Module 4 Notes
Trade-Off between Margin and Turnover
Operating Profit Margin (PM) and Asset Turnover (AT) largely affected by a company’s business model
INFINITE number of combinations of net operating PM and net operating AT yields a given RNOA
Oil and hotels = capital intensive with relatively low operating AT => need for higher PM
Food stores, wholesalers, retailers = fewer assets, greater AT => lower operating PM => sufficient RNOA
BEWARE of blindly comparing performance of companies across different industries
Highly capital intensive companies must earn higher PM to offset lower AT and achieve equivalent RNOA
All industries must earn acceptable ROI to attract investors and survive
Tradeoff between PM and AT relatively straightforward when comparing companies in same industry (pure-form
firms)
Analyzing conglomerates more challenging
Conglomerates’ PM and AT rates are a weighted average of the PMs and AT rates for the various industries in
which they operate
ROE = operating RNOA + nonoperating activities RNOA = NOPM X NOAT
NonOperating Return
Equity Only Financing
ROE = Operating Return + Nonoperating return
Profit from assets financed with equity ($1000 x 20%)
Profit from assets financed with debt ($500 x 20%)
Less: interest expense from debt ($500 x 7%)
Net Profit
$200
$100
($35)
$ 65
$265
Equity and Debt Financing
Shareholders benefit from increased use of debt provided that the assets financed with the debt earn a return that
exceeds the cost of the debt.
Covenants restrict debt holders in the face of increased risk. Covenants exist because debt holders do not have a
voice on the board of directors like stockholders do. These debt covenants impose a “cost” on the company beyond
that of the interest rate, and these covenants are more stringent as a company increases its reliance on debt financing.
Liquidity and Solvency
Companies can effectively use debt to increase ROE with returns from nonoperating activities.
Advantage of debt is that it typically is a less costly source of financing/
Currently the cost of debt is about 4% vs cost of equity or about 12% average
Although it reduces financing costs, debt does carry default risk. Creditors have several legal remedies when
companies default, including forcing a company into bankruptcy and possibly liquidating its assets.
Median ratio of total liabilities to stockholders’ equity (relative use of debt: equity) is about 1.0 for all publicly
traded companies – financing with half debt and half equity.
Utility companies have large portion of debt. Because they are regulated, profits and cash flows are relatively certain
and stable, and therefore can support a higher debt load.
Transportation industry also has a relatively high proportion of debt but they are not regulated. Therefore, its market
is more competitive and volatile so its use of debt carries more risk.
At low end of debt financing are pharmaceuticals and software companies which historically have had relatively
uncertain profits and cash flows so they use less debt in their capital structures.
At the core of debt financing analysis is the examination of a company’s ability to generate cash to service its debt.
Analysts, investors and creditors are primarily concerned about the company having sufficient cash available or can
generate the required cash in the future to cover its debt obligations.
This is called liquidity analysis. The analysis of the company’s ability to generate sufficient cash in the long run is
called solvency analysis.
Limitations of Ratio Analysis
Blindly analyzing numbers can lead to faulty conclusions and suboptimal decisions.
We need to acknowledge that current accounting rules (GAAP) have limitations, and be aware of the company’s
environment, its competitive pressures, and any structural and strategic changes.
GAAP Limitations
1. Measurability: Financial statements reflect what can be reliably measured. This results in nonrecognition
of certain assets, often internally developed assets, the very assets that are most likely to confer a
competitive advantage and create value. Examples are brand name, superior management team, employee
skills, and a reliable supply chain.
2. Non-capitalized costs. Related to the concept of measurability is the expensing of costs relating to “assets”
that cannot be identified with enough precision to warrant capitalization. Examples are brand equity costs
from advertising and other promotional activities, and R&D costs relating to future products.
3. Historical costs. Assets and liabilities are usually recorded at original acquisition or issuance costs.
Subsequent increases in value are not recorded until realized and declines in value are only recognized if
deemed permanent.
Thus, GAAP balance sheet items omit important and valuable assets. Our analysis of ROE and our assessment of
liquidity and solvency must consider that assets can be underreported and that ratios can be distorted.
Company Changes. Many companies regularly undertake mergers, acquire new companies and divest subsidiaries.
Such major operational changes can impair the comparability of company ratios across time.
Companies also change strategies, such as product pricing, R&D, and financing.
We must understand the effects of such changes on ratios and exercise caution when we compare ratios from one
period to the next.
Companies also behave differently at different points in their life cycles. – Growth companies possess a different
profile than do mature companies.
Seasonal effects also markedly impact analysis of financial statements at different times of the year.
