 Oh, and welcome to the session in which we would look at profitability ratios. We will cover return on assets, return on equity, and return on sales. So the first thing I want you to notice the commonality between all these ratios is the word return. Now the word return might be computed differently for different ratios. Sometimes we use EBIT earnings before interest and taxes. Sometimes we use net income. Your textbook might use different terms and I'll explain why you would use EBIT versus net income inserting circumstances. Before we start I would like to remind you to check out my website farhatlectures.com, especially if you are an accounting student or studying for your CPA exam. If you're studying for your CPA exam, I don't replace your course. So if you have Wiley, Gleim, Roger or Becker, I don't. What I do is I give you additional information or detailed explanation to help you complement. It's in addition to your CPA course. If you are an accounting student, I have plenty of courses to help you. Please connect with me on LinkedIn, subscribe to my YouTube, and connect with me on Instagram and Facebook. Let's go ahead and start to look at those three ratios. Starting with return on sales. Return on sales is computed by taking EBIT. EBIT is earnings before interest and taxes. Now in your textbook, some textbook they use the word net income. So whether your textbook use EBIT or net income, it doesn't matter. The concept is the same. Sometimes they want earnings or sometimes they use what's called operating income rather than income operating income. Now, why do we say operating income and EBIT? Because interest and taxes, the I and the T are not related to your operation. Interest related to how you finance yourself? Because the way if you borrow money, you have to pay interest and taxes has to do with the jurisdiction in which you operate. That's why EBIT is a better measurement of your return of your operation efficiency than net income. But simply put, all we are looking at is we want to see how much you are generating profit or operating profit from your total assets. So if you generated $100 in EBIT earning before interest and taxes and your average total asset. Now in the denominator, every time we use a balance sheet account like asset or equity or stockholders equity, we use the average, especially if in the numerator, we have an income statement account. EBIT is an income statement. Remember, an income statement covers a period of time. For example, one year, the balance sheet, if we're looking at the balance sheet, the balance sheet tells you what is the date numbers. So you're comparing a period of time versus a date. So to make this comparison more relevant, what you do is you take your beginning balance plus the ending balance for the balance sheet and you find the average. This way you'll find what is your average asset. This way you can divide net income divided by the average asset. So they're both covering the same period of time. So that's why in the denominator when you use asset, you want to use a balance sheet, you would use the average. So if EBIT is $100 and average total asset is $1,000, we would say your return on sales is 10%. It means for every dollar in assets you have, for every dollar in asset, for every dollar in asset, you are generating 10 pennies in profit. Is this good? Is this bad? Just like with any other ratio, you have to compare them to something else, either to a prior period, to a competitor or to the industry. So let's compare 0.1, 0.10 and let's assume the industry has a return of asset of 15%. Then you return an asset, we would say it's not good, it's below the industry. If the industry is 7%, then 10% looks good. So always ratios you'll take them in a form and a context, you don't just interpret them on their own. So return on asset is an indicator of how profitable a company is relative to its asset. So basically how well you are using, you are utilizing your assets. How efficient are you in utilizing your asset? Now return on equity, the second ratio, this is a very interesting ratio because return on equity is a very important ratio. We have a one-haul recording about return on equity when we look at the Dupont analysis and we decompose return on equity. But here we're just going to cover it real quick. But if you want more about return on equity, if you want to break it down into its five components, margin, leverage, return on asset, the tax burden and the interest burden, please view the return on equity recording that deals with the Dupont analysis. But simply put, it's net income divided by average stockholders' equity. It's a measure of the financial performance calculated by taking net income by shareholders' equity. Now because equity is equal to the company's asset minus its debt, return is considered, ROE is considered the return on net asset. Net asset is what? Net asset. When we say the word net asset, it means you are taking something from asset. Well, when we do, when we take assets minus liabilities equal to net assets. Well, what is assets minus liabilities equal to? Equal to equity or stockholders' equity. That's why what we do is we take net income. And here we are computing net income because what belongs to the shareholders' equity is after you pay your debt and your taxes. That's what's left for them. That's why you would use net income when you are computing return on equity. So on the return on equity, net income is an appropriate numerator because it's taken into account the cost of the debt and the cost of the taxes, which is something that the stockholders have to pay for. If you're a stockholder, basically you are paying the taxes from the profit. You are paying the interest for the bondholders before anything is left for you. So that's the, that's the, that's the component. Once again, the easiest way is to play with some figures. Again, I like to use, you know, simple numbers. If net income is 100 and shareholders' equity is 800, then your return on equity is 12.5. Is this good? Is this bad? Again, we