08 Aug 2015 12:51

Tags annual_report financial_statements profitability

Welcome to Part 2 of our Annual Report Financial Analysis. At the end of this series I will share the spreadsheet used throughout the exercise which will include all of the formulas to calculate the ratios and on which statement to find the values to populate.

As a reminder, to perform this exercise you will need the financial statements from your selected stock and one of its top competitors. Throughout this series we will be comparing Johnson & Johnson (JNJ) to Pfizer (PFE) as our example.

The formal definition of profitability refers to a company’s ability to retain a percentage of its income as profit and the ratio of said profit in relation to sales, assets, and equity.

Performing the Profitability analysis will require not just the evaluation of calculation ratios but also the trending of values over time to detect growth or shrinkage trends.

**Net Sales Change Trend** – A measure that trends the total % of sales trend over a period of time, usually over 3, 5, or 10 years.

*Net Sales Change Trend = (Current Year Net Sales - First Year Net Sales) / First Year Net Sales + 1*

**Net Sales Change Year over Year Trend** – A measure that trends the % of sales from year to year.

*Net Sales Change YoY = (Current Year Net Sales - Prior Year Net Sales) / Prior Year Net Sales*

**Net Income Change Trend** – A measure that trends the total % of net income trend over a period of time, usually over 3, 5, or 10 years.

*Net Income Change Trend = (Current Year Net Income - First Year Net Income) / First Year Net Income + 1*

**Net Income Change Year over Year Trend** – A measure that trends the % of net income from year to year.

*Net Income Change YoY = (Current Year Net Income - Prior Year Net Income) / Prior Year Net Income*

**Gross Profit Rate** – Sometimes referred to as gross margin. This calculation refers to how profitable a company’s products are. This ratio calculated by dividing the Gross Profit by Net Sales. (The higher the % result the better)

*Note: Gross Profit is calculated by subtracting Sales from Costs of Goods Sold. Costs of Goods Sold can be found on the Income Statement*

**Gross Profit Rate = Gross Profit / Net Sales**

**Operating Expense Ratio** – This calculation refers to % of net sales required to produce product or services. This ratio can be valuable for comparing companies with similar assets. This ratio calculated by dividing the Operating Expense by Net Sales. (The lower the % result the better)

*Operating Expense and Net Sales (or Revenue) can be found on the Income Statement*

**Operating Expense Ratio = Operating Expense / Net Sales**

**Operating Income** – This calculation represents the total income before interest and taxes, sometimes referred to as EBIT. EBIT is calculated by subtracting the Operating Expense from the Gross Profit.

*Operating Expense and Gross Profit can be found on the Income Statement*

**Operating Income = Gross Profit – Operating Expenses**

**Net Income as a % of Sales** – This calculation represents the percent of each dollar in sales that the company keeps as profit after interest and taxes. Net Income as a % of Sales is calculated by dividing Net Income by Net Sales. (The higher the % result the better)

*Net Income and Net Sales (Revenue) can be found on the Income Statement*

**Net Income as a % of Sales = Net Income / Net Sales**

**Return on Equity (ROE)** – This calculation represents how well a company uses investments to generate earnings growth before distributing dividends to shareholders. High or rapid growth companies should see a high ROE while mature companies typically operate with 15 to 25% ROE. ROE is calculated by dividing Net Income by Average Total Equity. (The higher the % result the better)

*Net Income and Net Sales (Revenue) can be found on the Income Statement*

**Return on Equity = Net Income / Average Total Equity**

**Return on Assets (ROA)** – This calculation represents how well a company earned a reasonable return on the assets under their control. This metric is useful when comparing companies to determine which is more efficient and if trended over time can indicate potential issues such as mismanagement, declining market share or obsolescence of assets if the ROA is dropping.

*Net Income can be found on the Income Statement and Total Assets can be found on the Balance Sheet Statement*

**Return on Assets = Net Income / Average Total Assets**

**Earnings per Share (EPS)** – This calculation represents a company’s profit on a per share of stock basis. This a popular metric used by investors to determine income growth but unlike other calculations used throughout this analysis it can be manipulated by decreasing or increasing the number of shares through buybacks or issuance. A more effective method would be to trend net income for true growth. EPS is calculated by dividing the Net Income by the Total Number of Outstanding shares.

*Net Income can be found on the Income Statement. Outstanding shares is not directly found on the Income Statement and is usually annotated as note where you can get the average number of shares.*

**EPS = Net Income / Total Outstanding Number of Shares**

Now we can try putting these to use by comparing Johnson & Johnson (JNJ) to Pfizer (PFE)

Which company had overall better profitability numbers? Pfizer (PFE) has slightly better gross profit rates and operating expense ratios but its sales and income growth are inconsistent. Additionally, Pfizer’s 2014 ROA of only 5% causes concerns and the need for further investigations.

Johnson and Johnson (JNJ) on the other hand demonstrates consistent income and sales growth from year to year as well as improved year to year ROE. In this round JNJ is the winner.

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