LECTURE 5: ANALYSING PROFITABILITY

Framework for anallysing the Profitability of the firm (ROIC0 and the Return on Shareholders
(ROE)

Source of Capita Net Operating Net operating Financing osts ROE

CI Assets IC = NOA Profit after Tax
NOPAT

Debt NFO Net working Net perating Profit Net borrowing Net profit =
Share holders capital before financing costs on Debt NOPAT less
Equity FE Long-term expenses NOPAT NBC borrowing costs
Retained earnings resourced: PPE, POIC = NOPAT / NBC
Paid capital intangibles IC ROE = Net profit /
SE

Analysing the Firm ROIC and Return on Shareholders ROE

ROE = ROIC + (financial leverage x Spread)

ROE = Net Profit (after tax) / Shareholders Equity

ROIC (also referred to as RNOA) is the return on invested capital (net operating assets) before financing
costs = NOPAT / Capital invested (or Net operating assets)

Financial leverage is the ratio of debt financial obligations (Debt) to shareholders equity (Debt /
Shareholders Equity)

Spread is the difference between ROIC and net borrowing costs (NBC)

Note that Total Capital Invested = Net operating assets NOA and therefore ROIC ca also be referred to
as Return on Net Operating Assets RNOA = NOPAT / NOA

Ex: Woolworths: ROE

ROE (39.71%) = ROIC + (financiel leverage x spread)
ROIC (ROIC or RNOA)= net operating profit after tax (NOPAT) / capital invested (or net operating
assets)
BENCHMARK FOR EVALUATING ROIC

2 possible benchmarks:
- An appropriate benchark for evaluating operating ROIC is the weighted average cist f (debt
and equity) capital (WACC)
+ Average for large Australian firms over longterm is 8 to 10%
+ Woolworths current WACC = 6.01%

- Competitor Companies
+ Benchmark Coles ROIC = 10.12%
+ Benchmark Consumer Staples ROIC = 16.1%

ROIC: Variations on Computation in practive

- While ROIC is one of the most important performance metrics there is significant variation in
practice as to how computed
- These variations could be motivated by providing a more informative or precise metric but could
also be motivated by opportunistic
- The 2 main choices and variations are:
+ the numerator (profit). Adjusting for non-recurring items
+ The denominator (capital). Adjusting and removing investments that are considered
non-operating such as invstments in financial assets
Evaluating Financial Mgt

Financing costs and leverage

- Higher leverage increases (decreases) ROCE when spread is positive (negative): ROE can be
made larger than ROIC by leveraging assets
- Why not increase ROE by increasing leverage: Risk, Lower sprad (as debt increases, interest will
increasing and this lower NPM)
- In general capital structure stay reasonably constant and determined by industry effects
+ Woolworths leverage = 311% (very high because lease large number of building)
+ Coles Leverage = 28%

Evaluating Operations and ROIC

What explains the level and changes in ROIC?

- Most economic production in our society is conducted through firms

- Analysis of drivers of firm performance is important for:
+ As a consultant and as a manager in order to identify areas for business improvement
+ For stewardship and corporate goverance over a firms
+ For Investment and valuation by fund managers, analyst and individual investors
+ As an auditor to identify business risk
+ For economic policy

Some Ratios: Decomposing ROIC

ROE = ROIC + (financial leverage x Spread)

ROIC = net profit margin x asset turnover

ROIC = net operating profit / capital invested = (NOPAT / sales) x (sales / capital invested NOA)

Net profit margin measures marins and thus how much the company is able to keep as profuts for each
dollar of sales and measures Price Premiums and Operating Efficientcy thus reflects both:
- Price premiums
- Operaiing costs

Asset turnover indicates how many dollars of sales the firm is able to generate for eah dolar of operating
assets and reflects:
- the efficiency of poductivity of the capital investment (asset use efficiency)

Ex

The Sales Growth Volume lever

Level and Growth in Sales is the most important friver of firm value
- What is the total size of the potential market and economic conditions?
- What is the firm’s share of the market?
+ At what point in the product life cycle is the firm’industry?
+ What is the competitive adv of the firms that will determine sales growth?

- High growth is unlikely to persist due to demand saturation and intra-industry competition
Evidence: sales growth rates tend to be ‘mean reverting’: firms with above or beloew average rates of
sale growth tend to be revert to the mean
Size of market and Cyclicality of Sales

- Cyclicality of Sales refers to the sensitivity of sales to economic conditions on the economy
- Some goods are highly sensitive to good/bad economic states (eg luxury goods, cars, digital
equipment). Other goods are less sensitiv to economic states (eg food, electric ultilities )
- Firms with more cyclical patterns incur more risk than firms with noncyclical sales and will have
more than variable ROIC

The sales volume lever: share of market - product life cycle

- the stage and length of a firm’s product life cycle affect Sales and thus ROIC
+ Introduction = Low Sales and Negative ROIC
+ Growth = Growing Sales and Positive ROIC
+ Maturity = Stable Sales and Growing ROIC
+ Decline = Declining Sales and Positive or Declining ROIC

Ex:

The Profit Margin Lever: Gross (and Net) Profit margin

Possible explanations for past and future increases (decreases) in gross profit margin
- an increase (decrease in PRICE):
Due to increase (decrease) in demand
Due to price premium

-an increase (decrease) in UNIT cost due to:

Changes in input prices of labour and raw material
Change in production COST EFFICIENCY
Changes in sales volume resulting lower (higher) unit costs as fixed costs allocated over a
greater number of units (operating leverage)

- An increase (decrease) in BOTH PRICE AND UNIT COSTS

Lower price to gain market share an increased volume sold gives rise to lower unit cost
Change in product mix sold

Profit Margin lever: Prices Premiums and Pricing Power

 - Price Premiums (the level of prices)
+ Can a firm sell their product at a price. Premium compared to competitors?

- Pricing Power(the changes in prices)

+ Can a firm pass on cost increases?
+ This is a function of price elasticity of demand (see microeconomics)
+ Determinants ofprice inelasticity:
● No or little Availability of substitutes
● Small Percentage of income
● Necessity

Sources of Price Premiums

To sell a product at a price premium, a company must find a way to deifferentiate its products from those
of competitors:
1. Unique Products. Through Innovation: Innovative good and services yield high returns on
capital if they are protected by patents, difficult to copy, or both
2. Real (or perceived) Quality: Quality refers to any real or perceived difference between one
product or service and another for which consumers are willing to pay a higher price
- in the car business, for example, BMW enjoys a price premium because customers peceive that
its cars handle and drive better than comparable product that cost less
3. Brand: a factor highly correlated and difficult to distinguish with “Quality”, Brand is especially
important when no particular quality difference is present and customer loyalty to brands in a
particular industry allows companies to charge higher prices for their producs
4. Customer Lock-in: makng the replacement costs expensive or impractical for consumers is an
ideal way to lock-in customers and keep ROIC high for a particular company

Cost of inputs and Provision for Stock Loss

- Cost of inputs being costs of raw materials and labour is a primary fundamental determinant of
costs and thus margins
- Provision for stock loss is included as part of the costs of goods sold:
AASB 102 Inventories requires stock o be written down to NRV
This write-down is included in COGS

Cost Efficiency
Is the ability to sell products and services at a lower cost than the competition

- Innovative Business method includes a combination of a company’s production, logistices, and

pattern of interaction with customers.
- benefits of Size and Scale include buying power and thus capacity to buy at a lower price from
suppliers and capacity to buy raw materials in bulk and get a discount

Ex: Slide

Operating Leverage

- Firms operate with a mixture of fixed and variable costs

- Frism with a high proportion of fixed costs to total costs are referred to as having high operating
leverage
 - Firms with high proportion of fixed costs experience significant increases (decreases) in operating
income as a sales increase (decrease)

Measuring. Operating Leverage

- Fixed and Variable cost are not disclosed and thus measuring operating leverage is difficult
- Some insight into the degree of operating leverage (DOL) can be obtained by computing

DOL = %deltaEBIT / %deltaSales

A DOL > 1 implies a firm has some operating leverage

The greater the DOL then the greater the operating leverage

Why have Woolworths margins increased?

The Investment Efficiency Lever and ATO

Investment (or Capital) efficiency is selling more products per dollar of invested capital than competitors
The sales to NOA (invested capital) ratio can provide an indication of investment efficiency, with higher
sales to capital ratios reflecting more efficiency

ATO = Sales / Net Operating Assets NOA =

Evaluating Investment Efficiency (Asset Turnover)

The Overall Asset Turnover can be attributed into 2 main components:

- Mgt of long-term assets (Sales to Long-term Assets)
PPE Turnover = Sales / Average Net PPE
- Working capital mgt (Sales to Working Capital)

Working Capital Asset Turnover

Ideally a firm would like to generate sales with minimum investment in working capital. This involves
trade-offs
- Can minimise inventory but then customers do not have choice or fast delivery
- Would like to collect sales early and pay accounts payable late but customers prefer delayed
payments and suppliers give incentive to pay early

