Profitability+Analysis

//**Profitability analysis**// is the study of the net profit a business can earn from its total assets, measured as the ratio of net income to total assets. Therefore, profitability is essentially a measure of efficiency because it illustrates how well a business is using its assets to generate a profit. Because we //**invest**// in our business' assets (the middle portion of the cash flow statement), profitability is frequently called **//return on investment//** (ROI). //**Earning power**// is a measure of two performance outcomes: (1) the business' ability to net income from its revenues (net profit margin) and (2) its ability to maximize revenues from its total assets (total asset turnover). Earning power is calculated by multiply these two ratios as shown here: Earning Power = Net profit margin X Total asset turnover

or

Having //revenues// appear in both the denominator and the numerator causes them to cancel each other out. The simplified equation is the same as the one presented for ROI:

Burgers and Bulldozers (aka "The Clown and The Cat")
Here's an example of how differing financial and operating structures can affect a company's earning power. McDonald's sells fast food in its retail stores by relying on a combination of sophisticated equipment and "sophisticated enough" labor. Caterpillar manufactures heavy construction equipment using a combination of highly specialized machines and expert labor. Here are some annual financial figures for both companies at the end of their 2011 fiscal year.



McDonald's generated more net income than Caterpillar with less than half the total assets and revenues of Caterpillar.

Earning power = Profit margin X Asset Turnover


McDonald's and Caterpillar are comparable in terms of the revenues they generate from their total assets. McDonald's higher net income and substantially lower average total assets give it a much higher earning power than Caterpillar. McDonald's is able to generate nearly 17% of the value of its total assets into profits for its shareholders. Earning power and ROI measure the same thing, but get there using two different means.