DIAGNOSING PROFITABILITY, RISK, AND GROWTH

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Chapter 5

• DIAGNOSING PROFITABILITY, RISK, AND GROWTH

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Background

• If higher sales and profits are achieved by a
  firm due to a larger balance sheet, that means
  that more capital is used to finance the firms
  activities
• Because capital is costly, what we really need to
  know is whether profits per dollar of assets
  employed have increased
• Alternatively, a drop in profits with a rise in
  interest expenses does not necessarily mean that
  it was borrowing that impaired the firms
  profitability
• An increase or a decrease in profits is not, by
  itself, a good indicator of a firms financial
  performance
• This chapter presents an integrated approach to
  profitability analysis

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Background

• After reading this chapter, students should
  understand
• How to measure a firms profitability
• The key drivers of profitability
• How to analyze the structure of a firms overall
  profitability
• How business risk and the use of debt financing
  affect profitability
• How to assess a firms capacity to finance its
  expected growth in sales

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Measures Of Profitability

• Managers adopt measures of profitability
  depending on their areas of responsibility
• Sales manager would look at return on sales (ROS)
• Manager of an operating unit would choose return
  on assets (ROA)
• Chief executive would pay attention primarily to
  return on equity (ROE)

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Return On Equity

• Return on equity (ROE) is the most comprehensive
  indicator of profitability
• Considers the operating and investing decisions
  as well as the financing and tax-related
  decisions
• ROE measures the firms profitability from the
  perspective of the owners whose reward is the
  firms net profit
• ROE Earnings after tax ? Owners equity

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Why ROE?

• Measuring Firm Performance
• Goal Maximize shareholder wealth (Generate
  Value for the firms owners)
• Can we simply evaluate shareholder returns and
  stock performance?
• Problems
• Stock returns are influenced by macroeconomic
  events not just micro events.
• Who determines stock price?
• less-informed outsiders? 

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ROE and Value

• Measures how well a company generates returns on
  Book-value of equity.
• Accounting measure
• Measures returns relative to book value equity
• However, there exists a strong positive
  relationship between Market value and ROE. 
• Remember
• Growth is influenced by ROE.

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Exhibit 5.1aTSPs Balance Sheets.Figures in
millions of dollars
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Exhibit 5.1bTSPs Balance Sheets.Figures in
millions of dollars
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EXHIBIT 5.2 TSPs Income Statements.Figures in
millions of dollars
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The DuPont Model

• Version 1
• ROE Return on Assets ? Fin. Lev
• ROA ? Lev.
• Version 2
• ROE Profit Margin ? Asset Turn ? Fin. Lev
• PM(ROS) ? AT ? LEV.

NI
Sales
Tot. Assets



Sales
Tot. Assets
Equity
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• The DuPont model breaks ROE into three drivers of
  financial performance
• PM (ROS) and AT reflect success or weakness in
  operating strategies
• LEV measures the impact of debt usage on firm
  performance
• Provides a systematic way of evaluating firm
  performance.

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There are Many Roads to Success
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The Three Levers of Performance

• Profitability (Net Income)
• A function of the value added
• Grocery Store vs Clothing Manufacturer
• Measures a companys efficiency at turning sales
  into Net Income
• Asset Utilization (Asset Turnover)
• Measures a companys efficiency at generating
  sales from assets.
• Productivity
• A function of capital intensity
• Utility Company vs. Software Co.

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• Financial Leverage
• Measures the impact of a firms debt usage on
  overall returns.
• Usually negatively related to business risk
• Public Utility vs. Software Company
• Debt usage is highest where the cash flows are
  most predictable.

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Example TSP Inc.
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• Common Size Balance Sheet

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(No Transcript)
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• Common Size Income Statement

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• First The DuPont Breakdown

• What are TSPs primary problems?

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• Profitability
• Asset Utilization
• Leverage

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Example TSP Inc.
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• Common Size Balance Sheet

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(No Transcript)
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• Common Size Income Statement

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• First The DuPont Breakdown

• What are TSPs primary problems?

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• Profitability
• Asset Utilization
• Leverage

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• But does ROE always work?

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• Calculate ROE, ROA
• Does Bs ROE imply it is a better company?
• No this is a natural result of higher leverage
• The company also has higher risk.
• What does As higher ROA imply?
• Again simply a result of the difference in
  leverage
• So how do we compare?

