Module 4 Notes Trade-Off between Margin and Turnover Operating Profit Margin (PM) and Asset Turnover



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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%)




$200

Profit from assets financed with debt ($500 x 20%)

$100




Less: interest expense from debt ($500 x 7%)

($35)

$ 65

Net Profit




$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 NFO: Net financing obligations

Nonoperating liabilities nonoperating assets

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%)




$200

Profit from assets financed with debt ($500 x 20%)

$100




Less: interest expense from debt ($500 x 7%)

($35)

$ 65

Net Profit




$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

Net operating assets (NOA)

(assets – liabilities)



Assets

Current Operating Assets



+ Long-term Operating Assets

= Total Operating Assets



Liabilities

Current Operating Liabilities



+ Long-term Operating Liabilities

= Total Operating Liabilities



Net nonoperating obligations (NNO)

(liabilities – assets)



Current Nonoperating Assets

+ Long-term Nonoperating Assets

= Total Nonoperating Assets



Current Nonoperating Liabilities

+ Long-term Nonoperating Liabilities

= Total Nonoperating Liabilities



Equity (NOA – NNO)

Total Assets

Equity

_____Stockholders’ Equity

Total Liabilities and Equity


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

Financial

Leverage




Asset

Turnover



  • 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 = Net income x _____Sales_______

Average total assets Sales Average total assets


Asset

Turnover

Profit

Margin


|______________________________|


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-in-process 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.


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