Analyzing Profitability

A major objective of Financial Statement Analysis is to evaluate various drivers related to a firm’s risk and expected return.  Profitability analysis of a firm’s recent past provides relevant information to an analyst about the firm’s future profitability and returns.

In the Financial Statement Analysis Module the sub branch above, “Analyzing Profitability” is organized around three sub-sections:






Margins address the question, how profitable are the operations of a firm?

Returns address the question, how profitable is the firm in generating a return on capital invested as well as capital under the control of management?

Growth addresses the question, how do the major firm decisions impact upon profitability?


Combined these three dimensions provide a broader picture of a firm’s profitability including raising flags regarding future profitability when trends are negative versus reinforcing positive outlooks about future profitability when comparisons and trends are positive.



In this topic we apply a common convention for working with ratios involving a mixture of stocks and flows.  A flow variable is a variable that is measured between two points in time.  A stock variable is a variable that is measured at a point in time.  The convention for constructing ratios is:


Convention:  Flow Variables / Average Stock Variable or Average Stock Variables / Flow Variables


For example, the income statement contains important flow variables such as sales, revenues and the balance sheet contains important stock variables such as assets, stockholders’ equity.  A ratio that relates earnings to stockholders’ equity divides a flow variable (net income) by a stock variable (stockholders’ equity).  As a result, applying the above convention requires that Net Income is divided by the Average Stockholders’ Equity.  Average Stockholders’ Equity is defined as follows:


Average Stockholders’ Equity = (Beginning Period Stockholders’ Equity + Ending Period Stockholders’ Equity)/2


The SEC requires that public companies file Balance Sheets that provide both the beginning and ending period values.




Margins immediately focusses on the Income Statement and Cash Flow Statements for a firm.  From the Income Statement three bottom line profitability measures are calculated and expressed relative to sales revenue:


Gross Profit Margin

Operating Profit Margin

Net Operating Profit after Tax Margin


From the Cash Flow Statement two major measures are produced:


Cash Flow Margin

Free Cash Flow Margin


The above ratios are formally defined below and combined provide immediate insights into how profitable the firm is relative to sales revenue and how successful management is with respect to converting profits to cash .


Returns immediately focus on measures of profitability defined relative to capital bases derived from the balance sheet as follows:


Return on Shareholders’ Equity (ROE)

Return on Assets (ROA)

Return on Invested Capital (ROIC)

Return on Capital Employed (ROCE)


This set of performance measures provide immediate insights into how profitable the firm is relative to the set of resources available to management.


Growth focusses on how the major decisions made by management, the investment, financing and dividend decisions, drive profitability.


Fundamental Growth

DuPont Analysis

DuPont Burden Analysis


Fundamental growth results from the product of all three major firm decisions (investing, financing and dividend) and the DuPont analyses further decompose ROE into the impact of decisions at a finer level (operating, financial leverage and tax).


Working with Profitability Ratios


Gross Margin = Sales Revenue less Cost of Sales


This is an important ratio for any firm reporting under the merchant model for sales revenue recognition.  Sales Revenue equals the total amount the company ultimately expects to collect from their customers.  It is gross revenue less discounts, and related items the company provides.  Under the merchant model of accounting the merchant bears all of the risk of the inventory and books the selling price as revenue when sold (Gross Revenue Recognition) and accounts for the immediate cost of the sales separately.  Combined this generates the Gross Margin.


Cost of sales can vary in nature under the “merchant model” ranging from the traditional cost of sales as illustrated by Wal-Mart to non-traditional as illustrated by Google.  Wal-Mart describes this in their 10-K report as follows:


“Cost of sales includes actual product cost, the cost of transportation to the company’s warehouses, stores and clubs from suppliers, the cost of transportation from the company’s warehouses to the stores and clubs and the cost of warehousing for our Sam’s Club segment.”


However, Google describe their cost of sales as follows:


“Cost of revenues consists primarily of traffic acquisition costs. Traffic acquisition costs consist of amounts ultimately paid to our Google Network members under AdSense arrangements and to certain other partners (our distribution partners) who distribute our toolbar and other products (collectively referred to as access points) or otherwise direct search queries to our website (collectively referred to as distribution arrangements). These amounts are primarily based on the revenue share and fixed fee arrangements with our Google Network Members and distribution partners.”


Technology has resulted in innovative business models that push accounting revenue revenue recognition to the limits.  For example, Groupon, provides an example of a business model that they initially applied the merchant model for revenue recognition until just prior to their IPO when they shifted to the Agent Model.  Under the agent model there is no Gross Margin because only net revenue is reported.


