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So, profitability measures are our first starting point.

Â And where do we go for that?

Â Not the balance sheet.

Â We start with the profit and loss statement.

Â The obvious starting point.

Â We could go straight to the bottom line, net income.

Â And we'll use and measure a little later on, but

Â really that is not particularly insightful if we not first account for

Â the size or the scale of the operation of production.

Â So just looking at the number for net income might be somewhat meaningful.

Â It's nice to see that net income is increasing in value over time.

Â But it would still be much more meaningful if we put it into context.

Â Because that increase in performance might have been the outcome of a significant new

Â investment.

Â So to get a better understanding of profitability of the firm.

Â Let's take a look at a series of measures that do actually account for

Â scale of production.

Â 2:20

So, both margins measure the firm's ability to sell its product.

Â To the sell the cereals for more than the direct cost,

Â that would be the gross margin.

Â Or for the direct cost plus indirect cost of production.

Â Gross margins and operating margins.

Â So taking a look at the values for these ratios for Kellogg's corporation.

Â We can see that the gross margin in 2014 was 35%

Â as compared in a time series analysis

Â with the gross margin in 2013, which was 41%.

Â We see that operating margin went from 19% in 2013 to 7% in 2014.

Â So both measures, both ratios,

Â indicate a deterioration for Kellogg's gross and operating margins.

Â And the financial analyst will then look into the causes of why this happened.

Â And a discussion with management might shed some light on that.

Â We won't focus on that for now.

Â We'll just introduce those measures to give you the whole pallet of information

Â that the financial analysts would have at its disposal

Â when they engage with management in that discussion.

Â Alternatively to comparing Kellogg's performance from 2013 with 2014 we

Â can also compare Kellogg's performance

Â on the basis of the same kind of metric with its competitor.

Â We've chosen one particular competitor which is

Â pretty comparable as you will see in a moment in terms of its operations, Kraft.

Â So in this particular case we've taken rather than gross margins or

Â operating margins, weâ€™ve taking the Net Profit Margin.

Â Net Profit margin is defined as net income, divided by total sales.

Â 4:13

So that would give us for Kellogg's in 2014, a net profit margin of 4.3%.

Â Kraft, in that very same financial year, managed to get a net income

Â of 1 billion dollars and a net profit margin of 5.7%.

Â So, Kraft's net profit margin is outperforming Kellogg's in 2014.

Â That could be meaningful information for

Â the shareholders in deciding to hold onto their shares in Kellogg's, or

Â instead deciding to take the higher net profit margin for

Â Kraft as an indicator, that, that might be a preferable investment opportunity.

Â It might also be an indicator for management of Kellogg's

Â that it is lagging in terms of performance against its competition and

Â might want to look at the causes for that under performance.

Â But keep in mind that this is just one of the pieces of the puzzle.

Â Alternatively, shareholders might want to know their return

Â on their investment in the corporation.

Â And that could be captured by a ratio like return on equity.

Â Probably one of the more popular performance metrics

Â used by financial analysts.

Â So return on equity is defined as net income

Â divided by the book value of equity, as you saw it appear on the balance sheet.

Â So return on equity is a ratio that reflects returns.

Â Recent returns as we measured them from the profit and loss statement,

Â as a fraction of the book value of equity.

Â Which is the sum of past investments made by shareholders in the firm.

Â So does that actually work?

Â Is that correct?

Â Look at it from this way.

Â We use a metric in the numerator, from the profit and loss statement.

Â The profit and loss statement catches what we know as flow measures.

Â An outcome which was achieved over a financial year.

Â Over a time period.

Â But we divide through by a balance sheet entry, a balance sheet line item.

Â The book value of equity.

Â You remember that the balance sheet gives analysts an indication of the financial

Â position of the firm at a point in time, not over a period of time.

Â We label those line items, stock measures taken at a particular point in time.

Â Dividing a flow measure by a stock measure is not appropriate.

Â So what we need to do is to work out over the time period over which

Â the flow measure was computed, over which the net income was computed,

Â over the financial year.

Â We need to work out what the average book value was over that time period.

Â So we can compute it by a simple adjustment.

Â Take the flow measure, as is,

Â from the profit and loss statement, net income, and divide through

Â by the average book value of equity over that same financial year.

Â How do we compute that?

Â Well, we simply take the book value of equity,

Â at the end of the financial year, say 2014.

Â We add the book value of equity for

Â Kellogg's from the end of financial year the year before, 2013.

Â And we divide by two.

Â A simple metric assuming that we can draw a straight line

Â between the two book values and take the average in the mid point of the year.

Â That would give us an appropriately adjusted ratio to

Â measure equity performance.

Â However, past investments didn't only include equity.

Â You remember the example I gave you

Â where you started operating your delivery service?

Â 8:31

You decided to invest part of your own money in purchasing the van.

Â In addition to getting a bank loan.

Â So, the assets, the van, was purchased by a combination of a liability and equity.

Â So past investments for your business,

Â were financed partly by equity, partly by liabilities.

Â Same for corporations.

Â So it might actually be better to attribute the performance of the firm not

Â just to equity but also to the fact that the company has borrowed money

Â to leverage up its operations.

Â The concept we will be discussing in quite some detail in this course and

Â in the next courses.

Â So to capture that joint investment in the firm's assets, equity, and liabilities,

Â we actually compute the returns that the corporation make over the sum total, which

Â of course, is captured on the left-hand side of the balance sheet, the assets.

Â So we compute, rather than return on just equity,

Â we compute a return, net income on assets, which is then measured again -

Â a stock variable, as the average of the book value of assets.

Â Analysts much prefer return on assets over a return on equity.

Â As it is not sensitive to the firm's choice of leverage.

Â Whereas, the return of equity clearly would be because it is simply not

Â including the relative size, the relative investment proportions of equity and

Â assets, and equity and liabilities.

Â So here you have it.

Â This diagram will give you an indication of the comparatives between the two firms

Â for different ratios, net profit margins, return on equity, return on assets.

Â It gives you a combination of, a comparison between firms,

Â vertical comparison.

Â But it also gives you some horizontal comparison,

Â because both firms give you those ratios for 2014 and 2013.

Â So not only can you compare them against each other,

Â you can also compare them over time.

Â