LINKS

Link to previous chapters

Chapters 9, 10, and 11 refo rmulated the financial statements to prepare them

for analysis.

This chapter

This chapter lays out the analysis of profitability

that is necessary for forecasting future

profitability and valuation.

Link to next chapter

Chapter 13 lays out the analys is of growth, to

complete the analysis of the financial statements.

Link to Web page

The Web site appli es the analysis in thi s chapter

to a wider range of firms (www.mhhe.com/

penmanSe).

The Analysis of Profitability

~ ~ What are the What are the

financial effects of

0 How is

operating statement financial and profitability drivers of operating analyzed? ROCE? li ability

leverage on ROCE?

~ How are

borrowing costs

analyzed?

The price-to-book valuation model of Chapter 5 directs us to forecast future residual e~rnings to value equities. The price-earnings valuation model of Chapter 6 directs us to forecast abnormal earnings growth, which is the same as residual earnings growth. Resid-ual earnings are detennined by the profitability of shareholders' investment, ROCE, and the growth in investment. So forecasting involves forecasting profitability and growth. To fore-cast, we need to understand what drives profitability and growth. The analysis of the drivers ofROCE is called profitability analysis and the analysis of growth is called growth analy-sis. This chapter covers profitability analysis. The next chapter covers growth analysis.

The reformulation of financial statements in the preceding chapters readies the state-ments for analysis . This and the next chapter complete the financial statement analysis.

Profitability analysis establishes where the firm is now. It discovers what drives current ROCE. With this understanding of the present, the analyst begins to forecast by asking how future ROCE will be different from current ROCE. To do so she forecasts the drivers that we lay out in this chapter. The forecasts , in turn , determine the value, so much so that the profitability drivers of this chapter are sometimes referred to as value drivers. Part Three of the book carries the analysis of this chapter over to forecasting and valuation.

Value is generated by economic factors, of course. Accounting measures capture these factors . In identifying the profitability drivers, it is important to understand the aspects of the business that determine them . Profitability analysis has a mechanical aspect, and the analy-sis here can be transcribed to a spreadsheet program where the reformulated statements are fed in and numerous ratios are spat out. But the purpose is to identify the sources of the value generation. So as you go through the mechanics, continually think of the activities of the firm that produce the ratios. Profitability analysis focuses the lens on the business.

Chapter 12 The Analysis of Profitability 365

After reading this chapter you should understand: After reading this chapter you should be able to:

How ratios aggregate to explain return on common Calculate ratio s that drive ROCE. equity (ROCE). Demonstrate how ratios combine to yield the ROCE.

How financial leverage affects ROCE. Perform a co m plete profitability analysis on reformu-

lated financia l statements. How operat ing liability leverage affects ROCE. The difference between return on net operating assets

(RNOA) and return on assets (ROA). How profit margins, asset turnovers, and their compos-

ite ratios drive RNOA. How borrowing costs are analyzed. How profitability analysis can be used to ask penetrat-

ing questions regarding the firm's activities.

Prepare a spreadsheet program based on the design in this chapte r. See the BYOAP feature on the text's Web site.

Answer "wha t-if" questions about a firm using the analysis in th is chapter.

With this thinking, profitability analysis becomes a tool for management planning, strategy analysis, and decision making, as well as valuation. The manager recognizes that generating higher profitability generates value. He then asks: What drives profitability? How will profitability change as a result of a particular decision, and how does the change translate into value created for shareholders? If a retailer decides to reduce advertising and adopt a "frequent buyer" program instead, how does this affect ROCE and the value of the equity? What will be the effect of an expansion of retail floor space? Of an acquisition of another firm?

The purpose of analysis is to get answers to questions like these. So you will find a number of "what-if" questions in this chapter. And you will see how analysis provides the answers to these questions.

THE ANALYSIS OF RETURN ON COMMON EQUITY As we have seen, the return on common stockholders' equity (CSE) is calculated as

. Comprehensive income Return on common eqmty (ROCE) = ---------Average CSE

We have also seen how the reformulated statements of Chapter 10 yield profitability mea-sures for a firm's operations- return on net operating assets (RNOA)- and for its financ-ing activities- net borrowing cost (NBC) or the return on net financial assets (RNFA). These are the drivers of ROCE.

Figure 12.1 shows how ROCE is broken down into its drivers, so follow this figure as we go through the analysis. The analysis proceeds over three levels. First, the effects of operating and financing activities are analyzed. Second, the effects of profit margins and asset turnovers on operating profitability are identified. Third, the drivers of profit margins, asset turnovers, and net borrowing costs at the lowest level of the figure are calculated. Acronyms that will be used as we proceed are given in The Analysts ' Toolkit at the end of the chapter.

366 Part Two The Analysis of Financial Statements

FIGURE 12.1 The Analysis of Profitability The breakdown of return on common equ ity (ROCE) into its drivers.

Operating liability leverage

Return on common equity

Return from operating activities

Return on net operating assets

Profit margin Asset tu r nover

00000 ooOoo Gross margin and expense drivers

Individual asset and li abil ity drivers

x

Return from financing activities

Financial leverage

Financial leverage x spread

Net borrowing cost drivers

FIRST-LEVEL BREAKDOWN: DISTINGUISHING FINANCING AND OPERATING ACTIVITIES AND THE EFFECT OF LEVERAGE

The first breakdown ofROCE distinguishes the contribution of the operating and financing activities. This involves the effect of leverage, which " levers" the ROCE up or down through liabilities. Leverage is also sometimes referred to as "gearing."

Financial Leverage Financial leverage is the degree to which net operating assets are financed by borrowing with net financial obligations (NFO). The measure FLEV = NFO/CSE, introduced in Chapter 10, captures financial leverage. To the extent that net operating assets are financed by net fi nancial obligations rather than equity, the return on the equity is affected. The typ-ical FLEV is about 0.4, but there is considerable variation among firms .

Financial leverage affects ROCE as follows (see Box 12.1 ):

Return on common equity = Return on net operating assets +(Financial leverage x Operating spread)

ROCE = RNOA + [FLEV x (RNOA - NBC)]

(12.1)

This expression for ROCE says that the ROCE can be broken down into three drivers:

1. Return on net operating assets (RNOA = OI/NOA). 2. Financial leverage (FLEY = NFO/CSE). 3. Operating spread between the return on net operating assets and the net borrowing cost

(SPREAD= RNOA - NBC).

ROCE Is Determined by Operating Profitability, Financial Leverage, and the Operating Spread 12.1

ROCE = Comprehensive earnings Average CSE

Comprehensive earnings in the numerator of ROCE is composed of operating income and net financial expense, as depicted in a reformulated income statement. Common shareholders' equity (CSE) in the denominator is net operating assets minus net financial obligations. Thus

ROCE = 01- NFE NOA-NFO

(Balance sheet amounts are averages over the period.) The op-erating income (01) is generated by the net operating assets (NOA), and the operating profitabil ity measure, RNOA, gives the percentage return on the net operating assets. The net fi-nancial expense (NFE) is generated by the net financial obliga-

tions (NFO), and the rate at which the NFE is incurred is the net borrowing cost (NBC). So the ROCE can be expressed as

ROCE =(NOA x RNOA)- ( NFO x NBC) CSE CSE

w here, to remind you, RNOA = 01/NOA and NBC = Net finan-cial expense/NFO. This expression for ROCE is a weighted average of the return from operations and the (negative) return from financing activities.

We get more insights by rearranging this expression:

ROCE = RNOA + - x (RNOA - NBC) [NFO ] CSE

= RNOA + (Financial leverage x Operating spread) = RNOA + (FLEV x SPREAD)

Both operating income and net financial expense must be after tax and comprehensive of all components, as in the reformulated income statements of Chapter 1 O; otherwise, this breakdown will not work.

This formula says that the ROCE is levered up over the return from operations if the firm has financial leverage and the return from operations is greater than the borrowing cost. The firm earns more on its equity if the net operating assets are financed by net debt, provided those assets earn more than the cost of debt.

Figure 12.2 depicts how the difference between ROCE and RNOA changes with finan-cial leverage according to the formula. Ifa firm has zero financial leverage, equation 12.1 says that ROCE equals RNOA. If the firm has financial leverage, then the difference be-tween ROCE and RNOA is determined by the amount of the leverage and the operating spread between RNOA and the net borrowing cost. We will simply refer to the operating spread as the SPREAD. If a firm earns an RNOA greater than its after-tax net borrowing cost, it is said to have favorable financial leverage or favorable gearing: The RNOA is "levered up" or "geared up" to yield a higher ROCE. If the SPREAD is negative, the lever-age effect is unfavorable . Box 12.2 gives a demonstration with General Mills, whose reformulated balance sheet is presented in Exhibit I 0.5 in Chapter I 0. The example high-lights the "good news/bad news" nature of financial leverage: Financial leverage generates a higher return for shareholders if the firm earns more on its operating assets than its borrowing cost, but financial leverage hurts shareholder return if it doesn't. Accordingly, leverage is a component of the risk of equity as well as its profitability, as we will see in Chapter 14. We will also ask the following question in that chapter: Can a firm increase its equity value by increasing its ROCE through financial leverage, or will it reduce its equity value because of the increase in risk?