Thus, we must compare life cycle and seasonality when comparing ratios across companies over time.
Conglomerate Effects. Few companies are pure play; instead, most companies operate in several businesses or
industries. Most publicly traded companies consist of a parent company and multiple subsidiaries, often pursuing
different lines of business.
Financial statements of conglomerates are consolidated and include financial statements of the parent and its
subsidiaries. Consequently, such consolidated statements are challenging to analyze. Typically, analysts break the
financials apart into their component businesses and separately analyze each component.
Fortunately, companies must report financial information for major business segments in their 10-Ks.
Means to an End. Ratios reduce, to a single number, the myriad complexities of a company’s operations.
No scalar can accurately capture all qualitative aspects of a company. Ratios cannot meaningfully convey a
company’s marketing and management philosophies, its human resource activities, its financing activities, its
strategic initiatives, and its product management.
We must learn t look through the numbers and ratios to better understand the operational factors that drive financial
results. Successful analysis seeks to gain insight into what a company is really about and what the future portends.
Our overriding purpose in analysis is to understand the past and present to better predict the future. Computing and
examining ratios is one step in that process.
Nonoperating Return Component of ROE
Infer the nonoperating return as the difference between ROE and RNOA.
The nonoperating return can also be computed directly as FLEV X Spread, where FLEV is the degree of financial
leverage and Spread is the difference between the assets’ after-tax operating return (RNOA) and the after-tax cost of
debt.
Nonoperating Return Framework
Nonoperating Return Definitions
NNO: Net nonoperating obligations (also known as
Nonoperating liabilities – nonoperating assets
NFO: Net financing obligations
FLEV: Financial leverage
Average NNO / Average equity
NNE: Net nonoperating expense
NOPAT – Net income; NNE consists of nonoperating
expenses and revenues, net of tax
NNEP: Net nonoperating expense %
NNE / Average NNO
Spread
RNOA - NNEP
Example:
Profit from assets financed with equity ($1000 x 20%)
Profit from assets financed with debt ($500 x 20%)
Less: interest expense from debt ($500 x 7%)
Net Profit
$200
$100
($35)
$ 65
$265
This company’s ROE is 26.5%, computed as $265/$1000 (assuming income received at EOY for simplicity and
average equity is $1000). RNOA is 20%, FLEV is 0.50 (computed as $500 average net nonoperating obligations /
$1000 average equity). Spread is 13% (computed as 20% - 7%). This company’s ROE, shown with nonoperating
return being directly computed, is as follows:
ROE = RNOA + [ FLEV x Spread }
= 20% + [ 0.50 x 13% ]
=
26.5%
We see that when a company’s nonoperating activities relate solely to the borrowing of money (with no investment
in securities), FLEV collapses to the debt-to-equity ratio.
Nonoperating Return – Without Debt Financing but with Nonoperating Assets
Many high-tech firms have no debt and maintain large portfolios of marketable securities. They hold these highly
liquid assets so that they can respond quickly to new opportunities or react to competitive pressures.
With high levels of nonoperating assets and no nonoperating liabilities, net nonoperating obligations (NNO) has a
negative sign (NNO = Nonoperating liabilities – Nonoperating assets).
Likewise, FLEV is negative: (Average NNO (-) / Average Equity (+)
Further, net nonoperating expense (NNE = NOPAT – Net income) is negative because investment income is a
negative nonoperating expense.
However, the net nonoperating expense % (NNEP) is positive because the negative NNE / negative NNO.
This causes ROE < RNOA (see below)
Cisco Systems ($ millions, except %)
2008
2009
NOA
$20,251
$19,360
NNO
($14,102)
($12,120)
Stockholders’ equity
$34,353
$ 31,120
Net income
$ 8,052
NOPAT
$ 7,524
NNE
($ 528)
FLEV
-0.3983
RNOA
37.99%
NNEP
4.03%
Spread
33.96%
Cisco’s NNO is negative because its investment in marketable securities exceeds its debt.
Cisco’s ROE is 24.46% and consists of the following:
ROE = RNOA + [ FLEV X Spread ]
= 37.99% + [ -0.3983 x 33.96%
= 37.99% + [
-13.53%
]
=
24.46%
Cisco’s ROE derives from operating and nonoperating assets. Their operating assets are providing an outstanding
return (38.05%), much higher than the return on its marketable securities (4.02%).
