Spring 2022
NBA 5060
Lectures 4 through 6 – Profitability Analysis
1. Why is profitability analysis important?
2. Profitability Analysis
 Relative vs. Absolute Analysis
 Cross-sectional vs. time-series
3. Profitability Ratios
 Return on Equity (ROE)
 Return on Assets (ROA)
 Decomposing these measures
4. Some Key Takeaways from Profitability Analysis
Additional Notes: Supplemental note on the economic relation between
accounting ratios and the cost of capital
Lectures 4 through 6
Page 1 of 15
1. Why is ratio analysis important?
The value of a company depends on its ability to grow and generate
profits:
Growth and Profitability
Product Market
Strategies
Operating
Management
Financial Market
Strategies
Investment
Management
Financing
Decisions
Payout
Decisions
Goal: Evaluate effectiveness of the firm’s policies in each of these areas.
The ability to grow and generate profits is a function of the firm’s
operating, investing, and financing decisions. Ratio analysis provides
a means of evaluating the effectiveness of the firm’s operating,
investing, and financing policies:
Sustainable
Growth Rate
Dividend
Payout Ratio
ROE
ROA
PM
Operating
Management
Lectures 4 through 6
CEL
CSL
ATO
Investment
Management
Financing
Decisions
Payout
Decisions
Page 2 of 15
2. Profitability Analysis
What is it? A means of placing structure on the financial statements to help
organize, evaluate, and digest the information provided about the firm’s
operating, investing, and financing activities. Allows meaningful comparisons
across companies and over time (relative analysis), as well as benchmarking
against rules of thumb (absolute analysis).
Relative Analysis – compares the financial metrics of a firm relative to the
financial metrics of some comparison (i.e. control) group. Absolute level of the
numbers does not matter as much as whether they are higher or lower than the
comparison group.
Two basic types of relative analysis:

Cross-sectional approach – compare the firm to industry peers on a
number of dimensions.

Time series approach – use the historic performance of a firm as the
benchmark.
Cross-sectional comparisons are useful in benchmarking how the firm is doing
relative to industry peers, while a time series approach can reveal trends within
the firm.
Absolute analysis – compares the financial metrics of a firm to absolute levels.
Matters less where they rank relative to other firms.
e.g. Is operating cash flow positive? Does ROE exceed the cost of capital?
Lectures 4 through 6
Page 3 of 15
3. Basic Profitability Ratios
Return on Equity
Financing Activities
(Debt Policy)
Return on Assets
Profit Margin
Operating
Activities
Lectures 4 through 6
Asset Turnover
Investing
Activities
Page 4 of 15
Return on Assets (ROA)
ROA 
NI  Interest Expense (1  t )
EBI

Average Total Assets
Average Total Assets
Other common variations:
This is common, but is
technically a mismatch of the
numerator and denominator.
ROA 
NetIncome
AverageTot alAssets
ROA 
EBI
Beginning or Ending Total Assets
Use of ‘Ending TA’
requires less data to
form a time series
Disaggregating ROA:
ROA Profit Margin

x
AssetTurnover
NI  IntExp (1  t )
Sales
x
Sales
AverageTot alAssets
What is a reasonable absolute benchmark for ROA?
What factors drive cross-sectional differences in ROAs?
Lectures 4 through 6
Page 5 of 15
Average Median ROAs, Profit Margins, and Asset Turnovers Across
Industries from 1982-2018
Lectures 4 through 6
Page 6 of 15
Decomposing ROA into Profit Margin and Asset Turnovers:
Can be used to check for sustainability of improvement (or decline) in ROA
ROA Profit Margin

x
AssetTurnover
NI  IntExp (1  t )
Sales
x
Sales
AverageTot alAssets
Profit Margin:
Profit margin is the amount the firm generates from every dollar of sales.
Economics of margin:

Industry factors
o Whether the industry is growing, mature or decline, patent
protection, monopoly rents etc.

Sales volume
o Fixed costs get allocated to a larger sales base.

Sales price
o Important to examine if market share is being generated through
lower pricing.