How does the analysis change when a firm like Nike has net financial assets (NFA) rather than net financial obligations (NFO)? In this case, financial income will be greater than financial expense and the firm will have a positive return on financing activities

367

368 Part Two The Analysis of Financial Statements

FIGURE 12.2 How Financial Leverage Affects the Difference Between ROCE and RNOA for Different Amounts of Operating Spread FLEV is financial leverage and the SPREAD is the difference between RNOA and the net borrowing cost.

8% SPREAD = 6%

6%

-2% -------------- --- --------

0.00 0.25 0.50 0.75 1.00 1.25 1.50

ROCE = RNOA + (FLEV x SPREAD)

1.75

SPREAD= 4%

SPREAD= 2%

SPREAD= 1%

2.00 FLEY

(RNFA) rather than net borrowing costs. Return on common equity is related to RNOA as follows:

ROCE = RNOA -[NFA x (RNOA - RNFA)] CSE

(12.2)

where RNFA = Net financial income/NFA, the return on net financial assets. Here a positive spread reduces the ROCE: Some of shareholders' equity is invested in financial assets and if financial assets earn less than operating assets, ROCE is lower than RNOA. Box 12.3 demonstrates this with Nike.

Operating Liability Leverage Just as financial liabilities can lever up the ROCE, so can operating liabilities lever up the return on net operating assets. Operating liabilit ies are obligations incurred in the course of operations and are distinct from financial obligations incurred to finance the operations. Chapter I 0 gave a measure of the extent to w hich the net operating assets (NOA) are comprised of operating liabilities (OL), the operating liability leverage:

Operating liability leverage (OLLEV) = OL NOA

The typical OLLEV is about 0.4. Operating liabilities reduce the net operating assets that are employed and so lever the return on net operating assets. To the extent that a firm

General Mills, a large manufacturer of packaged foods, has had considerable stock repurchases over the years, leaving it fairly highly leveraged. In Exhibit 10.5 in Chapter 10 you see that, for fiscal 2010, its average shareholders' equity was $5.533 billion, with average net financial obligations of $6.1 billion. Its average financial leverage was 1.102, based on these average balance sheet amounts.

The firm's ROCE for 201Owas16.7 percent. Further analy-sis reveals that this number was driven by the high leverage:

ROCE = RNOA + [FLEV x (RNOA - NBC)] 16.7% = 10.1 % + [1.102 x (10.1 % -4.1%)]

ROCE can exaggerate underlying operating profitability: RNOA is 10.1 percent but the high financial leverage, combined with

a SPREAD over a borrowing cost of 4.1 percent, yields a much higher ROCE. Beware of firms boasting high ROCE: Is it driven by financial leve r age rather than business operations?

A What-If Question What if the RNOA at General Mills fell to 2 percent? What wou ld be the effect on ROCE?

The answer is that the ROCE would turn negative:

-0.3% = 2.0% + [1.102 x (2.0% - 4.1 %)] The unfavorable leverage would produce losses and a nega-tive ROCE on a positive RNOA. That is the "bad news" aspect of leverage.

General Mills has minority interest on its balance sheet. This complicates the ROCE ca lculation . See Box 12.5.

can get credit in its operations with no explicit interest, it reduces its investment in net operating assets and levers its RNOA. But credit comes with a price. Suppliers who provide credit without interest also charge higher prices for the goods and services they supply than would be the case if the firm paid cash. And so operating liability leverage, like financial leverage, can be unfavorable as well as favorable.

To compute the leverage effect, first estimate the implicit interest that a supplier would charge for credit, using the firm's short-term borrowing rate for financial debt:

Implicit interest on operating liabilities= Short-term borrowing rate (after tax) x Operating liabilities

Then calculate a return on operating assets, ROOA, as ifthere were no operating liabilities:

R . (ROOA) OI + Implicit interest (after tax) eturn on operatmg assets = ------. ------Operatmg assets

RNOA is driven by operating liability leverage as follows:

Return on net operating assets= Return on operating assets (12.3) +(Operating liability leverage x Operating liability leverage spread)

RNOA = ROOA + (OLLEV x OLSPREAD) where OLSPREAD is the operating liability leverage spread, that is, the spread of the return on operating assets over the after-tax short-term borrowing rate:

OLSPREAD = ROOA - Short-term borrowing rate (after tax)

This leverage expression for RNOA is similar in form to the financial leverage equa-tion (12.1) for ROCE: RNOA is driven by the rate of return on operating assets as ifthere were no operating liability leverage, ROOA, plus a leverage premium that is determined by the amount of operating liability leverage, OLLEV, and the operating liability leverage spread, OLSPREAD. The effect can be favorable operating liability leverage-ifROOA

369

Nike has been very profitable. For fiscal 2008, the firm re-ported an ROCE of 25.9 percent on average common equity of $7.458 billion. But Nike had considerable (average) financial assets of $2.086 billion from cash generated from its opera-tions, giving it an average financial leverage that was negative: -0.280. The firm's return on average net financial assets was 2 .3 percent.

The RNOA of 3 5 .0 percent is weighted down by the low er return on financ ing activities in the overall ROCE. A What-If Question What if the cornpany used $1 .0 billion of its financial assets to pay a special d ividend? What would be the effect on ROCE?

The answer i s that with $1.0 billion less in average finan-cial assets and c ommon equity, the average financial lever-age would have been -0.168 rather than -0.280, and the ROCE would have been

The ROCE masks the profitability of operations of 35.0 percent:

370

ROCE = RNOA - [NFNCSE x (RNOA - RNFA)] 25.9% = 35.0% - [0.280 x (35.0% - 2.3%))

29.5% = 35.0% - [0.168 x (35.0% - 2.3%)) Note: Dividends (and stock repurchases) increase ROCE.

is greater than the short-term borrowing rate- o r unfavorable- if ROOA is less than the short-term borrowing rate. See Box 12.4 for an analysis of General Mills's operating liabil-ity leverage.

Operating liability leverage can add value for shareholders, so is important to identify ifthe analyst is to discover the source of the value generation. A firm that carries $400 mil-lion in inventory but has $400 million in account s payable to the suppliers of the inventory effectively has zero net investment in inventory. The suppliers are carrying the investment in inventory which represents investment in the operations that the shareholders do not have to make (and can, rather, invest elsewhere to generate returns). Dell, Inc. , whose reformulated balance sheets and income statements are presented in Exhibits 10.4 and 10.10 in Chapter I 0, is a case of a firm using operating liability leverage. Indeed, Dell has so many operating liabilities that its net operating assets are negative. Cast back to the dis-cussion on Dell surrounding those exhibits to see how its extreme operating liability lever-age adds value for shareholders: The operating liability leverage produces residual income from operations that is greater than income from operations!

Summing Financial Leverage and Operating Liability Leverage Effects on Shareholder Profitability Shareholder profitability, ROCE, is affected by both financial leverage and operating lia-bility leverage. Without either type of leverage, ROCE would be equal to ROOA, the rate of return on operating assets. Operating liability leverage levers RNOA over ROOA and financial leverage levers ROCE over RNOA:

ROCE = ROOA + (RNOA - ROOA) + (ROCE - RNOA) So, for the General Mills examples in Boxes 12.2 and 12.4, the ROCE of 16.7 percent is determined as follows:

ROCE = 7. 1% + (10.1% - 7 .1 %) + (16.7% - 10. 1%) = 7.1 % + 3.0% + 6.6% = 16.7%

General Mills had average net operating assets of $11 .632 bil-lion during fiscal year 2010 of which $5.494 billion was in op-erating liabilities. Thus its operating liability leverage ratio was 0.472 . Its borrowing rate on its short-term notes payable was 1.1 percent, or 0. 7 percent after tax. It reported operating income of $1.177 billion, but applying the after-tax short-term borrowing rate to operating liabilities, this operating income includes implicit after-tax interest charges of $38 million. So on average operating assets of $17 .126 billion,

ROOA= 1177 + 38 =7.09% 17, 126

The effect of operating liability leverage is favorable: RNOA = 10.1%=7.09% + [0.472 x (7.09% - 0.7%)]

A What-If Question What if suppliers were to charge the short-term borrowing rate of 1.1 percent explicitly for the credit supplied in accounts payable? What would be the effect on General Mills value?

The answer is probably none. The interest would be an additional expense. But to stay competitive, the supplier would have to reduce prices of goods sold to the firm by a corresponding amount so that the total price charged (in implicit plus explicit interest) remains the same. But supplier markets may not work as competitively as this supposes, so firms can exploit operating liability leverage if they have power over their suppl iers. Like Dell, Inc., they can add value in their supplier relationship, that is, through operating liability lever-age. Refer back to the discussion of Dell in Chapter 10.

