Factors Affecting Reported Profitability

Question 1

What are the factors involved that affect reported profitability?

Answer 1

Among the many factors involved in measuring profitability are:

1. Definition of income
2. Stability sources
3. Revenue trends
4. Revenue relationships
5. Expenses (including cost of sales)

Profitability analysis attempts to answer questions about the relevant income measure, income quality, the persistence of income and the firm’s earning power

Question 2

What does Income affect measuring profitability?

Factors affecting measuring profitability

Answer 2

Income = sum of revenues and gains - sum of expenses and losses

Estimates are necessary to calculate income (i.e. allocations of revenue and expense over accounting periods, useful lives of assets and amounts of future liabilities)

Income is measured in accordance with a selection from among GAAP

Incentives for disclosure about the income measure vary with the interest group: financial analysts, auditors, accountants, management, directors, shareholders, competitors, creditors and regulators. The pressures from some groups may lead to suboptimal financial reporting

Users have different needs, but financial statements are general purpose (i.e. investors are interested in profitability, but creditors are interested in security)

Question 3

How does revenue affect measurement of profitability?

Factors affecting measuring profitability

Answer 3

Revenue are inflows or other enhancements of assets of the firm or settlements of its liabilities from delivering or producing goods, rendering services or other activities that constitute the firm’s ongoing major or central operations

Understanding the sources of revenue is especially important in diversified firms. Common-size analysis is useful when markets and product lines have differing rates of growth, potential and profitability

Trend percentage analysis and evaluation of management’s discussion and analysis (MD&A) in the firm’s annual report are useful techniques for assessing the persistence of the firm’s revenues

Question 4

How does the relationship between revenues and receivables help assess a firm’s earnings quality?

(Factors affecting measuring profitability)

Answer 4

The relationship of revenues and receivables helps assess earnings quality

If revenue (sales) are growing more slowly than receivables, the analyst should consider management’s incentives, the relative leniency of credit policies and collectability issues

Question 5

How does the relationship between revenues and inventory help assess a firm’s earnings quality?

(Factors affecting measuring profitability)

Answer 5

The relationship of revenues and inventories is useful. For example, if materials and WIP inventories are falling while FG inventories are rising, future output and sales are likely to decline