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LECTURE 6PROFITABILITY ANALYSIS

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Profitability ratios ROA The Dupont model ROE

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These ratios can be calculated to determine how well resources used in the business have been utilised to earn profits

Two key measures◦ ROA measures a firm’s success in using assets

to generate earnings, independent of the financing method.

◦ ROE extends ROA to include the effect of financing

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This ratio describes the rate of return management was able to earn on the assets that it had available during the year.

An informed judgment about the firm’s profitability requires relating income from operations to the assets used to generate that net profit.

Average total assets NI + (1-Tax rate)*Interest exp + Minority interestROA =

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Return on Assets

EBIT Sales= Sales

Average Total Assets×

Margin Turnover

Emphasises that from every dollar of

sales revenue, some amount must work its way to net

profit.

Relates efficiency with which the

firm’s assets are used in the

revenue-generating process.

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Gross Profit Margin: Reflects the gross profit as a percent of sales◦ Reflects the company’s ability to increase or maintain

selling price◦ Declining gross profit margins generally indicate that

competition has increased◦ or that the company’s products have become less

competitive, or both. Operating Expense Margin: Measures the

company’s ability to control operating expenses◦ Need to be aware of “investment” costs, like advertising

and R&D. ◦ Reductions can lead to a short-term gain at a long-term

cost.

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Accounts Receivable turnover: Reflects how many times receivables are collected on average.

Inventories turnover: Reflects how many times inventories are sold and replaced on average.

Fixed asset turnover: Reflects the productivity of long-term operating assets.

Accounts Payable turnover: Reflects how quickly accounts payable are paid, on average.

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What factors explain the consistently high or consistently low ROAs of some industries compared to the average of some industries?

Why do some industries have high profit margin but low asset turnover, while others are the opposite?

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3 elements of risk that may explain the differences across firms and changes over time in ROA:◦ Operating leverage◦ Cyclicality of sales◦ Stage and length of product life cycle

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Operating leverage◦ Operating leverage is the level of the firm’s

commitment to fixed operating expenses◦ Firms that have capital intensive cost structures

will have a higher proportion of fixed costs than those firms that are less capital intensive

◦ Firms with high level of operating leverage experience greater variability in ROAs, incur more risk in their operations and should earn higher rates of return.

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Cyclicality of sales◦ Firms with cyclical sales patterns incur more

risk, they experience greater variability in ROA

Product life cycle◦ Introduction/early growth – negative ROA◦ Maturity – rapid increase in ROA◦ Decline – ROA may still increase

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Microeconomic theory

Business strategy◦ Product differentiation/low cost leadership

Capital intensity

Competition Likely strategic focus

High Monopoly Profit marginMedium Oligopolistic or

Monopolistic Competition

Profit margin Assets turnover or Some combination

Low Pure competition

Assets turnover

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ROCE measures the accounting return to common shareholders after subtracting all payments to providers of capital senior to common shareholders

ROCE =Net income – Preferred dividends

Average common shareholders’ equity

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Capital structure leverage

Common earnings leverageROAROCE

Equity Com Aver.assets Total Aver.

et)Interest(nNICommon toNI

assets Total Aver.et)Interest(nNI

Equity Com Aver.common toNI

Leverage AdjustedROAROCE

xx=

x+

x+

=

=

x=

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Common earnings leverage (CEL) indicate the proportion of operating income allocable to common shareholders.◦ The higher the cost of debt and preferred stock, the less

income will remain for common shareholders, the smaller the CEL

Capital structure leverage (CSL) measures the degree to which firms use common shareholders to finance assets.◦ The more capital obtained from debts and preferred stock,

the less capital obtained from common shareholders, the higher the CSL

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If suppliers of capital (other than common shareholders) receive less than ROA, then common shareholders benefit (ROCE > ROA); the reverse occurs when suppliers of capital receive more than ROA

The larger the difference in returns between common equity and other capital suppliers, the more successful (or unsuccessful) is the trading on the equity

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Financial leverage enables a firm to have an asset base larger than its equity

Financial leverage increases firm’s ROCE as long as cost of the liabilities is less than the return from investing

While a firm’s shareholders can potentially benefit from financial leverage, it also increase the risk

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Sustainable growth rate is the rate at which a firm can grow while keeping its profitability and financial policies unchanged

Sustainable growth rate provides a benchmark against which a firm’s growth plan can be evaluated.

Firm can grow at different rate if profitability, payout policy or leverage changes

Sustainable growth rate = ROCE (1 – Payout ratio)

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Criticism◦ EPS does not reflect assets or capital required to

generate earnings◦ Number of shares is a poor measure of the

amount of capital in use

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EPS =Net income – Preferred dividends

Weighted average number of shares outstanding

Comparisons with corresponding ratios of earlier periods- Analysis questions◦ Has the firm madea significant change in its

product, geographical or customer mix that affects the comparabilityof ratios over time?

◦ Has the firm made a major acquisition or divesture?

◦ Has the firm changed its methods of accounting over time?

Comparisons with corresponding ratios of other firms

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Problem 4.15 Problem 4.16 Problem 4.17 Problem 4.20 Problem 4.23

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