A couple of complications can arise when analyzing leverage effects. First, the presence of a minority (noncontrolling) interest calls for a modification. See Box 12.5. Second, if net borrowing is close to zero or borrowing rates are considerably higher than lending rates, it can happen that firms report net interest expense (interest expense greater than interest in-come) in the income statement but an average net financial asset position in the balance sheet (or vice versa). (This happened to Nike in 2010.)Also, because of small average net financial obligations (in the denominator), you can sometimes calculate a very high net bor-rowing cost. This problem arises because, strictly, average net borrowing should be an aver-age of daily balances, not just the beginning and ending balances. An analyst typically does not have access to daily numbers, although using amounts from quarterly reports alleviates the problem. One can always refer to the debt footnote for borrowing costs.

Return on Net Operating Assets and Return on Assets A common measure of the profitability of operations is the return on assets (ROA):

ROA == Net income+ Interest expense (after tax) Average total assets

(Minority interest in income, if any, is added to the numerator.) The net income in the numerator is usually reported net income rather than comprehensive income. But, this aside, the ROA calculation mixes up financing and operating activities. Interest income, part of financing activities, is in the m1merator. Total assets are operating assets plus financial assets, so financial assets are in the base. Thus the measure mixes the return on operations with the (usually lower) return from investing excess cash in financial assets. Operating liabilities are excluded from the base. Thus the measure includes the cost of operating liabilities in the numerator (in the form of higher input prices as the price of credit) but excludes the benefit of operating liability leverage in the base. The RNOA calculation appropriately distinguishes operating and financial items. As interest-bearing financial assets are negative financial obligations, they do not affect the return on

371

The presence of minority (noncontrol ling) interest calls for a slight revision in the calculations of the effect of financial leverage. Minority interest, unlike debtholder interests, does not affect the overall profitability of equity, the leverage, or the SPREAD. It just affects the division of rewards between dif-ferent equity claimants. The minority, like the majority com-mon, shares the costs and benefits of leverage. So the addi-tional step with m inority interest (Ml) is to distinguish ROCE for all common claimants from that for the (majority) common owners of the parent corporation in the consolidation:

ROCE befo re Ml = Comprehensive income before Ml CSE+MI

Comprehensive income/ Minority in"!-erest Comprehensive income before Ml shanng ratio = CSE/(CSE +Ml)

The first ratio here gives the return to total common equity, minor-ity and majority. T he second ratio gives the sharing of the return. Use ROCE before minority interest when applying the financing leveraging equat i on 12.1, as we did w ith General Mills in Box 12.2.

ROCE = ROCE before Ml x Ml sharing ratio This calcula t ion is cumbersome. Minority interests are

typically small i n the United States, and one can (as an approximation) u sually treat minority interest as a reduction in consolidated operating income and net operating assets.

where ROCE is the return on common equity to the share-holders of the parent company (the majority) and

TABLE 12.1 Return on Net Operating Assets (RNOA) and Return on Assets (ROA) for Selected Firms for 2007 Fiscal Year ROA typically understates operating profitability because it fai ls to incorporate operating liabil ity leverage and includes the profitability of financial assets.

372

operations. Operating liabilities reduce the needed investment in operating assets, provid-ing operating liability leverage, so they are subtra cted in the base.

Thus ROA typically measures a lower rate of return than RNOA. The median ROA for al 1 U.S. nonfinancial firms from 1963 to 2010 was 7 .1 percent. This is below what we would expect for a return to risky business investment: I t looks more like a bond rate. The median RNOA was 10.5 percent, more in line with what we expect as a typical return from running businesses. ROA is a poor measure of operating profitability.

Table 12. 1 compares ROA and RNOA for selected firms for 2007. You can see that ROA understates operating profitability. Look particula rly at Nike and General Mills. The RNOA measures identify Microsoft, Genentech, and Cisco Systems as the exceptional companies they indeed are.

Operating liability leverage (OLLEV) and the amount offinancial assets relative to total assets explain the difference between RNOA an d ROA, and you can see in the table that firms with the largest differences have high numbers for these ratios. Microsoft had an

Operating Liability Financial Assets/ Industry and Firm RNOA,% ROA,% Leverage (OLLEV) Total Assets, % Biotech

Genentech, Inc. 40.4% 20.9% 0.44 30.2% Amgen, Inc. 15.3 9 .9 0.25 19.6

High-tech Microsoft Corp. 134.3 21.2 2.86 43.4 Oracle Corp. 27.8 14.1 0.59 23.0 Cisco Systems, Inc. 49.1 14.8 1.02 41 .4

Retailers Walmart Stores, Inc. 14.4 8.9 0.50 4 .2 The Gap, Inc. 25.5 11 .1 1.12 27 .9

Oil producers and refiners ExxonMobil Corp. 41.4 17.7 0.95 14.6 Chevron Corp. 26.0 13.4 0 .82 6.9

Nike and General Mills Nike, Inc. 35.0 16.5 0.65 23.6 General M il ls, Inc. 15.1 8.5 0.44 2.5

Chapter 12 The Analysis of Profitability 373

RNOA of 134.3 percent in 2007, but inclusion of financial assets (43.4 percent of total assets) in the ROA measure and the omission or the operating liability leverage of 2.86 reduces the profitability measure to 21.2 percent.

These observations reinforce two points. To analyze profitability effectively, two proce-dures must be followed:

1. Income must be calculated on a comprehensive (clean-surplus) basis. 2. There must be a clean distinction between operating and financing items in the income

statement and balance sheet.

You will get "clean" measures only if these two elements are in place. So you can see the payoff to your work in this and the preceding chapters.

Financial Leverage and Debt-to-Equity Ratios A common measure of financial leverage is the de bt-to-equity ratio, calculated as total debt divided by equity. This measure is useful in credit analysis but, for the analysis of profitabil-ity, it confuses operating liabilities (which create operating liability leverage) with financial li abilities (which create financial leverage). And, as usually defined, it does not net out fi-nancial liabilities against financial assets.

The difference can be sizable: The median debt-to-equity ratio for U.S. firms from 1963 to 2004 was 1.22 while the median FLEV was 0.43. Microsoft had 43.4 percent of its as-sets in financial assets at the end 2007 and, with an operating liability leverage of2.86, had no financi al obligations. Its debt-to-equity ratio was 1.02, but all the debt in the debt-to-equity ratio was operating debt. So using the firm's debt-to-equity ratio as an indication of financial leverage would be quite misleading: Microsoft's FLEV (which includes the financial assets as negative debt) was - 0. 619.

SECOND-LEVEL BREAKDOWN: DRIVERS OF OPERATING PROFITABILITY

In the first-level breakdown, RNOA is isolated as an important driver of the ROCE. Follow-ing the scheme in Figure 12.1, RNOA can be broken down further into its drivers so that

ROCE = RNOA + [FLEV x (RNOA - NBC)] =(PM x ATO) + [FLEV x (RNOA - NBC)]

The two drivers of RNOA are

l. Operating profit margin (PM): PM= OI (after tax)/Sales

(12.4)

This we calculated as a common-size ratio in Chapter 10. The profit margin reveals the profitability of each dollar of sales.

2. Asset turnover (ATO): ATO = Sales/NOA

The asset turnover measures sales revenue per dollar of net operating assets put in place. It measures the ability of the NOA to generate sales. It is sometimes referred to as its in-verse, II ATO =NOA/Sales, which indicates the amount of net operating assets used to generate a dollar of sales: If the ATO is 2.0, the firm is using 50 cents of net operating assets to generate a dollar of sales.

374 Part Two T he A nalysis of Financial Statements

FIGURE 12.3 Profit Margin and Asset Turnover Combinations for Various Industries, 1963-2000 Industries with high profit margins tend to have low asset turnovers, and industries with low profit margins tend to have high asset turnovers.

Source: M. Soliman, "Using Industry-Adjusted DuPont Analysis to Predict Future Profitability," working paper, Stanford University, 2003 . With permission.

374

With$ l ,8 I 4 million of operating income and $ 5,930 million in average net operating as-sets, Nike generated an RNOA of30.6 percent in 2010. With sales revenue of$19,014 mil-lion, the operating income amounted to an operati ng profit margin (PM) of9.54 percent. The sales yielded an asset turnover (ATO) of3.2 l on the $5,930 million of operating assets. Thus RNOA =PM x ATO = 9.54% x 3.21=30.6%.

In 2010, General Mills's sales of$14,797 million earned $1 ,177 million ofoperating in-come on$ I 1,632 million of average net operating assets. Thus its RNOA was I 0.1 percent, made up of an operating PM of 7 .95 percent and an asset turnover of 1.2 7. You can see that Nike's higher RNOA came from both a higher Pl\1 and a higher ATO: Nike gets more profit per dollar of sales but also generated high sales per dollar of net operating assets. Nike re-quires 31.2 cents invested in net operating assets for every dollar of sales while General Mills needs 78.7 cents.

This decomposition of operating profitability is known as the DuPont model. It says that profitability in operations comes from two sources. First, RNOA is higher the more of each dollar of sales ends up in operating income; secon d, RNOA is higher the more sales are gener-ated from the net operating assets. The first is a profitability measure; the second is an effi-ciency measure. A firm generates profitability by increasing margins and can lever the margins up by using operating assets and operating liabilities more efficiently to generate sales.

The average (after-tax) profit margin is about 5 .3 percent and the average asset turnover is about 2.0. But it is clear that a firm can produce a given level ofRNOA with a relatively high profit margin but low turnover, or with a relatively high turnover but a low margin. Figure 12.3 plots median PM and ATO for various industries from 1963 to 2000. You see from the figure that industries with low asset turnovers tend to have high profit margins, and industties with high asset turnovers tend to have low profit margins. The figure draws a curve- sloping down to the right- that connects dots with the same 14 percent RNOA but different PMs and ATOs. An industry with a 30 percent margin and an AT O of 0.47 (like water supply) has the same 14 percent RNOA as a firm with a 2 percent margin and an ATO of 7 .0 (like grocery stores).

Table 12.2 gives median RNOAs, PMs, and ATOs for a number of industries. It ranks industries on their median ROCE and also gives their median financial leverage (FLEV) and

0.45

0.4

0.35

0.3

"' ~fj 0.25 E ~ 0.2 0::

0.15

0.1

0.05

+ Health services, hospitals, etc. Petroleum pipelines

+ Transportation + Electric services

+Gold and silver ores

+ +

+

Warehouse+

14% Return on net operating as set line

Comm unications

+Accounting services Business services, photocopying, art

Hotels,

' + + M~bile homls Mobile homes lo~ging ~ + + ~ + dealers Grocery stores

O-l--s_e_rv_ic_e_s ___ ~--~---~D_ur_a_bl_e4g~o_od_s~, _w_ho~l_es_a_le__~_W_ho_l_es_a_le~g~r_oc_e_rs~ 0 2 3 4 5 6 7 8 9

Asset turnover

TABLE 12.2 Median Return on Common Equity (ROCE), Financial Leverage (FLEV), Operating Liability Leverage (OLLEV), Return on Net Operating Assets (RNOA), Profit Margins (PM), and Asset Turnovers (ATO) for Selected Industries, 1963-1996

Source: Company: Standard & Poor's Cornpustat data.

Chapter 12 The Analysis of Profitabili!)' 375

Industry ROCE, % FLEV OLLEV RNOA,% PM,% ATO Pipelines 17.1% 1.093 0.154 12.0% 27.8% 0.40 Tobacco 15.8 0.307 0.272 14.0 9.3 1.70 Restaurants 15.6 0.3 1 3 0.306 14.2 5.0 2.83 Printing and publishing 14.6 0.154 0.374 13.6 6.5 2.20 Business services 14.6 0.056 0.488 13.5 5.2 2.95 Chemicals 14.3 0.198 0.352 13.4 7.1 1.91 Food stores 13.8 0.364 0.559 12.0 1.7 7.39 Trucking 13.8 0.64 1 0.419 10.1 3.8 2.88 Food products 13.7 0.414 0.350 12.1 4.4 2.74 Telecommunications 13.4 0.743 0.284 9.1 12.5 0.76 General stores 13.2 0.389 0.457 11.3 3.5 3.55 Petroleum refining 12.6 0.359 0.487 11 .2 6.0 1.96 Transportation equipment 12.5 0.369 0.422 11.2 4.5 2.47 Airlines 12.4 0.84 1 0.516 9.0 4.3 1.99 Utilities 12.4 1.434 0.272 8.2 14.5 0.59 Wholesalers, nondurable goods 12.2 0.584 0.461 10.2 2.3 3.72 Paper products 11 .8 0.436 0.296 10.2 5.9 1.74 Lumber 11.7 0.3 1 2 0.384 10.4 4.0 2.60 Apparel 11 .6 0.408 0.317 10.1 4.0 2.55 Hotels 11.5 1.054 0.201 8.5 8.2 1.04 Shipping 11.4 0.793 0.205 9.1 12.6 0.61 Amusements and recreation 11.4 0.598 0.203 10.1 9.5 1.10 Building and construction 11.4 0.439 0.409 10.6 4.5 2.06 Wholesalers, durable goods 11.2 0.448 0.354 9.9 3.4 2.84 Textiles 10.4 0.423 0.266 9.3 4.3 2.09 Primary metals 9.9 0.424 0.338 9.4 5.0 1.80 Oil and gas extraction 9.1 0.395 0.263 8.3 13.0 0.57 Railroads 7.3 0.556 0.362 7. 1 9.7 0.78

operating liability leverage (OLLEV). This table gives you a sense of the typical amounts for these measures. The median ROCE over all industries is 12.2 percent, and the median RNOA is 10.3 percent. The difference is due to financial leverage and a positive SPREAD. The median FLEV over all industries is 0.403 , but there is considerable variation. You can see that some industries-pipelines, utilities, and hotels- have produced ROCE through highly favorable financial leverage. Others- business services, printing and publishing, and chemicals- use little financial leverage to yield a high ROCE. Some- such as business services- have used operating liability leverage rather than financial leverage to lever ROCE. Others- such as trucking and airlines- have used both forms of leverage.

The PM and ATO tradeoff is apparent from the table . Some industries- printing and publishing and chemicals- produce a higher than average RNOA with both high profit margins and high asset turnovers. But industries with high margins typically have lower turnovers, and vice versa. Compare pipelines with food stores: Similar RNOAs are gener-ated with quite dissimilar margins and turnovers. Capital-intensive industries such as pipelines, shipping, utilities, and communications have low turnovers but high margins. Firms in competitive businesses- food stores, wholesalers, apparel , and general retail-often have low profit margins but generate RNOA through higher turnover.

Margins and turnovers reflect the technology for delivering products. Businesses with large capital investments- like telecommunications- typically have low turnovers and

376 Part Two The Analysis of Financial Statemems

high margins. Firms that generate customers with advertising- like apparel makers-typically have lower margins (after advertising e:x.pense) but, as a result of the advertising, high turnovers. Margins and turnovers also reflect competition. An industry where high turnover can be achieved- food stores that can generate a lot of sales per square foot of retail space- will attract competition. That competition erodes margins, if there is little barrier to entry, as sales prices fall to maintain turnover (as with food stores).

THIRD-LEVEL BREAKDOWN

Profit Margin Drivers We now move to the final step in the scheme in Figure 12.1, breaking down the profit margin and asset turnover into their drivers. The common-size analysis of the income statement in Chapter 10 broke the profit margin into two components:

PM = Sales PM + Other items PM (12.5) Other items in the income statement include shares of subsidiary income, special items,

and gains and losses on asset sales. These sources of income are not a result of sales rev-enue at the top of the income statement. So calculating a PM that includes these items dis-torts the profitability of sales. The sales PM, based on operating income before other items, includes only expenses incurred to generate sales, thus isolating the profitability of sales.

The two components of the profit margin have further components:

Sales PM = Gross margin ratio - Expense ratios

Gross margin Sales

Administrative expense Selling expense Sales Sales

R&D Operating taxes ----

Sales Sales

Other operating items PM = Subsidiary income + Other equity income Sales Sales

Special items Other gains and losses + +---------

Sales Sales

(12.6)

(12.7)

These component ratios are known as profit margin drivers. The drivers can be analyzed further by business segment if segment disclosures are available. Clearly, profit margins are increased by adding to gross margins (reducing cost of sales), by adding other items in-come, and by reducing expenses per dollar of sales.

Turnover Drivers The net operating assets are made up of many operating assets and liabilities and so the overall ATO can be broken down into ratios for the individual assets and liabilities:

1 Cash Accounts receivable Inventory PPE --=-- + + + + - - (12.8) ATO Sales Sales Sales Sales

Accounts payable Pension obligations + - - - ...

Sales Sales

Chapter 12 The Analysis of Profitability 377

Again, the balance sheet amounts are averages over the year. The turnover is expressed here as a reciprocal of the ATO, which is the amount of net operating assets to sup-port a dollar of sales, as are the individual turnovers. Thus the individual turnovers aggregate conveniently (in a spreadsheet, for example) to the overall turnover. However, conventionally, individual turnover ratios are expressed as sales per dollar of investment in the asset. For example,

Sales Accounts receivable turnover = ----------Accounts receivable (net)

and Sales PPE turnover = ---------------

Property, plant, and equipment (net)

(The PPE turnover is sometimes called the.fixed asset turnova) A firm increases its turnover (and thus RNOA) by maintaining operating assets at a min-

imum while increasing sales. But the ATO is also affected by operating liability turnovers, and this of course reflects operating liability leverage: Operating liability leverage increases ATO and, if operating liability leverage is favorable, RNOA.

Turnover ratios are sometimes referred to as activity ratios or asset utilization ratios. Some activity ratios are calculated in different ways but with the same concept in mind. So, for example,

. . bl 365 Days 111 accounts recetva e = ------------Accounts receivable turnover

(sometimes called days sales outstanding) . This gives the typical number of days it takes to collect cash from sales. It highlights that efficiency is increased by turning sales into cash quickly and is often used as a metric to evaluate collection departments . A typical number is 35 days, but it varies considerably from industry to industry, with department stores and hotels having less than 15 days and pharmaceuticals over 50 days. With an accounts re-ceivable turnover of 6.85, Nike's days in accounts receivable is 53 . General Mills, with an accounts receivable turnover of 15.15, has 24 days in accounts receivable.

The inventory turnover ratio is sometimes measured as

Cost of goods sold Inventory turnover = ---=-----Inventory

This differs from the sales/inventory calculation by not being affected by changes in profit margins. Using this definition, the efficiency of inventory management is sometimes expressed in terms of the average number of days that inventory is held, its shelf life:

D . ' 365 ays 111 111ventory = -------Inventory turnover

Inventory turnover increases if inventory builds up when sales are slow, so it is often taken as a red flag warning indicating a drop in demand. But the measure will also increase if firms are building up inventories in anticipation of more sales. The ratio is best applied in whole-saling or retailing concerns where there is just one type of inventory, finished goods inven-tory. In a manufacturing concern, inventories include materials and work in progress, which take different times to complete into finished goods. Footnotes sometimes break down inventory into finished goods and other inventories, in which case ratios for finished

378 Part Two The Analysis of Financial Statements

goods inventory can be calculated. Advertising and promotion reduce the inventory turnover but, as they incur additional expenses, they also reduce the profit margin. The management issue is the net effect of RNOA.

A metric that assesses the ability to get operating liability leverage by extending credit from suppliers is

. 3 65 x Accounts payable Days m accounts payable = ____ __ ....:..___.:...__ Purchases

where

Purchases= Cost of goods sold+ Change in inventory

But note that supplier credit has a cost: The supplier might raise prices to compensate. So the manager has to ask if operating liability leverage is favorable.

The profit margins and asset turnovers for Nike and General Mills are given in Table 12.3, along with their drivers. The profit margin drivers sum to the overall PM, and the inverse of the turnover drivers sum to the inverse of the overall ATO.

TABLE 12.3 Second- and Third-Level Breakdown: Nike and General Mills, 2009-2010

Nike General Mills 2010 2009 2010 2009

Second Level RNOA 30.6% 28.4o/o 10.1 % 4.1% Profit margin 9.54% 8.99% 7.95% 3.41% Asset turnover 3.21 3.16 1.27 1. 19

-- =

Third Level Profit margin drivers(%)

Gross margin ratio 46.3 44.9 39.7 35.6 Administrative expense ratio (20.9) (19.8) (14.3) (13.7) Advertising expense ratio (12.4) (12.3) (6, 1) (5.0) Other expense ratio 0.3 0.5 (1.5) (1.4) Sales PM before tax 13.3 13.3 17.8 15.5 Tax expense ratio (3.2) _Q.& (6.3) (5.8) Sales PM 10.0 9.7 11.5 9.8 Other items PM (0.5) 9.5 JQlL 9.0 (3.6) 7.9 (6.4) 3.4

Asset turnover drivers (inverse) ---Cash turnover 0.005 0.005 0.004 0.004 Accounts receivable turnover 0.146 0 .148 0.066 0.069 Inventory turnover 0. 116 0. 125 0.090 0.093 Prepayment turnover 0.043 0.036 0.029 0.033 PPE turnover 0.102 0.101 0.208 0.209 Goodwill and intangibles

turnover 0.036 0.048 0.700 0.715 Other asset turnover 0.060 0.050 0.058 0.091 Operating asset turnover 0.506 0.512 1. 157 1.212 Accounts payable turnover (0.056) (0.057) (0.056) (0.059) Accrued expenses turnover (0.090) (0.090) Taxes payable turnover (0.004) (0.005) Other liability turnover (0.045) 0.3 11 (0.044) 0.3 16 (0.3 14) 0.787 (0.314) 0.839

--- --

Note: Columns may not add precisely due to rounding error.

What if Nike increased its accounts receivable turnover from 6.85 to General Mills's level of 15.15 while maintaining the current level of sales? How would RNOA change?

Answer: The increase would reduce average accounts receivable by $1,395 million to $1,255 million, increase the overall asset turnover from 3.21 to 4.19, and increase RNOA from 29.6 percent to 40.0 percent. However, this is so only if the reduction in customers' payment terms has no effect on sales and margins. A complete sensitivity analysis traces the effects through to all the determinants of RNOA: How will sales, margins, and asset turnovers be affected?

What if Nike's gross margin ratio of 46.3 percent declines to 44.9 percent in 2009 due to higher production costs?

Answer: A reduction in the gross margin ratio of 1 .4 per-cent is an after-tax reduction of 0.89 percent at Nike's 36.3 percent tax rate. This results in a drop in the (after-tax) overall

profit margin fro rn 9.54 percent to 8.65 percent and a drop of RNOA from 30.6 percent to 27 .8 percent.

What if General M ills increased its annual advertising expendi-tures by $200 mi 11 ion to $1, 109 million, resulting in $1,200 mil-lion in additional sales at the same gross margin percentage?

Answer: The i ncreased advertising would result in an extra $476 million of gross margin at the current gross margin ratio of 39.7 percent. Net of the $200 million in additional advertis-ing expenses, the additional pretax income would be $276 mil-lion, or $173 mi 11 ion after tax. Accordingly, the profit margin ratio would increase to 8.4 percent. If receivables, inventory, and other net assets increase proportionally to support the sales, the ATO remains the same, so RNOA increases to 8.4 percent x 1.27 = 10.7 percent. Clearly, if the increased sales that the advertising draws were lower margin sales, the RNOA would be less.

The details in Table 12.3 provide a more granular view of the profitability. Changes over years are particularly informative for the analyst forecasting the future because they indi-cate how RNOA is evolving and thus its likely path ahead. (One needs more than two years for a good look.) Table 12.3 indicates that Nike's higher profitability in 2010 over General Mills comes from a higher gross margin, though higher advertising and administrative expense ratios to maintain sales cut into the overall profit margin. Gross margin, of course, reflects production costs. General Mills requires lower receivables and inventories to main-tain sales , but higher investment in property, p lant, and equipment. General Mills's lower ATO also comes from the investments in acquisitions (goodwill) and brands (intangible as-sets) to grow sales whereas Nike maintains its brand through advertising. Nike's increase in RNOA is due largely from an enhanced gross margin, which bodes well for the future, though sales are flat. All other drivers are fairly stable. General Mills's RNOA increased significantly in 20 I 0 over 2009, also with an increasing gross margin on flat sales and fairly constant asset turnovers. But the increase is also explained by charges for its pension plan and currency losses (in other items) in 2009.

Key Drivers The big issue for both firms : Can they grow sales while at the same time maintaining the enhanced gross margins? Can they do it without a considerable increase in the advertising expense ratio? Can they do it without large investment that will reduce their asset turnovers? These questions and the analysis here point to the three key drivers: sales, oper-ating profit margin, and asset turnover. Simply put, a firm increases value by growing sales, earning high income per dollar of sales (PM), and keeping its net operating assets that gen-erate the sales as low as possible (ATO). Accordingly, these three drivers will appear promi-nently when we come to valuation in the next part of the book.

Analysis does not end with the calculation ofratios. Indeed the calculations are the tools of analysi s. The analyst takes these tools and asks what-if questions- and gets answers. See Box 12.6. The profitability analysis for Nike continues on the BYOAP feature on the book's Web site. See Box 12.7 for a summary for years 2000-2008.

