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The bottom line - is it enough.

The Bottom Line -- Is It Enough?

Very often, a proprietor or manager will consider only the "bottom line" on an income statement. Net profit or loss will be viewed as the indicator of a company's financial condition. Good management, however, will use a much more extensive analysis of the financial statements to determine profitability and to plan future operations. The accountant can aid his client by providing this analysis.

Profitability is defined as the ability of an entity to earn income. It can be determined using several different measurements, including the ratio of net sales to assets, the rate earned on total assets, earnings per share or common stock and the price earnings ratio.

The ratio of net sales to assets is a measure used to show how effectively a company uses its assets. If the firm can increase sales in relation to total assets held, its profitability is then increased. The ratio is calculated by dividing net sales by total assets (excluding long-term investments since they are unrelated to sales). Total assets can be the year-end figure or a yearly average. (See Figure 1).

Profitability can also be measured by the rate earned on total assets. This is a similar measurement to the above ratio. However for this measurement, the profitability of the assets is determined without considering the means of financing the assets. The current year net income is used in place of net sales, but interest expense is added back before calculating the ratio of net income to total assets. The creditor and/or shareholder equity is then eliminated from the calculations. (See Figure 2).

The rate of income to total assets may be calculated using operating income only. If this is done, any investments yielding non-operating income should be eliminated from total assets.

Earnings per share on common stock is a measure of profitability that is frequently used in corporate annual statements. If only one class of stock is outstanding, earnings per share is calculated by dividing net income by the number of shares outstanding. If there is preferred stock, net income is first reduced by the amount due to the preferred shareholders. This figure can then be compared to actual dividends per share when making investment decisions. (See Figure 3).

Earnings per share on common stock is used to compute the price earnings ratio. This profitability figure is quoted frequently in the financial pages and is used as an indicator of a company's future earning capability. It is calculated by dividing the market price per share on a given date by the earnings per share. Using the earnings per share shown in Figure 3 and a market price of $22.50 per share on December 31, 1989, and $33 per share on December 31, 1990, the price earnings ratio would be calculated as shown in Figure 4.

These profitability measurements are useful tools and an excellent service which an accountant can provide for his client. The resulting ratios can be used to evaluate a present business, to determine if profitability has increased from year to year and, if information is available, to compare this company with others in the same industry. [Figures 1 to 4 Omitted]

Marlyn A. Schwartz Director of Education & Professional Development
COPYRIGHT 1990 National Society of Public Accountants
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1990 Gale, Cengage Learning. All rights reserved.

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Author:Schwartz, Marlyn A.
Publication:The National Public Accountant
Article Type:column
Date:Sep 1, 1990
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