CHAPTER TWELVE (cont.

Lecture 8 – Module on Financial Statement Analysis

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Profitability2

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
 Prepared by: Stephen H. Penman – Columbia University
With contributions by (and adaptations from)
Nir Yehuda – Northwestern University
Mingcherng Deng – University of Minnesota
Peter D. Easton and Gregory A. Sommers – Notre Dame and Southern
Methodist Universities
Luis Palencia – University of Navarra, IESE Business School
12-27
 What You Will Learn from this Lecture

— How operating liability leverage affects ROCE

— The difference between Return on Net Operating Assets (RNOA) and Return on Assets (ROA)
— The difference between Financial Leverage (FLEV) and Debt-to-equity ratio (D/E)
— How profit margins, asset turnovers and their composite ratios drive RNOA
— How borrowing costs are analyzed
— How profitability analysis can be used to ask penetrating questions regarding the firm’s activities

12-28
 Analyzing ROCE: The Scheme

Return on common equity

(ROCE)

Return from operating activities Return from financing activities

Operating Return on net Financial

liability leverage operating assets leverage First level

Financial
Profit margin Asset turnover Second level
leverage x spread

Third level
Profit margin drivers Turnover drivers Borrowing cost drivers 12-29
 The Financial Leverage Equation
𝑅𝑂𝐶𝐸 = 𝑅𝑁𝑂𝐴 + 𝑅𝑁𝑂𝐴 − 𝑁𝐵𝐶 ×𝐹𝐿𝐸𝑉

The equation says that ROCE is driven by three factors:

'(
1. Profitability of operations: 𝑅𝑁𝑂𝐴 = )'*

2. Operating Spread: RNOA – NBC

)/'
3. Financial Leverage: 𝐹𝐿𝐸𝑉 = 012

The comparison between RNOA and NBC is fundamental, if RNOA> NBC

the financial sources invested in the company yields more than their cost.

12-30
 B. The Analysis of Operating Liability Leverage (OLLEV)
Operating liabilities lever the Return on Net Operating Assets
'(< '(
RNOA = = =
()'*<@)'*<A= ) '* C'D
>

Implicit Interest on OL (as a benchmark) = Short-term Borrowing Rate (after tax) x OL

What would be the operating profitability without operating liabilities?
'(@(PQRSTSU (VUWXWYU (*ZUWX [\])
Return on Operating Assets (ROOA) = '*

𝑂𝐿
𝑅𝑁𝑂𝐴 = 𝑅𝑂𝑂𝐴 + (𝑅𝑂𝑂𝐴 − 𝑆ℎ𝑜𝑟𝑡 𝑡𝑒𝑟𝑚 𝑏𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔 𝑟𝑎𝑡𝑒 \ZUWX U\] )×
𝑁𝑂𝐴
OLSPREAD OLLEV

𝑅𝑁𝑂𝐴 = 𝑅𝑂𝑂𝐴 + (𝑂𝐿𝑆𝑃𝑅𝐸𝐴𝐷×𝑂𝐿𝐿𝐸𝑉)

12-31
 OLLEV effect
𝑂𝐿
𝑅𝑁𝑂𝐴 = 𝑅𝑂𝑂𝐴 + (𝑅𝑂𝑂𝐴 − 𝑆ℎ𝑜𝑟𝑡 𝑡𝑒𝑟𝑚 𝑏𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔 𝑟𝑎𝑡𝑒 \ZUWX U\] )×
𝑁𝑂𝐴
Theta Zeta
CSE = NOA CSE = NOA
1,500,000 1,000,000
OA OA
3,000,000
OL 3,000,000 OL
1,500,000 2,000,000

ROOA = (OI + Implicit interest)/OA = 9%

Short term borrowing rate (after tax) = 7%
OLLEV = 1,500,000/1,500,000= 1 OLLEV = 2,000,000/1,000,000= 2
Implicit Interest = 7% x 1,500,000=105,000 Implicit Interest = 7% x 2,000,000=140,000
OI + Implicit Interest = 9% x 3,000,000=270,000 OI + Implicit Interest = 9% x 3,000,000=270,000
OI = 270,000 – 105,000 = 165,000 OI = 270,000 – 140,000 = 130,000

RNOA = 165,000/1,500,000=11% RNOA = 130,000/1,000,000=13%

11% = 9% + [(9% – 7%)x1] 13% = 9% + [(9% – 7%)x2]
12-32
 OLLEV effect
𝑂𝐿
𝑅𝑁𝑂𝐴 = 𝑅𝑂𝑂𝐴 + (𝑅𝑂𝑂𝐴 − 𝑆ℎ𝑜𝑟𝑡 𝑡𝑒𝑟𝑚 𝑏𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔 𝑟𝑎𝑡𝑒 \ZUWX U\] )×
𝑁𝑂𝐴
Theta Zeta
CSE = NOA CSE = NOA
1,500,000 1,000,000
OA OA
3,000,000
OL 3,000,000 OL
1,500,000 2,000,000

ROOA = 9%
Short term borrowing rate (after tax) = 12%
OLLEV = 1,500,000/1,500,000= 1 OLLEV = 2,000,000/1,000,000= 2
Implicit Interest = 12% x 1,500,000=180,000 Implicit Interest = 12% x 2,000,000=240,000
OI + Implicit Interest = 9% x 3,000,000=270,000 OI + Implicit Interest = 9% x 3,000,000=270,000
OI = 270,000 – 180,000 = 90,000 OI = 270,000 – 240,000 = 30,000