Groupon Example:  If Groupon sell a coupon for $25 that promises $50 in services under the merchant model they would record $25 for sales revenue whereas under the agent model this is recorded as $12.50 because Groupon remits 50% (i.e., $12.50) to the merchant that actually provides the goods or services.  The difference is clearly significant for recorded sales revenue on an income statement, depends upon the extent to which Groupon bears the risks associated with the ultimate goods and services being provided.


Operating Profit Margin = Operating Income (EBIT) divided by Sales Revenue


The operating profit margin measures profitability relative to a broader set of costs from operations than are included in a gross margin.  Many of these costs are associated with the same accounting period for the company’s operations as opposed to being directly associated with the goods and services provided during the period.  Profits generated from a firm's continuing operations are referred to as “Operating Income” or departing from US GAAP but more conventionally described as “Earnings Before Interest and Taxes” (EBIT). 


EBIT is computed by starting with Gross Margin or Sales Revenue net of any remittances to the merchant who actually provides the goods and or services.  Additional operating expenses are then subtracted away that result from supporting the frm’s ability to generate revenues from their continuing operations.  These support activities under EBIT do not include financing activities and costs arising from discontinued operations.  Major examples here are marketing costs, selling costs, general and general administration.  Some operating costs arise from accounting principles that determine whether a cost is expensed to the period or capitalized on the balance sheet in the period in which they were incurred.  For example, research and development (R&D) fall into this latter category under US GAAP.  For most industries R&D is expensed to the period in which it is incurred but an exception is software development costs which can be capitalized on the balance sheet as an asset and subsequently amortized over their economic life.  As a result, operating costs arise from a combination of the economics associated with the operations as well as GAAP.


Net Operating Profit after Tax (NOPAT) = After tax profit from operations (EBIT * (1 – Effective Tax Rate)
NOPAT Margin = NOPAT divided by Sales Revenue


This profitability measure further extends the concept of operating profit margin to take into account corporate taxes.  That is, the profitability measures such as Operating Profit Margin and NOPAT margin are carefully teasing out the impact of important firm decisions from their continuing operations.  For the case of the Operating Profit Margin the effects from the firm’s financing and tax decisions are excluded from consideration. For the case of the NOPAT  margin only the impact of the financing decision is ignored.


Cash Flow Margin = Cash flows from operating activities divided by Sales Revenue


An important function for management is not only to generate profits from sales revenue but to convert these profits into cash.  The cash flow related margins have the objective of providing insight into how the firm is performing along this dimension.  The cash flow from operations measure provided on the Consolidated Cash Flow Statement in its indirect form starts with net income and then “undoes” the effects of accounting accruals on net income.  What results, is an estimate of the cash that was generated from operations over the accounting period in question.


Free Cash Flow to the Firm (FCFF) = Cash Flow from Operating Activities less Capital Expenditure plus after tax net interest expense (FCFF).


This measure provides some additional refinements to Cash Flows from Operating Activities in order to account for the effects of Capital Expenditure (expenditures required for maintaining the physical capacity for generating cash from operations.  In addition, the impact of accounting standards mixing operating and financing activities upon the measurement of cash flows from operations is also eliminated.  In particular, the tax benefit from interest expense is subtracted out.


Return on Total Assets (ROA) = Net Income attributable to shareholders’ divided by the average Total Assets


The average total assets is used to reflect the fact that net income was generated over the entire accounting period and the denominator should also reflect this.  This profitability measure provides insight into how well the total resources under control of management are used to generate income independently of how they are financed.  By considering the fundamental accounting equation Total Assets equals Total Equities, alternatively, ROA can be viewed as the return generated to the Total Equities or the total providers of capital to the firm.  From this perspective one variation of ROA is to add back Interest Expense net of tax.  That is, net income is an after tax number that treats interest paid to debt-holders as an expense but not dividends paid to shareholders.  So the above adjustment treats each class of equity holder equal.


Adjusted Return on Total Assets (ROA) = (Net Income attributable to shareholders’ + Interest Expense (1 – tax rate)) divided by the Average Total Assets


The Return on Equity measures the return provided to the shareholders’ over the time period.


Return on Shareholders’ Equity (ROE) = Net Income attributable to shareholders divided by Average Shareholders’ Equity for the period


The average shareholders’ equity is used to reflect the fact that net income is generated over the entire accounting period and so the denominator should also reflect this.  This is a bottom line measure of overall performance that results from the firm’s investment and financing decisions.  The investment decision is the primary driver of the numerator, net income attributable to shareholders, and the financing decision is the primary driver of the average shareholders’ equity.  Shareholders’ Equity equals Total Assets minus Total Liabilities plus Non-Controlling Interests.   As a result, the more successful investing activities have been the higher is net income and the more financial leverage employed the smaller average shareholders’ equity will be relative to the available total assets. The performance measure is useful for comparing companies within the same or similar industries because significant cross sectional differences arise when working across industries.  One cause of this is the nature of technology applied within an industry.  For example, some industries are capital intensive which will result in a larger fixed asset base while other industries are human capital and talent driven which usually implies a smaller fixed asset base.


