The Analysis of Profitability

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Chapter 11

• The Analysis of Profitability

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The Analysis of Profitability
More profitability analysis is on the web page
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What you will learn from this chapter

• How ratios aggregate to explain Return on Common
  Equity (ROCE)
• How economic factors determine ratios
• How financial leverage affects ROCE
• How operating liability leverage affects ROCE
• The difference between Return on Net Operating
  Assets (RNOA) and Return on Assets (ROA)
• How profit margins, asset turnovers and their
  composite ratios drive RNOA
• How borrowing costs are analyzed
• How profitability analysis can be used to ask
  penetrating questions regarding the firms
  activities

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Analysis Preamble to Forecasting and Valuation

• Analysis establishes where the firm is now
• Forecasting asks how it will be different in the
  future

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Analyzing ROCE The Scheme
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Cutting to the Core ROCE Drivers

• ROCE is decomposed into drivers over three levels
  of analysis
• Analysis of Leverage
• Analysis of Operating Profitability
• Analysis of Net Borrowing Costs

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First-Level Breakdown Analysis of Effects of
Financial Leverage (FLEV)

• So, ROCE is a weighted return to operating
  activities and financing activities
• or,
• RNOA OI (After tax) / NOA (Return on Net
  Operating Assets)
• FLEV NFO / CSE (Financial Leverage)
• NBC NFE (after tax) / NFO (Net Borrowing
  Cost)
• SPREAD RNOA NBC (Operating Spread)

Spread
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The Financial Leverage Equation

• ROCE RNOA FLEV x RNOA NBC
• The equation says that ROCE is driven by three
  factors
• Profitability of Operations RNOA
• Financial Leverage FLEV NFO
• 
  CSE
• 3. Operating Spread RNOA - NBC

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How Financial Leverage Explains the Difference
Between ROCE and RNOA
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Financial LeverageGeneral Mills, Inc.
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Financial Leverage Microsoft Corp.
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The Effects of Operating Liability Leverage
(OLLEV)

• Operating liabilities lever the Return on Net
  Operating Assets
• What would be the operating profitability
  without operating liabilities?
• where Implicit Interest on Operating
  Liabilities Short-term Borrowing Rate x
  Operating Liabilities
• The Effect of OLLEV
• where

RNOA ROOA (OLLEV x OLSPREAD)
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Operating Liability Leverage General Mills, Inc.
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A Case of Extreme Operating Liability Leverage
Dell Computer
Reformulated Balance Sheet, 2002 (millions)
Net Operating Assets (NOA) are negative! Does
this leverage add value? Yes! Residual income
from operations 1, 284 (0.09 x -3,048)

1,558 million
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Summing Financial Leverage and Operating
Liability Leverage Effects on ROCE
ROCE ROOA (RNOA ROOA) (ROCE RNOA)
Return with no leverage
Effect of Financing Liabilities
Effect of Operating Liabilities
For General Mills, 121.6 15.5 (21.6 -
15.5) (121.6 - 21.6)
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Return on Net Operating Assets and Return on
Assets

• Problems with ROA
• Financial assets in denominator
• Financial income in numerator
• Operating liabilities not in denominator
• Net income is not comprehensive income
• Median ROA is 6.8 Since 1962 for U.S firms
• Median RNOA is 10.1

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RNOA and ROA for Selected Firms, 1996
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FLEV and Debt-to-Equity Ratios

• Problems with Debt-to-Equity ratio
• Excludes financial assets (which effectively
  defease debt)
• Includes operating liabilities
• Median Debt-to-Equity is 1.21
• Median FLEV is 0.42

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Reformulated Financial Statements Nike, Inc.
Reformulated Statements of Common Stockholders
Equity
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Nike, Inc.
Reformulated Balance Sheets
1 Cash and cash equivalents are split between
operating cash and cash investments. 2 Some
accounts payable are interest bearing but this
cannot be discovered. 3 Other liabilities are
primarily long-term deferred endorsement payments
for promotions. 4 Notes payable are interest
bearing. 5 Preferred stock is less than 0.5
million.
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Nike, Inc.
Reformulated Income Statements
1 Broken out from selling and administrative
expenses in published income statement. 2
Included in other expense in income statement.
The nonrecurring changes in 1995 and 1994 relate
to shutdown of certain facilities. 3 Marginal
tax rate was 38.5, 38.5 and 39.1 in 1996, 1995
and 1994, respectively.
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Reformulated Financial StatementsReebok
International, Ltd.
Reformulated Statements of Common Stockholders
Equity
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Reebok International, Ltd.
Reformulated Balance Sheets
1 Cash and cash equivalents divided between
operating cash and cash investments. 2 Excludes
dividends payable which is included in
stockholders equity.
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Reebok International, Ltd.
Reformulated Income Statements
1 Broken out from selling and administrative
expenses in published income statement. 2 The
change in 1995 is due to consolidation and
streamlining of facilities and to the sale of the
Avia subsidiary. 3 Marginal tax rate was 35.4,
36.2 and 36.9 for 1996, 1995 and 1994,
respectively.
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First Level Breakdown of ROCE Nike, Inc. and
Reebok Intl, Ltd.
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Second-Level Breakdown of ROCE Drivers of
Operating Profitability

• Operating profit margin The profitability of
  each dollar of sales
• Asset turnover The ability to generate sales
  for a given asset base
• Effect of financial leverage

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Profit Margin and Asset Turnover Combinations for
238 Industries, 1963-96
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Typical Levels for ROCE, FLEV, OLLEV, RNOA, PM
and ATO
Source Standard Poors COMPUSTAT
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Third-Level Breakdown of ROCE Profit Margin
Drivers

• PM Sales PM Other operating income PM

by product or line of business
GM Sales Cost of Sales
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Third-Level Breakdown of ROCE Asset Turnover
Drivers

• Some times other measures are used
• Days in Acc. Receivable Acc. Receivable/ Avg.
  Sales per day
• 365 /
  Accounts receivable turnover
• Inventory Turnover Cost of Sales / Avg.
  Inventories
• Acc. Payable Turnover Purchases / Avg. Acc.
  Payable

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Third-Level Breakdown Nike, Inc. and Reebok
Intl, Ltd.
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What-If Questions Nike, Inc. and Reebok Intl,
Ltd
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Third-Level Breakdown Analysis of Net Borrowing
Cost
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Analysis of Net Borrowing Cost Nike, Inc.
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Tracking Profitability for Nike BYOAP