Expenses
o While improving margins through expense reduction is good, it has
limits.
Decomposing Profit Margin – simply divide each net income line item by sales:
Sales:
COGS:
Selling & Admin:
Depreciation & Amortization:
Other Revenue:
Income Taxes (add back tax on interest expense):
EBI:
Decomposition allows the analyst to trace changes in profit margin to specific line
items for additional analysis.
Lectures 4 through 6
Page 7 of 15
General Issues in Computing Net Income
One of the primary objectives of analyzing the income statement is to get a
sense of the relative permanence of a firm’s earnings.
Items Affecting Earnings Permanence and the Prediction of
Future Earnings
Income from continuing operations:
Should include only the normal, recurring, relatively
sustainable, ongoing economic activities of the organization. The one
exception is often termed ‘Special Items’
Special items or unusual items include any relatively
infrequent or non-recurring items that nevertheless tend to arise from
a firm’s on-going, continuing operations.
Some frequent special items to consider when assessing the
permanence of earnings:
 Gains and losses on sale of securities.
 Restructuring charges.
 Gain or loss on sale of PPE.
Beyond this, review the MD&A, where you’ll for the business reasons
explaining changes in income statement line items. This information
is useful not only for understanding changes in recent performance
but also for developing expectations for future earnings.
Lectures 4 through 6
Page 8 of 15
Asset Turnover:
ATO 
Sales
AverageTot alAssets
Asset turnover is a measure of asset efficiency
 Can be changed by
o Increasing sales revenue using the same assets
o Outsourcing
o Disposing less productive assets
o Decreases when additional investments generate lower marginal
revenue
Asset turnover has a balance sheet orientation and can be disaggregated
into:
 Inventory turnover ratio (COGS/Inventory), Current asset turnover ratio
(Sales/Current assets), PPE turnover ratio (Sales/PPE) etc.
Turnover Components (note this is not really a decomposition as the
components do not sum to asset turnover):
Sales
AR Turnover 
Average or Ending AR
Inv. Turnover 
Sales or COGS
Average or Ending Inventory
Fixed Asset Turnover 
Technically, should be
‘sales on account’, but
this is hard to measure.
Sales is more appropriate as a Total Asset
decomposition, while COGS give s a better
measure of actual times inventory turns over.
Sales
Avg. or Ending Net Property, Plant, and Equipment
PM, ATO, and their decompositions are useful for (1) explaining trends in ROA
(and ROE), (2) forecasting future financial statements and conducting sensitivity
analysis, (3) explaining changes in value through their impact on ROE.
Lectures 4 through 6
Page 9 of 15
Return on Net Operating Assets (aka Return on Invested Capital, ROIC)
RONA 
EBI
EBI

Avg.(Equity  Debt) Avg.(Total Assets  Operating Liabs)
You can decompose RONA similarly to ROA by simply multiplying and
dividing by sales.
What is the appropriate absolute benchmark for RONA?
In general, which is a more appropriate profitability ratio, ROA or RONA?
Lectures 4 through 6
Page 10 of 15
Return on Equity (ROE)
ROE 
Net Income
Average Shareholde rs Equity
Other variations you might run across:
ROCE 
ROE 
NI  Div on Preferred Shares
Avg .CommonShar eholdersEq uity
Net Income
Beginning or Ending Sharehold ers Equity
Disaggregating ROE:
#1 ROE 
NI  Int Exp (1  t )
AverageTA
NI
x
x
Average TA
NI  Int Exp (1  t ) AverageSha reholdersE quity
#2 ROE  RONA 
AvgDebt 
InterestExpense(1  t ) 
 RONA 

AvgEquity 
AvgDebt

What is a reasonable absolute benchmark for ROE?
What factors will drive cross-sectional variation in ROEs?
Lectures 4 through 6
Page 11 of 15
Profitability ratios with preferred stock or minority interest
Preferred stock and minority interest require adjustment to the ROE
decompositions:
ROE decomposition #1
ROE 
NI  Int Exp(1  t)  MII
NI  Pref Div
AverageTA
x
x
Average TA
NI  Int Exp(1  t)  MII Avg Common Equity
ROE decomposition #2
ROE  RONA' 

AvgDebt 
InterestExpense(1  t) 
AvgMI 
MII 
 RONA' 
 
 RONA' 

AvgEquity 
AvgDebt
AvgMI 
 AvgEquity 
AvgPrefEquity 
PrefDiv 
 RONA' 

