The lemon dilemma in the used car market is mainly caused by the effect of an informed

seller and uninformed buyer. It occurs when there is information asymmetry as sellers of
the used cars are better informed than the buyers (car shoppers) regarding the quality of
the used car for sale, but sellers are not able to credibly communicate information about
the quality of their car. Hence car shoppers are not able to distinguish between the “good”
and
“bad” used cars. This is because of the third-party intermediary (salesperson) who
communicates and deals with potential car buyers directly instead of the used car owner,
which would increase the risk of information asymmetry since the seller (used car owner)
who knows the actual quality, would have more relevant information held as compared to
the salesperson. As such, car shoppers who are not aware of the quality of the car as they
deal via the salesperson, will not be willing to pay as much as the actual value of the car in
good repair. The undervaluing of the existing good used cars and unattractive financial
terms will potentially break down the functioning of the capital market as the ‘lemon’ cars
crowd out the well-handed cars.

Capital market intermediaries, in general, help to prevent market breakdown by providing

service and skill sets in investments to minimize the lemon dilemma, thereby increasing
information transparency among investors. This helps to improve potential investors’
understanding of a firm’s current performance and future prospects, allowing them to
distinguish the “good” and “bad” investments before making investing decisions. However,
during the dot-com bubble of 2000, the information and expertise asymmetry, including
potentially conflicting interests among capital market intermediaries, led to an overinflated
market (internet stock market bubble). In a well-functioning market, it allows the channeling
of financial resources from individuals who have savings that they want to invest, to
companies who need the capital to finance and expand their business. However,
information gap exists between investors and companies since investors usually do not have
enough information or expertise to determine the good investments from the bad ones and
companies usually do not have the infrastructure and know-hows to directly receive the
capital from investors.

There are several key players within the capital market intermediaries, such as venture
capitalists whose purpose is to provide high rate of return to investors according to the
associated risk through screening good business ideas from bad ones. The main form of
compensation for venture capitalists would be a significant share of profits in addition to a
relatively low fee based on the assets under management. However, they had invested in
public companies that did not have sound business models and/or had not proven
themselves operationally. For instance, in general, companies would not go public until they
have shown profits for at least 3 quarters. However, one of the companies among the rapid
wave of new internet companies, Netscape, became the industry standard and its
tremendous gain in popularity as it was a new internet company, prompted the company to
go public on the stock market even before being profitable.

At first, firms in a new sector such as the IT may seem identical to an uninformed bystander,
while some “insiders” may have better information about the future profitability of such
firms. There was no sign that they had secure revenue streams or long-term strategies to
ensure sustainability in the long run. Furthermore, they did not foster newly formed
companies and ensured that they were well functioned by monitoring and guiding with their
expertise, before going public. Even though many of the dot-com stocks were highly
unprofitable and went launching initial public offerings before gaining any profit as they
spent significant amounts on advertisements, the euphoria of the market caused the stocks
to skyrocket in value from the first day of trading. Firms with lower than average
profitability will therefore be overvalued and more inclined to finance new projects by
issuing their own shares as compared to high profitability firms which are undervalued by
the market. In addition, venture capitalist were unduly influenced by the general public
market consensus such as the public’s expectations of high stock market valuations and
wanted to capitalize on the growing opportunity, which led to them making speculative
investments without taking caution instead of performing their intended role effectively,
which is using their expertise to monitor the stock market.

Entrepreneurs relied on investment banks in the actual process of doing an initial public
offering (IPO), facilitating the gaining of capital from investors in the market. Its intended
role would be to provide advisory financial services, underwriting of shares, pricing of
offerings and banks were paid on a commission basis, depending on the amount of money
that the company managed to raise in its offering, which is typically 7%. Since their earnings
are tagged directly to the initial public offerings, there may be misaligned incentives that
causes the failure in their intended role to provide expertise.

