Profitability Analysis

1
Profitability Analysis

• Lecture 3

2
Topics

• An overall measure of profitability
• Analyzing profitability
• Profitability from shareholders perspective
• A reformulated approach

3
Why measure profitability?

• Performance evaluation
• Whether the firm is performing as per
  expectations
• Whether the managers are doing a good job
• Forecasting and valuation
• What does current performance tell us about the
  future
• If current performance is above expectations,
  will this persist in future?
• If current performance is below expectations, is
  this a sign of things to come?
• Investors and stakeholders can accordingly adjust
  their stakes in the firm.

4
Rate of Return on Assets (ROA)

• ROA
• Where Net Profit is defined as
• Net income (1-Tax Rate) (Interest Expense)
• Minority Interest in Earnings
• Whose point of view are we taking?
• Shareholders perspective?
• All stakeholders? (that is, the overall
  performance)

5
Factors influencing ROA

• Obviously, performance of the firm
• Macroeconomic and industry conditions
• Accounting measurements
• Managerial incentives and reporting behavior

6
Definition of Net Profit

• Time horizon
• Short-term or long-term?
• Financing considerations
• Excludes financing considerations
• Adding back interest expense (net of taxes)
• Why add back minority interest in earnings?

7
Definition of average total assets

• Some use total assets at the beginning of the
  year
• Should we use the original book value of fixed
  assets or net book value?
• What is the effect on ROA?
• What if we use current cost?
• What should we include in average total assets?
• operating assets and financial assets?

8
Topics

• An overall measure of profitability
• Analyzing profitability
• Profitability from shareholders perspective
• A reformulated approach

9
How to analyze ROA?

• Evaluate against a benchmark
• Last years ROA (i.e., look at change in ROA)
• More generally, time series trends in ROA
• Industry ROA
• More specifically, ROAs of close competitors with
  similar size, business models, cost structure

10
Disaggregating ROA

• ROA
• Profit Margin for ROA Assets Turnover
• Profit Margin Net Profit / Sales
• Assets Turnover Sales/Average Total Assets

11
Two issues

• Why do some industries systematically have higher
  or lower ROAs that others?
• Why do different industries have different mixes
  of PM and ATO?

12
Factors Affecting ROAs
A
Profit Margin
B
Competitive Constraint
ROA6
C
ROA3
Capacity Constraint
Assets Turnover
13
Differences in ROAs

• We are using realized ROA as a measure of
  expected profitability
• Expected profitability is indicative of the
  return we expect from investing in an asset
• Capital providers demand higher return from
  riskier assets
• The famous risk-return tradeoff
• We should find higher ROAs, on average, in
  industries where the risk level is higher

14
Industry ROAs
15
Risk factors

• Demand conditions
• Cyclical sales
• Markets with less predictable sales patterns
• Emerging markets and technologies
• Economy-wide (and industry-specific) upswings and
  downswings
• Investment and cost structure
• Operating leverage
• The proportion of fixed costs in total costs at
  any given business volume
• Higher the operating leverage, higher the
  sensitivity of profit to changes in volume
• Problem? Often, we do not have enough information
  in financial statements to assess operating
  leverage accurately!

16
Cost Structure and Operating Leverage
Dollars of Revenue of Cost
Total Revenue A and B
Total Cost A
Total Cost B
Firm B
Firm A
0
Revenues
17
Cost Structure and Operating Leverage
Operating Income B
Operating Income A
0
Revenues
Firm A
Firm B
18
Risk factors

• Stage in life cycle
• Higher uncertainty during introduction and growth
  stages
• Difficult to predict demand-price points
• Difficult to predict what future investments and
  product improvements that may be needed
• Problem? Where is product-specific information?
  At the most, we have segment-level information

19
Relation between Sales, Operating income, and
Investment during Product Life Cycle
Revenue
Introduction
Growth
Maturity
Decline
Operating Income Investment
Negative
Positive
Negative
Large Outflow
Small Outflow
Small Outflow
Net Inflow
20
Relation between Sales and ROA during Product
Life Cycle
ROA
ROA
0
Growth
Introduction
Maturity
Decline
21
Differences in Profit margin/asset turnover
A
Profit Margin
B
Competitive Constraint
ROA6
C
ROA3
Capacity Constraint
Assets Turnover
22
Differences in Profit margin/asset turnover

• Low asset turnover, High profit margin (A)
• High capital intensity
• High operating leverage
• Need to make high contribution margins to be
  profitable
• Benefit from entry barriers
• Examples?
• High asset turnover, Low profit margin (C)
• High asset turnover
• Commodity products
• Intense competition, less barriers to entry
• Cost leadership strategies
• The middle case (B)
• More flexibility
• More desirable?
• Should firms strive to move toward B?
• An (A) firm can move toward (B) by outsourcing
  and reducing in-house capital investments
  (Example, Nike, Manufacturing Firms?)
• A (C) firm can move toward (B) by going after
  Niche markets and offering specialty products at
  higher margins (Example, Whole Foods)

23
Analyzing profit margin

• Main components
• Cost of goods sold
• Other period expenses
• Factors affecting COGS as a percentage of sales
• Efficiency
• Demand conditions and pricing
• Shifts in product mix
• Looking at over-time trends in COGS and sales
  revenues is helpful
• Looking at trends in period expenses such as
  selling and administrative expenses (as a
  percentage of sales) can also be helpful in
  evaluating prospects
• Segment level analysis
• Which segments offer greater profit margins?
• Do over-time trends reveal any shift in the
  emphasis on various segments?