AvgEquity 
AvgPrefEquity 
Where RONA’ =
RONA ' 
NI  Int Exp(1  t)  MII
Average(De bt  Common Equity  Preferred Equity  Minority Interest)
When will these adjustments matter most?
Lectures 4 through 6
Page 12 of 15
4. Some Key Takeaways from Profitability Analysis:
I know how to compute all the ratios, but I’m still not sure I know when to actually
use them.
There are two primary objectives to profitability analysis at this point. First,
use ROA and ROE as a baseline evaluation of the firm relative to past
performance (e.g. ROA seems to be deteriorating) or relative to other firms (e.g.
Dell consistently has a higher ROE than other computer manufacturers). This
will give you a quick glimpse of whether the firm is well positioned going forward.
Second, use the ROA decomposition to determine the cause of increases
(decreases) in profitability. This can help determine if the change in ROA is likely
to be permanent or transitory. Finally, both ROA and ROE often tell similar
stories. As we’ll see, ROA drives the value of the firm, while ROE drives the
value of the equity. Hence, ROA tells you something about overall profitability
and firm value while ROE tells you how effectively the firm is using its capital
structure. Thus, they are important ratios for valuation purposes, as we’ll see
later.
Firm X increased their asset turnover from 1.8 to 2.0. Is this good? Is this
significant? How do I know?
More generally, this question reflects the lack of intuitive definitions for
several of the ratios we examine. So the best way to evaluate this is to consider
what the ratio actually means and do some sensitivity analysis (i.e. ‘as if’
calculations). In this case, the increase from 1.8 to 2.0 means that for every
dollar of assets employed by the firm, the firm increased sales by $0.20. Thus, if
the firm has $100 million in assets, efficiency improvements alone are
responsible for a $20 million increase in revenue. You can then trace the
improvement to earnings (via the profit margin), and EPS, which is particularly
meaningful. If you tell investors that efficiency improvements alone contributed
an additional $0.10 to this year’s EPS, they will be able to judge the economic
significance of the improvement more readily than if you simply report a 0.2
increase in the asset turnover ratio.
I know weighted cost of capital (cost of equity capital) is a decent benchmark for
RONA (ROE). Is there anything else I should look for?
Look for the relation between strategy and the components of RONA. If a
firm is trying to be a cost leader, it should have relatively high turnover and low
margins. The opposite is true for a product differentiator. If the ratios don’t seem
to match up with the firm’s strategy, this requires further investigation.
Lectures 4 through 6
Page 13 of 15
A Supplemental Note On
The Economic Relationship Between
Accounting Ratios and the Cost-of-Capital
Three accounting based return-on-investment (ROI) measures are among the most commonly
used financial ratios in fundamental analysis: return-on-total-assets (ROA), return-on-net-assets
(RONA), and return-on-equity (ROE). Students who encounter these financial ratios for the first
time often find them a little confusing. The purpose of this note is to explain the rationale behind
these ratios and discuss the economic relationship between each ratio and the cost-of-capital.
1. Constructing an accounting ROI
All three ratios use accounting numbers to measure the rate of return on investment (ROI). Each
is a measure of earnings divided by a measure of the capital (or investment) base. The difference
between the three lies in the definition of the capital base, earnings to that capital base, and the
cost of that capital base.
The single most important concept to keep in mind in working with accounting ROIs is that the
earnings and the cost of capital must be consistent with the capital base as defined in the
denominator of the ratio.
Consider the following table:
Ratio
Representative Formula
ROA
RONA
ROE
Capital
Defn
Total
Assets
Earnings
Defn
EBI
Cost of
Capital
Cost of
financing
TA
‘Normal’
levels
Approx.
6%
EBI
Avg .TA  S .T .Liab
Net
Assets
EBI
Cost of
financing
Net Assets
Approx.
9%
Net Income
Average Shareholde rs Equity
Common
Equity
NI
Cost of
financing
Equity
Approx.
12%
NI  Interest Expense (1  t )
Average Total Assets
Notice that each ratio has a different definition of capital. Once you have selected a given definition
of capital, you are constrained to choose a definition of earnings and a definition of the cost of
capital which are consistent with that capital base. Mismatches result in ROIs that either understate
or overstate economic performance.
2. ROA
For example, the capital base for ROA is total assets. What is the earnings generated by
this capital base? It’s EBI (called “NOPAT” in your PH textbook for “Net Operating Profit After
Taxes”) This is the after-tax earnings with interest expense added back. We add the interest
expense back because this expense is used to service debt, which is part of the capital base. We
want to measure the return generating power of total assets. If we do not add back interest
expense, we would understate the firm’s return generating power pertaining to its total assets.
Lectures 4 through 6
Page 14 of 15
What is the cost of this capital base? It’s the cost associated with financing the total assets of the
company. The balance sheet equation tells us that total assets = s/t liab + l/t liab + shareholders’
equity so the appropriate cost of this capital should be the weighted average cost of capital (WACC)
for these three sources of financing. For example, the typical firm has a capital structure of 1/3 s/t
liabs (such as current payables and accruals), 1/3 l/t liabs (such as bonds etc.) and 1/3 equity.
The WACC for this firm would be computed approximately as follows:
Source of
Financing
Short term
liabilities
Pretax Cost
of Financing
Nil
Effect of Tax
Shield
none
After-tax Cost
of Financing
Nil
% Weight
1/3
Contribution
to WACC
0.0%
Long term
liabilities
10.0%
t=40%
6.0%
1/3
2.0%
Equity
Investors
12.0%
none
12.0%
1/3
4.0%
Estimated WACC for Total Assets
6.0%
In a competitive environment, the average firm’s ROA should be close to the cost of financing total
assets. Indeed, as we saw in class, average ROA’s mean revert to 6%.
3.
RONA
The same argument goes for returns on net asset. In this case, the denominator is total assets
minus s/t liabilities. That is, we are interested in the returns to l/t debt and equity holders only.
Therefore the WACC calculation is:
Source of
Financing
Long term
liabilities
Pretax Cost
of Financing
10.0%
Effect of Tax
Shield
t=40%
After-tax Cost
of Financing
6.0%
% Weight
½
Contribution
to WACC
3.0%
Equity
Investors
12.0%
none
12.0%
½
6.0%
Estimated WACC for Total Assets
9.0%
In fact we find that in large samples average RONA is around 9% (PHB, p. 9-7).
4. ROE
The capital base for ROE is capital provided by shareholders only. The earnings to this capital is
therefore Net Income (that is, the earnings after we have paid interest and taxes). Moreover, the
appropriate cost of this capital is the cost of financing by equity, which is approximately 12% to
13% in the U.S. (based on a market premium of 5 to 6 percent and a riskless rate of 6 to 7
percent -– see, for example the Copeland et.
Lectures 4 through 6
Page 15 of 15