The role of accountants as part of the information intermediaries, did not manage to include
the going concern clause that the company may not be able to remain in operation for the
next 12 months, for the dotcoms that subsequently went bankrupt. There may be a
misalignment of incentives in the system as auditors receive auditing fees (payment) from
the same company that they are evaluating and providing an audit opinion as to whether
the FS provide a true and fair view. The public who contributed significantly into the capital
market and saw the rapid increase in prices fueled the enthusiasm of investors that were
not supported by fundamental reasons and encouraged more trading as they gain
confidence. As a result, low profitability firms tend to grow more rapidly, and the stock
market will initially be dominated by “lemons”. When uninformed investors eventually
discover their mistake, share prices fall and the IT bubble bursts.

The five-forces framework analyses five competitive forces that shape every industry, which
can be used to determine the reasons behind Adidas’ high profitability in 2017. Even though
the barriers to entry in the sportswear industry are high, with main competitors such as
Nike, Under Armour and PUMA, it managed to find its place and retain majority of the profit
in the industry by concentrating operations in its least competitive segments. In this case,
Adidas competes primarily on brand image rather than price, such that customers are
willing to pay higher prices for the superior product quality that they are attracted to
because of the brand image.

Rivalry among existing firms

The greater the degree of competition among firms in an industry, the lower average
profitability is likely to be.

Industry growth rate

The concentration of the sportswear industry is relatively high. There are many players that
compete on a global basis and the key players in the market hold dominant shares of the
market. Due to low degree of fragmentation, there is minimal price wars among
competitors to gain market share. (Balance of competitors)

Degree of differentiation and Switching costs: There is product differentiation such as the
type of technology used on a shoe but generally, these differences do not reduce the level
of competition within the industry, switching cost encouraging buyers to look for the lowest
price.
Scale/learning economies
Ratio of fixed to variable costs
High fixed costs eg , low variable cost of materials and labor,

Excess capacity
Shoes that may be subjected to inventory obsolescence when it is no longer in trend, hence
there will be periods of excess capacity where Adidas will cut prices to clear stock.

Exit barriers

Threat of new entrants

The threat of new entrants can force firms to set prices to keep industry profits low. The
threat of new entry can be mitigated by economies of scale, first mover advantages to
incumbents, greater access to channels of distributions and existing customer relationships,
and legal barriers to entry.

The barriers to entry in the sportswear industry are high, with existing main competitors
such as Nike, Under Armour and PUMA. There is a high initial upfront capital required to
design and develop products, manufacture products while ensuring quality and affordability,
distribute products through appropriate distribution channels. In the sportswear industry, it
is critical to develop strong brand awareness and requires a substantial amount of
craftsmanship and creativity. Hence, it takes many years to achieve the scale and market
share that the current market giants enjoy.

The threat of new entrants is restricted by limited access to adequate distribution channels,
valuable brand name created by Adidas, and its expertise in design and development. While
sportswear is relatively inexpensive and easy to make given the large number of
independent manufacturers, a sportswear manufacturer would have difficulty finding a
distributor that could get its products to retail stores and placed in desirable shelf space.
The high levels of advertising that Adidas has invested in, including sponsoring contracts
with celebrity athletes and collaborations with non-athlete celebrities such as Kanye West,
have created a highly valued, universally recognized brand which would be difficult for a
potential competitor to replicate.

Threat of substitute products

The threat of substitute products can force firms to set lower prices, reducing industry
profitability. The importance of substitutes will depend on the price sensitivity of buyers and
the degree of substitutability among the products.

In recent years, there has been an increasing interest in sports and being mindful of one’s
health, which has contributed to the rapid growth of the sportswear industry due to strong
consumer demand. There are alternative innovative brands that places emphasis on
consumer trends and demands, but customers may continue to opt for sportswear based on
Adidas’ strong branding and functionality that has garnered the public’s trust in the
sportswear industry, such as the Boost technology that changed the game in the footwear
industry. The opening of Adidas’ production facilities closer to its consumers as a strategy to
be more responsive to the rapid changes in consumer trends and demands will also help the
company in appealing its image to customers by positioning itself as a friendly and loyal
sportswear brand located in the neighbourhood. There is low switching costs and buyers
may be price sensitive if products are undifferentiated in general.

