October 2008 Archive

EPS is the traditional measure of the relationship between a companys profits and the ownership interest of the companys common shareholders. It is the most widely used financial ratio. GAAP require that EPS be reported on the income statement after net income. EPS reports the amount of net income available to common shareholders for each share of common stock outstanding.Therefore, the actual net income may be adjusted for amounts that are not related to common shareholders (e.g., dividends on preferred stock would be (more…)

The return on sales (ROS) is derived from the ROE model reviewed here:

ROE = ROA FL = ROS ATO FL
Net income = Net income Assets = Net income Sales Assets
Stockholders Assets St. Equity Sales Assets St. Equity
equity Operating Investing Financing

The ROS is also known as the profit margin. Net income is the bottom line on the income statement, and of course sales revenue is the firstline item. So the PM is the last line as a percentage of the first line and therefore shows how much of every dollar of sales a company can report as profit. Improving a PM (increasing it) can result from cutting costs relative
to sales.

Just as there are modifications of the ROA ratio, there are modifications to the PM.They all come from substituting various subtotals on the income statement for the net income in the numerator of the PM ratio. Some variations are (working down from the top of the income
statement):

Gross PM rate = Gross PM = Sales Cost of sales
Sales Sales

EBITDA margin rate = EBITDA
Sales

Operating PM rate = Operating income
Sales

OR EBIT
Sales

Pretax margin rate = Income before income taxes
Sales

As mentioned before, these margin ratios concern the success of the companys operations. All of these margin ratios will actually show up inwhat is referred to as common-sized income statements (covered in Chapter 6), prepared from multistep income statements that include subtotals. Exhibit 2.9 shows the margin ratios for Dow Chemical.The margin ratios
do not become negative in 2001 until after interest is deducted.
Taken From : ESSENTIALS of Financial Analysis

A more in-depth analysis of ROA is possible. According to Palepu, Bernard, and Healy (1997)4, the traditional measure of ROA is internally inconsistent since the denominator is total assets and represents all the resources or capital provided by both creditors and owners.However, the numerator is net income (after deduction of interest expense) and therefore represents profits available only to stockholders. A more internally consistent (since both numerator and denominator include debt-related information) measure of profitability is (more…)

We end up with a measure of success (ROE) made up of three components:

1. Profit margin (PM)to reflect the operating success of a company
2. Asset turnover (ATO)to reflect the investing success of a company
3. Financial leverage (FL)to reflect the financing activities of a company (more…)

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