379

The profitabi lity analysis for Nike is continued on the Build Web site, whic h provides a full analysis of the firm from Your Own Analysis Product (BYOAP) feature on the book's 2000-2010. He re are some of the salient numbers up to 2008:

2008 2007 2006 2005 2 004 2003 2002 2001 2000

Sales revenue ($ billions) 18.6 16.3 15.0 13.8 1 2.3 10.7 9.9 9.5 9.0 Profitability: Return on common equity(%) 25.9 25.1 24.1 26.1 2 3.0 10.3 17.0 16.5 16.6 Return on net operating assets(%) 35.0 33.5 29.5 29.4 2 3 .3 9.6 14.4 12.9 13.3

Profit margin (%) 10.1 10.1 9.6 10.0 8 .4 4.0 6.5 6.1 6.2 Asset turnover 3.5 3.3 3.1 3.0 2 .8 2.4 2.2 2.1 2.1

Leverage: Financial leverage - 0.280 -0.269 - 0.198 - 0.116 - 0 .1 60 0.116 0.216 0.342 0.295 Operating liability leverage 0.646 0.579 0.515 0.479 0.462 0.383 0.283 0.258 0.290

You see that Nike's return on common equity (ROCE) increased over the years even though financial leverage declined: In 2000, Nike was positively levered, but by 2004 it had become a holder of net financial assets. The increase in ROCE is explained by operations: RNOA increased from 13.3 percent in 2000 to 35.0 percent by 2008 (but declined to 30.6 in 2010, as we have seen). Not only did profit margins from

operations increase, but so did asset turnovers, accompanied by an increase in operating liability leverage. The increased asset turnover was accompanied by significant sales growth but with the firm requiri ng lower net operating assets to support sales.

These meas ures are the drivers of growth. They are em-bellished by a d eeper analysis of drivers, as in Table 12.3. We turn to the form al analysis of growth in t he next chapter.

380

Borrowing Cost Drivers The final component of ROCE is the operating spread, RNOA - NBC. As the RNOA com-ponent of this spread has been analyzed, this leaves the analysis of the net borrowing cost or, in the case of net financial assets, the return from net financial assets.

The net borrowing cost is a weighted average of the costs for the different sources of net financing. It can be calculated as

NB = -- x ------------~~-~-C [ FO After-tax interest on financial obligations (FO)]

NFO FO

_ [ FA x After-tax interest on financial assets (FA)] FO FA

( FA Unrealized gains on FA) ( Preferred stock Preferred dividend )

- - - x + x + FO FA NFO Preferred stock

General Mills's 2010 after-tax net borrowing cost of 4.1 percent is made up of after-tax interest expense and interest income components, weighted as follows. Refer again to the reformulated statements in Exhibits 10.5 and 10. 11.

NBC= [6,752 x 256 ] - [ 652 x-5-] 6,100 6,752 6,100 652

= [ 1.11 x 3.79%]-[ 0.11 x 0.77%]

= 4.1 % (allow for rounding error).

Chapter 12 The Analysis of Profitabilit)' 381

The weights are calculated from balance sheet averages. This calculation separates the after-tax borrowing cost for the obligations (3.79 percent) from the return on financial assets (0. 77 percent).

A lower rate of return on financial assets than the borrowing rate on obligations increases the composite net borrowing cost over that for the obligations. The difference in the rates for the two components is called the spread between lending and borrowing rates (- 3.02 percent here). Banks make money with higher lending than borrowing rates and thus (if they are successful) their overall net rate is higher than the borrowing rate. Gen-eral Mills has a negative lending and borrowing rate spread, typical of nonfinancial firms.

As with all calculations, these numbers should be checked for their reasonableness. Foot-notes give rates for some borrowings as a benchmark. If your calculated borrowing costs seem "out of line," you may have misclassified operating and financing items (and this means that your RNOA is also incorrect). It may be that disclosures are not sufficient to make a clear distinction. To the extent this is material, it will affect not only the net borrowing cost but also financial and operating leverage calculations. The inability to unravel capitalized interest will introduce errors. And errors will be made ifthe averaging of balance sheet amounts does not reflect the timing of changes in those amounts during the period.

BUILD YOUR OWN ANALYSIS ENGINE You are now at the stage where you can build your own financial statement analysis engine along the lines of this chapter. The spreadsheet starts with a reformatting of the equity statement (as in Chapter 9) to isolate comprehensive income, followed by the reformatting of income statements and balance sheets to separate operating and financing activities (Chapter I 0). If you also want a statement of cash flow, remember the lesson learned in Chapter 11 : Once you have appropriately reformatted income statement and balance sheets, free cash flow falls out by the press on a button. To add the financing section of the cash flow statement, simply take the net payout to shareholders in the equity statement and identify cash flow to net debtholders as the remainder of the free cash flow.

With income statements and balance sheets reformatted into their appropriate cells in the spreadsheet, the decomposition of the ROCE into its drivers follows by the press of a button once you have entered the template for the calculations. If you enter reformatted statements for a number of years you will have a detailed history of the evolution ofa firm 's profitability and the drivers of the profitability. Keep your eye on the key drivers: sales growth, operating profit margins, and asset turnovers.

Once you have built the spreadsheet, experiment with sensitivity analysis. That involves asking "what-if" questions for different scenarios, such as those in Box 12.6. Observe how RNOA and ROCE can change as particular drivers change. As we proceed, you will see how that exercise will help you get an insight into risk, for the analysis ofrisk involves un-derstanding outcomes under different scenarios. You will also see how the sensitivity analy-sis also involves simulating management (albeit as a desk job!). You ask: How can this firm be managed differently and what would be the effect on profitability and its drivers?

Note one important structural point in the scheme in Figure 12.1: The various measures are nested such that any change within the system can be tracked back directly to ROCE. So, for example, the effect of a change in a profit margin driver at the lowest level of ROCE is automatically delivered by the program ifthe spreadsheet follows the struchire of the figure . And ROCE, of course, drives residual earnings and value- that is where we are headed.

With this analysis tool , you are ready for forecasting and valuation. The final stage of the project will be to combine your valuation engines (Chapter 5 and 6) with your analysis

382 Part Two The Analysis of Financial Statements

Ir\~~~: -~~''~~,.~ ... ~.~~ ~~-~ The Web Connection

Find the following on the Web page for this chapter: Profitability analysis when fi rms classify expenses by nature rather than function.

Further exploration of the effects of financial leverage, with consideration of both risk and profitability effects. A spreadshee t engine to carry out profitability analysis.

Further exploration of operating liability leverage and how it is particularly pertinent for an insurance company.

The Readers ' Corner.

Summary

Key Concepts

engine here to give you a complete analysis and v aluation product. This is Part Three of the book. Again, BYOAP on the Web site will guide you.

This chapter has laid out the analysis of profitab ility. The analysis is summarized in Fig-ure 12.1. The methods are orderly, with lower levels of analysis nested in higher levels. And the analysis aggregates up from the bottom to ROCE at the top, so it is amenable to simple programming. Once the reformulated income sta tement and balance sheet are entered into a spreadsheet program and the template in Figure 12.1 overlaid, the analysis proceeds automatically.

The analysis uncovers the financial statement drivers of the return on common equity, but each of these drivers refers to an aspect of business activity. The analysis here is a way of penetrating the financial statements to observe those activities. But it is also a way of or-ganizing your knowledge of the business and understanding the effects of business activi-ties on value. Understanding how the business affects the financial statement drivers means that the analyst understands how the business affects ROCE and, in turn, how the business affects residual earnings and the value of the business. So, for example, the analyst under-stands how a change in the profit margin or asset turnover affects residual earnings. And the analyst- or the manager of the business-can ask "what-if" questions of how ROCE and the value might change with a planned or unplanned change in margins or turnovers.

favorable financial leverage (or favorable gearing) is an increase in ROCE over RNOA, induced by borrowing. 367

favorable operating liability leverage is an increase in return on net operating assets over return on operating assets, induced by operating liabilities. 369

growth analysis is the analysis of the determinants of growth in residual earnmgs. 364

operating liability leverage spread is the difference between the return on operating assets and the implicit borrowing rate for operating liabilities. 369

operating spread is the difference between operating profitability and the net borrowing cost. 367

profitability analysis is the analysis of the determinants of return on common equity (ROCE). 364

spread is a difference between two rates of return. Examples are the operating spread, the operating liability leverage spread, and the spread between borrowing and lending rates. 367

spread between borrowing and lending rates is the difference between the return on financial obligations and the return on financial assets. 381

Chapter 12 The Analysis of Profitability 383

Analysis Tools Page Key Measures Page Acronyms to Remember The analysis of financial Return on common equity ATO asset turnover=

leverage (ROCE) 365 sales/NOA equations 12.1 , 12.2 366 Return on net operating CSE common

The analysis of operating assets (RNOA) 366 shareholders' equity liability leverage Net borrowing cost (NBC) 366 FLEV financial leverage= equation 12.3 369 Return on net financial NFO/CSE

DuPont analysis of return on assets (RNFA) 368 NBC net borrowing cost= net operating assets Financial leverage (FLEV) 366 NFE/NFO equation 12.4 373 Operating liability leverage NFA net financial assets

Analysis of profit margin (OLLEV) 368 NFE net financial expenses equations 12.6, 12.7 376 The operating spread NFI net f inancial income

Analysis of asset turnovers (SPREAD) 366 NOA net operating assets equation 12.8 376 Operating liability leverage OA operating assets

Analysis of borrowing costs 380 spread (OLSPREAD) 369 01 operating income What-if analysis 379 Return on operating assets OL operating liabilities

(ROOA) 369 OLLEV operating liability Minority interest sharing leverage = OUNOA

ratio 372 OLSPREAD operating liability Operating profit margin leverage spread =

(PM) 373 ROOA - short-Asset turnover (ATO) 373 term borrowing rate Sales profit margin 376 PM profit margin = Other operating items 01/sales

profit margin 376 PPE property, plant, and Gross margin 376 equipment Expense ratios 376 RNFA return on net Individual asset turnover financial assets=

ratios 376 NFl/NFA Days in accounts receivable 377 RNOA return on net Days in inventory 377 operating assets= Days in accounts payable 377 01/RNOA Borrowing cost drivers 380 ROA return on assets = Spread between lending net income + interest

and borrowing rates 381 expense (after tax)/total assets

ROOA return on operating assets= (01 +implicit interest on OL)/OA

SPREAD operating spread = RNOA-NBC

A Continuing Case: Kimberly-Clark Corporation

A Self-Study Exercise In the Continuing Case for Chapter 10, you reformulated Kimberly-Clark's balance sheets and income statements. The reformulation prepares the statements for analysis, which you will carry out here.