Low bargaining power of buyers

The greater the bargaining power of buyers, the lower the industry’s profitability. Bargaining
power of buyers will be determined by the buyers’ price sensitivity and their importance to
the individual firm. As the volume of purchases of a single buyer increases, its bargaining
power with the supplier increases.

Low bargaining power of suppliers

The greater the bargaining power of suppliers, the lower the industry’s profitability.
Suppliers’ bargaining ability increases as the number of suppliers declines when there are
few substitutes available. Adidas’ valuable brand name and the great demand for the
company’s products improve the company’s bargaining power over its distributors (retail
stores). Furthermore, Adidas operates its own stores in an increasingly large number of
cities around the world.

Adidas also makes money by licensing other companies to produce and distribute products
under Adidas’ brand name. The sport licensing business tends to be highly competitive,
which allows Adidas to have substantial bargaining power over licensees.

Adidas chose to outsource its production to manufacturers located throughout the world.
Since Adidas had made large investments in licensed independent companies across
countries, it would have a significant supplier network, offering it the flexibility of choosing
among a large number of manufacturers. By entering into contracts with independent
manufacturers, it is highly likely that Adidas would be the manufacturer’s sole customer. As
a big company that operates internationally, it would be able to obtain cheaper prices
through larger quantities (bulk buying). This would allow Nike to have substantial bargaining
power in its dealings with its suppliers, keeping input costs to a minimum.

By moving towards more in house production and design, it will improve the speed in which
Adidas can bring new products to the markets, a concept which is similar to fast-fashion
retailers. Hence, even though it may appear at first glance that this change will result in
Adidas capturing a smaller part of the margin, Adidas’ primary objective of this change is to
improve product differentiation to better meet customer demands, which is likely to help
Adidas in boosting its profitability margins.
Depreciation of fixed assets
Estimates about economic useful lives and residual values

Fair value of assets acquired and liabilities assumed due to M&A

Estimation of fair value sometimes requires significant judgment

Impairment of intangible assets

Impairment testing strongly relies on assumptions about future cash flows and discount
rates

Under the assumption that the lease payments in the sixth and subsequent years are equal
to the lease payment in the fifth year, the present value of the operating leases using a 7.5%
discount rate is as follows:
FV = PV (1+i)^n
PV = FV / (1+i)^n
Eg 1218/(1+7.5%)^1

3,754/4 years = 938.50 (FV)

8,450 – 1218 /938.50 = 7.71 = 7 years
8450 – 1218 – (7 x 938.50) = 662.50 (FV)
Year 2016 (FV) 2016 (PV)
1 1,218 1,133.02
2 938.50 938.5/(1+7.5%)^2 = 812.11 (2dp)
3 938.50 755.46
4 938.50 702.75
5 938.50 653.72
6 938.50 608.11
7 938.50 565.69
8 938.50 526.22
9 662.50 662.50/(1+7.5%)^9 = 345.55 (2dp)

Total PV = 6102.63
Optimal inventories = 45 days x (2553/52 days) = 2209 million
Excess inventory = 2553 million – 2209 million = 344 million
344million x 50% = 172 million

Adjustments
Balance Sheet Assets Liabilities
Inventories 344 x 50% = -172
Deferred Tax Liability 30.5% x 172 = -52

Ordinary Shareholders’ Equity 172-52 = -120

Income Statement (Adjustments)

Cost of Sales +172
Tax Expense (30.5%) -52
Net Profit -120
Net operating profit margin: NOPAT/Revenue or Sales x 100
Net operating asset turnover: Revenue or Sales/Net Operating Asset or Biz Asset
Operating ROA = Net operating profit margin x Net operating asset turnover
ROA + (NIPAT/Investment Assets)

Spread = Return on invested capital (ROIC) or ROA – Effective interest rate after tax
Effective interest rate after tax = interest expense after tax / debt
A = L+OE OE = A – L = Business Assets – Net Debt
Financial Leverage (Alternative Method) = Debt/Equity = 25,840/(36194-25840)
UK/US: set aside pension fund for permanent employees (estimate how much ee will stay)
Compensation linked to firm performance, motivation, possibility of large sh acting at the
exp of small sh, not doing well approaching threshold of violating covenant motiv to choose
less accurate accounting strategy to boost numbers.

Information that we want to see: Described compensation roughly or in detail. Inform us

how they actually recognize revenue according to rules & regulations or just saying abiding
by certain regulations.

Po
tential red flags that needs to be analysed further
(gather info from other public resources to see if these are really problems. If yes, adjust
accounting numbers accordingly. If no, use accounting numbers directly.)

There is a reduction in the allowance for uncollectible receivables but there is increased
trade receivables & liability for deferred revenue (more uncollected revenues should
increase allowance, co is doing opp)
Related party transactions: Direct & Indirect costs (Are numbers given more explanations or
lump sum) question material lump sum (large controlling sh issue?)

Sig tax loss carry forward, bigger than revenue amount (firm not using it, assuming that it
can carry forward forever – can choose any year they want to realise it) potential for firm to
manipulate the numbers at the years that they want to recognize this number to reduce
cost or increase profit.

Step 6: Recast FS and undo acc distortions

More condensed financial statements with fewer items (easier to make use in future to
calculate financial ratios or forecasting for the future) If potential red flags even after
analyzing cannot be removed, we will undo accounting distortions.

3 challenging areas that will lead to distortion of asset value.

Lease – can belong to the lessee or lessor

Firm can spend a lot on R&D but no one can predict for sure how much benefits the R&D
investment can bring to the firm.
How do we adjust the numbers if the resource values have changed (valuation of properties,
write-downs) some values of the assets are easier to estimate because there is a second
hand market where theres more transactions and we can rely on the market information.
Some assets are more specialized and only a few firms would have this high value and
specialized asset then it is hard to find secondary market, market information for us to refer
to.
Whether the firm has incurred a liability, whether amount and timing can be measured
easily
A=L+E

Uncertainty of when the options will be exercised, how much will be exercised, will it be
exercised. Convertible bond owners can decide how much to convert, when to convert,
whether they want to convert or not. Distortions when these questions cannot be answered
with certainty.

In reality, we don’t see all types of distortions because even if some items are distorted, it
accounts for too little % of firm’s performance. Typical examples seen in reality:
- Depreciation & Amortisation (Firms in the same industry have the flexibility to
choose their depreciation policy: how many years for assets to be used, residual
value)
 To see if firm is using a depreciation policy that is too aggressive on the impact of
its financial numbers.
64.03% x 12 = 7.68yrs
Dep Rate = Cost/Useful Life

Aircraft cost 22,486 Reported

Original depreciation rate 7.08% (1-0.15)/12 x 100
New depreciation rate 3.8% (1-0.15)/25 x 100
Revised accumulated depreciation 1/1/12 6,566 7.684 x 3.8% x 22,486
Accumulated depreciation 1/1/12 12,238 Reported
Reduce annual depreciation rate by 50%, accumulated dep will be reduced by 50%.

Adjustments to 2011 & 2012 BS & Income Stm:

*Asset value should now be higher than originally reported (less depreciation now)
Annual expense numbers (Annual dep exp dropped due to lower dep rates, more net
income of the firm, more shareholders’ equity through retained earnings) Less
annual dep exp  Firm will defer tax payment to the future (Tax rate: 25%)
*Allocate to DTL and SE, balance the balance sheet even after adjustments

Adjustments (2011)
Balance Sheet Assets Liabilities
Non-Current Tangible Assets 12,238 – 6,566 = + 5,672

Deferred Tax Liability 5,672 x 25% = + 1,418

Shareholders’ Equity 5,672 x (1-25%) = + 4,254
 Balance sheet is accumulated hence 2011 adjustments will be carried forward to
2012. Lower dep cost leads to increase in Assets.
Adjustments (2012)
Balance Sheet Assets Liabilities
Non-Current Tangible 12,238 – 6,566 = + 5,672
Assets
[22,486 + (1,902/2)] x (7.08% - 3.8%)
= + 769
Deferred Tax Liability 5,672 x 25% = + 1,418
769 x 25% = + 192
Shareholders’ Equity 5,672 x (1-25%) = + 4,254
769 – 192 = + 577

Income Statement (2012) – only for that year, annual number.

Cost of Sales -769
Tax Expense (DTL) +192
Profit or Loss (SE) +577
Lower dep rates, record less dep exp, cost of sales will be reduced.
Cost is lower, taxable income is higher

Similar to tb pg 123

- Off-balance sheet operating leases: Operating leases are not contained in the assets
(for some firms it will be a small part of the assets but for others, it could be big
portion of the assets)  Is it accurate for the firm to classify the lease as operating
lease?
Capitalising of Operating Leases

Financial Lease (Loan) 165 = Principal: 67 (PV) Interest: 165-67= 98

Total PV = Borrowed amount = 1,225
Interest rate = Interest/Principal = 98/1,225 = 8%

PV = FV/(1+i)^n
2,457/4 = 614.25 2,155/4 = 538.75
(5,789 – 768)/614.25 = 8 (5,251 – 687)/538.75 = 8
5,789 – 768 – (8*614.25) = 107 5,251 – 687 – (538.75 x 8) = 254

Year 2014 (FV) 2014 (PV)@7.5% 2013 (FV) 2013 (PV) @7.5%
1 768 714.42 687 639.07
2 614.25 531.53 538.75 466.20
3 614.25 494.45 538.75 433.67
4 614.25 459.95 538.75 403.42
5 614.25 427.86 538.75 375.27
6 614.25 398.01 538.75 349.09
7 614.25 370.24 538.75 324.73
8 614.25 344.41 538.75 302.08
9 614.25 320.38 538.75 281.00
10 107 51.92 254 123.24
5,789 4,113.17 5,251 3,697.77
 Use the PV values to make the adjustments for 2013 & 2014.

Similar to tb pg 125
 - Immediate expensing off of intangible assets (R&D): Some firms deem R&D will not
bring benefit for the firm hence they expense them off directly. However, maybe it
should be an asset of the firm. (Capitalising of R&D)

Expected life of 3 years, only half a year amortization is taken on latest year’s spending
Start from 2010 to 2014 (Half of amortization / Useful life)
Whatever not amortised will be capitalized.
Year R&D Proportion Asset Proportion Expense
Outlay Capitalized Amortized
2010 3.1 1-(0.5/3) 2.583 0.5/3 0.517
2011 (Full Yr Amortisation) 1-(0.5/3)-1/3 1.55 1/3 1.033
2012 1-(0.5/3)-1/3-1/3 0.517 1/3 1.033
2013 0.5/3 0.517
2014

Year R&D Proportion Asset Proportion Expense

Outlay Capitalized Amortized
2011 2.9 1-(0.5/3) 2.417 0.5/3 0.483
2012 1-(0.5/3)-1/3 1.45 1/3 0.967
2013 1-(0.5/3)-1/3-1/3 0.483 1/3 0.967
2014 0.5/3 0.483

Year R&D Proportion Asset Proportion Expense

Outlay Capitalized Amortized
2012 3.0 1-(0.5/3) 2.5 0.5/3 0.5
2013 1-(0.5/3)-1/3 1.5 1/3 1
2014 1-(0.5/3)-1/3-1/3 0.5 1/3 1
2015 0.5/3 0.5
 Year R&D Proportion Asset Proportion Expense
Outlay Capitalized Amortized
2013 3.2 1-(0.5/3) 2.667 0.5/3 0.533
2014 1-(0.5/3)-1/3 1.6 1/3 1.067
2015 1-(0.5/3)-1/3-1/3 0.533 1/3 1.067
2016 0.5/3 0.533

Year R&D Proportion Asset Proportion Expense

Outlay Capitalized Amortized
2014 3.6 1-(0.5/3) 3 0.5/3 0.6
2015 1-(0.5/3)-1/3 1.8 1/3 1.2
2016 1-(0.5/3)-1/3-1/3 0.6 1/3 1.2
2017 0.5/3 0.6

Compile all 2013 figures according to respective R&D outlay

Year R&D Proportion Asset Proportion Expense
Outlay Capitalized Amortized
2014 3.6
2013 3.2 1-(0.5/3) 2.667 0.5/3 0.53
2012 3.0 1-(0.5/3)-1/3 1.52 1/3 1
2011 2.9 1-(0.5/3)-1/3-1/3 0.483 1/3 0.96
2010 3.1 0.5/3 0.51
Total 4.67 3.00

Compile all 2014 figures according to respective R&D outlay

Year R&D Proportion Asset Proportion Expense
Outlay Capitalized Amortized
2014 3.6 1-(0.5/3) 3 0.5/3 0.6
2013 3.2 1-(0.5/3)-1/3 1.6 1/3 1.067
2012 3.0 1-(0.5/3)-1/3-1/3 0.5 1/3 1
2011 2.9 0.5/3 0.483
2010 3.1
Total 5.13 3.14

Adjustments (2013)
Balance Sheet Assets Liabilities
Non-Current Tangible +4.67
Assets
Deferred Tax Liability 25% x +4.67 = 1.1675
Shareholders’ Equity 4.67 – 1.1675 = 3.5025

2013 R&D outlay of 3.2 we don’t want to expense off directly, hence minus the amount.

Income Statement (2013 Adjustments)

Other Operating Expenses -3.2
Other Operating Expenses +3
 Tax Expense (3.2 – 3) x 25% = 0.05
Profit or Loss (3.2 – 3) x 75% = 0.15

Adjustments (2014)
Balance Sheet Assets Liabilities
Non-Current Tangible +5.13
Assets
Deferred Tax Liability 25% x 5.13 = 1.2825
Shareholders’ Equity 75% x 5.13 = 3.8475

Income Statement (2014 Adjustments)

Other Operating Expenses -3.6
Other Operating Expenses +3.14
Tax Expense (3.6 – 3.14) x 25% = +0.115
Profit or Loss (3.6 – 3.14) x 75% = +0.345

Revenue Recognition and Sales of Receivables

3.35 billion that was not sold to customers  need to decrease trade receivables, increase
inventory (*cost of sales to sales ratio to infer rs between trade receivables & inventory)
Tax rate: 35% Since revenue should not be recognized, we decrease taxes and SE
($billions) Adjustments (2001)
Balance Sheet Assets Liabilities
Trade Receivables -3.35
Inventories 3.35 x (5,454/18,139) = +1.00
Deferred Tax Liability (3.35-1) x 35% = -0.82
Ordinary Shareholders’ (3.35-1) x 65% = -1.53
Equity

Income Statement (2001 Adjustments)

Sales -3.35
Cost of Sales -1.00
Tax Expense -0.82
 Net Profit -1.53
Write-downs and Impairment: Does the firm delay the write-downs for some reason?
Eg Impairment of current assets (*reduce asset value, increase cost of the year)

a. Optimal inventories: 40 days x (5,946/44days) = 5,405 million

Excess inventory = 5,946 million – 5,405 million = 541 million

b.
($billions) Adjustments to FS
Balance Sheet Assets Liabilities
Inventories 50% x 541 = -271
Deferred Tax Liability -271 x 30% = -81
Ordinary Shareholders’ -271 x 70% = -190
Equity

Income Statement (Adjustments)

Cost of Sales +271
Tax Expense -81
Net Profit -190
Impairment of non-current assets (Goodwill)

1. Reduce asset value by impaired amount, impact on IS: Increase cost (tax rate
50%)
($billions) Adjustments to FS
Balance Sheet Assets Liabilities
Non-Current Intangible Assets -1.410
Deferred Tax Liability -1.410 x 50% = -0.705
Shareholders’ Equity -1.410 x 50% = -0.705

Income Statement (Adjustments)

Other Expenses +1.410
Tax Expense -0.705
Net Profit -0.705

2. No impact, goodwill will not be amortized/depreciated, thus would not have any
impact on annual depreciation expens (Don’t amortize goodwill, only
impairment)
 Allowances and Provisions: Firms should not change the numbers without proper
justification  If they do so, need to readjust the numbers.

