LECTURE 6
PROFITABILITY ANALYSIS
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Profitability ratios
ROA
The Dupont model
ROE
These ratios can be calculated to
determine how well resources used in the
business have been utilised to earn profits
Two key measures
ROA measures a firms success in using assets
to generate earnings, independent of the
financing method.
ROE extends ROA to include the effect of
financing
ROA = NI + (1-Tax rate)*Interest exp + Minority interest
Average total assets
This ratio describes the rate of return
management was able to earn on the assets that
it had available during the year.
An informed judgment about the firms
profitability requires relating income from
operations to the assets used to generate that
net profit.
Return on
=
Assets
EBIT
Sales
AverageSales
Total Assets
Margin
Turnover
Emphasises that
from every dollar of
sales revenue,
some amount must
work its way to net
profit.
Relates efficiency
with which the
firms assets are
used in the
revenue-generating
process.
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Gross Profit Margin: Reflects the gross profit as a
percent of sales
Reflects the companys ability to increase or maintain
selling price
Declining gross profit margins generally indicate that
competition has increased
or that the companys products have become less
competitive, or both.
Operating Expense Margin: Measures the
companys ability to control operating expenses
Need to be aware of investment costs, like advertising
and R&D.
Reductions can lead to a short-term gain at a long-term
cost.
Accounts Receivable turnover: Reflects how many
times receivables are collected on average.
Inventories turnover: Reflects how many times
inventories are sold and replaced on average.
Fixed asset turnover: Reflects the productivity of
long-term operating assets.
Accounts Payable turnover: Reflects how quickly
accounts payable are paid, on average.
What factors explain the consistently high or
consistently low ROAs of some industries
compared to the average of some
industries?
Why do some industries have high profit
margin but low asset turnover, while others
are the opposite?
3 elements of risk that may explain the
differences across firms and changes over
time in ROA:
Operating leverage
Cyclicality of sales
Stage and length of product life cycle
Operating leverage
Operating leverage is the level of the firms
commitment to fixed operating expenses
Firms that have capital intensive cost structures
will have a higher proportion of fixed costs than
those firms that are less capital intensive
Firms with high level of operating leverage
experience greater variability in ROAs, incur
more risk in their operations and should earn
higher rates of return.
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Cyclicality of sales
Firms with cyclical sales patterns incur more
risk, they experience greater variability in
ROA
Product life cycle
Introduction/early growth negative ROA
Maturity rapid increase in ROA
Decline ROA may still increase
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Microeconomic theory
Capital
intensity
Competition
Likely strategic focus
High
Monopoly
Profit margin
Medium
Oligopolistic or
Monopolistic
Competition
Profit margin
Assets turnover or
Some combination
Low
Pure
competition
Assets turnover
Business strategy
Product differentiation/low cost leadership
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ROCE =
Net income Preferred dividends
Average common shareholders equity
ROCE measures the accounting return to
common shareholders after subtracting all
payments to providers of capital senior to
common shareholders
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ROCE = ROA
NI to common
=
Aver. Com Equity
NI + Interest(n et)
=
Aver. Total assets
ROCE
ROA
x
x
Adjusted Leverage
NI to Common
Aver. Total assets
x
NI + Interest(n et)
Aver. Com Equity
Common earnings
x
leverage
Capital structure
leverage
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Common earnings leverage (CEL) indicate the
proportion of operating income allocable to
common shareholders.
The higher the cost of debt and preferred stock, the less
income will remain for common shareholders, the smaller
the CEL
Capital structure leverage (CSL) measures the
degree to which firms use common shareholders to
finance assets.
The more capital obtained from debts and preferred stock,
the less capital obtained from common shareholders, the
higher the CSL
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If suppliers of capital (other than common
shareholders) receive less than ROA, then
common shareholders benefit (ROCE > ROA); the
reverse occurs when suppliers of capital receive
more than ROA
The larger the difference in returns between
common equity and other capital suppliers, the
more successful (or unsuccessful) is the trading
on the equity
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Financial leverage enables a firm to have an
asset base larger than its equity
Financial leverage increases firms ROCE as
long as cost of the liabilities is less than the
return from investing
While a firms shareholders can potentially
benefit from financial leverage, it also
increase the risk
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Sustainable growth rate = ROCE (1 Payout ratio)
Sustainable growth rate is the rate at which a
firm can grow while keeping its profitability and
financial policies unchanged
Sustainable growth rate provides a benchmark
against which a firms growth plan can be
evaluated.
Firm can grow at different rate if profitability,
payout policy or leverage changes
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EPS =
Net income Preferred dividends
Weighted average number of shares outstanding
Criticism
EPS does not reflect assets or capital required to
generate earnings
Number of shares is a poor measure of the
amount of capital in use
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Comparisons with corresponding ratios of
earlier periods- Analysis questions
Has the firm madea significant change in its
product, geographical or customer mix that
affects the comparabilityof ratios over time?
Has the firm made a major acquisition or
divesture?
Has the firm changed its methods of accounting
over time?
Comparisons with corresponding ratios of
other firms
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Problem
Problem
Problem
Problem
Problem
4.15
4.16
4.17
4.20
4.23
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