 Hello and welcome to this session in which we would look at the profitability ratio. This is part of the financial statement analysis six of seven. In the first one we looked at introduction to financial statement analysis. In part two we looked at horizontal vertical and common size. In part three we looked at the liquidity ratio, part four activity ratios, part five solvency ratios, and in this session we would look at the profitability ratio. What are the profitability ratios? It measures the profitability of the company relative to other measures like assets, equity, net income to sales, so on and so forth. The best way to illustrate those important concept is to actually take a look at numbers, try to interpret them, and see how they make sense in the context of an investor, or if you are an auditor, how should you critically look at those figures. As always we're going to be looking at this balance sheet as we are working through the series of financial statement analysis and this income statement. Those can be found at farhatlectures.com on my website. So let's start to take a look at the profitability ratios. The first ratio we're going to look at is something called the profit margin. So I'm assuming you are familiar with the income statement and what is the profit margin? The profit margin is taking the bottom number on the income statement, which is net income, and dividing it by the top number, which is sales. For the sake of illustration, let's assume I started with sales of $100. I subtracted all my expenses, cost of goods sold, everything else, and my net income is 10. All what I'm doing is I'm taking this number, dividing it by this number. So if I take 10 divided by 100, I will get 0.1 or 0.1 or 10%. How do you interpret this number? Well, you would say, so for every dollar in sales, I'm keeping 10%, which is 10 pennies for every dollar in sales. So it tells you for every dollar in sales that the company is generating how much it's keeping to the bottom line. And obviously, no offense about it. The higher this number, the better you off as a company, the better you off as an investor, the better you off as a creditor. So you want to have a high profit margin. The company that we are working with has a profit margin year one, 16.77% based on sales, based on net income in sales, and 17.73% for year X2. Now what I want to do just to show you how this works, I want to go back to the financial statement and I want to make a small change to show you how this all fits. Right now, I am assuming the tax rate that I am using is 21%. If I change the tax rate from 21% to 35%, which is the prior corporate tax rate basically before the 21%, if I go and I make it 35% and if I go back to my profitability ratios, notice I went down from 16 and 17 to 14 and 14 and a half profit margin. What am I trying to say? I'm trying to say is you have to look at if there's any changes from year to year. For example, just the tax rate changes because the government, the company has nothing to do with this. It changes those ratios. So you always have to look at those ratios in a particular context. For example, if you are dealing with companies retailers like Walmart, Amazon, these companies they should have a small profit margin. They don't make a lot of profit on every dollar they sell. As far as profit margin concerned, we're going to see how they make their profit. Just bear with me in a moment. However, if you're looking at a company like Apple, well, they would have a high profit margin. If you're looking at a company like Nike, they will have a high profit margin. Why? Because they're selling a specialty. They're selling an item that you cannot buy anywhere else. But you can go to Walmart, you can go to Amazon, you can go to Target, all those retailers selling you the same thing. Therefore, as an auditor, before you start the audit, you have a profit margin expectation. And if that profit margin is out of whack right from the get go, you would say, wow, I have a lot of work to do because something's unusual going on. And remember, this is a macro ratio. You're looking at the overall picture. The second ratio we're going to look at is return on asset. And usually, usually not necessarily true. To remember those ratios, every time you hear the word return, it means net income or EBIT earning before interest and taxes, depending the textbook that you are using. But usually it means net income. If you're saying return on asset, it means return net income divided by asset. Remember, net income is an income statement. Asset is a balance sheet account. What does that mean? It means when you compute, when you input the denominator, always use the average because the income statement is for the whole year. And the asset has to be for the whole year as well. You average the asset. And for this company, net income divided by total asset is 11.11.08. How do we interpret this? Again, the best way to do this is to work with simple numbers. Let's assume you have net income of $10 and average total asset of 100. Well, you're going to get 10%. How do you interpret this 10%? Well, here's what I can say. I would say that for every dollar in asset, I'm generating $10 in profit. So how are my assets helping me? Well, every dollar in asset, I'm generating $10 in profit. Now, how can I improve this ratio? Well, you either want to make more profit, more net income or reduce their assets. You become more efficient, then this ratio will go up. Again, you want it to be as high as possible by increasing your net income and reducing your total asset at the same time. It means using less asset to generate more income, becoming mean and lean, right? You're using less asset. Here, 11.8. Again, the auditor, before they start, they are going to have an expectation of return on asset. And if it's not with an expectation, well, they're going to question this and try to see what's going on. They'll try to ask questions, then they will follow up with collecting evidence to find out if everything makes sense. Before we proceed to the Dupont formula, I would like to remind you whether you are an accounting student or a CPA candidate to take a look at my website, farhatlectures.com. I don't replace your CPA review course nor your accounting course. I'm a useful addition to your accounting career. My motto is saving CPA candidate one at a time. You really want to pass the exam, finish with your certification, focus on your career so you can have a bright future you are investing in yourself. My course catalog include intermediate accounting, cost accounting, advanced governmental tax, so on and so forth that include lectures, multiple choice that's going to help you prepare very well. Also, my CPA resources are aligned with your Becker, Gleam, Roger and Wiley, so you can go back and forth between my material and your CPA review course. I do have all the AI CPA previously released questions, 1500 with detailed solution. If you have not connected with me on LinkedIn, please do so. Take a look at my LinkedIn