CHAPTER 3

PROFITABILITY ANALYSIS AND

INTERPRETATION
Learning Objective

• Compute and interpret return on equity (ROE)

• Apply Dupont disaggregation of ROE into return on assets

(ROA) and financial leverage.

• Disaggregate ROA into profitability and productivity and

analyze both.

• Identify income statement operating items and compute net

operating profit after tax.
Learning Objective

• Compute and interpret return on net operating assets (RNOA)

• Disaggregate RNOA into net operating profitability and net

operating asset turnover.

• Compute and interpret nonoperating return

 Return on Equity (ROE)

The most common analysis metric used by managers and

investors alike, is the return on equity (ROE)

ROE relates net income to the average total stockholders’

equity from the balance sheet

ROE measures return from the perspective of the company’s

stockholders.
 Intel’s Return on Equity

Intel’s income statement and balance sheet data used to

compute its ROE for 2015 of 19.53%
 Disaggregation of Return on Equity

There are two methods for disaggregating ROE into its

components; each provides a different perspective that can
inform our analysis.

The traditional DuPont analysis that disaggregates return on

equity into components of profitability, productivity, and leverage.

The second method extends the traditional DuPont analysis by

taking an operating focus that separates operating and nonoperating
activities.
 DuPont Disaggregation of ROE

ROE reflects both:

Company performance

How assets are financed

ROE is higher when there is more debt and less equity for a given level of
assets.

Tradeoff-greater debt means higher risk for the company.

 Return on Assets
Income Statement

Balance Sheet

Return on assets (ROA) measures return from the perspective of

the entire company.

ROA analysis encourages managers to focus on the profit achieved

from the invested capital under their control.
 Financial Leverage Component

Many ways to measure

financial leverage:
Here: FL
Later: FLEV

Financial leverage measures the degree to which the company finances its
assets with debt versus equity

Financial leverage is measured in the DuPont analysis as the ratio of average

total assets to average stockholders’ equity.

As financial leverage increases so does the level of debt payments, which all
else equal, increases the probability of default and possible bankruptcy.
 Accounts to Use to Compute ROE

Preferred Stock. The ROE formula takes the perspective of the

common stockholder.

Noncontrolling Interests. ROE is computed from the perspective of

the controlling (parent company) stockholders
 Disaggregation of Return on Assets

What the company earns

on each sales dollar?

Sales generated from each

dollar invested in assets

Managers can increase ROA by:

Increase PM: Increase profitability for a given level of assets

Increase AT: reduce assets while still generating same profit level.
Analysis of Profitability and Productivity
 Analysis of Profitability and Productivity

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
Profit margin (PM) =
𝑆𝑎𝑙𝑒𝑠
𝑆𝑎𝑙𝑒𝑠
Asset Turnover (AT) =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
Return on assets (ROA) =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
Financial leverage (FL) =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑠𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠′ 𝑒𝑞𝑢𝑖𝑡𝑦
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚
Return on equity (ROE) =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑠𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠′ 𝑒𝑞𝑢𝑖𝑡𝑦
Analysis of Profitability and Productivity
 Analysis of Profitability

• Gross Profit Margin

• Gross profit margin (Gross profit/Sales) is influenced by
both the selling price of a company’s products and the
cost to make or buy those products.
• Operating Expense Margin
• The operating expense margin measures general
operating costs for each sales dollar.
 Analysis of Productivity
• Cash Conversion Cycle

• The cash conversion cycle measures the average time (in days):
• Buy inventory on credit (accounts payable)
• Sell inventories of credit (accounts receivable)
• Collect the receivable
 Analysis of Plant, Property and Equipment
(PPE)

𝑺𝒂𝒍𝒆𝒔
• PPE turnover =
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑷𝑷𝑬 𝒂𝒔𝒔𝒆𝒕𝒔

• Lower levels of PPE turnover indicate a higher level of capital

intensity.
• Improvements in PPE turnover are not easy to achieve
 Analysis of Financial Leverage