*Past due on the reporting date

Increase allowance, impairment on trade receivables (reduced)
i.
($billions) Adjustments (2013)
Balance Sheet Assets Liabilities
Trade Receivables 20% x 4,764 = -953
Deferred Tax Liability 30.7% x 952.80 = -292
Ordinary Shareholders’ Equity 69.3% x 952.80 = -660
ii.
Allowances 2014
Beginning Balance 1,344 + 953 = 2,297
+ Currency translation adjustments 15
+ Provisions/Allowance 2,775 – 15 - (-410) – (222) – 2,297 = 1,095
(additions to estimation amount) (Balancing Figure)
+ Use (410)
+ Reversal (222)
= Ending Balance 1,368 + (20% x 7,036) = 2,775

Income Statement (Adjustments for 2014)

 Cost of Sales 1,095 – 641 = +454
Tax Expense 454 x 30.7% = -139
Net Profit 454 – 139 = -315
Ratio Analysis:
- DuPont Analysis: Easy to calculate but it only tells us the Net Profit Margin ratio &
total asset turnover, did not distinguish between the different assets owned by the
firm (assets mainly for operations/assets for investment purposes) Financial leverage
tells us the level of borrowing that the firm engages but it does not inform us
whether an increase or decrease in the value is good for the firm. When a firm
engages in borrowing, it will incur interest which is a cost to the firm. The higher the
leverage, the higher the cost. If the firm engages in increasing debt/liability, can the
firm generate enough to even cover cost? DuPont can’t answer.  Alternative ROE
Decomposition

ROE is a comprehensive measure of and is a good starting point to systematically analyse

firm performance. (profitability)
ROA: Profit generated by the firm based on per dollar of asset owned by the firm
The higher the asset turnover, the higher the revenue the firm is able to generate/utilizing
asset.

Asset Turnover: For every $1 of assets own by the firm, it generates $xx.
Financial Leverage: Total Asset to Total Equity
Return on sales (ROS) is a ratio used to evaluate a co's operational efficien. (Net profit
margin)
Spread = Return on invested capital (ROIC) – Effective interest rate after tax
NPM trend: decreasing, 2014 bad year due to losses & bad performance hence -ve value
Asset turnover is stable around – range, fluctuates a bit.
Compared to net profit margin, asset turnover did not impact firm’s ROE that much.
Financial leverage fluctuates, increase & decrease in 20xx.
Firm is in rising trend in terms of using financial leverage but does that contribute +ve/-ve to
firm’s ROE? Cant say for sure. ROE is decreasing a lot. Not a good trend for the firm.

2; Traditional method using reported numbers (DuPont Analysis)

Net Profit Margin = Profit or Loss/Revenue
Asset Turnover = Revenue/Total Assets (Reported)
Total Assets/Equity (Ordinary shareholders’ equity)

3; Alternative ROE dec to answer more queries (increasing use of financial lev – good or
bad?)

ROA is decreasing, operating activities contributes to it.

Return on investment assets is decreasing not as much, lower fluctuation compared to the
return on operating assets

Weight of Operating Assets & Investment Assets = 1.0

Spread tells us whether firm is generating positive returns or losses due to utilization of
debt. Only 2013 is positive spread, which means that the return on invested capital is higher
than interest expense. 3 years -ve values, returns generated by the firm is not even enough
to cover interest expense. Firm is increasing the usage of financial leverage over the years,
worsen the effect as interest expense increase. ROE formula: if financial leverage gain is
negative, financial policy or decision made by the firm is making it worse off. Reconsider
firm capital structure, consider reducing the use of leverage until spread becomes positive.
(Able to get from alternative not traditional DuPont Analysis)