recommendations, like this recording, share it with other, connect with me on Instagram, Facebook, Twitter and Reddit. So let's discuss the Dupont return on asset ratio. Well, Dupont return on asset can be breaking down further, but I'm going to break it only for two components for this session. Here's what we know. We know that if we take net income divided by sales and if we take sales divided by average total asset, and what we can do if we eliminate sales, what we're left with is net income divided by average asset. So we are back to return on asset. So why are we going through all this trouble if we already computed return on asset? Well, let me show you why we're going through all of this. If we break down this into two parts, if we break this into two parts, what's going to happen is this. Net income divided by sales, this ratio is right here. This is called the profit margin. It's shown us how much the company is making for every dollar in sales. For this particular company, the profit margin is 14.59. We already computed this. It means for every dollar in sales, they're making 14.59. Now, remember, if I change my tax rate, it's going to increase. Let me go back and change my tax rate to 21%. Let's make those companies more profitable. 21 and 21. Okay, let's go back here. Now, it's the same thing to just increase the profit margin just to show you how the taxes will affect your bottom line. So now the profit margin is 17.73. That's fine. Now, we also can compute sales divided by average total asset. Remember, this was asset turnover. We saw this ratio earlier in a prior session. How efficient the company is utilizing their asset. In other words, how efficient are they utilizing their asset to produce sales? And here, for every dollar in asset, they are generating 75 cent in sales. Well, if we take 17.73 times 75.93, it's going to give us the same one, 13.46. So why did we do this? Why did we break down the Dupont? And why did we break down return on asset into two components? It can be broken down further. I do have a separate recording for that. The reason is to find out what is the competitive advantage of this company. In my opinion, the competitive advantages of this company is their profit margin. It means they make a lot of profit from their sales. No company can be good at both, can be good at profit margin A and B and turnover. In other words, no company can keep on making high profit and making a lot of sales. Why? Because at some point, some competitor will come in. And once you have a competitor, you have to make a choice. If you want to keep selling, you have to reduce your prices. It means you have less profit. If you don't want to, if you want to keep making a lot of profit, your sales will slow down because your competitor will start to take away your sales. You cannot be good in both. So the reason why we compute the Dupont is to find out what's the competitive advantage of this company? Are they competing on their profit margin or are they relying on their turnover? They're trying to gain market share. Now, why is this important? Also from an auditor's perspective, you want to break down this ratio into as many pieces as possible and find out and compare the pieces from year to year because 13.46 versus 13.46, it's not going to tell us a lot. But once we break down the last year ratio profit margin and last year turnover, then it makes more sense. We have more information to work with. Another ratio, another profitability ratio is return on equity. Here it's telling us how much the equity holders, the owners of the company are making, are making. Basically, what's the return on their investment return? This is return on equity. And how do we do so? We take net income divided by the average total equity. Again, because net income is an income statement, we use the average equity and we find out that the equity shareholders on average, the return on equity is 28.57. Well, is this good? Is this bad? Again, all these ratios will have to be put into a context. But I would say 28.57 is pretty good given any context, unless you are a gambler or you are going with a really high risk investment. But that's what it is. And if you see something unusual, too high or too low, deviate from the expectation. This is where the auditor would question this. Return on sales. Return on sales can be computed income before interest income and interest income, interest income, interest expense and taxes, or sometimes we use EBIT earning before interest and taxes divided by sales. Just to find out how much we are making in income relative to our sales. And here what we're saying is we are keeping income before we pay any interest and before we pay any interest expense and any taxes, approximately a quarter for every dollar we're keeping a quarter. That's pretty good. Now this quarter, it's going to still have to pay interest and it's still going to have to pay the taxes for us. So just after we pay the interest and the taxes from those 24 pennies or 25 pennies for the latest year, what's left will be the profit margin. So simply put, the difference between, you know, to go from 25.33 to 17.73, we're going to have to take out the taxes and we're going to have to take out the interest and we're going to get to that. The gross profit margin is another profitability ratio and Auditor used this a lot because gross profit affect inventory. If inventory is misstated, it will show on cost of goods sold. Again, this ratio is very predictable in a sense that in the absence of any unusual circumstances, the ratio should stay the same or should have a predictable figure. And in year one for us, 44.71 in year two, 44.44. How do we compute this again? Taking gross profit, which is sales minus cost of goods sold divided by sales. How do we interpret this? We say that for every dollar in sales, we are keeping profit of 44.71. It means the remainder is cost of goods sold. So it's given us an idea about what's cost of goods sold is because one minus, if we take one minus the profit margin, and I'm going to go ahead and tell you how much it's cost, 55.29. 55.29 percent is the cost of goods sold. So in year one, every time we sell something for $100, $55.29 cent is cost, what's left in profit is $44.71. Then this profit, we deducted operating expenses, and then we cut down to how much left of it return on sales was 25 pennies. Then from the 25 pennies, we deducted the taxes and the interest and what's left is 14. So this 44.71, it's going to have to pay for all the operating expenses, depreciation. Well, we don't pay for depreciation in cash, but from an accrual perspective, pay for all the expenses, then what's left is net income. And that's not bad. The gross profit is 44.44, and they're keeping close to half of it in profit after they pay for the cost of goods sold. So it's not bad by any regular measures. So how would you learn more about these ratios, the profitability ratios? Go to farhatlectures.com. Your CPA exam is worth it. Study hard, invest in yourself, and of course, stay safe.