RNOA = 90,000/1,500,000=6% RNOA = 30,000/1,000,000=3%

6% = [9% + (9% – 12%)x1] 3% = [9% + (9% – 12%)x2]
12-33
 OLLEV effect
𝑂𝐿
𝑅𝑁𝑂𝐴 = 𝑅𝑂𝑂𝐴 + (𝑅𝑂𝑂𝐴 − 𝑆ℎ𝑜𝑟𝑡 𝑡𝑒𝑟𝑚 𝑏𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔 𝑟𝑎𝑡𝑒 \ZUWX U\] )×
𝑁𝑂𝐴

If ROOA > 𝑆ℎ𝑜𝑟𝑡 𝑡𝑒𝑟𝑚 𝑏𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔 𝑟𝑎𝑡𝑒 \ZUWX U\] OLLEV RNOA

But….
If ROOA < 𝑆ℎ𝑜𝑟𝑡 𝑡𝑒𝑟𝑚 𝑏𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔 𝑟𝑎𝑡𝑒 \ZUWX U\]
OLLEV RNOA

12-34
Summing Operating Liability Leverage and Financial
Leverage Effects on ROCE

ROCE = ROOA + (ROCE – RNOA) + (RNOA – ROOA)

A B
Return Effect of Effect of
With no Financing Operating
leverage Liabilities Liabilities

For General Mills,

ROCE = 7.1% + (16.7% – 10.1%) + (10.1% – 7.1%)

= 7.1% + 6.6% + 3.0%
= 16.7%

12-35
 Return on Net Operating Assets and Return on Assets

'(
RNOA = '* C'D

mno pqrstn@pqonunvo wxynqvn z{onu ozx

ROA = |}nuz~n osoz• zvvnov

Problems with ROA:

• Financial income in numerator
• Financial assets in denominator
• Operating liabilities not in denominator
• Net income is not comprehensive income

Median ROA is 7.1% for U.S firms (1962-2010)

Median RNOA is 10.5%
12-36
 FLEV and Debt-to-Equity Ratios

NFO
FLEV =
CSE
Total debt
Debt to Equity =
Equity

Problems with Debt-to-Equity ratio:

• Excludes financial assets (which effectively defease debt)
• Includes operating liabilities

Median Debt-to-Equity is 1.22 for U.S. firms (1963-2004)

Median FLEV is 0.43

12-37
 Second-Level Breakdown of ROCE: Drivers of Operating Profitability

𝐑𝐎𝐂𝐄 = 𝐑𝐍𝐎𝐀 + [𝐅𝐋𝐄𝐕 × 𝐑𝐍𝐎𝐀 − 𝐍𝐁𝐂 ]

3. Effect of financial leverage

𝑃𝑀 × 𝐴𝑇𝑂

OI Sales
1. Operating profit margin PM = 2. Asset turnover ATO =
Sales NOA

12-38
Profit Margin and Asset Turnover Combinations for 238 Industries, 1963-2000

12-39
 Third-Level Breakdown of ROCE: Profit Margin Drivers

PM = Sales PM + Other operating income PM

by product or
Sales PM = Gross margin ratio − Expense ratio
line of business
GM Admin Exp Selling Exp R&D Operating taxes
= − − − − …
Sales Sales Sales Sales Sales
GM = Sales – Cost of Sales

Other Operating Income

Other Items PM =
Sales
ª«¬v-®-zu¯ pqrstn w°«-o¯ ±-}-®nq®v ªynr-z• pontv ²o³nu mno ´z-q &µsvvnv
= + + + + …
ªz•nv ªz•nv ªz•nv ªz•nv

12-40
 Third-Level Breakdown of ROCE: Asset Turnover Drivers

1 Cash Acc. Rec. Inventory PPE Subsidiary Inv. Payables Pension Oblig.
= + + + ⋯+ + + ⋯− − −⋯
ATO Sales Sales Sales Sales Sales Sales Sales

Sales
Accounts receivable turnover =
Accounts receivable (net)

Sales
PPE turnover =
Property, plant and equipment (net)

Cost of goods sold

Inventory turnover =
Inventory

12-41
 Third-Level Breakdown of ROCE: Average days in…

Some times other measures are used:

Accounts Receivable 365 x Accounts receivable

Days in accounts receivable = =
Average sales per day Sales

365 x Inventory
Days in inventory =
Cost of goods sold

365 x Accounts payable

Days in accounts payable =
Purchases

Purchases = Cost of goods sold + Change in inventory

12-42
 Cash

Focus: Operating and Cash Conversion Cycles

Receivables Payables

Operating cycle
Inventories
Cash conversion cycle (CCC)

Days inventory outstanding

Payables period Collection period

150
0 dayst0 60 days t
1
100 dayst2 days t3
Company acquires Company pays Company sells Customer pays for
inventory for inventory product product

Cash outflow CCC = 90 gg Cash inflow

Cash conversion cycle (CCC) = Operating cycle – Payables period =

= Days inventory outstanding + Collection period – Payables period
12-43
 Third-Level Breakdown: Analysis of Net Borrowing Cost

𝐹𝑂 𝐴𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑜𝑛 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝑂𝑏𝑙𝑖𝑔𝑎𝑡𝑖𝑜𝑛𝑠

𝑁𝐵𝐶 = ×
𝑁𝐹𝑂 𝐹𝑂
𝐹𝐴 𝐴𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑜𝑛 𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
− ×
𝑁𝐹𝑂 𝐹𝐴
𝐹𝐴 𝑈𝑛𝑟𝑒𝑎𝑙𝑖𝑧𝑒𝑑 𝐺𝑎𝑖𝑛𝑠 𝑜𝑛 𝐹𝐴 𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑆𝑡𝑜𝑐𝑘 𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑
− × + × +⋯
𝑁𝐹𝑂 𝐹𝐴 𝑁𝐹𝑂 𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑆𝑡𝑜𝑐𝑘

For General Mills (2010):

12-44
 Tracking Profitability for Nike Over Years

3rd

1st
2nd
2nd
1st

12-45