EPS of
10,000

It means that ABC’s stock is selling 10 times its earnings.

Is it good or bad?
  A Low P/E can be good because it means that the stock is selling for
“cheap”, and is good value for investors i.e the P/E ratio is 5,000 but having
a low P/E ratio can also mean that the company is having or expecting
financial problems that the stock must be sold cheaply or people only buy it
at a cheap price in the stock market.
 A high P/E can be bad because it is “expensive” and is not good value for
investors but it can also be good because it can indicate that it has a good
forecast and the company is expecting to have a good news in their
profitability and therefore selling their stocks at a high price.
 But sometimes you can find a very good stock with a low P/E ratio. So why
does a company sells a good stock in low P/E? Maybe because the said stock
does not much news reports about the stock or many investors are not aware
of the said stock.

16. Capitalization Rate or Earning Price Ratio

Indicates the rate at which the stock market is apparently capitalizing the
value of current earnings.
Formula:

17. Dividends per Share

Shows the amount of distributed earnings per share.
Formula:

18. Yield on Common Stock

Shows the percentage of distributed earnings based on market value.
Formula:

19. Payout Ratio

Indicates the percentage of distributed earnings based on earnings made
per share.
Formula:

20. Retained Earnings to Capital Stock

Indicates the profitability of dividend declaration
Formula:

.
21. Market Price to Book Value per Share
Indicate whether the stock is undervalued or not.
Formula: