Chapter 5

DIAGNOSING
PROFITABILITY,
RISK, AND GROWTH

Hawawini & Viallet Chapter 5 © 2007 Thomson South-Western

Background
n  If higher sales and profits are achieved by a firm due to
a larger balance sheet, that means that more capital is
used to finance the firm s activities
n  Because capital is costly, what we really need to know is
whether profits per dollar of assets employed have increased
n  Alternatively, a drop in profits with a rise in interest
expenses does not necessarily mean that it was
borrowing that impaired the firm s profitability
n  An increase or a decrease in profits is not, by itself, a
good indicator of a firm s financial performance
n  This chapter presents an integrated approach to
profitability analysis

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Background
n  After reading this chapter, students should
understand:
n  How to measure a firm’s profitability
n  The key drivers of profitability
n  How to analyze the structure of a firm’s overall
profitability
n  How business risk and the use of debt financing
affect profitability
n  How to assess a firm’s capacity to finance its
expected growth in sales

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Measures of Profitability
n  Managers
adopt measures of profitability
depending on their areas of responsibility
n  A sales manager would look at return on
sales (ROS)
n  The manager of an operating unit would
choose return on assets (ROA)
n  The chief executive would pay attention
primarily to return on equity (ROE)

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Return on Equity
n  Mostcomprehensive indicator of
profitability
n  The final outcome of all the firm s activities
and decisions made during the year
n  Considers the operating and investing
decisions as well as the financing and tax-
related decisions

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Measuring Return on Equity
n  Returnon equity measures the firm s
profitability from the perspective of the
owners whose rewards is the firm s net
profit
n  Return on equity (ROE) = Earnings after tax
(EAT) ÷ Owners equity

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EXHIBIT 5.1a:
OS Distributors Balance Sheets.
Figures in millions of dollars.

1 Consists of cash in hand and checking accounts held to facilitate operating activities.
2 Prepaid expenses is rent paid in advance (when recognized in the income statement, rent is included in
selling, general, and administrative expenses).
3 In 2004, there was no disposal of existing fixed assets or acquisition of new fixed assets. However,

during 2005, a warehouse was enlarged at a cost of $12 million, and existing fixed assets, bought for $9
million in the past, were sold at their net book value of $2 million.

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EXHIBIT 5.1b:
OS Distributors Balance Sheets.
Figures in millions of dollars

4 Accrued expenses consist of wages and taxes payable.

5 Long-term debt is repaid at the rate of $8 million per year. No new long-term debt was incurred during
2004, but during 2005 a mortgage loan was obtained from the bank to finance the extension of a
warehouse (see Note 3).
6 During the three years, no new shares were issued, and none was repurchased.

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EXHIBIT 5.2:
OS Distributors Income Statements.
Figures in millions of dollars

1 There is no interest income, so net interest expenses are equal to interest expenses.
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The Effect of Operating Decisions
on Return on Equity
n  Operatingdecisions involve the
acquisition and disposal of fixed assets
and the management of the firm s
operating assets
n  Net profit, however, is obtained after
deducting interest expenses—the outcome of
financing decisions
•  Therefore, ROS and ROA do not reflect only
operating decisions

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Return on Invested Capital
Before Tax (ROICBT)
n  A relevant measure of operating profitability is return on
invested capital or ROIC
n  ROICBT = EBIT ÷ Invested Capital
•  ROICBT is the same as return on net assets (RONA) and return
on capital employed before tax (ROCEBT)
•  OS Distributors' ROICBT is shown in the last column of Exhibit 5.4
n  ROICBT can also be measured after tax by using EBIT (1 – tax
rate)
•  Important measure of performance when estimating the value
created by a business
n  Other measures of operating profitability include
n  Return on business assets (ROBA)
n  Return on total assets (ROTA)

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EXHIBIT 5.3:
OS Distributors Managerial Balance Sheets.
All data from the balance sheets in Exhibit 5.1; figures in millions of dollars

1 WCR = (Accounts receivable + Inventories + Prepaid expenses) – (Accounts payable + Accrued

expenses).
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EXHIBIT 5.4:
The Structure of OS Distributors Return on Invested Capital.
All data from the income statements in Exhibit 5.2 and the balance sheets in Exhibit 5.3;
figures in millions of dollars

1 Invested capital = Cash + Working capital requirement + Net fixed assets.

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The Drivers of Operating
Profitability
n  Any improvement in ROICBT must be the outcome of a
higher operating profit margin or a higher capital
turnover

n  A higher operating profit margin is achieved by:

•  Increasing sales through higher prices and/or higher volume at a
higher rate than operating expenses
•  Reducing operating expenses at a higher rate than sales
n  A higher capital turnover is achieved through a better use of the
firm s assets

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The Drivers of Operating
Profitability
n  A study analyzing the factors affecting pretax operating
profitability found that beyond the specific
characteristics of the market in which a business
competes (the degree of innovation and technical
change, the relative power of customers and suppliers,
and the market s rate of growth), the following factors
emerge:
n  The firm s competitive position in terms of market share
n  The relative quality of its products and services
n  The firm s cost and asset structures
•  Compositions and concentration of assets
•  Structure of its costs
•  Degrees of vertical integration and capacity utilization

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The Drivers of Operating
Profitability
n  High market share and superior product
quality boost operating profitability
n  High investments and high fixed costs
depress operating profitability
n  The link between return on equity and
operating profitability
n  If
a firm does not borrow, its ROICBT (i.e.,
operating profitability) is equal to its pretax
return on equity

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The Effect of Financing Decisions
on Return on Equity
n  When a firm does not borrow, its ROIC and
ROE are the same
n  Thus, any difference between them must be due to
the use of debt
n  There is a financial cost effect that reduces
ROE and a simultaneous financial structure
effect that increases ROE
n  Thus, we cannot predict how financial leverage
affects ROE

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EXHIBIT 5.5:
The Structure of OS Distributors Return on Equity.
All data from the income statements in Exhibit 5.2 and the balance sheets in Exhibit 5.3; figures in
millions of dollars.

