Profitability Ratio Analysis

Profitability Ratios

ƒ Purpose:
– Provide insight about ability to generate income
ƒ Return on assets
= Net income + interest * (1 - tax rate)
Assets
ƒ Return on equity
= Net income / equity
ƒ Favorable vs. unfavorable financial leverage
– After-tax cost of debt vs. ROA and ROE.

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 Return on Equity
ƒ Simply stated:
ROE = Net income / equity
ƒ Fails to reveal underlying factors
» What is the contribution of operating activity to profitability?
» Can asset management improve profitability?
» Has debt financing provided favorable leverage?
» How have income taxes impacted profitability?
» What is the influence of non-operating activities on
profitability?
» Can the firm sustain its current level of growth?
ƒ Decompose to obtain an understanding.
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DuPont ROE

ƒ Decompose: ROE = Net income / equity

ƒ Into:
ROE = Return on sales
* Asset turnover
* Financial leverage
ƒ Analyze trends in the components
ƒ Critically examine both “good” and “bad”
performance.
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 Extended DuPont Analysis
ƒ Operations via a common-size analysis
ƒ Asset turnover
ƒ Financial leverage
– Interest expense
– Debt vs. equity proportions in the balance sheet
ƒ Tax effect
ƒ Unusual items effect
ƒ Discuss using handout example.

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Common-Size
Income Statement

ƒ Usefulness:
– Are the company’s margins consistent with its
stated competitive strategy?
– Are the company’s margins changing? Why?
What are the underlying causes?
– Is the company managing its overhead and
administrative costs well? What are the
activities driving these costs? Are the activities
necessary?

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 Efficiency in Managing Assets
ƒ Detailed analysis reveals effectiveness of
investment management
– Use turnover ratios
ƒ Two primary areas:
– Net working capital management
» Receivables, inventory, payables
» Support normal operations
– Long-term asset management
» Assets generate long-term earnings.

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Turnover Ratios
ƒ Purpose:
– Measure efficiency in managing assets
ƒ Definition:
– Sales / asset
ƒ A slight digression:
» Assume total assets
= Cash + receivables + inventory + fixed assets
$1,000 = $100 + $300 + $200 + $400 & sales = $5,000
ƒ Calculate turnover ratio for each component
Questions:
» Are the ratios additive for the components?
» Interpretations?
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 Net Working Capital Management

ƒ Net current assets / sales

= (Cash + marketable securities) / sales
+ Accounts receivable / sales
+ Inventories / sales
+ Prepaids / sales
- Accounts payable & accruals
ƒ 1 / (Net current assets / sales)
= Sales / net current assets
= Turnover of net current assets.
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Turnover: Receivables Issues

ƒ How well does the company manage its

credit policies?
ƒ Are these policies consistent with its
marketing strategy?
ƒ Is the company artificially increasing sales
by loading distribution channels?

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 Turnover: Inventory Issues

ƒ How well does the company manage its

inventory?
ƒ Does the company use modern manufacturing
techniques?
ƒ What is the underlying business reason for change
in inventory ratios?
ƒ Are new products being planned?
ƒ Is there a mismatch between demand forecasts and
actual sales?

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Long-Term Asset Management

ƒ Long-term assets / sales

= Gross fixed assets / sales
- Accumulated depreciation / sales
+ Other long-term assets / sales
ƒ 1 / (Long-term assets / sales)
= Sales / long-term assets
= Turnover of long-term assets.
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 Long-Term Investment Issues

ƒ Is investment in plant and equipment consistent

with the competitive strategy?
ƒ Does the company have a sound policy of
acquisitions and divestitures?
ƒ How is product quality affected?
ƒ What is the estimated age of the assets?
» Gross fixed assets / depreciation expense
» Accumulated depreciation / depreciation expense
» Net fixed assets / depreciation expense.

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Operating Return on Assets

ƒ Operating return on assets before taxes is:

– EBIT / assets
ƒ It is also the product of:
– Operating return on sales = EBIT / sales
– Asset turnover ratio = Sales / assets
ƒ Note:
– All financing costs are excluded from EBIT
– Taxes have been excluded from EBIT
» Show a separate tax effect later.

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 Financial Leverage Effect

ƒ Financial leverage increases ROE if rate of return

earned on the invested funds > cost of debt financing
ƒ However, financial leverage increases risk of
financial distress
ƒ Debt obligations have priority over equity payments
ƒ Financial leverage consists of two components
» Interest expense multiplier
» Balance sheet financing multiplier

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Interest Expense Multiplier

ƒ Defined as:
1 - (interest expense) / (operating earnings)
or as 1 - (interest expense) / EBIT
or as (EBIT - interest expense) / EBIT
or as EBT / EBIT
ƒ Interpretation:
– The proportion of $1 of operating earnings (before
interest expense) that is left after paying interest.

