Measuring Firm Profitability

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Measuring Firm Profitability
The Modern View of Financial Statement Analysis

• The focus of financial statement analysis
• should on valuation. The valuation of
• firm assets
• firm debt
• firm equity

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1. Value firm assets
Value of Non Operating Assets
PV of Corporate Overhead
2. Subtract cost of corporate overhead
Excess securities, land for future use, other
investments
Market Value of Debt
Value of Operating Assets
3. The remaining value belongs to debt
equity owners.
Residual Equity Value
Present Value of future cash flow from operating
assets
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Value of Operating Assets

• Depends on two basic financial variables
• The return management can be expected to earn on
  investments in operating assets (ROIC), and
• The firms cost of capital (WACC).
• Modern financial analysis focuses on the return
  the firm is able to earn on operating invested
  capital - ROIC
• To be complete, we relate ROIC to RIC, ROA ROE.

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• How profitable has the firm been?

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The PointThe Answer Depends on the Question
Asked

• What accounting return was earned on equity
  investment?ROE - Return on Equity
• What accounting return was earned on total assets
  of the firm?ROA - Return on Assets
• What accounting return was earned on invested
  capital?RIC - Return on Invested Capital
• What accounting return was earned on capital
  invested in operating assets?ROIC - Return on
  Operating Invested Capital

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Definitions
Why is NI Interest Recd by Debt
Owners different from NOPAT

• ROE Net Income / Equity
• ROA NOPAT / Total Assets
• RIC Net Income Interest / Interest bearing
  debt Equity
• ROIC NOPAT / Operating Assets - Non Interest
  Bearing Debt

Invested Capital
Operating Invested Capital
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Basic Data to Illustrate Concepts

• Current Assets 825
• Net Plant Equip 2,700
• Investments at Equity 250
• Net Goodwill 830
• Other Operating Assets 230
• Total Assets 4,835
• A/P Accruals 410
• Short Term Debt 50
• Taxes Payable 30
• Current Liabilities 490
• Long Term Debt 1,410
• Retirement Benefit Obls 300
• Deferred Income Taxes 150
• Equity 2,485
• Total Liabilities and Equity 4,835

• Sales 3,500
• Cost of Goods Sold -1,900
• Gross Profit 1,600
• S,GA Expense - 500
• Depreciation - 320
• Investment Income 20
• Net Operating Profit BT 800
• Interest Expense - 80
• Non-Operating Income 10
• Net Income BT 730
• Taxes (at 30) - 219
• Goodwill Amortization - 40
• Discontinued Operations - 21
• Net Income 450

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Comments about Income Statement
Income from partial ownership of unconsolidated
subsidiaries. Usually not included as operating
income from the firms assets.(Non consolidated
subsidiaries are valued separately from the
operating assets of the firm.

• Sales 3,500
• Cost of Goods Sold -1,900
• Gross Profit 1,600
• S,GA Expense - 500
• Depreciation - 320
• Investment Income 20
• Net Operating Profit BT 800
• Interest Expense - 80
• Non-Operating Income 10
• Net Income BT 730
• Taxes (at 30) - 219
• Goodwill Amortization - 40
• Discontinued Operations - 21
• Net Income 450

Usually interest income. Assuming the firm does
not have excess securities, this will actually be
on-going and should be treated by us as an
operating income item.
Like depreciation. This is the write-off of
Goodwill shown on the Balance Sheet. A non-cash
expense that is not tax deductible.
Profits or losses during the year from business
ventures that have been discontinued and, thus,
will not be part of future operating income.
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Calculation of NOPAT
NOPAT

• Sales 3,500 3,500
• Cost of Goods Sold -1,900 -1,900
• Gross Profit 1,600
• S,GA Expense - 500 - 500
• Depreciation - 320 - 320
• Investment Income 20
• Net Operating Profit BT 800
• Interest Expense - 80
• Non-Operating Income 10 10
• Net Income BT 730 NOPBT 790
• Taxes (at 30) - 219 - 237
• Goodwill Amortization - 40 NOPAT 553
• Discontinued Operations - 21
• Net Income 450

Investments at Equity in Balance Sheet
not treated as an Operating Asset. Thus income
from such excluded from NOPAT
Because we assume this will occur
naturally during operations. No excess
marketable securities.
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Comments about Balance Sheet

• Current Assets 825
• Net Plant Equip 2,700
• Investments at Equity 250
• Net Goodwill 830
• Other Operating Assets 230
• Total Assets 4,835
• A/P Accruals 410
• Short Term Debt 50
• Taxes Payable 30
• Current Liabilities 490
• Long Term Debt 1,410
• Retirement Benefit Obls 300
• Deferred Income Taxes 150
• Equity 2,485
• Total Liabilities and Equity 4,835

Investments in other companies that have not been
consolidated. Shown at cost.
Purchase Price of Acquisitions - Book Value of
Assets Acquired Goodwill of Acquisition Written
off to income over 40 years or less
These are non-interest bearing debts of the firm.
They do not represent invested capital
This is a debt to employees that is interest
bearing.
This is simply an accounting entry to force the
balance sheet to balance. It should be added to
Equity
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Calculation of Invested Capital OIC
Operating Invested Capital

• Current Assets 825
• Net Plant Equip 2,700
• Investments at Equity 250
• Net Goodwill 830
• Other Operating Assets 230
• Total Assets 4,835
• A/P Accruals 410
• Short Term Debt 50
• Taxes Payable 30
• Current Liabilities 490
• Long Term Debt 1,410
• Retirement Benefit Obls 300
• Deferred Income Taxes 150
• Equity 2,485
• Total Liabilities and Equity 4,835

825 2,700 230 - 410 -
30 3,315
Invested Capital
50
1,410 300 2,485 150 4,395
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Deferred Income Taxes

• This is not a liability.
• It is an entry to get the balance sheet to
  balance.
• It arises because Tax Expense reported to
  shareholders is greater than actual Taxes Paid
• Should be treated as an addition to Equity.

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The Return Measures

• ROE Net Income / Equity 450 / 2,485
• Correct ROA NOPAT / Total Assets 553 / 4,835
• RIC Net Income Interest / Interest bearing
  debt Equity
• 450 80 / 4,395
  
• ROIC NOPAT / Operating Assets - Non Interest
  Bearing Debt
• 553 / 3,315