Nonoperating Return – with Debt Financing
Assets
Liabilities
Current Operating Assets
Current Operating Liabilities
+ Long-term Operating Assets
+ Long-term Operating Liabilities
= Total Operating Assets
= Total Operating Liabilities
Net nonoperating obligations (NNO)
Current Nonoperating Assets
Current Nonoperating Liabilities
(liabilities – assets)
+ Long-term Nonoperating Assets
+ Long-term Nonoperating Liabilities
= Total Nonoperating Assets
= Total Nonoperating Liabilities
Equity (NOA – NNO)
Equity
_____Stockholders’ Equity
Total Assets
Total Liabilities and Equity
Net operating assets (NOA)
(assets – liabilities)
Net nonoperating obligations are total nonoperating liabilities – total nonoperating assets. Therefore,
Net operating assets (NOA) = Net nonoperating obligations (NNO) + Stockholders’ equity
Net nonoperating expense % (NNEP) = Net nonoperating expense (NNE)_________
Average net nonoperating obligations (NNO)
Nonoperating return = Average net nonoperating obligations (NNO) x (RNOA – NNEP)
Average stockholders’ equity
Derivation of Nonoperating Return Formula
= RNOA + (FLEV x Spread)
Special Topics
Discontinued Operations – subsidiaries or business segments that the board of directors has formally decided to
divest. Companies must report discontinue operations on a separate line, below income from continuing operations.
Separate line item includes the net income (loss) from discontinued operations along with any gains (loss) on the
disposal of discontinued net assets.
Although not required, many companies disclose the net assets of discontinued operations on the balance sheet to
distinguish them from continuing net assets. If the net assets are not separated on the balance sheet, the footnotes
provide details to facilitate a disaggregated analysis. These net assets of discontinued operations should be treated as
nonoperating and their after-tax profit (loss) should be treated as nonoperating as well. Although the ROE
computation is unaffected, the nonoperating portion of the ROE for the year will include the contribution of
discontinued operations.
Preferred Stock – The ROE formula takes the perspective of the common shareholder in that it relates the income
available to pay common dividends to the average common shareholder. As such, preferred stock should not be
included in average stockholders’ equity in the denominator of the ROE formula.
Any dividends paid on preferred stock should be subtracted from net income to yield the profit available to pay
common dividends. (Dividends are not an expense in computing net income; thus, net income is available to both
preferred and common shareholders. To determine net income available to common shareholders, we must subtract
preferred dividends.) Thus, the presence of preferred stock requires two adjustments to the ROE formula.
1. Preferred dividends must be subtracted from net income in the numerator
2. Preferred stock must be subtracted from stockholders’ equity in the denominator
This modified return on equity formula is more accurately labeled return on common equity j(ROCE).
ROCE =
Net income – Preferred dividends__________
Average stockholders’ equity – Average preferred equity
Minority (or Noncontrolling Interest – For firms with noncontrolling interest, we compute RNOA as usual because
NOPAT is operating income before any noncontrolling interest on the income statement, and NOA excludes
noncontrolling interest on the balance sheet. Similarly, we compute Spread as usual.
However, we must make two modifications because a company’s operating and nonoperating activities must
generate returns to both the controlling interest (the common shareholders’ equity, labeled CSE) and minority
shareholders’ (labeled MI).
First, we adjust FLEV as follows: FLEV = NNO / CSE + MI).
Second, a ratio that captures the relative income statement and balance sheet effects of the noncontrolling (minority)
interest, called the minority interest sharing ratio, is computed as follows:
( __________ Net income ___________ )
Minority interest sharing ratio = ___ Net income = Minority interest expense
( __________Common equity___________)
Common equity + Minority interest equity
Further, with a noncontrolling (minority) interest, the disaggregated return on common equity is expressed as:
ROCE = [RNOA + {[NNO/(CSE + MI)] x Spread x Minority interest sharing ratio
Liquidity Analysis
Current ratio =
Current Assets
Current Liabilities
Quick Ratio = Cash + Marketable securities + Accounts receivables
Current liabilities
Net operating working capital (NWOC) = Current operating assets – Current operating liabilities
Solvency Analysis
Solvency refers to a company’s ability to meet its debt obligations, including both periodic interests payments and
the repayment of the principal amount borrowed.
Solvency is crucial because an insolvent company is a failed company.
There are two general approaches to measuring solvency.
1. Use balance sheet data and assess the proportion of capital raised from creditors.
2. Use income statement data and assess the profit generated relative to debt payment obligations
Liabilities-to-Equity – this ratio conveys how reliant a company is on creditor financing compared with equity
financing. A higher ratio indicates less solvency and more risk.
Liabilities-to-equity ratio = ____Total liabilities___
Stockholders’ equity
A variant of this ratio considers a company’s long-term debt / equity. This approach assumes that current liabilities
are repaid from current assets (so-called self-liquidating). Thus, it assumes that creditors and stockholder need only
focus on the relative portions of long-term capital.
