CHAPTER III:

THE OPERATIONAL
EFFICIENCY ANALYSIS

1
 OVERVIEW

• Efficiency: a measure of the extent to which input is well used for an intended
task or function (output)
o Input: assets, employed capital, human resource…
o Output: revenue, profit….

Efficiency = Outputs - Inputs

Outputs
Efficiency =
Inputs

2
 OVERVIEW

• Content of operating efficiency analysis:

o Overall financial performance analysis
o Asset use efficiency analysis
o Profitability analysis

• Meaning of operating efficiency analysis

• Note in data using

3
OVERALL FINANCIAL PERFORMANCE ANALYSIS

• Overall analysis of revenue and profit

Decomposing approach in revenue and profit
• Common ratios:
o Expense/revenue ratio –

o Net income/sales ratio (ROS)

o Net income/expenses ratio

4
 OVERALL FINANCIAL PERFORMANCE ANALYSIS

Profit before tax

Return on sales -
= *100%
ROS Total sales and revenues

Meaning: This indicator indicates how many dong of

profit before tax in 100 dong of sales and revenue. It is
related to the revenue-expenses management, the pricing
policy and the accounting policy. Therefore, the indicator
can be adjusted flexibly by the profit measurement
methods.

5
 Illustration: Overall analysis of revenue and profit (3.1)
… Year Year N variance
N-1 Amount %

1. Revenue from sales of goods and provision of services

2. Sales deductions
3. Net revenue
4. Cost of gold sold
5. Gross profit
6. Finance incomes
7. Finance expenses
In which: Interest expense
8.Selling expenses
9. Administrative expense
10. Net operating profit
11. Other incomes
12. Other expenses
13. Other profit
14. Accounting profit before tax
15. Income tax expense - current
16. Income tax expense - deferred
6
 Illustration: cost saving efficiency analysis (3.2)
… Year Year % of sales variance
N-1 N N-1 N N-1/N-2 N/N-1

1. Revenue from sales of goods and provision of services

2. Sales deductions
3. Net revenue
4. Cost of gold sold
5. Gross profit
6. Finance incomes
7. Finance expenses
In which: Interest expense
8.Selling expenses
9. Administrative expense
10. Net operating profit
11. Other incomes
12. Other expenses
13. Other profit
14. Accounting profit before tax
15. Income tax expense - current
16. Income tax expense - deferred 7
 Example: sales mix analysis

… Year N-1 Year N Variance

Amount % Amount % Amount %
1. Revenue of product A
2. Revenue of product B
3. ……
Total revenue

… Year N-1 Year N Variance

Amount % Amount % Amount %
1. Revenue of branch/market A
2. Revenue of branch/market B
3. ……
Total revenue
8
 Example: profit contribution analysis

… Year N-1 Year N Variance

Amount % Amount % Amount %
1. Profit of product A
2. Profit of product B
3. ……
Total profit

… Year N-1 Year N Variance

Amount % Amount % Amount %
1. Profit of branch/market A
2. Profit of branch/market B
3. ……
Total profit
9
 Illustration: net operating profit (3.3)

… value Variance
Year N- Year N
1
1. Net revenue
2. Cost of gold sold
3. Gross profit
4.Selling expenses
5. Administrative expense
6. Net operating profit

10
 Illustration: factors influenced to net operating profit
(3.4)

% of The degree of
net revenue influence
N-1 N CL From From
revenue cost
saving
efficiency
1. Net revenue
2. Cost of gold sold
3. Gross profit
4. Selling expenses
5. Administrative expense
6. Net operating profit
11
 factors influenced to net operating profit

Net profit increase

increase expense/revenue
(decrease) from the
influence of = (decrease) of
revenue
* ratio of base
year
revenue

Net profit increase increase

Revenue of
(decrease) from the (decrease) of
influence of cost
=
expense/revenue * base year
saving efficiency ratio