• Judicial use of financial leverage is beneficial to stockholder

• It is a relatively inexpensive source of capital
• But the use of borrowed money adds risk as debt
payments are contractual obligations.
• Analysis typically involves ratios:
• Investigate the level of borrowed money relative to
equity capital
• The level of profit and cash flow relative to required debt
payments.
 Analysis of Financial Leverage

𝑻𝒐𝒕𝒂𝒍 𝒍𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔
• Total liabilities to equity =
𝑻𝒐𝒕𝒂𝒍 𝒆𝒒𝒖𝒊𝒕𝒚

𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒃𝒆𝒇𝒐𝒓𝒆 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒂𝒏𝒅 𝒕𝒂𝒙

• Times interest earned =
𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒆𝒙𝒑𝒆𝒏𝒔𝒆,𝒈𝒓𝒐𝒔𝒔
Return Ratios
Ratio Computation What It Positive
Measures Indicators
Return on Equity Net income ÷ Return to Improvement
(ROE) Avg. shareholders over time;
stockholders’ using net income Favorable peer
equity and equity. comparison;
or ROA × Higher share
Financial from operations
leverage
Return on Assets Net income ÷ Return on total Improvement in
(ROA) Avg. total assets assets using net margins and
or Profit margin × income. asset turnover;
Asset turnover Efficiency-driven
Profitability Ratios
Ratio Computation What It Positive
Measures Indicators
Gross Profit Gross profit ÷ Markup between Increased
Margin Sales cost and selling margins;
price. Favorable
comparison
Operating SG&A expenses ÷ Overhead Expense
Expense Margin Sales expenses as a % reduction;
(SG&A Margin) of sales. Sustainable cost
control
Net Profit Margin Net income ÷ Total profitability Margin
Sales including non- improvement;
operating. Peer-leading
performance
Productivity Ratios
Ratio Computation What It Positive
Measures Indicators
Accounts Sales ÷ Avg. A/R Credit efficiency Faster collection;
Receivable with customers. Peer-leading
Turnover
DSO 365 × (Avg. A/R ÷ Receivables Lower DSO;
Sales) collection speed. Maintain sales
Inventory COGS ÷ Avg. Inventory usage High turnover;
Turnover inventory efficiency. Peer comparison
Productivity Ratios (Cont.)
DIO 365 × (Avg. Inventory Shorter cycle;
inventory ÷ holding duration. Effective stock
COGS) mgmt
AP Turnover COGS ÷ Avg. A/P Payment Timely payments;
frequency to Competitive
suppliers.
DPO 365 × (Avg. A/P ÷ Payment time to Balanced policy;
COGS) suppliers. Improved cash
flow
Cash Conversion DIO + DSO − DPO Cash flow from Shorter cycle;
Cycle operations. Liquidity gains
PPE Turnover Sales ÷ Avg. PPE Fixed asset More sales per
assets efficiency. asset; Peer-
leading
Financial Leverage Ratios
Ratio Computation What It Positive
Measures Indicators
Liabilities-to- Total liabilities ÷ Capital structure Lower ratio;
Equity Stockholders’ balance. Stronger equity
equity position
Times Interest EBIT ÷ Gross Ability to cover Higher coverage;
Earned interest expense interest. Strong earnings
Apply DuPont Disaggregation of ROE
Refer to the balance sheet and income
statement information for Home Depot,
from M3-18.
a. Compute ROE and disaggregate the
ratio into its DuPont components of ROA
and financial leverage.
b.Disaggregate ROA into profitability and
productivity components
 Operating Focus to Analysis of ROE

• ROE disaggregation with an operating focus recognizes that

companies create value mainly through core operations of
the business.
• The balance sheet and income statement include both
operating and nonoperating items.
 Operating Focus to Analysis of ROE

• Return on assets in the traditional DuPont method, reflects

a blend of the return on a company’s operating assets and
its nonoperating return.
• Accordingly, analysis of a company can be improved if we
separately identify the operating and nonoperating
components of the business and their separate returns
 ROE
Operating Focus

• ROE consists of two returns:

Return from operating Return from financing and

activities investing activities
Earned from operating assets Earned from nonoperating
& liabilities assets & liabilities
 Financial Leverage in Traditional DuPont

• Financial leverage in the traditional DuPont analysis is the

ratio of total assets to stockholders’ equity:

• Liabilities used in this computation include all liabilities

• Liabilities = Borrowed money + Operating liabilities
• The operating focus ROE treats these two types of liabilities
differently for ROE analysis
 Return on Net Operating Assets
(RNOA)

• Operating returns are measured by return on net operating

assets (RNOA)

• Average NOA = (NOA start of year + NOA end of year)/2

 Net Operating Assets
(NOA)

• We compute NOA as follows.

Operating Profit
Balance Sheet: Operating vs. Nonoperating Items

Net operating assets (NOA) = Operating assets – Operating liabilities

• Operating assets = Current operating assets + Long-term operating assets
• Operating liabilities = Current operating liabilities + Long-term operating liabilities

Net nonoperating obligations (NNO) = Nonoperating liabilities –

Nonoperating assets
• Nonoperating liabilities = Current + Long-term nonoperating liabilities
• Nonoperating assets = Current + Long-term nonoperating assets

Equity = Net operating assets (NOA) – Net nonoperating obligations (NNO)

Total Assets = Total Liabilities + Equity

 Net operating Profit After Tax
(NOPAT)

• Net operating profit before tax (NOPBT) = Sales – Operating expenses

 Return on Net Operating Assets
(RNOA)

• RNOA measures operating returns:

• Average NOA = (NOA start of year + NOA end of year)/2

 RNOA Disaggregation Into Margin and Turnover

• We can disaggregate RNOA into net operating profit margin

and net operating asset turnover:
 Interpretation of NOPM and NOAT
NOPM – affected by the level of
Gross profit
Operating expenses
Competition
NOAT can be increase by
Either increasing sales for a given level of investment in operating
assets or by reducing the amount of operating assets necessary to
generate a dollar of sales, or both.
Reducing operating working capital is usually easier than reducing
long-term net operating assets.
Long-term operating assets can be reduced by corporate alliances,
outsourcing, and use of special purpose entities.
 Interpretation of NOPM and NOAT

NOAT can be increase by

Either increasing sales for a given level of investment in
operating assets or by reducing the amount of operating assets
necessary to generate a dollar of sales, or both.
Reducing operating working capital is usually easier than
reducing long-term net operating assets.
Long-term operating assets can be reduced by corporate
alliances, outsourcing, and use of special purpose entities.
Nonoperating Return
 Liquidity Analysis

• Liquidity refers to cash availability: how much cash a company

has, and how much it can raise on short notice.

• Two of the most common ratios used to assess the degree of

liquidity are:
• Current ratio
• Quick ratio

• Both of these ratios link required near-term payments to cash

available in the near-term.
 Liquidity Analysis – Current Ratio

• The current ratio is more commonly used than working

capital because ratios allow comparisons across
companies of different size.
 Liquidity Analysis—Quick Ratio

• The quick ratio focuses on quick assets, which are assets

likely to be converted to cash within a relatively short
period of time.
 Solvency Analysis

• Solvency refers to a company’s ability to meet its debt

obligations.

• Solvency is crucial because an insolvent company is a failed

company.

• There are two general approaches to measuring solvency.

• The first approach uses balance sheet data and assesses the
proportion of capital raised from creditors.

• The second approach uses income statement data and assesses

the profit generated relative to debt payment obligations.
 Liabilities-to-Equity

• The liabilities-to-equity ratio is defined as follows:

• This ratio conveys how reliant a company is on creditor

financing compared with equity financing.

• A higher ratio indicates less solvency, and more risk.

• A variant of this ratio considers a company’s long-term

debt divided by equity.
 Times Interest Earned Ratio

• A common measure for this type of solvency analysis is

the times interest earned ratio, defined as follows:
 Vertical and Horizontal Analysis

• Vertical analysis expresses financial statements in ratio form,

typically as a percent of net sales, and balance sheet items as a
percent 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.