384 Part Two The Analysis of Financial Statements

Concept Questions

PROFITABILITY ANALYSIS FOR KMB Proceed with a comprehensive profitability analysis of Kimberly-Clark for 2009 and 2010. Let Figure 12.1 in this chapter be your guide; proceed through the three levels of analysis. Be sure to distinguish operating profitability from the effects of financing activities, and then analyze the operating activities in detail. Show how the leveraging equations for financial leverage and operating liability leverage work for KMB. For the latter, set the short-term borrowing rate, before tax, at 1.2 percent.

WHAT DOES THE ANALYSIS IVI EAN? After making the requisite calculations, state in words what the array of numbers mean. How would you discuss KMB's performance if you were an analyst talking to clients?

SENSITIVITY ANALYSIS: WHAT IF? After you have completed the analysis, introduce some "what-if" questions and supply the answers. Examine the effects of changes in margins and turnovers on profitability. What if gross margins decline? What if advertising becomes less productive? What if individual asset turnovers change?

BUILDING YOUR OWN ANALYSIS ENGINE FOR KMB If you entered KMB 's reformulated statement s into a spreadsheet in Chapter 10, you might add profitability analysis to that spreadsheet. The BYOAP feature on the book's Web page will guide you. Also look at the profitability analysis engine on the Web page for this chapter. Once you have the analysis automated, you can apply it to the sensitivity analysis that supplies answers to the what-if questions you raised above. Just change the inputs (the reformulated statements) and the program will supply the answer at the press of a button.

Cl2.l. Under what conditions would a firm's return on common equity (ROCE) be equal to its return on net operating assets (RNOA)?

Cl2.2. Under what conditions would a firm's return on net operating assets (RNOA) be equal to its return on operating assets (ROOA)?

C12.3. State whether the following measures drive return on common equity (ROCE) positively, negatively, or depending on the circumstances: a. Gross margin. b. Advertising expense ratio. c. Net borrowing cost. d. Operating liability leverage. e. Operating liability leverage spread. f. Financial leverage. g. Inventory turnover.

C12.4. Explain why borrowing might lever up the return on common equity. C12.5. Explain why operating liabilities might lever up the return on net operating assets.

Chapter 12 The Analysis of Proficability 385

Cl2.6. A firm should always purchase inventory a nd supplies on credit rather than paying cash. Correct?

C12.7 . A reduction in the advertising expense ra tio increases return on common equity and share value. Correct?

C12 .8. A firm states that one of its goals is to earn a return on common equity of 17-20 percent. What is wrong with setting a goal in terms of return on common equity?

Cl2 .9. Why might operating losses increase after -tax borrowing cost? C 12 .10. Some retail analysts use a measure called "inventory yield," calculated as gross

profit-to-inventory. What does this measure tell you? Cl2.l l. Return on total assets (ROA) is a common measure of profitability. The historical

average is about 7.0 percent. The historical yield on corporate bonds is about 6.6 percent. Why is the ROA so low? Would not investors expect more than a 0.4 percent higher return on risky operations?

Cl2.12. Low profit margins always imply low return on net operating assets. True or false? C12.13. A firm has financial assets invested in short-term government bonds but has no

financial obligations. a. Suppose RNOA exceeds ROCE. Explain how this can be due to the financial

assets. b. Suppose now that ROCE exceeds RNOA. Explain how this can happen to this

firm . c. Apple Inc. has no financial obligations but had $68.8 billion of financial assets

in March 2011. Does it belong in case (a) or (b)?

Exercises Drill Exercises E12.1. Leveraging Equations (Easy)

The following information is from reformulated financial statements (in millions):

2012 2011

Operating assets $2,700 $2,000 Short-term debt securities 100 400 Operating liabil ities (300) (100) Bonds payable (1,300) (1,400) Book value 1,200 $ 900 Sales 2,100 Operating expenses (1,677) Interest revenue 27 Interest expense (137) Tax expense (tax rate= 34%) (106) Earnings (net) $ 207

a. (1) Calculate the dividends, net of capital contributions, for 2012. (2) Calculate ROCE for 2012; use average book value in the denominator. (3) Calculate RNOA for 2012; use the average net operating assets in the denominator. ( 4) Supply the numbers for the formula

ROCE =PM x ATO + [Financial leverage x (RNOA - Borrowing cost)]

386 Part Two The Analysis of Financial Statements

b. The firm's short-term borrowing rate is 4.5 p ercent after tax. Supply the numbers for the formula

RNOA = ROOA + (OLL EV x OLSPREAD) c. Repeat the exercise in part (a) using the follo wing information (in millions):

2012 2011 Operating assets $2,700 $2,000 Short-term debt securities 1,000 800 Operating liabilities (300) (100) Book value 3,400 $2,700 Sa les 2,100 Operating expenses (1 ,677) Interest revenue 90 Tax expense (tax rate= 34%) (174) Earn ings $ 339

---

E12.2. First-Level Analysis of Financial Statemen1:s (Easy) A finn whose shares traded at three times their book value on December 31 , 2012, had the accompanying financial statements. Amounts are in millions of dollars. The firm's marginal tax rate is 33 percent. There are no dirty-surplus income items in the equity statement.

a. The firm paid no dividends and issued no shares during 20 12, but it repurchased some stock. Calculate the amount of stock repurchased.

b. Calculate the following measures: Return on common equity (ROCE) Return on net operating assets (RNOA) Financial leverage (FLEV) The operating spread (SPREAD) Free cash flow

c. Does it make sense that this firm's shares should trade at three times book value?

Assets

Operating cash Short-term investments Accounts receivable Inventories Property and plant (net)

Sales Interest income Operating expenses Interest expense Tax expense Net income

Balance Sheet, Decem ber 31 , 2012

Liabilities and 2012 2011 Sh areholders' Equity

$ 50 $ 20 Accounts payable 150 150 Long-term debt 300 250 420 470 Common equity 840 790

$1,760 $1,680 - --

Income Statement, Year End ed December 31 , 2012

2012 2011 $ 215 $ 205

450 450

1,095 1,025

$ 1,760 $1,680 --- - --

$3,295 9

$3,048 36 61 (3, 145)

$ 159 ---

Chapter 12 The Analysis of Profitability 387

E12.3. Reformulation and Analysis of Financial Statements (Medium) This exercise continues Exercise 10.6 in Chapter 10. The following financial statements were reported for a firm for fiscal year 2012 (in millions of dollars):

Balance Sheet

2012 2011

Operating cash 60 50 Accounts payable Short-term investments (at market) 550 500 Accrued liabi lities Accounts receivable 940 790 Long-term debt Inventory 910 840 Property and plant 2,840 2,7 10 Common equity

5,300 4,890

Statement of Shareholders' Equity

Balance, end of fiscal year 2011 Share issues Repurchase of 24 million shares Cash dividend Unrealized gain on debt investments Net income Balance, end of fiscal year 2012

2012

1,200 390

1,840

1,870 5,300

1,430 822

(720) (180)

50 468

1,870

2011

1,040 450

1,970

1,430 4,890

The firm's income tax rate is 35%. The firm reported $15 million in interest income and $98 million in interest expense for 2012. Sales revenue was $3,726 million.

a. Prepare a reformulated balance sheet and comprehensive income statement (as required in Exercise 10.6).

b. Calculate free cash flow for 2012. c. Calculate the operating profit margin, asset turnover, and return on net operating

assets for 2012. (For simplicity, use beginning-of-period balance sheet amounts in denominators.)

d. Calculate individual asset turnovers and show that they aggregate to the total asset turnover.

e. Show that the financing leverage equation holds for this firm:

ROCE = RNOA + (FLEV x Operating spread) f. Calculate the after-tax net borrowing cost. If this borrowing cost were to be sustained

in the future, what would the rate of return of common equity (ROCE) be if operating profitability (RNOA) fell to 6% and financial leverage decreased to 0.8?

g. The implicit cost of credit for accounts payable and accrued liabilities is 3% (after tax). Show that the following leverage equation holds in this example:

RNOA = ROOA + [OLLEV x (ROOA - 3.0%)] E12.4. Relationship Between Rates of Return and Leverage (Medium)

a. A firm has a return on common equity of 13.4 percent, a net after-tax borrowing cost of 4.5 percent, and a return of 11.2 percent on net operating assets of $405 million. What is the firm's financial leverage?

b. The same firm has a short-term borrowing rate of 4.0 percent after tax and a return on operating assets of 8.5 percent. What is the firm's operating liability leverage?

c. The firm reported total assets of $715 million. Construct a balance sheet for this firm that distinguishes operating and financial assets and liabilities.