12
 Illultration: expenses/net operating ratio (3.5)

… amount variance

N-1 N
1. Cost of gold sold
2. Selling expenses
3. Administrative expense
4. Net operating profit
5. Net operating profit / Cost of gold sold (4/1)
6. Net operating profit / Selling expenses (4/2)
7. Net operating profit / Administrative expense
(4/3)
8. Net operating profit / total expense (4/(1+2+3))

13
 ANALYSIS OF ASSETS USE EFFICIENCY

• Assets use efficiency

• Fixed assets use efficiency
• Working capital use efficiency

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 ANALYSIS OF ASSETS USE EFFICIENCY
Total sales and revenues
Assets use efficiency
(assets turnover) = Average total assets

Total sales and revenues = Net sales + Financial revenues + Other

revenues
• Purpose: to evaluate the company’s asset management.
The asset use efficiency also represents the capacity of
business management.
• Meaning: “how many dong of net sales and revenue can
be generated using one dong of invested assets”. The
higher the asset turnover ratio, the better the company is
performing
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 ANALYSIS OF ASSETS USE EFFICIENCY

Total sales
Assets use efficiency
(assets turnover) = Average total assets

Total sales in department i

Assets use
efficiency
= Average total assets in department i
(assets turnover)
in department i

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 ANALYSIS OF FIXED ASSETS USE EFFICIENCY

Total sales
Fixed assets use
efficiency = Average historical cost of
(fixed assets turnover) fixed assets

Average historical cost of fixed assets or Average book value

of fixed assets ?

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 ANALYSIS OF WORKING CAPITAL USE EFFICIENCY

Net sales
Working capital use efficiency
=
(Working capital turnover) Average working capital
360/90/30
Average days of working
capital turnover = Working capital turnover
Average working capital
Average days of working
capital turnover = Net sales * 360

- Working capital save (-) or wastage (+):

Net sales of then-year
Average days of Average days
working capital of working
360 turnover of then- - capital turnover
year of base-year 18
 DISAGGREGATING WORKING CAPITAL TURNOVER

∆HWC = HWC OF THEN-YEAR - HWC OF BASE-YEAR

∆HWC = ∆NET SALES + ∆WC

net sales of subject-year net sales of base-year

∆NET = -
SALES WC of base-year WC of base-year

net sales of subject-year net sales of subject-year

∆WC = WC of subject-year
- WC of base-year

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 ANALYSIS OF WORKING CAPITAL USE EFFICIENCY
Cost of goods sold
Inventories turnover =
Average inventories
Cost of gold sold or net sales?
360/90/30
Inventories turnover period
(days of Inventories turnover )
= Inventories turnover
Net sales +VAT
Accounts receivable from
customer turnover = Average accounts
receivable from customer
360/90/30
Accounts receivable from
customer period = accounts receivable from
customer turnover 20
 ILLUSTRATION: ANALYSIS OF ASSETS USE EFFICIENCY
OF COMPANY (3.6)

No Ratio Year N-2 Year N- Year N

1
1 Net sales
2 Net sales and revenues
3 Average assets
4 Average historical cost of fixed
assets
5 Average working capital
6 Assets use efficiency (2/3)
7 Fixed assets use efficiency (1/4)
8 Working capital turnover (1/5)
9 Days of working capital turnover

21
 DISAGGREGATING WORKING CAPITAL TURNOVER

∆HWC = HWC OF THEN-YEAR - HWC OF BASE-YEAR

∆HWC = ∆NET SALES + ∆WC

net sales of subject-year net sales of base-year

∆NET = -
SALES WC of base-year WC of base-year

net sales of subject-year net sales of subject-year

∆WC = WC of subject-year
- WC of base-year

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 ANALYSIS OF OPERATING PROFITABILITY

• Purpose: to analyze the company’s ability to generate

profit from business operations. This profitability is
influenced by both the revenue-expense management and
the asset use efficiency.

• Ratios:
o Return on assets – ROA, RE
o Return on owner’s equity – ROE
o Return on capital employed
o Other ratios (for listed company): EPS, ESPC, P/E
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 ANALYSIS OF OPERATING PROFITABILITY

Operating
expense

Depreciation Earning
Expenses
expense before
Sales and interest
Revenue Interest and tax
Earning
expense and
before
depreciation
interest
Profit accumulated
and tax
(EBT) (EBITDA)
(EBIT)

24
 ANALYSIS OF OPERATING PROFITABILITY

“Profit” will be adjusted to eliminate the effect of the accounting

policy and the funding policy.
• Eliminating the effect of the funding policy:
Earning before interest and tax (EBIT) = Earning before tax
(EBT) + Interest expense
• Eliminating the effect of the depreciation policy:
Earning before tax and depreciation (EBTD) =EBT+
Depreciation expense
• Eliminating the effect of the funding policy and the depreciation
policy:
Earning before interest, tax and depreciation accumulated
(EBITDA) = EBT+ Interest expense +Depreciation expense

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 RETURN ON ASSETS

Profit before tax

Return on assets
= *100%
- ROA Average total assets

Meaning: ROA refers that 100 dong of the invested assets

will generate how many dong of profit before tax. The
higher ROA is, the greater the profitability of assets is.

Disadvantage: ROA has not completely reflected the

operating efficiency because the profit is also influenced by
the funding policy

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 RETURN ON ASSETS

Profit before tax + interest expense

Return on assets
variation - RE = Average total assets *100%

• RE excludes the effect of the funding policy

• RE expresses the asset use efficiency without the use of
debt-equity
• RE is compared with the interest rate to determine
whether the company should borrow money from banks
or raise equity from owners

27
 example: (unit: million VND)

Company A and company B have the same business

characteristics and performance. However, these
companies have different financial structure. Company A
is financed by 100% owner’s equity and company B is
financed by 100% loan. Two companies have the same
value of assets (1,000), earnings before interest and tax
(100). The interest expense of company B is the same as
dividend payment of company A (20). Determine the ROA
and RE for each company.

28
 example: (unit: million VND)

comp Total Profit ROA EBIT RE

any assets before tax

A
B

29
ANALYSIS OF RETURN ON ASSETS

30
 ANALYSIS OF RETURN ON ASSETS

Profit before tax

Return on assets
ROA =
Average total assets
*100%
Dupont system of analysis:

Profit before tax Total sales and revenues

Return on
= *
assets - ROA Total sales and revenues Average total assets

= Return on sales * Assets turnover

This equation supports to evaluate the effects of influence
factors to ROA within the company; exposes differences in the
pricing strategy and the asset management among companies
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ROA
 DISAGGREGATING ROA

Profit before tax Total sales and revenues

Return on
= *
assets - ROA Total sales and revenues Average total assets

Return on assets
- ROA = HROS * HAT

∆ROA = ∆ HROS + ∆HAT

∆ HROS = (HROS - HROS ) * HAT 1 0 0

∆ HAT = HROS * (HAT - HAT )

1 1 0

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 RETURN ON EQUITY

Profit after tax

Return on equity -
= * 100%
ROE Average shareholder equity

• a profitability ratio that measures the ability of a

firm to generate profits from its shareholders
investments in the company
• how many dong of profit after tax can be
generated using 100 dong of invested assets
• Influence factors: ROS, assets turnover, self-fund
ratio, debt to equity ratio, interest coverage ratio
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 Influence factors: ROS, assets turnover

Profit after tax

Return on equity -
= * 100%
ROE Average shareholder equity

Profit before Net sales & Total average

tax revenue assets
ROE = Net sales &
* Total average
* Total average * (1-T)
revenue assets equity

Total average
assets
ROE = ROS * Assets turnover * Total average
* (1-T)
equity
35
 Influence factors: self-fund ratio

Profit after tax

Return on equity -
= * 100%
ROE Average shareholder equity
Profit before tax *(1-T) Total average assets
ROE = *
Total average assets Total average equity

Profit before tax *(1-T) Total average equity

* 1/
ROE =
Total average assets Total average assets

Profit before tax *(1-T)