Times Interest Earned – compares profits to liabilities. This approach assesses how much operating profit is
available to cover debt obligations.
Times interest earned = Earnings before interest and taxes
Interest expense
The times interest earned ratio reflects the operating income available to pay interest expense. The underlying
assumption is that only interest needs to be paid because the principal will be refinanced. This ratio is sometimes
abbreviated as EBIT/I. The numerator is similar to net operating profits after tax (NOPAT), but it is pretax instead
of after tax.
Management wants this ratio to be sufficiently high so that there is little risk of default.
Vertical and Horizontal Analysis
Vertical analysis expresses financial statements in ratio form. Specifically, it is routine to express income statement
items as a % of net sales, and balance sheet items as % of total assets. Such common-size financial statements
facilitate comparisons across companies of different sizes and comparisons of accounts within a set of financial
statements.
Horizontal analysis is the scrutiny of financial data across time. Comparing data across two or more consecutive
periods assists in analyzing trends in company performance and in predicting future performance.
DuPont Disaggregation Analysis – Disaggregation of return on equity (ROE) into three components
 Profitability
 Turnover (asset utilization)
 Financial leverage
Each of these measures is generally positive, in which case an increase in any one would increase ROE. A focus on
these measures encourages managers to focus on both the balance sheet and the income statement. Such an analysis
typically examines each of these components over time. Manager then seek to reverse adverse trends and to sustain
positive trends.
Basic DuPont Model
Basic DuPont Model disaggregates ROE as follows:
ROE = _________Net income______ = Net income x _____Sales_______ x _____Average total assets___
Average stockholders’ equity
Sales
Average total assets
Average stockholders’ equity
Profit
Margin



Asset
Turnover
Financial
Leverage
Profit margin is the amount of profit that the company earns from each dollar of sales. A company can
increase its profit margin by increasing its gross profit margin (Gross profit / Sales) and/or by reducing its
expenses (other than cost of sales) as a % of sales.
Asset turnover is a productivity measure that reflects the volume of sales that a company generates from
each dollar invested in assets. A company can increase its asset turnover by increasing sales volume with
no increase in asset and/or by reducing asset investment without reducing sales.
Financial leverage measures the degree to which the company finances its assets with debt rather than
equity. Increasing the % of debt relative to equity increases the financial leverage. Although financial
leverage increases ROE (when performance is positive), debt must be used with care as it increases the
company’s relative riskiness.
Return on Assets
ROA = ______Net income =
Average total assets
Net income x _____Sales_______
Sales
Average total assets
Profit
Margin
Asset
Turnover
|______________________________|
|
Return on
Assets (ROA)
Return on assets combines the first two terms in the ROE disaggregation, profit margin and turnover. It measures
the return on investment for the company without regard to how it is financed (the relative proportion of debt and
equity in its capital structure).
The ROA approach to performance measurement encourages managers to focus on the returns that they achieve
from the invested capital under their control. Those returns are maximized by a joint focus on both profitability and
productivity.
Profitability – is measured by the profit margin (Net income/Sales). Analysts of profitability typically examines
performance over time relative to benchmarks (such as competitors’ or industry performance), which highlight
trends or abnormalities. When abnormal performance is discovered, managers either correct suboptimal
performance or protect superior performance. There are two general areas of profitability analysis:
Gross profit margin (Gross profit/Sales) is crucial. It measures the gross profit (sales – cost of goods sold) for each
sales dollar. Gross profit margin is affected by both the selling prices of products and their manufacturing costs.
When markets are more competitive (or when products lose their competitive advantage), a company must reduce
product prices to maintain market share and any increases in manufacturing costs cannot be directly passed on to
customers; suggesting managers must focus on reducing costs. This might result in outsourcing of activities to lower
labor costs and/or finding lower-cost raw materials. Such measures can yield a loss of product quality if not
managed properly, which could further deteriorate the product’s market position. Another strategy is to reduce
product features not valued by the market. Focus groups of consumers can often identify these non-value-added
product features that can be eliminated to save costs without affecting the product’s value to customers.
Expense Management – Managers can focus on reducing manufacturing and/or administrative (overhead) expenses
to increase profitability. Manufacturing overhead refers to all production expenses other than labor and materials.
These expenses include utilities, depreciation, and administrative costs. Administrative overhead refers to all
expenses not in cost of goods sold such as administrative salaries and benefits, marketing, legal, accounting, R&D.
