ASSET
UTILIZATION
ANALYSIS
Chapter 13
CHAPTER 13 OBJECTIVES
Explain how the definitions of
investment, capital and assets affect
asset utilization analysis.
 Indicate the significance of return on
investment measures in the analysis of
asset productivity.
 Compute return on assets and equity
measures and their components.

CHAPTER 13 OBJECTIVES
Discuss the need for technical
adjustments to return on investment
measures.
 Present a preliminary asset utilization
analysis for a company or industry.

OBJECTIVE FOR ANALYZING ASSET
UTILIZATION

An assessment of an entity’s wealth
creating abilities

Measures the relationship between
inputs (assets) and output (income)
OBJECTIVE FOR ANALYZING ASSET
UTILIZATION (CONT.)

Asset utilization provides analysts with
information about
Managerial effectiveness
 Shareholders’ earnings
 Future performance

INVESTMENT ACTIVITIES
Return on investment is the primary
means for measuring asset utilization
 The term investment has multiple
meanings
 Its definition is context specific

INVESTMENT ACTIVITIES
(CONT.)
Asset Valuation
 Most assets are measured on the basis
of historical cost

Trend toward more market based
valuations
 Revisions only occur when reliable market
data exist
 Examples include security investments and
derivative instruments

INVESTMENT ACTIVITIES
(CONT.)

Reporting limitations affect asset
valuation
Underreported items—for example,
research and development costs
 Unreported items—for example, human
capital

INVESTMENT ACTIVITIES
(CONT.)

Capital is any form of wealth used to produce
additional wealth




Assets are an entities’ capital as defined in its
broadest sense
Shareholders’ equity is a narrower definition of
capital
Legal equity is the regulatory view of capital; it is
even more restrictive than shareholders’ equity
definition
An analyst can modify GAAP-based investment
disclosures to gain additional insights about asset
utilization
INVESTMENT ACTIVITIES
(CONT.)

Asset utilization is a function of how
capital is defined
Return on assets (ROA) and return on
equity (ROE) measure asset utilization
 ROA is based on the total asset definition
of capital
 ROE is based on the shareholders’ equity
definition of capital

RETURN ON ASSETS
Reports the percentage of income
earned for each dollar invested in an
entity’s resources
 Computed as: net income / average
total assets
 It is a measure of the productivity of an
enterprise’s total resources

RETURN ON ASSETS (CONT.)

Managerial orientation
Analysts use ROA to assess managerial
performance
 Measures manager’s ability to create
wealth with its given store of value
 Reports their efficiency in creating that
wealth

RETURN ON ASSETS (CONT.)

Components of return on assets





Analysts gain greater insight about ROA results by
examining the measure’s components
Profit margin measures the earnings per revenue
dollar
Computed as net income / revenues
Asset turnover measures the revenues produced
per dollar invested in assets
Computed as: revenues / average total assets
RETURN ON ASSETS (CONT.)
An infinite number of profit margins and
asset turnover ratios produce an
equivalent ROA (Exhibit 13-1B)
 Increasing one ROA component to a
greater extent than a decrease in the
other one increases overall ROA (Exhibit
13-1C)

RETURN ON ASSETS (CONT.)
Technical adjustments to return on
assets
 Financial leverage

Substitution of fixed-charged financing for
common equity financing
 Financial leverage can either increase or
decrease ROA, depending on its cost and
the return on assets

RETURN ON ASSETS (CONT.)
Technical adjustments to return on
assets
 Debt Cost

Interest expense affects net income
(Exhibit 13-2)
 The actual cost of debt is less than the
effective rate of borrowing because interest
expense is tax deductible

RETURN ON ASSETS (CONT.)

Computational procedure for interest
adjustment
Undertaken to eliminate bias in assessing
managerial effectiveness
 Adds net interest expense back to net
income in computing overall return on
assets and the profit margin component to
ROA

RETURN ON EQUITY
Reports the percentage of income
earned for each dollar invested by the
owners of an entity
 Common shareholder orientation

Analysts use ROE to determine the rate of
earnings produced by the owners’
investment
 Measures wealth creation accruing to risk
capital

RETURN ON EQUITY (CONT.)
Return on Equity (ROE) Ratio
 Computed as: net income / average
common shareholders’ equity
 Disaggregating the ratio into its
components produces more information

RETURN ON EQUITY (CONT.)

Financial structure leverage ratio
A component of the ROE ratio
 Computed as: average total assets /
average common shareholders’ equity
 It is multiplied by profit margin and asset
turnover (the components of ROA) to
produce ROE

RETURN ON EQUITY (CONT.)
Components of return on equity
 The profit margin and asset turnover
(the components of ROA) are multiplied
by the financial structure leverage ratio
to yield ROE
 Computed as: ROE = profit margin *
asset turnover * financial structure
leverage ratio

RETURN ON EQUITY (CONT.)
The multiplicative nature of the financial
structure leverage ratio increases ROE if
the profit margin and asset turnover
ratios are positive
 The multiplicative nature of the financial
structure leverage ratio decreases ROE
if the profit margin is negative

eSTUFF’S ASSET UTILIZATION
RATIOS
Asset Utilization Ratios
Unadjusted profit margin
Unadjusted asset turnover
Unadj. financial structure leverage
Unadjusted return on assets
Unadjusted return on equity
Adjusted profit margin
Adjusted asset turnover
Adj. financial structure leverage
Adjusted return on assets
Adjusted return on equity
Financial structure index
2003
-0.687%
1.523
1.534
-1.05%
-1.61%
0.229%
1.52
1.53
0.35%
-1.61%
-460.30%
2002
1.855%
1.418
1.577
2.63%
4.15%
2.823%
1.42
1.58
4.00%
4.15%
103.64%
2001
1.750%
1.486
1.633
2.60%
4.25%
2.750%
1.49
1.63
4.09%
4.25%
103.92%
ADDITIONAL ASSET UTILIZATION
CONSIDERATIONS

Fixed asset turnover





Subset of asset turnover ratio
Measures the revenue produced per dollar of fixed
investment
Gauges the productivity of an entity’s long-term
resources
Computed as: revenues / average fixed assets
The denominator often includes intangible assets
to reflect their contributions to generating
revenues
ADDITIONAL ASSET UTILIZATION
CONSIDERATIONS (CONT.)

