Spring 2009 NBA 5060

Lecture 5 – Profitability Analysis

1. Why is profitability analysis important?

2. Profitability Analysis
• Relative vs. Absolute Analysis
• Cross-sectional vs. time-series

3. Profitability Ratios
• Return on Equity (ROA)
• Return on Assets (ROE)
• Decomposing these measures

4. Some Key Takeaways from Profitability Analysis

Additional Notes (not covered in class): Supplemental note on the economic

relation between accounting ratios and the cost of capital

For 2/5/08: Compute the profitability, liquidity and solvency ratios for CBRL.

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1. Why is ratio analysis important?
The value of a company depends on its ability to grow and generate
profits:

Growth and Profitability

Product Market Financial Market

Strategies Strategies

Operating Investment
Financing Payout
Managemen Manageme
Decisions Decisions
t nt

Goal: Evaluate effectiveness of the firm’s policies in each of these areas.

The ability to grow and generate profits is a function of the firm’s

operating, investing, and financing decisions. Ratio analysis provides
a means of evaluating the effectiveness of the firm’s operating,
investing, and financing policies:

Sustainable
Growth Rate
Dividend
Payout Ratio

ROE

ROA CEL CSL

PM ATO

Operating I nvestment Financing Payout

Management Management Decisions Decisions

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2. Profitability Analysis

Relative Analysis – compares the financial metrics of a firm relative to the

financial metrics of some comparison (i.e. control) group. Absolute level of the
numbers does not matter as much as whether they are higher or lower than the
comparison group.

Two basic types of relative analysis:

• Cross-sectional approach – compare the firm to industry peers on a

number of dimensions.

• Time series approach – use the historic performance of a firm as the

benchmark.

Cross-sectional comparisons are useful in benchmarking how the firm is doing

relative to industry peers, while a time series approach can reveal trends within
the firm.

Absolute analysis – compares the financial metrics of a firm to absolute levels.

Matters less where they rank relative to other firms.

e.g. Is operating cash flow positive? Does ROE exceed the cost of capital?

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3. Basic Profitability Ratios

Return on Equity

Net Income
ROE =
Average Shareholders Equity

Financing Activities
(Debt Policy)

Return on Assets

NI + Interest Expense(1 − t )
ROA =
Average Total Assets

Profit Margin Asset Turnover

NI + IntExp(1 − t ) Sales
= =
Sales AverageTotalAssets

Operating Investing
Activities Activities

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 Return on Assets (ROA)

NI + Interest Expense(1 − t ) EBI

ROA = =
Average Total Assets Average Total Assets

Other common variations: This is technically a mismatch

of the numerator and
denominator.
NetIncome
ROA =
AverageTotalAssets
Use of ‘Ending TA’
EBI
ROA = requires less data to
Beginning or Ending Total Assets form a time series

Disaggregating ROA:

ROA = Profit Margin x Asset Turnover

NI + IntExp(1 − t ) Sales
= x
Sales AverageTotalAssets

What is a reasonable absolute benchmark for ROA?

What factors drive cross-sectional differences in ROAs?

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 Return on Net Operating Assets (operating ROA)

EBI EBI
RONA = =
Avg.(Equity + Debt) Avg.(Total Assets − Operating Liabs)

You can decompose RONA similarly to ROA by simply multiplying and

dividing by sales.

What is the appropriate absolute benchmark for RONA?

In general, which is a more appropriate profitability ratio, ROA or RONA?

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Average Median ROAs, Profit Margins, and Asset Turnovers for 22
Industries from 1990-2004 (Source: Stickney, Brown and Wahlen,
2007, Financial Reporting and Statement Analysis, p.206)

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Decomposing ROA into Profit Margin and Asset Turnovers:

Can be used to check for sustainability of improvement (or decline) in ROA

Decomposing Profit Margin – simply divide each net income line item by sales:

Sales:
COGS:
Selling & Admin:
Depreciation & Amortization:
Other Revenue:
Income Taxes (add back tax on interest expense):

EBI:

Turnover Components (note this is not really a decomposition as the

components do not sum to asset turnover):

Sales Technically, should be

AR Turnover = ‘sales on account’, but
Average or Ending AR this is hard to measure.