These overhead costs must be managed carefully as they represent investments. Reductions in spending on
advertising and research yield short-run, positive impacts on profitability, but usually yield long-run deterioration in
the company’s market position. Likewise, requiring employees to work harder and longer can delay increases in
wage-related costs, but the likely decline in employee morale can create long-run negative consequences.
Productivity in the DuPont Model refers to the volume of dollar sales resulting form each dollar invested in assets.
When a decline in productivity is observed, managers have two avenues of attack:
1. Increase sales volume from the existing asset base, and/or
2. Decrease the investment in assets without reducing sales volume
The first approach focuses on capacity utilization. Increasing throughput lowers per/unit manufacturing costs as
fixed costs are spread over a larger sales base.
The second approach focuses on elimination of excess assets. That reduction increases cash and also reduces
carrying costs associated with the eliminated assets.
Manager efforts to reduce assets often initially focus on working capital (current assets – liabilities). Receivables can
be reduced by better credit-granting policies and better monitoring of outstanding receivables. Inventories can be
reduced through just-in-time delivery of raw materials, elimination of bottlenecks in production to reduce work-inprocess inventories, and producing to order rather than to estimated demand to reduce finished goods inventories.
Companies can also delay payment of accounts payable to generate needed cash. Payables management is more art
than science, and reductions must be managed with care so as not to threaten valuable supply channels.
Manager efforts to reduce long-term assets are more difficult. Recent years have witnessed an increase in use of
corporate alliances, joint ventures, and activities that seek joint ownership of assets such as manufacturing,
distribution, service facilities, and information technology (IT). Another strategy is to outsource production to
reduce manufacturing assets. Outsourcing is effective provided the benefits fro eliminating manufacturing assets
more than offset the increased costs of purchasing goods from outsourced producers.
Financial Leverage – is the relative proportion of debt versus equity in the company’s capital structure. Financial
leverage in the DuPont model is measured by the ratio of average total asset : average stockholders’ equity. An
increase in this ratio implies an increase in the relative use of debt. This is evident from the accounting equation:
assets = liabilities + equity.
The measure of financial leverage is important because debt is a contractual obligation (dividends are not), and a
company’s failure to make required debt payments can result in legal repercussions and even bankruptcy. As
financial leverage increases, so do the required debt payments along with the probability that the company is unable
to meet its debt obligations in a business downturn.
Adjustments in the Basic DuPont Model – the basic DuPont model disaggregates ROE into three components in a
multiplicative process. This formulation makes it easy to see that increasing any of the components will increase
ROE (as each term is typically positive). This basic model, however, is not entirely accurate, and further
modifications are typically made to address these inaccuracies. These variations include adjusting the return on
assets and the return on equity.
Return on Assets Adjustment – typically focuses on the operating side of the business (profit margin and asset
turnover). Further, ROA is typically under the control of operating managers while the capital structure decision (the
relative proportion of debt to equity) is not. Accordingly, an adjustment is often made to the numerator of ROA, and
sometimes to the denominator. The numerator adjustment adds back the after-tax expense related to interest on
borrowed funds and is computed as follows:
ROA = Net income + [Interest expense (1-Statutory tax rate)]
Average total assets
This adjusted numerator better reflects the company’s operating profit as it measures return on assets exclusive of
financing costs (independent of the capital structure decision). This adjusted ROA is typically reported by data
collection services such as Compustat and Capital IQ, while the unadjusted is not.
The denominator adjustment is less common. That adjustment removes non-interest-bearing short-term liabilities
(accounts payable and accrued liabilities) from total assets. The adjusted assets in the denominator are considered to
better approximate the net assets that must be financed by long-term creditors and stockholders. In sum, adjustments
to ROA move the numerator closer to net operating profit after-tax (NOPAT) and move the denominator closer to
net operating assets (NOA). The resulting ROA ratio is then closer to the return on net operating assets (RNOA).
Return on Common Equity Adjustment
The typical return on equity reported by the data collection services is the return on common equity (ROCE) which
is computed as follows:
ROCE = __________Net income – Preferred dividends______
Average common equity – Average preferred equity
This ratio focuses on the common shareholder. Namely, the numerator seeks to compute earnings available to pay
common dividends, and the denominator is the equity investment form common shareholders. This reflects the
reality that common shareholders have a junior claim on earnings (they are paid after interest is paid to creditors and
after dividends are paid to preferred shareholders). Net income is already net of after-tax interest expense paid to
creditors, but dividends are not an expense in computing net income. Accordingly, preferred dividends are
subtracted in the numerator leaving profits from which common dividends can be paid. This ROE measure then
divides this income available for common dividends by the average investment from common shareholders.