Operating Assets Defined

are long-lived assets that are used in normal business operations. They are not held for resale to customers. Investments in operating assets are essential to the success of most businesses. There are three major categories of operating assets: property, plant, and equipment, sometimes referred to as plant assets or fixed assets; natural resources; and intangible assets. Property, plant, and equipment includes land; land improvements, such as driveways, parking lots, fences, and similar items that require periodic repair and replacement; buildings; equipment; vehicles; and furniture. Natural resources, such as timber, fossil fuels, and mineral deposits, are created by natural processes that may take thousands or even millions of years to complete. Companies use up natural resources by cutting or extracting them, so natural resources are sometimes called wasting assets. Intangible assets, which lack physical substance, may nevertheless provide substantial value to a company. Patents, copyrights, and trademarks are examples of intangible assets.
Operating assets According to the matching principle, the costs of operating assets other than land must be matched with the revenues they help to generate over their useful lives. Allocating these costs to expense is called depreciation for plant assets, depletion for natural resources, and amortization for intangible assets. The cost of land is never depreciated because land is considered to have an unlimited useful life. Natural resources are usually listed within the property, plant, and equipment category on the balance sheet. Intangible assets are placed in a separate category.
Digby Pitts Strip Mining Partial Balance Sheet December 31, 20X4 ASSETS

Current Assets

Cash

$ 16,000

Accounts Receivable

84,000

Inventory

89,000

Supplies

3,000

Prepaid Insurance

8,000

Total Current Assets

300,000

Property, Plant, and Equipment

Land

$ 300,000

Buildings and Equipment

$ 500,000

Less: Accumulated Depreciation (200,000)

300,000

Coal Deposits

5,000,000

300,000

Less: Accumulated Depletion

(2,000,000) 3,000,000 3,600,000

Intangible Assets

Leaseholds

100,000

Goodwill

400,000

Less: Accumulated Amortization

(100,000)

400,000

Total Assets

$4,300,000

Return on equity (ROE) is a closely watched number among knowledgeable investors. It is a strong measure of how well the management of a company creates value for its shareholders. The number can be misleading, however, as it is vulnerable to measures that increase its value while also making the stock more risky. Without a way of breaking down the components of ROE investors could be duped into believing a company is a good investment when it's not. Read on to learn how to use DuPont analysis to break apart ROE and get a much better understanding about where movements in ROE are coming from. (To learn the basics and value of return on equity, check out Keep Your Eyes On The ROE.) ROE: Simple, Perhaps Too Simple The beauty of ROE is that it is an important measure that only requires two numbers to compute: net income and shareholders equity.

ROE = net income / shareholder's equity If this number goes up, it is generally a great sign for the company as it is showing that the rate of return on the shareholders equity is going up. The problem is that this number can also rise simply when the company takes on more debt, thereby decreasing shareholder equity. This would increase the leverage of the company, which could be a good thing, but it will also make the stock more risky. Three-Step DuPont To avoid mistaken assumptions, a more in-depth knowledge of ROE is needed. In the 1920s the DuPont corporation created a method of analysis that fills this need by breaking down ROE into a more complex equation. DuPont analysis shows the causes of shifts in the number. There are two variants of DuPont analysis, the original three-step equation, and an extended five-step equation. The three-step equation breaks up ROE into three very important components: ROE = (Net profit margin)* (Asset Turnover) * (Equity multiplier) These components include:

Operating efficiency - as measured by profit margin. Asset use efficiency - as measured by total asset turnover. Financial leverage - as measured by the equity multiplier.

The Three-Step DuPont Calculation Taking the ROE equation: ROE = net income / shareholder's equity and multiplying the equation by (sales / sales), we get:

ROE = (net income / sales) * (sales / shareholder's equity)

We now have ROE broken into two components, the first is net profit margin, and the second is the equity turnover ratio. Now by multiplying in (assets / assets), we end up with the three-step DuPont identity:

ROE = (net income / sales) * (sales / assets) * (assets / shareholder's equity)

This equation for ROE, breaks it into three widely used and studied components:

ROE = (Net profit margin)* (Asset Turnover) * (Equity multiplier)

We have ROE broken down into net profit margin (how much profit the company gets out of its revenues), asset turnover (how effectively the company makes use of its assets), and equity multiplier (a measure of how much the company is leveraged). The usefulness should now be clearer. If a company's ROE goes up due to an increase in the net profit margin or asset turnover, this is a very positive sign for the company. However, if the equity multiplier is the source of the rise, and the company was already appropriately leveraged, this is simply making things more risky. If the company is getting over leveraged, the stock might deserve more of a discount, despite the rise in ROE . The company could be under-leveraged as well. In this case it could be positive, and show that the company is managing itself better. (Learn to take a deeper look at a company's profitability with the help of profit-margin ratios in The Bottom Line On Margins.) Even if a company's ROE has remained unchanged, examination in this way can be very helpful. Suppose a company releases numbers and ROE is unchanged. Examination with DuPont analysis could show that both net profit margin and asset turnover decreased, two negative signs for the company, and the only reason ROE stayed the same was a large increase in leverage. No matter what the initial situation of the company, this would be a bad sign. Five-Step DuPont The five-step, or extended, DuPont equation breaks down net profit margin further. From the three-step equation we saw that, in general, rises in the net profit margin, asset turnover, and leverage will increase ROE. The five-step equation shows that increases in leverage don't always indicate an increase in ROE. The Five-Step Calculation

Since the numerator of the net profit margin is net income, this can be made into earnings before taxes (EBT) by multiplying the three-step equation by 1 minus the company's tax rate:

ROE = (earnings before tax / sales) * (sales / assets) * (assets / equity) * (1 tax rate)

We can break this down one more time, since earnings before taxes is simply earnings before interest and taxes (EBIT) minus the company's interest expense. So, if a substitution is made for the interest expense, we get:

ROE = [(EBIT / sales) * (sales / assets) (interest expense / assets)] * (assets / equity) * (1 tax rate)

The practicality of this breakdown is not as clear as the three-step, but this identity provides us with:

ROE = [(operating profit margin) * (asset turnover) (interest expense rate)] * (equity multiplier) * (tax retention rate)

If the company has a high cost of borrowing, its interest expenses on more debt could mute the positive effects of the leverage. (To learn how to use revenue and expenses to break down and analyze a company, read Understanding the Income Statement.) Learn The Cause Behind The Effect Both the three- and five-step equations provide deeper understanding of a company's return on equity, by examining what is really changing in a company rather than looking at one simple ratio. As always with financial statement ratios, they should be examined against the company's history and its competitors. For example, when looking at two peer companies, one may have a lower ROE. With the five-step equation, you can see if this is lower because: creditors perceive the company as riskier and charge it higher interest, the company is poorly managed and has leverage that is too low, or the company has higher costs that decrease its operating profit margin. Identifying sources like these leads to better knowledge of the company and how it should be valued. (To learn how to easily compare companies, read Peer Comparison Uncovers Undervalues Stocks.) Deepen Your Understanding A simple calculation of return on equity may be easy, and tell quite a bit, but it does not provide the whole picture. If a company's ROE is lower than its peers, the three or five-step identities can help to show where the company is lagging. It can also shed light on how a company is lifting or propping up its ROE. DuPont analysis helps significantly broaden understanding of ROE. Read more: http://www.investopedia.com/articles/fundamental-analysis/08/dupont-analysis.asp#ixzz1PU4oVdKu