CH 3

Financial
Statement
Analysis &
Valuation Sixth Edition
Peter D. Easton
Mary Lea McAnally
Gregory A. Sommers
Module 3
Profitability Analysis and
Interpretation
© Cambridge Business Publishers, 2021

Learning Objective 1
Compute and interpret
return on equity (ROE).

Return on Equity (ROE)
▪ The most common analysis metric used by managers

and investors alike
▪ ROE relates net income to the average total
stockholders’ equity.
▪ ROE measures return from the perspective of the

company’s stockholders.
© Cambridge Business Publishers, 2021 4

ROE Calculated
ROE for the S&P 500 firms has ranged from 13.5% to
15.6% from 2014 to 2018.

S&P 500
▪ 500 of the largest U.S. publicly traded companies

▪ Accounts for about 75% of the U.S. stock market
capitalization
▪ U.S. based companies are selected for inclusion based
on market cap, industry, long-term profitability, and
trading volume.
▪ In 2019, Boston Scientific was #97 on the S&P 500 list.

Apply DuPont disaggregation
of ROE into return on assets (ROA)
and financial leverage.

Return on Equity
▪ Performance analysis seeks to uncover the drivers of

ROE and how those drivers have trended over time to
better predict future performance.
▪ Two methods to measure ROE drivers:
1. Traditional DuPont analysis that disaggregates ROE into
components of profitability, productivity, and leverage
2. ROE analysis with an operating focus that distinguishes
between operating and
nonoperating activities
Operating activities
drive shareholder
value

DuPont Disaggregation of ROE
▪ ROE reflects both

▪ Company performance (as measured by ROA)
▪ How assets are financed (as measured by Financial Leverage)
▪ ROE is higher when there is more debt and less equity

for a given level of assets.
▪ Tradeoff―greater debt means higher risk for the
company

Return on Assets
Income Statement
Balance Sheet
▪ Return on assets (ROA) measures return from the

perspective of the entire company (enterprise level).
▪ This return includes both profitability (numerator) and
total company assets (denominator).
▪ To earn a high ROA, the company must be profitable
and manage assets (hold the lowest level of assets
possible to achieve the desired profit).
▪ ROA analysis encourages managers to focus on both
the income statement and the balance sheet.
Return on Assets
Boston Scientific
Median ROA for S&P 500 firms:

▪ 6.1% in 2018
▪ Ranged from 5.2% to 6.1% from 2014 – 2018

Financial Leverage
▪ Financial leverage measures the
relative use of debt versus equity to
finance the company’s assets.
▪ Financial leverage is important
because debt is a contractual
obligation and a company’s failure to
repay principal or interest can result in
legal repercussions or even
bankruptcy.
Many ways to measure ▪ Higher financial leverage means
financial leverage: higher debt and interest payments.
Here: FL ▪ All else equal, higher financial
Later: FLEV leverage increases the probability of
default and possible bankruptcy.

Financial Leverage
Boston Scientific
Median FL for S&P 500 firms:

▪ 2.66 in 2018
▪ Ranged from 2.46 to 2.74 from 2014 – 2018

Accounts to Use to Compute ROE
ROE measures return to the common stockholders
Preferred Stock necessitates two adjustments:

1. Numerator: Subtract preferred dividends from
net income
2. Denominator: Subtract preferred stock from
stockholders’ equity

Accounts to Use to Compute ROE
ROE measures return to the controlling (parent

company) stockholders.
Noncontrolling interests: Must use the correct line items

1. Numerator: Use net income attributable to the
parent company’s stockholders
2. Denominator: Use equity attributable to the
parent company’s stockholders

Disaggregate ROA into
profitability and productivity
and analyze both.