* 1/
ROE = self-fund ratio
Total average assets 36
 Influence factors: debt to equity ratio
Profit after tax
Return on equity -
= * 100%
ROE Average shareholder equity
Profit before tax *(1-T) Total average assets
ROE = *
Total average assets Total average equity

Profit before tax *(1-T) debt + equity

ROE = *
Total average assets Total average equity

Profit before tax *(1-T)

ROE = * (1 + debt to equity ratio)
Total average assets
37
 Influence factors: debt to equity ratio
RE = Profit before tax + interest expense
Total average assets
RE = Profit before tax + (debt * interest
rate)
Profit before tax Total
RE average
* Total assets
assets – (debt * interest rate)
=
Profit before tax = RE * (debt + equity) – (debt *r)
Profit before tax = debt * (RE -r) + equity * RE
Profit after tax = [debt * (RE -r) + equity * RE] * (1-T)

ROE = [debt * (RE -r) + equity * RE] * (1-T)

equity
ROE = [debt to equity ratio* (RE -r) + RE] * (1-T)
38
 Influence factors: debt to equity ratio

Example 1: Company A and company B have the same

asset size with 40 million VND and same value of
return of assets variation. In term of financial structure,
company A is financed by 100% owner’s equity and
company B is financed by 30% loan. The current
average interest rate is 12% per year. Evaluate the
influence of financial structure to return of equity of
these companies in two cases: RE=10% và RE=20%

39
ROE = [debt/equity * (RE – r) + RE] * (1-T)
 RE = 10% < r = 12% :

 RE = 20% > r = 12% :

 Influence factors: interest coverage ratio (ICR)
Profit after tax
Return on equity -
= * 100%
ROE Average shareholder equity
Profit before tax
Profit before tax (1-T) Total assets
+ interest expense *
ROE = *
Profit before tax (PBT)
Total assets Owner’s equity
+ interest expense (IE)

PBT + IE - IE PBT + IE Debt

ROE =
PBT + IE
*(1 - T) * Total assets
* 1+
OE
IE PBT + IE Debt
ROE = 1 - PBT + IE * (1 - T) * Total assets
* 1 +
OE
1
ROE = 1 - ICR
* (1 - T) * RE * (1 + debt/equity )
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42
43
 Return on capital employed

EBIT
ROCE = Capital employed * 100%

EBIT
ROCE = Owner’s equity + long term liabilities
* 100%

EBIT
ROCE = Total Assets – short term liabilities * 100%
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 PROFITABILITY ANALYSIS…. (FOR PUBLIC
COMPANY)

EPS (earnings per share): is the monetary value of

earnings per outstanding share of common stock for a
company
Profit after tax - Dividends on Preferred Stock
EPS =
Weight average number of common shares outstanding

Example: One corporation had 10,000 shares of common

stock outstanding at the beginning of the year. On July 1, it
issued 2,000 shares and on October 1, it issued another
3,000 shares.
The weight average number of common shares outstanding
is
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 PROFITABILITY ANALYSIS…. (FOR PUBLIC
COMPANY)

P/E (price/earnings ratio)

market price per share

P/E = earnings per share

• P/E ratio as a gauge of future earning power of the firm

(high-growth opportunities generally have high P/E
ratio)
• Investors may be wrong in their estimates of growth
potential

46
 Illustration: PROFITABILITY ANALYSIS (3.7)
… N -1 N
1. Average owner’s equity
2. Average capital employed
3. Average total assets
4. Profit before tax
5. Interest expense
6. Profit after tax
7. ROA (4/3)
8. ROE (6/1)
9. Interest coverage ratio ((4 + 5)/5)
10. ROCE ((4-5)/2)
11. EPS
12. P/E 47
 CASH FLOW BASED RATIOS

CFO
CF
margin = Total revenue

CFO
CF from operations to net
income = Net income

CFO
CF per
=
share Average number of common shares of outstanding

48
 CASH FLOW BASED RATIOS

CFO
CF return on assets = Total assets

Net income
Net income to cash
provided by operating =
income Cash provided by operating activities

49