Sales or COGS Sales is more appropriate as a Total Asset

Inv. Turnover = decomposition, while COGS give s a better
Average or Ending Inventory measure of actual times inventory turns over.

Sales
Fixed Asset Turnover =
Avg. or Ending Net Property, Plant, and Equipment

These ratios are useful for (1) explaining trends in ROA (and ROE), (2)
forecasting future financial statements and conducting sensitivity analysis, (3)
explaining changes in value through their impact on ROE.

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Return on Equity (ROE)

Net Income
ROE =
Average Shareholders Equity

Other variations you might run across:

NI − Div on Preferred Shares

ROCE =
Avg.CommonShareholdersEquity

Net Income
ROE =
Beginning or Ending Shareholders Equity

Disaggregating ROE:

NI + Int Exp(1 − t ) NI AverageTA

#1 ROE = x x
Average TA NI + Int Exp(1 − t ) AverageShareholdersEquity

Debt  InterestExpense(1 − t ) 
#2 ROE = RONA +  RONA − 
Equity  Debt 

What is a reasonable absolute benchmark for ROE?

What factors will drive cross-sectional variation in ROEs?

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4. Some Key Takeaways from Profitability Analysis:

I know how to compute all the ratios, but I’m still not sure I know when to actually
use them.

There are two primary objectives to profitability analysis at this point. First,
use ROA and ROE as a baseline evaluation of the firm relative to past
performance (e.g. ROA seems to be deteriorating) or relative to other firms (e.g.
Dell consistently has a higher ROE than other computer manufacturers). This
will give you a quick glimpse of whether the firm is well positioned going forward.
Second, use the ROA decomposition to determine the cause of increases
(decreases) in profitability. This can help determine if the change in ROA is likely
to be permanent or transitory. Finally, both ROA and ROE often tell similar
stories. As we’ll see, ROA drives the value of the firm, while ROE drives the
value of the equity. Hence, ROA tells you something about overall profitability
and firm value while ROE tells you how effectively the firm is using its capital
structure. Thus, they are important ratios for valuation purposes, as we’ll see
later.

Firm X increased their asset turnover from 1.8 to 2.0. Is this good? Is this
significant? How do I know?

More generally, this question reflects the lack of intuitive definitions for
several of the ratios we examine. So the best way to evaluate this is to consider
what the ratio actually means and do some sensitivity analysis (i.e. ‘as if’
calculations). In this case, the increase from 1.8 to 2.0 means that for every
dollar of assets employed by the firm, the firm increased sales by $0.20. Thus, if
the firm has $100 million in assets, efficiency improvements alone are
responsible for a $20 million increase in revenue. You can then trace the
improvement to earnings (via the profit margin), and EPS, which is particularly
meaningful. If you tell investors that efficiency improvements alone contributed
an additional $0.10 to this year’s EPS, they will be able to judge the economic
significance of the improvement more readily than if you simply report a 0.2
increase in the asset turnover ratio.

I know weighted cost of capital (cost of equity capital) is a decent benchmark for
ROA (ROE). Is there anything else I should look for?

Look for the relation between strategy and the components of ROA. If a firm is
trying to be a cost leader, it should have relatively high turnover and low margins.
The opposite is true for a product differentiator. If the ratios don’t seem to match
up with the firm’s strategy, this requires further investigation.

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 A Supplemental Note On
The Economic Relationship Between
Accounting Ratios and the Cost-of-Capital

Three accounting based return-on-investment (ROI) measures are among the most commonly
used financial ratios in fundamental analysis: return-on-total-assets (ROA), return-on-net-assets
(RONA), and return-on-equity (ROE). Students who encounter these financial ratios for the first
time often find them a little confusing. The purpose of this note is to explain the rationale behind
these ratios and discuss the economic relationship between each ratio and the cost-of-capital.