388 Part Two Tlie Analysis of Financial Statements

E1 2.5. Profit Margins, Asset Turnovers, and Retu r n on Net Operating Assets: A What-If Question (Medium) A firm earns a profit margin of3 .8 percent on sal es of$435 million and employs net oper-ating assets of $150 million to do so. It considers a dding another product line that will earn a 4.8 percent profit margin with an asset turnover of2.3.

What would be the effect on the firm's return Gn net operating assets of adding the new product line?

Applications E12.6. Profitability Measures for Kimberly-Clark C orporation (Easy)

Below are summary numbers from reformulate d balance sheets for 2007 and 2006 for Kimberly-Clark Corporation, the paper product company, along with numbers from the reformulated income statement for 2007 (in mill i ons).

2007

Operating assets $18,057.0 Operati ng liabilities 6,01 1.8 Financial assets 382.7 Fi nancial obligat ions 6,496.4 Operating income (after tax) $ 2,740.1 Net financial expense (after tax) 1 47. 1

a. Calculate the following for 2007 and 2006: (1) Net operating assets (2) Net financial obligations (3) Shareholders' equity

2006

$16,796. 2 5,927.2

270.8 4,395.4

b. Calculate return on common equity (ROCE ) , return on net operating assets (RNOA), financial leverage (FLEV), and net borrowing cost (NBC) for 2007. Use beginning-of-period balance sheet numbers in denominators.

c. Show that the financing leverage equation w orks with your calculations. d. Calculate the operating profit margin (PM) and asset turnover (ATO) for 2007 and

show that RNOA = PM x ATO. Sales for 2007 were $18,266 million. Real World Connection Exercises E4.9, E7.16, E8.10, and E l 1.10 also cover Kimberly-Clark, as does Minicases M2 . l and M5.3. The Continuing Case at the end of each chapter is a comprehensive analy-sis of the firm .

E12.7. Analysis of Profitability: The Coca-Cola Co mpany (Easy) Here is a reformulated income statement for the C oca-Cola Company for 2007 (in millions):

Sales Cost of sales Gross margin Advert ising expenses General and administrative expenses Other expenses (net) Operating income from sales (before tax) Tax Operati ng income from sales (after tax) Equity income from bottling subsidiaries (af ter tax) Operating income Net financial expense (after tax) Earn ings

$28,857 10,406 18,451 2,800 8,145

81 7,425 1,972 5,453

668 6, 121

140 $ 5,981

Chapter 12 The Analysis of Profitability 389

Summary balance sheets for 2007 and 2006 are as follows (in millions):

2007 2006

Net operating assets $26,858 $18,952 Net financial obligations 5,114 2,032 Common shareholders' equity $21 ,744 $16,920

For the following questions, use average balance sheet amounts. a. Calculate return on net operating assets (RNOA) and net borrowing cost (NBC) for

2007. b. Calculate financial leverage (FLEV). c. Show that the financing leverage equation that explains the return on common equity

(ROCE) holds for this firm. d. Calculate the profit margin and asset turnover (ATO) for 2007 and show that RNOA =

PMxATO. e. Calculate the gross margin ratio, the operating profit margin ratio from sales, and the

operating profit margin ratio. Real World Connection Coca-Cola is covered in Exercises E4.7, E4.8, EIS. 7, E16.12, E l 7.7, and E20.4 and also in Minicases M4.l, M5 .2, and M6.1.

E12.8. A What-If Question: Grocery Retailers (Medium) In the late 1990s, many grocery supermarkets shifted from regular storewide sales to issuing membership in discount and points programs, much like frequent flyer programs run by the airlines.

A supermarket chain with $120 million in annual sales and an asset turnover of 6.0 pon-ders whether to institute a customer membership program. It currently earns a profit margin of 1.6 percent on sales. Its marketing research indicates that a customer membership program would increase sales by $25 million and would require an additional investment in inventories of $2 million but no additional retail floor space. Costs to run the membership program, including the discounts offered to members, would reduce profit margins to 1.5 percent.

What would be the effect on the firm's return on net operating assets of adopting the customer membership program?

E12.9. Financial Statement Reformulation and Profitability Analysis for Starbucks Corporation (Medium) Refer to the financial statements for Starbucks, the coffee vendor, in Exercise ElO. l 0 in Chapter 10. Be sure to read the notes under the financial statements.

a. Prepare a reformulated income statement for fiscal year 2007 and reformulated balance sheets for 2007 and 2006 in a way that distinguishes operating and financing activities and identifies taxes applicable to various components of income.

b. For fiscal year 2007, calculate the following: return on common equity (ROCE), return on net operating assets (RNOA), and net borrowing cost (NBC). Use beginning-of-year balance sheet amounts in denominators.

c. Calculate the financing leverage ratio (FLEV) at the beginning of the year and show that the following leverage equation for 2007 is satisfied:

ROCE = RNOA + [FLEV x (RNOA- NBC)]

390 Part Two The Analysis of Financial Statements

d. Calculate the operating profit margin ratio CPM) and the asset turnover (ATO). Also calculate the operating profit margin ratio from sales.

e. Calculate the operating liability leverage ratio at the beginning of2007. f. The firm's borrowing cost on its short-ten n commercial paper is 5 .5 percent, or

3.6 percent after tax. Show how operating lia bility leverage levers up the return of net operating assets.

Real World Connection See Exercises E9.8, El0.10, E13 .8, and E15.8 on Starbucks Corporation.

Minicase

Chapter 12 The Analysis of Profitability 391

M12.1

Financial Statement Analysis: Procter & Gamble III Financial statements for the Procter & Gamble Co. are presented in Exhibit 10.15 in Chapter 10. If you worked Minicase 10.1 , you will have reformulated the statements in preparation for financial statement analysis. If not, do so now.

Proceed to carry out a comprehensive profitability analysis for fiscal years 2008-2010 along the lines of this chapter. Figure 12.1 will guide you. If you have built the reformulated statements into a spreadsheet, you might add this profitability analysis to the spreadsheet. The BYOAP guide on the book's Web site will help. (There is also an analyis spreadsheet on the Web page for this chapter.) You might also extend the analysis to subsequent years, as they become available, to track P&G's profitability and its drivers as the firm evolves. The financial statements for 2005- 2008 are available on the Web page for this chapter, both in their original form and in their reformulated form, to provide further history.

Your analysis should have the following feature :

A. Operating profitability should be distinguished from return on common equity. Apply the financing leverage equation to highlight the difference. How much leverage does P&G carry? Is the firm favorably leveraged?

B. Distinguish operating income from sales from other operating income. Calculate return on net operating assets (RNOA) with total operating income and then only with operat-ing income from sales.

C. Carry out an analysis of operating liability leverage. Footnotes to the firm's financial statements reveal that its short-term borrowing rate averaged 1.8 percent (before tax). The firm 's combined federal , state, and local statutory tax rate is 38 percent.

D. Carry out a comprehensive analysis of profit margins and asset turnovers.

After making the various calculations, step back and ask what they all mean. Refer to the background on P &G in Minicase l 0 .1 before you begin your interpretation. As a bench-mark, you might compare the measures you have calculated with those for General Mills in this chapter. As a packaged food products company, General Mills is not quite a compara-ble company but, like P&G, it is primarily a brand management operation.

Comment on the change in P&G's profitability from 2008 to 2010. Now conduct some sensitivity analysis. Ask some "what-if" questions. What would be

the effect on ROCE if operating profitability fell? What would be the effect on RNOA if profit margins changed? If asset turnovers changed? How might an increase in advertising expenditures affect profitability? If you have built the analysis into a spreadsheet, you will be able to answer these questions with the press of a button.

A final question: After excluding nonsales items from operating income, the return on net operating assets is quite low for a brand company. Why?

Real World Connection Minicases MlO.l , Ml 1.1 , Ml3.l, Ml5.l , and M16.l also deal with the analysis and valu-ation of Procter & Gamble. See also Exercise E3 .14.