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Chapter 10

Chapter 10. Profitability and Return on Investment. Profitability and Return on Investment. Investments are made with a view to: earnings capital appreciation Investors will assess investment under: profitability return on investment dividend policy capital appreciation

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Chapter 10

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  1. Chapter 10 Profitability andReturn on Investment

  2. Profitability and Return on Investment • Investments are made with a view to: • earnings • capital appreciation • Investors will assess investment under: • profitability • return on investment • dividend policy • capital appreciation • Ratios, etc. developed to assess these Financial Information Analysis

  3. Profitability • Critical for long-term viability • Gross Profit rate • (Gross Profit / Revenue) x 100% • focus on trading activity • inter-company comparison • Operating Profit rate • (Operating Profit / Revenue) x 100% • Net Profit rate • (PBIT / Revenue) x 100% Financial Information Analysis

  4. Return on Investment • Relationship between investment & earnings • Numerator (Earnings) must be consistent with denominator (Investment) • Return on Capital Employed (ROCE): • (PBIT / Capital Employed) x 100% • Capital Employed usually long-term funding • Denominator can also include short-term debt • ROCE = Net Profit Rate x Asset Turnover Financial Information Analysis

  5. Return on Investment ctd. • Return on Equity (ROE) • focus on return enjoyed by owners • i.e. denominator is Equity (Shareholders Funds) • numerator changes to reflect this, i.e., profit after interest, tax and preference dividends • ROE = • Profit after interest, tax and preference dividends. Equity (Shareholders Funds) Financial Information Analysis

  6. Earnings Per Share (EPS) • Widely used and closely regulated • EPS = Earnings / Equity shares in issue • Must be provided at end of Income Statement with workings in Notes • IAS 33: Basic and Diluted EPS • Calculation of denominator complicated by: • new issues • share options Financial Information Analysis

  7. Market ratios • Price/Earnings Ratio (PER) • relationship between earnings and market price • important benchmark - industry averages available • = market price per share / EPS • Earnings yield inverts this ratio • = EPS / market price per share • measures earnings generated in relation to market price • Widely used by investors: • Higher PER = expectation of EPS growth • PEG = PER/Prospective growth in EPS • Prospective growth based on various assumptions Financial Information Analysis

  8. Payouts • Investors invest to earn a return • Total Shareholder Return: • = Share price appreciation + Dividends • Increasingly companies also engaged in Share Buybacks • Involves company acquiring own shares in market • Benefits for both shareholder and company • Occasionally used to favourably impact ratios • Attractive to companies with cash surplus Financial Information Analysis

  9. Dividend Policy • Company dividend policy depends on: • previous policy • availability of profits and cash • market expectations • Dividend Yield • (Dividend per share/Market Price per share) x 100% • Dividend Cover • Profit after Tax and Pref Dividend / Ordinary Dividend • Dividend Payout • Ordinary Dividend/ Profit after Tax and Pref Dividend Financial Information Analysis

  10. Summary • Businesses must generate returns • profits • capital appreciation • Ratios developed to assess earnings/return • relate earnings to investment being assessed • Profitability ratios assess success of firm in generating profits • Earnings ratios assess performance of firm from perspective of investors Financial Information Analysis

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