The definition of ROE implies a positive relationship between financial leverage and ROE if net income increases with total assets.  Whether or not this relationship translates into the same predicted relationship in the capital markets between leverage and returns, is subject to much controversy.  That is, higher leverage is predicted to be associated with higher expected returns but empirical evidence is mixed with respect to leverage and returns. 


From the fundamental accounting equation shareholders’ equity equal Total Assets minus the sum of Total Liabilities and other equity classes.  As a result, again some common adjustments are to subtract out distributions to these classes.  As noted earlier, Net Income already accounts fr Debt-holders but Net Income does not account for preferred stockholders.  As a result, a common adjustment is to subtract out Preferred Dividends from Net Income.


Adjusted Return on Shareholders’ Equity (ROE) = (Net Income attributable to shareholders – Preferred Dividends) divided by Average Shareholders’ Equity for the period


Another important question asked of profitability measures is whether or not management is adding value?  The answer to this question depends upon whether the return generated for the firm exceeds the weighted average cost of capital taking into account the various classes of equity holders.  A popular measure for assessing whether management is adding value is the Return on Invested Capital (ROIC).


Return on Invested Capital (ROIC) = Net Income attributable to shareholders’ minus Dividends divided by the sum of Average Debt, Average Lease Obligations and Average Shareholders’ Equity


The Return On Invested Capital (ROIC) measure provides a profitability measure relative to the invested capital in a firm.  If this measure is less than the firm’s after tax Weighted Average Cost of Capital (WACC) then management’s investment decisions are failing to add value.  This is because the discount rate is greater than the returns generated from the investment. 


Return on Capital Employed is a popular performance measure among value investors.  It assesses profitability from the perspective of re-investing profits into the business.  It is defined as follows:


Return on Capital Employed (ROCE) = Net Operating Profit After Tax (NOPAT) divided by Capital Employed
Capital Employed = Average Total Assets – (Average Short Term plus Average Long Term Security Investments) – Average Current Liabilities or equivalently,
Capital Employed = Average Fixed Assets + Average Working Capital - (Average Short Term plus Average Long Term Security Investments)


ROCE provides insight into what income is earned from reinvesting in the firm’s normal operations.  If this is too low then the company will have less available for future investments and shareholders would prefer that the income be paid out as a dividend.  What is too low again depends upon the opportunity cost of capital for the firm which is measured as the firm’s after tax weighted average cost of capital.  As a result, from the perspective of the accounting equation, Assets equal Equities, ROIC provides insight into profitability from the perspective of equity holders and ROCE provides insight into profitability and future profitability, from the perspective of total assets or capital employed for productive purposes.


Fundamental Growth


An important dimension to understanding the profitability of a firm is forecasting future profitability in terms of how profits grow over time.  In particular, when viewed from the perspective of current stockholders it is profits retained in a business that drive the growth of stockholders’ equity over time.   As a result, fundamental growth is defined from the perspective of growth in stockholders’ equity defined relative to income retained times the return on equity generated:


Fundamental Growth = ROE * RR where ROE equals the return on shareholders’ equity and RR equals the retention ratio (= 1 – Dividend Payout Ratio)


In the above we are assuming that there have not been any additional contributions or distributions of capital from or to owners.


Fundamental growth is an important relationship because it represents the outcome from three major decisions management make for a firm.  These are the Investment Decision, the Financing Decision and the Dividend Decision.  That is, RR captures the effects from the Dividend decision and ROE captures the effects from both the investment and financing decisions.  To see why this is the case for ROE we need to introduce a powerful concept in ration analysis which is referred to as “decomposition analysis.” 



For example, return on equity can be viewed as the outcome of two major firm decisions, the investment and financing decisions.  Consider multiplying ROE by Total Assets/Total Assets or 1.  Clearly, ROE times 1 equals ROE.  However, the advantage of doing this is that we can rearrange the terms as follows:


ROE * Average Total Assets/Average Total Assets = Net Income/Average Total Assets * Average Total Assets/Average Stockholders’ Equity


The above has re-expressed ROE into two components, ROA (Return on Assets) and Financial Leverage.  The ROA term results from the investment decision, and the financial leverage term results from the financing decision.  As a result, ROE can be viewed as the outcome from the product of two major firm decisions and Fundamental Growth results from the product of three major firm decisions.


The major advantage of decomposing ratios is to understand how major firm decisions affect a firm’s profitability.  Motivations along these lines gave rise to a major decomposition which has become known as the DuPont Decomposition.