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The Effect of Financing Decisions
on Return on Equity
n  The financial cost ratio
n  Financial cost ratio = Earnings before tax (EBT) ÷
Earnings before interest and tax (EBIT)
n  Times-interest-earned, or interest coverage,
ratio
n  Times interest earned = Earnings before interest and
tax (EBIT) ÷ Interest expenses
n  The financial structure ratio
n  Financial structure ratio= Invested capital ÷ Owners
equity
n  Other measures of financial leverage
n  Debt-to-equity ratio
n  Debt-to-invested capital ratio
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The Incidence of Taxation on
Return on Equity
n  Third determinant of a firm s ROE
n  Incidence of corporate taxation
•  The relevant tax rate is the effective tax rate, not
the statutory tax rate

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EXHIBIT 5.6:
Comparison of Effective Tax Rates in 2004.
Figures in thousands of dollars

Source: Companies annual reports.

Exhibit 5.6
illustrates the point
that a firm should
plan to minimize its
tax liabilities.

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Putting It All Together: The Structure of
a Firm s Profitability
n  ROE is the product of five ratios
n  Operating profit margin
n  Capital turnover
n  Financial cost ratio
n  Financial structure ratio
n  Tax effect ratio

Capture the impact of the Reflect the impact of the

firm s investing and operating financial policy on the
decisions firm s overall profitability.
Their product is called
the financial leverage
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Putting It All Together: The
Structure of a Firm s Profitability
n  ROE = ROICBT × Financial Leverage
Multiplier × (1 – Effective tax rate)
n  Pretax ROE = ROICBT × Financial
Leverage Multiplier
n  If financial leverage multiplier > (<) 1 then
pretax ROE > (<) ROICBT

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EXHIBIT 5.7:
The Drivers of Return on Equity.

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EXHIBIT 5.8:
The Structure of Return on Equity for Five Firms in
Different Sectors (2004).1

1 Compiled by the authors with accounting data from the firms annual reports.
2 See text for names of companies.
3 Operating profit margin = Earnings before interest and tax/Sales.
4 Capital turnover = Sales/Invested capital, where invested capital = Cash + Working capital requirement

+ Net fixed assets.

5 Return on invested capital = Earnings before interest and tax/Invested capital.
6 Financial leverage multiplier = Pretax return on equity/Return on invested capital.
7 Pretax return on equity = Earnings before tax/Owners equity.
8 Tax effect = Earnings after tax/Earnings before tax = (1 – Effective tax rate).
9 Return on equity = Earnings after tax/Owners equity.

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Other Measures of Profitability
n  The following are a few ratios that combine
financial accounting data with financial market
data
n  Earnings per share (EPS)
•  Earnings per share (EPS) = Earnings after tax ÷ Number of
shares outstanding
n  The price-to-earnings ratio (P/E)
•  Price-to-earnings ratio (P/E) = Share price ÷ Earnings per
share
n  The market-to-book ratio (MBR)
•  Market-to-book ratio = Share price ÷ Book value per share

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Financial Leverage and Risk
n  Two
firms with identical net assets are
considered
n  The only difference between them is their
financing strategy
•  One firm is financed exclusively with equity, while
the other finances half of its net assets with
borrowed funds
n  The two firms are assumed to face the same
business risk (i.e., the same changes in
EBIT)

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EXHIBIT 5.9:
Effect of Financing on Profitability for
Different Levels of EBIT.

n  The levered firm s ROE varies more widely than that
for the unlevered firm
n  Financial leverage magnifies a firm s business risk
n  In other words, borrowing at a fixed interest rate adds
financial risk to the firm s existing business risk
n  The levered firm is riskier and its risk increases with
rising levels of borrowing

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How Does Financial Leverage
Work?
n  A
firm seeking to enhance its ROE should
borrow as long as its ROICBT exceeds its
cost of debt
n  Should refrain from borrowing whenever its
ROICBT is lower than its cost of debt

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Two Related Caveats: Risk and the
Ability to Create Value
n  The above conclusion suggesting that financial
leverage enhances the firm s overall profitability
(its ROE) as long as the firm achieves ROICBT
that exceeds the borrowing rate has two
caveats
n  Managers do not know their firm s future ROICBT
n  A high expected ROE does not necessarily mean
that the firm is creating value for its owners

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Self-Sustainable Growth
n  As sales increase, the related growth in assets will have
to be financed with
n  Debt
n  Equity
n  A combination of these two sources of funds
n  Self-sustainable growth rate
n  The maximum rate of growth in sales a firm can achieve without
issuing new shares or changing either its operating policy or its
financing policy
•  Self-sustainable growth rate = Retention rate × Return on equity
n  If the five factors comprising ROE stay fixed, a firm
cannot grow its sales faster than its self-sustainable
growth rate unless it issues new shares

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EXHIBIT 5.10:
OS Distributors Self-Sustainable Growth Rate
Compared with Growth in Sales.

Exhibit 5.10 shows OS Distributors self-

sustainable growth rate computed as a product
of its retention rate and return on equity.

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Self-Sustainable Growth
n  Firms with sales growing faster than their self-
sustainable growth rate will eventually
experience a cash deficit
n  While firms with sales growing slower than their self-
sustainable growth rate will eventually generate a
cash surplus
n  Given the constraints, the firm s self-sustainable
growth rate can only be increased through an
improvement in the firm s operating profitability

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EXHIBIT 5.11:
Sales Growth and Cash Condition.

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