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 Balance Sheet
Financing Multiplier
ƒ Financial leverage = Assets / equity
ƒ But, Assets = Debt + Equity
Thus, Assets / equity = (Debt / equity) + 1
ƒ Assets / equity
= Current liabilities / equity
+ Long-term debt / equity
+ Other LT liabilities / equity
+ Preferred stock / equity
+ 1.
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Joint Financial Leverage Effect

ƒ Defined as the product of:

– Interest expense multiplier
– Balance sheet financing multiplier
ƒ Interpretation of joint effect:
– Positive financial leverage if product > 1
– Negative financial leverage if product < 1.

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 W.T. Grant’s
Management of Financial Leverage

1974 1973 1972 1971 1970

Assets/Equity 3.962 3.410 2.983 2.762 2.531
CL/Equity 1.761 1.544 1.145 1.246 1.025
LTL/Equity 0.697 0.389 0.406 0.110 0.127
Other/Equity 0.480 0.451 0.403 0.373 0.338
Preferred/Equity 0.024 0.026 0.029 0.033 0.041
Equity/Equity 1.000 1.000 1.000 1.000 1.000
Accounting identity: Assets = Liabilities + equity

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W.T. Grant’s
Interest Rate Environment

9
8
7 Jan. ‘74 Jan. ‘70
Jan. ‘73
6
5 Jan. ‘69
Jan. ‘71
% 4
3 Jan. ‘72
2
1
0
0 2 4 6 8 10 12 14 16 18 20
Years
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 Income Tax Multiplier

ƒ Income tax multiplier

– Defined as:
1 - (income tax) / (pretax income)
or as (EBT - income taxes) / EBT
or as NI / EBT
ƒ Interpretation
– The proportion of $1 of pretax income left after
paying income tax.

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ROE: Excluding Unusual Items

ƒ ROE is the product of:

– Operating return on sales
– Asset turnover ratio
– Joint interest & financial leverage multiplier
– After income tax multiplier
ƒ By excluding unusual items
– Better fix on profitability of normal operations.

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 Effect of Unusual Items

ƒ Restructuring charges, extraordinary

gains/losses, etc... can seriously change ROE
ƒ Adjusting ROE for these items lets you see
the impact of nonrecurring items
ƒ Although not unusual, an adjustment for
preferred dividends is necessary
– Why?
» Preferred shareholders are not residual owners of the
business.
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Background for
Sustainable Growth

ƒ Sustainable growth relies on:

Return on equity
Dividend policy.

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 Sustainable Growth
ƒ Definition:
– Growth the firm can sustain
» Without issuing new equity
» Maintaining current financial policies
ƒ Based on “sources” = “uses” concept
ƒ Formula:
Growth = Retention ratio * ROE .
1 - (Retention ratio * ROE)
ƒ Compare: Sustainable growth vs. actual growth.
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An Example
LY TY LY TY
Assets 200 330 Sales 400 700
Debts 40 80 Costs 300 550
Equity 160 250 Profit 100 150
Sales growth = 75% Dividends 40 60
Asset growth = 65% Retained 60 90
Growth = Retention ratio * ROE .
1 - (Retention ratio * ROE)
= .60 x .625/[1 - .60 x .625] 60.0%
= .60 x .60/[1 - .60 x .60] 56.3%
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 W.T. Grant’s
Sustainable Growth
1974 1973 1972 1971 1970
Return on sales .004 .023 .025 .031 .034
Inverted asset turnover .677 .675 .687 .644 .584
Financial leverage 2.962 2.410 1.983 1.762 1.531
Retention rate -1.542 .444 .402 .477 .532
Sustainable growth -.038 .054 .046 .068 .085
Actual growth (sales) .125 .196 .096 .036 .096

Formula: Sustainable growth = ROS * Retention Rate * Assets/Equity .

Assets/Sales - ROS * Retention Rate * Assets/Equity
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Inflation-Adjusted Statements

Important considerations:
– Inflation sensitivity of assets and liabilities
– Old assets vs. relatively new assets
– Price vs. volume gains
– Productivity gains?

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 W.T. Grant’s Inflation
Management Performance
As Reported Adjusted
Sales 1,849,802 1,849,802
Cost of sales 1,163,998 1,300,000 Õ
Depreciation 13,579 17,282 Õ
Other expenses 623,646 623,646
Operating earnings 48,579 -91,126
Interest expense 7,033 7,033
Taxes 787 787
Net income 3,778 -135,927
Dividends 21,122 21,122
Retained earnings -12,693 -152,398
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The End

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