The most significant working capital account and associated standard turnover ratios are:
- Account Receivable Turnover:
Receivable turnover = Sales / Average Accounts receivable
Days in Acc. Receivable = 365 / Accounts Receivable Turnover
- Inventory Turnover
Inventory Turnover = Cost of Sales / Avg Inventores
Days in Inventory = 365 / inventory Turnover
- Accounts payable Turnover
Acc. Payable Turnover = Purchases / Avg Acc. Payable

Days-in-Inventory (Inventory Turnover)

- the interpretation of the level and changes in days-in-inventory involves opposing considerations:
 - Low and decreasing days-in-inventory could be:
+ Good as implies an efficient inventory system, liquid stock and thus involves lower cost for
financing to carrying inventory and lower risk of obsolescence
+ Bad as firm is carrying too little inventory and misses sales

- High and increasing days-in-inventory could be:

+ good as it suggests mgt is anticipating an increase in sales
+ Bad as company has experienced a negative demand shock and/or mgt has overstocked

Days-in-Receivable (Acc Rec turnover)

- Increases (decreases) in Days-in-Receivable could a negative or positive signal. It could reflect:

+ Decreases (increases) i credit worthiness of customers; and’or
+ Changes in a firms credit extension policies to stimulate sales

Forecasting and the Investment Efficiency Lever and ATO

- To grow, companies have to invest in production capacity
What assets (eg plant, intangibles) and working capital need to be invested into generate the
forecasted sales?
- A ‘benchmark’ ATO (. = Sales / NOA) for example from similar companies, or the firms past
history, can be used to provide some insight into required investment in assets:
The forecast NOA = Forecast Sales / benchmark ATO

SUSTAINABLE COMPETITIVE ADV, INDUSTRY STRUCTURE AND STATISTICAL

PROPERTIES OF ROIC

The economics of Competition

- One of the most important principles in a market economy and thus business is that competition
will drive ROIC to ‘normal’ levels over time (reversion to the mean)
- Firms with abnormally high (low) ROIC tend to experience earnings declines (increases)
Highly profitable firms attract competition
Poorly performing firms are made more productive or capital is reallocated
- However some firms may have ROIC above or below normal for long periods of time due to a
sustainable competitive adv or below because lack of market discipline

ROIC and Reversion to the Mean

Sustainable Competitive Adv

Porter 5 sources of competitive Adv
- Rivalry amongst existing competitors
- Threat of new entrants
- Bargaining power of buyers
- Bargaining power of suppliers
- Threats of substitute products/services

Some empirical Properties of Profit margins and Asset Turnover (to discuss in workshop)

- Profit margin reverts to the mean: due to price competition

- Total asset turnover ratio an the total leverage retios are stabe: these reatios are determined by
industry structure
- Trade-off between asset turnover and profit margin

We can characterise different firms and industries by the different trade-offs required between margins
and turnover. Determined by:
- Industry structure
- Firms strategy

Industry Structure: trade-off between asset turnover and profi margin

Industry Structure:
- Capital-intensive industries (which can be a carrier to entry), such as construction and heavy
equipment manufacturing, have low turnovers and therefore charge higher margins to get a
competitive return on their assets
- Commodity-like industries (discount retailers and fast food chais) with intense competition have
low margins and therfore must have high-asset turnovers to get a competitve return on their
assets

Business strategy
- A cost leadership strategy of produciing at lowest cost will have low prices and thus low margins
and high turnover
- A produc differentiation strategy with a premium product gives rise to market pricing power and
thus high margins and low turnover

Ex
LIMITATIONS OF RATIO ANALYSIS

- Biases and Random Errors in GAAP and Reported Accounting Numbers

+ Non-recognition of assets and liabilities
+ Random and Biased Measurement

- Effects of scale in the Denominator

+ Given the wide variation in firm size we ned to scale and this is the benefit of ratios
+ The problem with scaled variables and thus ratios is that the denominator is often a noisy proxy
for the true scale of the ariable of interest such as size

- Aggregation of non-homogenous divisions and subsidiaries

+ Financial ratios based on aggregated information may not be representatve of divisions and
indiviaul companies within the group (mask poor performnace)
+ There may be lack of uniformity in measurement of transactions (for ex fai and HC) making them
non-addictive

- Computed ratios may be biased because mgt is aware ratios will be computed and may try to
make them look good

Conclusions

The economic determinants of firm value ROIC is sales, margins and efficiency of capital ultilization
The return on sharehilders ROE will differ from ROIC due to leverage
Financial statement and ratio analysis can provide some insight into the value of the economic drivers
These returns are driven by competitive advs that enable companies to realise price premiums, cost and
capital efficiencies, or some combination of these
CAVEATS: ratios are only a guide they dont have provide answers
TUTORIAL