Disaggregation of Return on Assets
What the company earns

on each sales dollar
Sales generated from each

dollar inv ested in assets
Managers can increase ROA by:

▪ Increase PM: increase profitability for a given level of assets
▪ Increase AT: reduce assets while still generating same profit level
Or Both

Putting It All Together

Analysis of
Profitability and Productivity

Analysis of Profitability
Gross Profit Margin
▪ = Gross profit / Sales
▪ Influenced by both the selling price of a company’s
products and the cost to make or buy those products
▪ Generally high and increasing gross profit margin is better
▪ Low or decreasing gross profit margin signals more
competition or less demand for the company’s products
▪ Competitive intensity has increased
▪ Product line has lost appeal
▪ Product costs have increased
▪ Product mix has changed
▪ Volume has declined and fixed costs have not

Analysis of Profitability
Operating Expense Margin
▪ Measures general operating costs for each sales dollar
▪ Consider each expense in whatever detail the company
provides in its income statement
▪ Compare margins over time and against peers (making
sure that peers have similar business models)

Analysis of

Analysis of Productivity
Sales
▪ Asset Turnover (AT) =
Average Total Assets
▪ Turnover =
Income statement item Natural
Average Balance sheet item linkage
▪ Working capital turnover ratios:
A/R turnover Inventory turnover A/P turnover
Sales COGS COGS

= = =
Average A/R Average Inventory Average A/P

Cash Conversion Cycle
▪ Cash conversion cycle is the average number of days to:
▪ Buy inventory on credit (accounts payable)
▪ Sell inventories of credit (accounts receivable)
▪ Collect the receivables
▪ Pay the accounts payable
365 365 365

DSO = DIO = DPO =
A/R turnover Inventory turnover A/P turnover
CCC = DSO + DIO – DPO

▪ Generally, companies prefer a lower cash conversion cycle
because then the operating cycle is generating profit and
cash flow quickly.
▪ Our analysis of this measure focuses on trends over time
and comparisons to peers (with similar business models).

Apple’s
▪ Apple carries little inventory as its products are pre-sold and

shipped when manufactured.
▪ Quick sales and relatively longer time to pay suppliers results
in a negative cash conversion cycle of (73.6) days.
▪ The negative number means that Apple can invest the
cash it receives from product sales for 73.6 days before that
cash is needed to pay suppliers.
▪ Apple generates profit from the sale and from investing its
cash.
▪ A negative cash conversion cycle is viewed positively.
Merck’s

Merck’s
Compare 2017 and 2018:

Merck’s
Compare 2017 and 2018:
▪ Trends for Merck are favorable

▪ TOO favorable?
▪ Beware of short-term improvement at the expense of longer-term
market position and supplier relations.

Analysis of PPE
Sales
PPE turnover =
Average PPE
Improving PPE turnover is not easy; it often entails:

▪ Divesting of unproductive assets or entire business lines
▪ Joint ventures to share assets such as distribution networks,
information technology, production facilities, transportation fleets,
and warehouses
▪ Selling production facilities with agreements to purchase finished
goods from the facilities’ new owners
▪ Sale and leaseback of administrative buildings

Analysis of

Analysis of Financial Leverage
▪ Judicial use of financial leverage benefits stockholders

▪ It is a relatively inexpensive source of capital
▪ But, adds risk because debt repayment is mandatory
▪ Analysis of financial leverage typically involves:

▪ The level of borrowed money relative to equity capital
▪ The level of profit or cash flow relative to required debt
payments
Total liabilities
Total liabilities to equity =
Total equity
Earnings before interest and tax

Times interest earned =
Interest expense, gross

Analyst Adjustments 3.1

Net Income
Return on Assets =
Average Assets
▪ Return on assets uses net income which includes the effects

of financing decisions.
▪ Managers who oversee assets rarely also control financing
decisions.
▪ Analysts adjust ROA to exclude effects of financing.
Net Income + (1 − tax rate) × Net interest expense
Adjusted ROA =
Average Assets
▪ Boston Scientific 2018:
▪ ROA = 8.35% Difference is minimal due to small net interest.


▪ Many balance sheets report small or negative equity
because of large stock buybacks.
▪ Small equity balances in the denominator inflates ROE.
▪ Negative equity balances arise when amounts spent for
stock repurchases exceeds the original contributed capital
from shareholders and make ROE negative and
uninterpretable.
▪ Analysts address this issue in two ways:
1. Use return metrics that are less sensitive to low or negative equity
(ROA or RNOA)
2. Compute ROE after adding back treasury stock. For example, for
Johnson & Johnson in 2018:

Identify balance sheet
operating items and compute
net operating assets.

Operating Focus to ROE Analysis
▪ ROE disaggregation with an operating focus recognizes

that companies create value mainly through core
operations
▪ The balance sheet and income statement include both
operating and nonoperating items.
▪ Return on assets in the traditional DuPont method, reflects
a blend of the return on a company’s operating assets and
its nonoperating return.
▪ Analysis can be improved if we separately identify the
operating and nonoperating components of the business
and their separate returns.

ROE
Operating Focus
ROE consists of two returns:
▪ Return from operating ▪ Return from financing and

activities investing activities
▪ Earned from operating ▪ Earned from nonoperating
assets & liabilities assets & liabilities

Financial Leverage
in Traditional DuPont
▪ Financial leverage in the traditional DuPont analysis is the
ratio of total assets to stockholders’ equity:
▪ Liabilities used in this computation include all liabilities.

▪ Liabilities = Borrowed money + Operating liabilities
▪ Loans/Bonds/Mortgages ▪ Accounts payable/Accruals

▪ Interest bearing ▪ Interest rate
▪ Sev ere legal repercussions ▪ Self-liquidating
▪ The operating focus ROE treats these two types of liabilities

differently for ROE analysis.
Return on Net Operating Assets
(RNOA)
Operating returns are measured by return on net

operating assets (RNOA).
Average NOA = NOA start of year + NOA end of year

2

Net Operating Assets
(NOA)
Operating Assets
= $20,853
Net Operating Assets

= $15,636
Operating Liabilities
= $5,217

Net Nonoperating Obligations
(NNA)
Nonoperating Assets
= $146
Net Nonoperating
Obligations
= $6,910
Nonoperating Liabilities
= $7,056

Appendix 3A

Identify income statement
operating items and compute
net operating profit after tax.

Net Operating Profit After Tax
(NOPAT)
NOPBT = Sales – Operating expenses

▪ Revenues
▪ Costs of goods sold (COGS)
▪ SG&A including wages, advertising, occupancy, insurance,
depreciation and amortization, litigation, and restructuring
expenses
▪ Research and development
▪ Impairments of operating assets such as goodwill
▪ Income from strategic investments (not marketable securities)—
including joint ventures, partnerships, and associated companies
▪ Gains and losses on asset disposals
▪ “Other” operating expenses or income
Boston Scientific’s Income Statement
NOPBT = $1,506

Net Operating Profit After Tax
(NOPAT)
▪ The amount in parentheses is called the tax shield, which are the
taxes that a company saves by having tax-deductible
nonoperating expenses.
▪ By definition, the taxes saved (by the tax shield) do not relate to
operating profits.
▪ Thus, we must add back the tax shield to total tax expense to
compute the tax on operating profit.
▪ Our starting point to determine tax on operating profit, is the
PRETAX net nonoperating expenses.
Pretax net operating expenses

= $241 – $156 = $85

Income tax expense

= (249)
A TAX BENEFIT !

Boston Scientific’s NOPAT
▪ Assume a 22% statutory tax rate

Appendix 3A


Compute and interpret
return on net operating assets
(RNOA).

Return on Net Operating Assets
(RNOA)
▪ RNOA measures operating returns
Average NOA = NOA start of year + NOA end of year

2

RNOA at Boston Scientific
Boston Scientific’s return on net operating assets (RNOA)

for 2018 is computed as follows:
RNOA for S&P 500 firms:

▪ 11.3% in 2018
▪ Ranged from 9.3% to 12.5% from 2014 – 2018

RNOA vs. ROA
▪ RNOA > ROA for two reasons:

▪ Numerator effect: NOPAT > Net income because of the after-
tax effect of nonoperating expenses, $66 million
▪ Denominator effect: Average NOA < Average assets because
NOA is net of operating liabilities & Assets includes
nonoperating assets

ROE and Financial Leverage
ROE = Operating return (via RNOA) + Nonoperating return

21.24% = 12.37% + 8.87%
Effects of nonoperating activities

~~ Financial Lev erage~~
Financial leverage quantifies risk associated with use of debt.