24
Decomposing asset turnovers

• Looking at turnovers of particular assets can
  help in understanding the business
• Accounts receivables turnover (A/R/sales per day)
• A measure of ability to collect (expressed in
  number of days of sales)
• All else equal, improving this measure is good
  working capital management
• However, an increase in the turnover ratio need
  not necessarily be bad news if giving easier
  credit terms improves profit
• Industry plays a role
• Inventory turnover (Inventory/COGS per day)
• Watch out for how inventory turnover changes
• Weak demand A firm may be reducing prices to
  move inventory (Higher COGS/Sales)
• Strong demand Price increases (Lower COGS/Sales)
  as well as fast moving inventory
• Fixed asset turnover (Sales/Fixed assets)
• Low fixed asset turnover is not necessarily bad
• Could signal bad performance or expansion
• Historical basis of assets tends to overstate
  fixed asset turnover
• Case 4.2 (Wal-Mart)

25
Topics

• An overall measure of profitability
• Analyzing profitability
• Profitability from shareholders perspective
• A reformulated approach

26
ROCE (or ROE)

• Isolates returns to shareholders income
  available after meeting obligations of all other
  stakeholders
• Creditors are interested in interest. Interest
  expense is already deducted from Net income
• We then subtract preferred dividends to arrive at
  what is available to common shareholders
• Decomposition of ROCE Profit margin Asset
  turnover Leverage

27
EPS

• Analysts use different definitions of earnings
• A share of one firm is not the same as a share of
  another firm
• Yet, widely used

28
Topics

• An overall measure of profitability
• Analyzing profitability
• Profitability from shareholders perspective
• A reformulated approach

29
Limitations of ROE Decomposition

• Does not separate the effects of operating and
  investing decisions from the effects of financing
  decisions
• Operating and investing decisions are the primary
  long-term value generators

30
Limitations of ROE Decomposition

• The numerator of ROA includes earnings to equity
  investors but the denominator includes assets
  financed by all providers of capital
• Earnings include the effects of operating and
  financing decisions (interest expense and
  revenue)
• Assets include operating and financial assets
  (cash, marketable securities)

31
Limitations of ROE Decomposition

• PM includes the results of operating and
  financing decisions
• Asset TO includes financial assets in the
  denominator (which do not generate sales)
• FL does not recognize that financial assets are,
  in effect, negative debt and that many assets are
  financed by operating liabilities

32
Reformulated Balance Sheet

• Assets Liabs. SE
• Operating Assets Operating Liabs.
• Financial Assets Financial Obligations
• ______________ Shareholders Equity
• Total Assets Total Liab. SE

33
Reformulated Balance Sheet

• Operating Assets Fin. Obligations SE
• Oper. Assets OA Fin. Obligations FO
• Oper. Liabs. (OL) Fin. Assets
  (FA)
• Net Debt ND
• Stk. Equity SE
• Net Op. As. NOA ND SE

34
Reformulating the Income Statement

• Oper. Revenue OR
• Oper. Expense (OE)
• Net Oper. Profit NOP
• Less Inc. Tax on NOP NOPx(1-t)
• Net Oper. Profit after Tax NOPAT
• Interest Expense IE
• Interest Revenue (IR)
• Net Int. Expense NIE
• Less Inc. Tax on NIE NIEx(1-t)
• Net Int. Exp. after tax (NIEAT)
• Net Income NI

35
Alternative Measure of ROA --Operating ROA
Operating ROA
Net Operating Profit after Taxes (NOPAT) Net
Operating Assets (NOA) Operating ROA measures a
firms success in using its operating assets to
generate operating earnings -It separates the
effects of the financing decisions from the
results of the operating decisions
36
Definitions

• NOPAT
• Net Income Net Interest Expense x (1-tax
  rate)
• NOA
• Operating assets operating liabilities
• (Total assets financial assets)
• (Total liabs. financial obligations)
• Net Debt
• Fin. Obligations Fin. Assets
• ND

37
Definitions

• Net Borrowing Rate
• Net interest expense after tax/ Net debt
  NIEAT/ND
• This is the return on (cost of) financing
  activities
• Net Financial Leverage
• Net Debt/Sh. Equity
• ND/SE
• This is the degree to which the NOA are financed
  by debt or equity

38
Relating Operating ROA to ROE

• ROE Op. ROA
• (Op. ROA Net Borrowing Rate) x Net
  Fin. Leverage
• Op. ROA Spread x Net Fin. Leverage
• If Net Fin. Lev 0, ROE Op. ROA
• The second term is the gain/loss in ROE from
  having Financial Leverage (Financial leverage or
  FL gain)
• Spread 0, if Op. ROA Net Borr. Rate
• If Spread 0 (financial leverage increases with Net Fin.
  Leverage

39
(No Transcript)
40
Drivers of Operating ROA

• Operating ROA NOPAT/NOA
• (NOPAT/Sales) x (Sales/NOA)
• Operating Margin x NOA Turnover
• Note A firm can produce a given level of
  Operating ROA with a relatively high margin and
  low turnover, or with a relatively low margin and
  high turnover

41
Reformulation example

• Refer to the next two slides for income
  statements and balance sheets for TJX, GAP,
  NORDSTROM
• Reformulate the balance sheets and income
  statements
• Calculate Op. ROA, Op. margin, NOA turnover, FL,
  FL gain/loss
• Compute the traditional ROA, Profit Margin, Asset
  turnover, and compare.

42
(No Transcript)
43
(No Transcript)
44
(No Transcript)
45
(No Transcript)
46
(No Transcript)