1. Constructing an accounting ROI

All three ratios use accounting numbers to measure the rate of return on investment (ROI). Each
is a measure of earnings divided by a measure of the capital (or investment) base. The
difference between the three lies in the definition of the capital base, earnings to that capital base,
and the cost of that capital base.

The single most important concept to keep in mind in working with accounting ROIs is that the
earnings and the cost of capital must be consistent with the capital base as defined in the
denominator of the ratio.

Consider the following table:

Ratio Representative Formula Capital Earnings Cost of ‘Normal’
Defn Defn Capital levels
NI + Interest Expense(1 − t ) Total EBI Cost of Approx.
ROA Assets financing TA 6%
Average Total Assets
EBI Net Assets EBI Cost of Approx.
RONA financing 9%
Avg.TA − S .T .Liab Net Assets

Net Income Common NI Cost of Approx.

ROE Equity financing 12%
Average Shareholders Equity Equity

Notice that each ratio has a different definition of capital. Once you have selected a given
definition of capital, you are constrained to choose a definition of earnings and a definition of the
cost of capital which are consistent with that capital base. Mismatches result in ROIs that either
understate or overstate economic performance.

2. ROA

For example, the capital base for ROA is total assets. What is the earnings generated by
this capital base? It’s EBI (called “NOPAT” in your PHB textbook for “Net Operating Profit After
Taxes”) This is the after-tax earnings with interest expense added back. We add the interest
expense back because this expense is used to service debt, which is part of the capital base. We
want to measure the return generating power of total assets. If we do not add back interest
expense, we would understate the firm’s return generating power pertaining to its total assets.

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What is the cost of this capital base? It’s the cost associated with financing the total assets of the
company. The balance sheet equation tells us that total assets = s/t liab + l/t liab + shareholders’
equity so the appropriate cost of this capital should be the weighted average cost of capital
(WACC) for these three sources of financing. For example, the typical firm has a capital structure
of 1/3 s/t liabs (such as current payables and accruals), 1/3 l/t liabs (such as bonds etc.) and 1/3
equity. The WACC for this firm would be computed approximately as follows:

Source of Pretax Cost Effect of Tax After-tax Cost % Weight Contribution

Financing of Financing Shield of Financing to WACC
Short term Nil none Nil 1/3 0.0%
liabilities

Long term 10.0% t=40% 6.0% 1/3 2.0%

liabilities

Equity 12.0% none 12.0% 1/3 4.0%

Investors
Estimated WACC for Total Assets 6.0%

In a competitive environment, the average firm’s ROA should be close to the cost of financing
total assets. Indeed, as we saw in class, average ROA’s mean revert to 6%.

3. RONA

The same argument goes for returns on net asset. In this case, the denominator is total
assets minus s/t liabilities. That is, we are interested in the returns to l/t debt and equity holders
only. Therefore the WACC calculation is:

Source of Pretax Cost Effect of Tax After-tax Cost % Weight Contribution

Financing of Financing Shield of Financing to WACC
Long term 10.0% t=40% 6.0% ½ 3.0%
liabilities

Equity 12.0% none 12.0% ½ 6.0%

Investors
Estimated WACC for Total Assets 9.0%

In fact we find that in large samples average RONA is around 9% (PHB, p. 9-7).

4. ROE

The capital base for ROE is capital provided by shareholders only. The earnings to this capital is
therefore Net Income (that is, the earnings after we have paid interest and taxes). Moreover, the
appropriate cost of this capital is the cost of financing by equity, which is approximately 12% to
13% in the U.S. (based on a market premium of 5 to 6 percent and a riskless rate of 6 to 7
percent -– see, for example the Copeland et.

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