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So, profitability measures are our first starting point.

And where do we go for that?

Not the balance sheet.

We start with the profit and loss statement.

The obvious starting point.

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

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

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

the size or the scale of the operation of production.

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

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

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

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

investment.

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

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

scale of production.

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

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

that would be the gross margin.

Or for the direct cost plus indirect cost of production.

Gross margins and operating margins.

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

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

as compared in a time series analysis

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

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

So both measures, both ratios,

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

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

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

We won't focus on that for now.

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

that the financial analysts would have at its disposal

when they engage with management in that discussion.

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

can also compare Kellogg's performance

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

We've chosen one particular competitor which is

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

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

operating margins, we’ve taking the Net Profit Margin.

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

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

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

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

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

That could be meaningful information for

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

instead deciding to take the higher net profit margin for

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

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

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

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

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

Alternatively, shareholders might want to know their return

on their investment in the corporation.

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

Probably one of the more popular performance metrics

used by financial analysts.

So return on equity is defined as net income

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

So return on equity is a ratio that reflects returns.

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

as a fraction of the book value of equity.

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

So does that actually work?

Is that correct?

Look at it from this way.

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

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

An outcome which was achieved over a financial year.

Over a time period.

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

The book value of equity.

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

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

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

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

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

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

over the financial year.

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

So we can compute it by a simple adjustment.

Take the flow measure, as is,

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

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

How do we compute that?

Well, we simply take the book value of equity,

at the end of the financial year, say 2014.

We add the book value of equity for

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

And we divide by two.

A simple metric assuming that we can draw a straight line

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

That would give us an appropriately adjusted ratio to

measure equity performance.

However, past investments didn't only include equity.

You remember the example I gave you

where you started operating your delivery service?

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

In addition to getting a bank loan.

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

So past investments for your business,

were financed partly by equity, partly by liabilities.

Same for corporations.

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

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

to leverage up its operations.

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

in the next courses.

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

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

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

So we compute, rather than return on just equity,

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

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

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

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

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

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

assets, and equity and liabilities.

So here you have it.

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

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

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

vertical comparison.

But it also gives you some horizontal comparison,

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

So not only can you compare them against each other,

you can also compare them over time.