Appendix 3C
Liquidity and Solvency
Analysis

Perform vertical and horizontal
analysis.

Vertical and Horizontal Analysis
▪ Vertical analysis expresses financial statements in ratio form

▪ Income statement items: as a percent of net sales
▪ Balance sheet items: as a percent of total assets.
▪ Such common-size financial statements facilitate

comparisons across companies of different sizes and
comparisons of accounts within a set of financial
statements.
▪ Horizontal analysis is the scrutiny of financial data across
time.
(Current balance – Previous balance) / Previous balance
▪ We compare data across two or more consecutive periods
to analyze trends in company performance and to predict
future performance.
Limitations of Ratio Analysis
▪ Blindly analyzing numbers can lead to faulty
conclusions and suboptimal decisions.
▪ Must consider factors that limit usefulness of ratio
analysis
▪ GAAP limitations―current accounting rules omit many assets
▪ Company changes―mergers and divestitures as well as
changes in strategies can impair the comparability of
company ratios across time
▪ Conglomerate effects―Few companies are a pure-play;
consolidated statements are challenging to analyze
▪ Fuzzy view―Ratios reduce, to a single number, the myriad
complexities of a company’s operations. No scalar can
accurately capture all qualitative aspects of a company.
Financial
Statement
Analysis &
Valuation Sixth Edition
Cambridge Business Publishers

www.cambridgepub.com

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Financial

© Cambridge Business Publishers, 2021

© Cambridge Business Publishers, 2021

▪ The most common analysis metric used by managers

▪ ROE measures return from the perspective of the

© Cambridge Business Publishers, 2021 4

© Cambridge Business Publishers, 2021 5

▪ 500 of the largest U.S. publicly traded companies

© Cambridge Business Publishers, 2021 6

© Cambridge Business Publishers, 2021

▪ Performance analysis seeks to uncover the drivers of

© Cambridge Business Publishers, 2021 8

▪ ROE reflects both

▪ ROE is higher when there is more debt and less equity

© Cambridge Business Publishers, 2021 9

▪ Return on assets (ROA) measures return from the

Median ROA for S&P 500 firms:

© Cambridge Business Publishers, 2021 11

© Cambridge Business Publishers, 2021 12

Median FL for S&P 500 firms:

© Cambridge Business Publishers, 2021 13

ROE measures return to the common stockholders

Preferred Stock necessitates two adjustments:

© Cambridge Business Publishers, 2021 14

ROE measures return to the controlling (parent

Noncontrolling interests: Must use the correct line items

© Cambridge Business Publishers, 2021 15

© Cambridge Business Publishers, 2021

What the company earns

Sales generated from each

Managers can increase ROA by:

© Cambridge Business Publishers, 2021 17

© Cambridge Business Publishers, 2021 18

© Cambridge Business Publishers, 2021 19

▪ Product costs have increased

▪ Product mix has changed

▪ Volume has declined and fixed costs have not

© Cambridge Business Publishers, 2021 20

© Cambridge Business Publishers, 2021 21

© Cambridge Business Publishers, 2021 22

▪ Working capital turnover ratios:

A/R turnover Inventory turnover A/P turnover

Sales COGS COGS

© Cambridge Business Publishers, 2021 23

365 365 365

CCC = DSO + DIO – DPO

© Cambridge Business Publishers, 2021 25

▪ Apple carries little inventory as its products are pre-sold and

© Cambridge Business Publishers, 2021 27

Compare 2017 and 2018:

© Cambridge Business Publishers, 2021 28

Compare 2017 and 2018:

▪ Trends for Merck are favorable

© Cambridge Business Publishers, 2021 29

Improving PPE turnover is not easy; it often entails:

© Cambridge Business Publishers, 2021 30

© Cambridge Business Publishers, 2021 31

▪ Judicial use of financial leverage benefits stockholders

▪ Analysis of financial leverage typically involves:

Earnings before interest and tax

© Cambridge Business Publishers, 2021 32

© Cambridge Business Publishers, 2021 33

▪ Return on assets uses net income which includes the effects