Asset impairment
Exists when an asset’s expected cash flow
is less than its book value
 Losses on impaired assets are reported as
part of other gains and losses
 Judgment is required in determining if and
when an asset is impaired
 Some entities attempt to bury impaired
assets as part of restructuring charges

ADDITIONAL ASSET UTILIZATION
CONSIDERATIONS (CONT.)

Segment returns





Companies report revenues, income, and assets of
their business divisions
Management determines what its segments are
and reports on them accordingly
Analysts use segment disclosures to determine
how well various aspects of the enterprise have
fared
Segment ROA can be computed
Segment ROE cannot be calculated, due to an
inability to divide shareholders’ equity into
segments
ADDITIONAL ASSET UTILIZATION
CONSIDERATIONS (CONT.)

Knowledge-based assets




Knowledge and information increasingly produce
value and wealth
Such items are more difficult to measure than
traditional resources
They are often underreported or unreported on
the balance sheet
Their existence limits the usefulness of return on
investment measures, especially for new economy
firms
ANALYSIS OF THE PC
INDUSTRY
Intellectual Asset Factors
 Property, plant, and equipment compose a
very small proportion of industry resources



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Financial reporting requirements reduced asset
disclosures on the balance sheet
Underreported assets, such as research and
development
Aggressive elimination of other intangibles, such
as goodwill and in-process research and
development
Unreported assets, such as human capital
ANALYSIS OF THE PC
INDUSTRY (CONT.)
Component purchases and out sourcing
reduce fixed asset requirements
 Knowledge-based, relatively small sized
products also decrease demand for
fixed assets
 Industry emerged toward product
creation and distribution from product
manufacturing

ANALYSIS OF THE PC
INDUSTRY (CONT.)

Return on assets--data indicated diverse
results




Dell provided the highest rate of return on assets
in the industry (Exhibit 13-6)
Gateway demonstrated steady improvement,
except for 1997
Compaq’s poor ROA in 1998 offset an otherwise
steady rate of return
Apple lagged its competition, even in its profitable
years
PC Industry
Annual Return on Assets
40%
30%
20%
%
10%
0%
-10%
1994
1995
1996
1997
-20%
-30%
Apple
Compaq
Dell
Gateway
1998
ANALYSIS OF THE PC
INDUSTRY (CONT.)

The cumulative rates of direct computer
sellers (Dell and Gateway) far surpassed
those of the indirect sellers (Compaq
and Apple), as evidenced by Exhibit 138
PC Industry
Weighted Average Annual Return on Assets
1994-1998
20%
15%
%
10%
5%
0%
Apple
-5%
Compaq
Dell
Gateway
ANALYSIS OF THE PC
INDUSTRY (CONT.)

ROA components reflected overall ROA
results




Dell increased its profit margin and asset turnover
throughout the period analyzed (Exhibit 13-7A)
The asset turnovers for Gateway, Compaq, and
Apple decreased over time (Exhibit 13-7B)
Apple’s profit margin and asset turn lagged those
of the other firms
Lack of debt financing precluded the need to
adjust ROA and profit margin for the effect of
interest expense on net income (Exhibit 13-9)
PC Industry
Annual Net Profit Margin
10%
5%
0%
%
1994
1995
1996
1997
-5%
-10%
-15%
-20%
Apple
Compaq
Dell
Gateway
1998
PC Industry
Annual Asset Turnover
8%
7%
Number of Times
6%
5%
4%
3%
2%
1%
0%
1994
1995
1996
1997
1998
ANALYSIS OF THE PC
INDUSTRY (CONT.)
Return on Equity
 None of the four firms were highly leveraged,
due to





Small fixed asset bases
A history of venture equity capital
Substantial retention of earned income
Dell earned substantially higher returns on
common shareholders’ equity than its competition
ANALYSIS OF THE PC
INDUSTRY (CONT.)

The PC industry illustrates the dual nature of
financial leverage (Exhibit 13-11A and 1311B)




It can produce returns on equity that are greater
than returns on assets
For example, the equity returns earned by Dell
and Gateway
It can produce ROE that are less than ROA
For example, the negative equity returns earned
by Apple in 1996 and 1997
PC Industry
Annual Returns on Equity
100%
80%
60%
%
40%
20%
0%
-20%
1994
1995
1996
1997
-40%
-60%
-80%
Apple
Compaq
Dell
Gateway
1998
ANALYSIS OF THE PC
INDUSTRY (CONT.)

Segment returns (Exhibit 13-12A, 13-12B,
and 13-12C)




The American market is the largest market for PC
companies
Dell’s return on assets in the American market
exceeded those of its competition and contributed
to its improver investment returns
Apple performed poorly in the domestic market
Compaq’s segments could not be analyzed
because they did not disclose segment information
1998 Net Profit by Geographical Segment
16%
14%
12%
%
10%
8%
6%
4%
2%
0%
-2%
Americas
Europe
Apple
Dell
Asia
Gateway