DuPont Decompositions 


Among the stocks that currently make up the Dow Jones Industrial Index the oldest is E. I. du Pont de Nemours And Company more commonly referred to simply as DuPont.  DuPont was originally a gunpowder mill founded in July 1802 by Eleuthère Irénée du Pont and today is one of the largest chemical companies in the world. DuPont was a pioneer with respect to management accounting systems, including devising the accounting ratio Return on Investment (ROI).  Around 1912 their ROI approach was extended by one of their financial officers, Donaldson Brown, who decomposed the ROI calculation into a product of the sales turnover ratio and the profit margin ratio.  In 1914 DuPont invested in General Motors (GM) to assist the struggling automobile company.  In 1920, Pierre DuPont became chairman of GM, and during his tenure implemented a pioneering management accounting system that focused sharply on understanding the drivers of return on investment.  By organizing resources around this system GM grew to be the largest automobile company in the world.  In 1957 DuPont had to divest itself of General Motors because of the Clayton Antitrust Act.  The DuPont decomposition became popular after its successful use at GM and DuPont.


Formally, the Return on Equity (ROE) equals Net Income for the period divided by the Average Shareholders Equity.  Under the DuPont decomposition ROE is decomposed into Return on Assets (ROA) and Financial Leverage by multiplying and dividing by the average total assets for the period.  ROE measures the rate at which shareholder wealth is increasing.  ROA measures the productivity of the assets in generating income, and therefore measures the efficiency of the investment decision and financial leverage measures the extent to which the firm is using debt.  In the traditional DuPont formula ROA is further decomposed by multiplying ROA by Sales/Sales and recombining the terms into Net Income/Sales and Sales/Average Total Assets.  This breaks the investment decision outcome into two components, operating efficiency (i.e., profitability) and asset turnover efficiency (i.e., utilization).


Formally, the DuPont formula is:


ROE = (Net Income/Sales) * (Sales/Average Total Assets) * (Average Total Assets/Average Shareholders’ Equity)


Each term in the decomposition has a specific meaning:


Profit Margin Ratio = Net Income/Sales


Asset Turnover Ratio or Asset Use Efficiency = Sales/Average Total Assets


Financial Leverage Ratio= Average Total Assets/Average Shareholders’ Equity


The first two terms provide important insights into the investment decision and how it affects ROA whereas the latter provides insights into the role played by financial leverage to boost ROE relative to ROA.


For the case of ROA the profit margin ratio provides insight into the effectiveness of managing costs.  That is, how profitable is a dollar of sales?  When contrasted with immediate competitors a relatively low margin implies higher costs and a relatively higher margin implies lower costs compared to the competitors.  This of course may be a result of the business strategy employed (e.g., full service firm versus a discounter) or it may be the result of poor managerial cost controls.  The numbers raise questions that guide the further analysis of ratios, some of which go beyond just profitability analysis and some considered next.


Extended DuPont Analysis


The objective of extending the DuPont analysis is to provide a finer decomposition of the major firm decisions into the Investment, Financing and Tax decisions.  The Extended DuPont analysis provides this by conducting an additional decomposition of the Profit Margin Ratio (Net Income/Sales) into two burden components, Tax and Interest, times the Operating Profit Margin.  This provides a refinement of the profit margin ratio into the operating profit margin ratio by taking out the effects arising from taxes and interest expense.  As a result, it provides both management and the financial analyst with finer information about a company and its immediate competitors.


Formally, the Extended DuPont formula is:


ROE = (Net Income/EBT) * (EBT/EBIT) * (EBIT/Sales) * (Sales/Average Total Assets) * (Average Total Assets/Average Shareholders’ Equity)


Each term in the decomposition has a specific meaning:


Profit Margin Ratio =Net Income/Sales now decomposes into:


Net Income/Earnings Before Taxes = Tax Burden Ratio


Earnings Before Taxes/Earnings Before Interest and Taxes = Interest Burden Ratio


Earnings Before Interest and Taxes/Sales = Operating Profit Margin


Asset Turnover Ratio or Asset Use Efficiency = Sales/Average Total Assets


Financial Leverage Ratio= Average Total Assets/Average Shareholders’ Equity


Net Income is measured after taxes.  So if taxes are zero the tax burden equals one and so the lower this number, the higher the tax burden.  Similarly, if Interest Expense is zero then interest burden ratio equals one and therefore the higher the financial leverage, the lower is this number.  The advantage of adjusting for taxes and interest is to gain better insight into the firm’s profit margin by focusing upon the operating profit margin.


Note that the product of the first four terms is now ROA.  This is driven by operations, financing and the management of taxes.  A nice property of the Extended DuPont formula is that one can examine the breakdown of ROA from the perspective of major firm decisions --- investment, financing and tax decisions.


The remainder of this decomposition is as before.  That is, the fifth term is again related to the financing decision; a highly leveraged firm has low Shareholders Equity compared to Assets.