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PROFITABILITY
Analysis and Interpretation
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HEADING ONE
HEADING TWO
Accounting Entity
The business is separate from the owner(s).
The affairs of the business are separate from the owner(s).
Accounting Period
The life of the business is divided up into arbitrary periods.
Matching Principle
A business must match expenses with related revenues in order to report profit.
Accounting Assumptions
Monetary Assumption
This assumption assumes all transactions can be recorded in money terms.
Historical Cost
Items are recorded at their original purchase price.
Going Concern (Continuity) Assumption
Accounting reports are prepared under the premise (assumption) that the business will continue to operate – it will not close down.
Accounting Assumptions
The function of accounting is to present information to
interested parties for the following purposes:
to enable evaluation of a business’ performance
assist in decision making
discharge accountability
Accounting for Decision Making
Interested parties make decisions about the information in the financial reports:
Interested parties include:
Management/owners (owners, executives, directors and managers)
Resource providers (lenders, accounts payable and employees)
Government (ATO, ASIC, other government departments)
Other interested parties (investors, unions, print/electronic media and special interest groups)
Interested Parties
Business Performance – Key Issues
Profitability Is the business making a profit?
How efficient is the business at turning revenues into profit?
Is it enough to finance reinvestment?
Is it growing?
Is it sustainable (high quality)?
How does it compare with the rest of the industry?
Financial Efficiency Is the business making best use of its resources?
Is it generating adequate returns from its investments?
Is it managing its working capital properly?
Business Performance – Key Issues
Liquidity and Gearing Is the business able to meet its short-term debts as they fall due?
Is the business generating enough cash?
Does the business need to raise further finance?
How risky is the finance structure of the business?
Shareholder Return What returns are owners gaining from their investment in the business?
How does this compare with similar, alternative investments in other businesses?
Analysis of Accounts
Profitability
Profitability is the ability of the business to earn income within the present financial structure of the business.
Profitability Ratios
Gross profit
Net profit
Expenses to sales
Selling and distribution expenses to sales
General and administrative expenses to sales
Finance expenses to sales
Return on total assets
Return on equity
Analysis of Accounts
Profitability
Gross Profit Ratio
Gross Profit x 100 = x%
For example:
105 000 x 100 = 72.4%
Net Sales = Sales – Sales Returns
The gross profit ratio indicates:
the ability of the business to generate gross profit from the sale of goods and services
the number of cents in the dollar that represents the gross profit in every dollar of sales
High ratio – the business:
is able to source goods cheaply and have a high mark up
can easily cover all of its selling, administrative and financial costs
has the capacity to earn an acceptable net profit
has the capacity to earn an adequate return on investment
Low ratio:
the business will have difficulty in covering other operating costs
a net loss may occur
mark up is too low
Analysis of Accounts (1)
Profitability
Net Profit Ratio
Net Profit x 100 = x%
7000 x 100 = 4.8%
Analysis of Accounts
Profitability
Analysis of Accounts
Profitability
The net profit ratio indicates:
the ability of the business to generate net profit from the sale of goods and services
the number of cents in the dollar that represents net profit in every dollar of sales
High ratio:
revenue is high and/or
operating expenses are low (under control)
Low ratio:
selling margin is very low
revenue is low or
operating expenses are too high (have not been well controlled)
Ratio of Expenses to Sales Ratio
Total Expenses x 100 = x%
98 000 x 100 = 67.6%
Analysis of Accounts
Profitability
The ratio of expenses to sales indicates the amount of sales dollars needed to cover expenses.
High ratio:
weak control over expenses in proportion to sales
Low ratio:
tight control over expenses in proportion to sales
Analysis of Accounts
Profitability
Selling and Distribution Expenses x 100 = x%
General and Administrative Expenses x 100 = x%
Finance Expenses x 100 = x%
Analysis of Accounts (1)
Profitability
Common expenses to sales ratios:
Selling and Distribution Expenses x 100 = x%
30 000 x 100 = 20.7%
General and Administrative Expenses x 100 = x%
56 000 x 100 = 38.6%
Finance Expenses x 100 = x%
12 000 x 100 = 8.3%
Return on Total Assets
Net profit + Interest expense x 100
Average Total Assets
52 000 + 3000 x 100 = 34.6%
Analysis of Accounts
Profitability
The return on total assets indicates the ability of the business to generate profits using its assets.
High ratio:
may indicate good performance of assets
effective use of assets to generate profit
Low ratio:
poor performance of assets
Ineffective use of assets
Analysis of Accounts
Profitability
Return on Equity
Net profit x 100
Average Owner’s Equity
52000 x 100 = 142.9%
(10400 + 62400)/2
Analysis of Accounts (1)
Profitability
The return on equity ratio indicates the return to the owner on the amount invested in the business.
High ratio:
very good investment for the owner
may indicate management efficiency
Low ratio:
could be more beneficial for the owners to invest elsewhere
may indicate an inefficiency management
Analysis of Accounts
Profitability
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