go back to the same concept. You have to compare your return on equity to prior periods, to competitors. What happened if you put your money with a competitor? What's your return on equity? What happened if you compare your return on equity for your company, the software industry, let's assume you're in the software industry versus the return on equity for the other, the average software industry. Are you doing better than the industry or less than the industry? It's better to compare yourself to a competitor or compare yourself to a prior period. I don't like comparing to the industry, although it's, it's a legitimate, it's a legitimate comparison because the industry might have many, many differences. And we're going to talk about those differences later. So it's, it's harder to compare your performance to the industry. That's a negative, but also the positive is when you compare yourself to the industry, all these differences will average up. So some people they have, for example, aggressive revenue recognition, other companies might have conservative revenue recognition, they also kind of average out, average out. But I prefer to compare yourself to yourself from a prior period or to the closest competitor. Now, also the competitor, when you compare yourself to a competitor, they might be using a different accounting standard than you are. But usually what happens is analysts, they will take those changes into consideration. And I will have a recording about, you know, the differences, what are the limitations of financial statement analysis when you compare yourself to someone else. So the best is to compare yourself to yourself from a prior period. But the other comparison are perfectly legitimate and good. The third ratio is return on sales or profit margin. Here you are taking your EBIT earnings before interest and taxes and dividing it by sales. So notice here you don't do averages. Why don't you use averages? Because EBIT is an income statement figure. Sales is an income statement figures. They're both income statement. So you don't have to use averages. Okay. So what is the profit margin or return on sales? It tells us, and this is an important figure, how much profit is being produced per $1 in sales. So simply put, another way to look at this is look, taking the bottom number of the income statement divided by the top number. What do I mean by that? When you look at an income statement, the first number on the income statement sales, then you have cost of goods sold, then you have operating expenses, then you might have other expenses, as well as other, you know, other minor deductions, taxes, interest, so on and so forth. Until you get to your earnings, oh, let's not deduct interest and taxes, then you get to be EBIT. Then after EBIT, you deduct your interest. You will get from that, you will get your earnings before taxes, then you compute your taxes to get your net income. So what we're doing here is you could use net income if you want to, but what they're doing here is they're using EBIT here. So your earnings from operating your business, ignoring interest and ignoring taxes and dividing this by sales. But usually when we think of the profit margin, because you have to pay taxes and interest before you come up to your profit margin, but in this session, I would use EBIT as in the numerator. So simply put, if your EBIT is, let's assume 100 and your sales is, let's make it 500, okay? So if your sales is 500, your EBIT is 100, what does that mean? That's one or 100 divided by 500 or one fifth or equal to 20%. That's considered a high profit margin or a high return on sales. It means for every dollar in sales, for every dollar in sales, you are keeping 20 pennies, 20 pennies. Now bear in mind, different companies in different industries will have different profit margin. For example, the retailers like Walmart, Costco, any place that you can think of that sells the same item, Target, any place that go into the mall and look around, most places they sell pretty much similar items unless it's a luxury place. Like forget about the mall because in the mall you might have a jewelry store, they have a high profit margin. But if you think of Target, Walmart, these companies, they have a very low profit margin, maybe two and maximum three, three and a half percent their profit margin. They don't make a lot per one dollar of sales. But what they do is they make up this profit with their turnover. They have a high turnover. So although their profit is not much, but they sell a lot. So when you take 2% and you multiply, for example, by 10, then you will get a decent return on your asset. Other industries like the pharmaceutical, they will have a high margin, especially if they're selling some type of medication that's unique. They have an exclusive patent for 20 years. They're going to demand a high margin or like the Apple phone will have a high margin, Apple product will have a high margin. But it doesn't mean high, high is usually good, but low, it doesn't mean it's bad. It all depends on your industry. So I just want to make sure you understand that the profit margin will have to be taken into a particular context to be interpreted properly. And obviously the best way to do it is to compare yourself to another period, how well you were doing in the other period, the prior period, and try to compare yourself to a direct competitor. That's the best way to do it. You could also look at the industry, but the industry have to really understand your industry overall industry. If you like this recording, please like it and share it. In the next session, I would look at market price ratios like the market to book value, earnings yield, so on and so forth. As I mentioned earlier, I don't replace your CPA CPA course. So if you're taking a CPA course, keep it. I don't want you to replace it, but if you want additional resources for yourself, whether you're studying for your CPA exam or you're taking your accounting courses, check out my website, farhatlectures.com. Stay safe and study hard.