Fourth Edition
Peter D. Easton
Mary Lea McAnally
Greg Sommers
MODULE 3
Profitability Analysis
and Interpretation
©Cambridge Business Publishers, 2015
Xiao-Jun Zhang
Learning Objective 1
Compute return on equity (ROE) and
disaggregate it into components of
operating and nonoperating returns.
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Analysis Structure
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Return on Equity
Return on equity (ROE) is computed as:
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Operating Return (RNOA)
 The income statement reflects operating activities through
revenues, costs of goods sold (COGS), selling, general and
administrative expenses (SG&A) and other expenses.
 Net operating assets typically include current assets other
than cash and marketable securities (cash is typically
comprised mostly of short-term investments, called cash
equivalents) and noncurrent assets like PPE, less current
liabilities other than short-term debt, and less long-term
operating liabilities like pension obligations and deferred
taxes.
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Operating Items in the Income Statement
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Walmart’s Operating Items
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Computing Tax on Operating Profit
For Walmart:
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Treatment of Noncontrolling Interests
in Tax Shield Computation
 Our computation of NOPAT adjusts reported tax
expense for the tax shield on net nonoperating
expense (NNE).
 Should noncontrolling interest be included in NNE?
 While noncontrolling interests are treated as nonoperating,
they represent an allocation of net income to the parent
company and the noncontrolling shareholders.
 The allocation of consolidated net income to noncontrolling
interests is not an expense that is deductible for tax purposes.
 Thus, noncontrolling interest should not be included in the tax
shield computation.
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Net Operating Assets (NOA)
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Walmart:
Operating
Assets &
Liabilities
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Walmart: NOA
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Walmart: RNOA and ROE
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Key Definitions
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Learning Objective 2
Disaggregate operating return (RNOA)
into components of profitability
and asset turnover.
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Disaggregation of RNOA
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Net Operating Profit Margin (NOPM)
 Reveals how much operating profit the company
earns from each sales dollar.
 NOPM is affected by
 The level of gross profit
 The level of operating expenses
 The level of competition and the company’s
willingness and ability to control costs
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Walmart: NOPM
 This result means that for each dollar of sales at
Walmart, the company earns just over 4¢ profit
after all operating expenses and tax.
 As a reference, the median NOPM for all
publicly traded firms is about 8¢.
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Net Operating Asset Turnover (NOAT)
 Measures the productivity of the company’s net
operating assets.
 This metric reveals the level of sales the
company realizes from each dollar invested in
net operating assets.
 All things equal, a higher NOAT is preferable.
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Walmart: NOAT
 This result means that for each dollar of net
operating assets, Walmart realizes $3.73 in
sales.
 As a reference, the median for all publicly
traded companies is $1.30.
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Margin vs. Turnover
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Learning Objective 3
Explain nonoperating return
and compute it from return on equity
and the operating return.
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Nonoperating Return Component of ROE
 Assume that a company has $1,000 in average
assets for the current year in which it earns a
20% RNOA. It finances those assets entirely with
equity investment (no debt).
 Its ROE is computed as follows:
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Effect of Financial Leverage
 Next, assume that this company borrows $500 at
7% interest and uses those funds to acquire
additional assets yielding the same operating
return.
 Its net operating assets for the year now total
$1,500 and its profit is $265.
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Effect of Financial Leverage on ROE
 Next, We see that this company has increased its
profit to $265 (up from $200) with the addition of
debt, and its ROE is now 26.5% ($265 / $1,000).
 The reason for the increased ROE is that the
company borrowed $500 at 7% and invested those
funds in assets earning 20%.
 The difference of 13% accrues to shareholders.
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Median Liabilities to Equity
for Selected Industries
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GAAP Limitations of Ratio Analysis
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, a 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 research and development 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.
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Global Accounting
 IFRS companies routinely report “financial assets” or
“financial liabilities” on the balance sheet.
 IFRS defines financial assets to include receivables
(operating item), loans to affiliates or associates (can be
operating or nonoperating depending on the nature of
the transactions), securities held as investments
(nonoperating), and derivatives (nonoperating).
 IFRS notes to financial statements usually detail what
financial assets and liabilities consist of.
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Global Accounting
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Appendix 3A
Nonoperating Return Component
of ROE
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Nonoperating Return Framework
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Nonoperating Return with Debt Financing
and No Nonoperating Assets
$500 / $1,000
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20% - 7%
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Nonoperating Return with Debt Financing
and No Nonoperating Assets
- Target -
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Nonoperating Return
without Debt Financing and
with Nonoperating Assets - Intel
 Intel’s excessive liquidity is penalizing its return on
equity.
 Intel’s operating assets are providing an outstanding
return (27.17%), much higher than the return on its
marketable securities (1.72%).
 Holding liquid assets that are less productive means
that Intel’s shareholders are funding a sizeable level
of liquidity, and sacrificing returns in the process.
 This is the cost of gaining financial flexibility.
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Nonoperating Return
with Debt Financing, Nonoperating
Assets, and Noncontrolling Interest
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Nonoperating Return with Debt
Financing, Nonoperating Assets,
and Noncontrolling Interest - Walmart
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Special Topics:
Discontinued Operations
 Discontinued operations are subsidiaries or business
segments that the board of directors has formally decided to
divest.
 Companies must report discontinued operations on a
separate line, below income from continuing operations.
 The net assets of discontinued operations should be
considered to be nonoperating (they represent an
investment once they have been classified as discontinued)
and their after-tax profit (loss) should be treated as
nonoperating as well.
 Although the ROE computation is unaffected, the
nonoperating portion of that return will include the
contribution of discontinued operations.
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Special Topics:
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
investment.
 Thus, the presence of preferred stock requires two
adjustments to the ROE formula (called ROCE).
1. Preferred dividends must be subtracted from net income in
the numerator.
2. Preferred stock must be subtracted from stockholders’ equity
in the denominator.
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Learning Objective 4
Appendix 3B
Describe and illustrate traditional
DuPont disaggregation of ROE.
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DuPont Disaggregation Analysis
 Profit margin is the amount of profit that the company
earns from each dollar of sales.
 Asset turnover is a productivity measure that reflects the
volume of sales that a company generates from each dollar
invested in assets.
 Financial leverage measures the degree to which the
company finances its assets with debt rather than equity.
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Return on Assets
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Return on Assets Adjustment
The 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).
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DuPont Disaggregation for Walmart
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The End