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The Impact Of Operating Decisions On Return On
Equity

• Operating decisions involve the acquisition and
  disposal of fixed assets and the management of
  the firms operating assets
• Net profit, however, is obtained after deducting
  interest expensesthe outcome of financing
  decisions
• Therefore, ROS and ROA do not reflect only
  operating decisions

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Return on Invested Capital (ROIC)

• A relevant measure of operating profitability is
  return on invested capital or ROIC
• ROIC EBIT ? Invested Capital
• ROIC is the same as return on net assets (RONA)
  and return on capital employed (ROCE)
• OS Distributors' ROIC is shown in the last column
  of Exhibit 5.4
• ROIC can also be measured after tax by using EBIT
  (1 tax rate)
• Also called net operating profit after tax or
  NOPAT
• Other measures of operating profitability include
  
• Return on business assets (ROBA)
• Return on total assets (ROTA)

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EXHIBIT 5.3 TSPs Managerial Balance
Sheets.All data from the balance sheets in
Exhibit 5.1 figures in millions of dollars
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The Structure of TSPs Return on Invested
Capital.figures in millions of dollars
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The Drivers of Operating Profitability

• Any improvement in ROIC must be the outcome of a
  higher operating profit margin or a higher
  capital turnover

• A higher operating profit margin is achieved by
• Increasing sales through higher prices and/or
  higher volumeat a higher rate than operating
  expenses
• Reducing operating expenses at a higher rate than
  sales
• A higher capital turnover is achieved through a
  better use of the firms assets
• The link between return on equity and operating
  profitability
• If a firm does not borrow, its ROIC (i.e.
  operating profitability) is equal to its pretax
  return on equity

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The Impact Of Financing Decisions On Return On
Equity

• When a firm does not borrow, its ROIC and ROE are
  the same
• Thus, any difference between them must be due to
  the use of debt
• There is a financial cost effect that reduces ROE
  and a simultaneous financial structure effect
  that increases ROE
• Thus, cannot predict how financial leverage
  affects ROE

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The Impact Of Financing Decisions On Return On
Equity

• Financial cost ratio (FCR)
• FCR Earnings before tax ? EBIT
• Times-interest-earned (TIE), or interest
  coverage, ratio
• TIE EBIT ? Interest expenses
• Financial structure ratio or equity multiplier
• FSR Invested capital or net assets ? Owners
  equity
• Other measures of financial leverage
• Debt-to-equity ratio
• Debt-to-invested capital ratio

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The Incidence Of Taxation On Return On Equity

• Third determinant of a firms ROE
• Incidence of corporate taxation
• Relevant tax rate is the effective tax rate, not
  the statutory tax rate

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EXHIBIT 5.6 Comparison of Effective Tax Rates
in 1999.Figures in thousands of dollars
Exhibit 5.6 illustrates the point that a firm
should plan to minimize its tax liabilities.
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Putting It All Together The Structure Of A
Firms Profitability

• ROE is the product of five ratios
• Operating profit margin
• Capital turnover
• Financial cost ratio
• Financial structure ratio
• Tax effect ratio

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EXHIBIT 5.7 The Drivers of Return on Equity.
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EXHIBIT 5.8 The Structure of Return on Equity
for Five Firms in Different Sectors (1999).1
1 Compiled by the authors with accounting data
from the firms annual reports. 2 See text for
names of companies. 3 Operating profit margin
Earnings before interest and tax/Sales. 4 Capital
turnover Sales/Invested capital, where invested
capital Cash Working capital requirement
Net fixed assets. 5 Return on invested capital
Earnings before interest and tax/Invested
capital. 6 Financial leverage multiplier Pretax
return on equity/Return on invested capital. 7
Pretax return on equity Earnings before
tax/Owners equity. 8 Tax effect Earnings after
tax/Earnings before tax (1 effective tax
rate). 9 Return on equity Earnings after
tax/Owners equity.
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Other Measures Of Profitability

• The following are a few ratios that combine
  financial accounting data with financial market
  data
• Earnings per share (EPS)
• EPS Earnings after tax ? of shares
  outstanding
• Price-to-earnings ratio (P/E)
• P/E Share price ? EPS
• Market-to-book ratio (MBR)
• MBR Share price ? Book value per share

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Financial Leverage And Risk

• Two firms with identical net assets are
  considered
• The only difference between them is their
  financing strategy
• One firm is financed exclusively with equity,
  while the other finances half of its net assets
  with borrowed funds
• The two firms are assumed to face the same
  business risk, i.e. the same changes in EBIT

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Effect of Financing on Profitability for
Different Levels of EBIT.

• Levered firms ROE varies more widely than that
  for the unlevered firm
• Financial leverage magnifies a firms business
  risk
• In other words, borrowing at a fixed interest
  rate adds financial risk to the firms existing
  business risk
• The levered firm is riskier and its risk
  increases with rising levels of borrowing

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How Does Financial Leverage Work?

• A firm seeking to enhance its ROE should borrow
  as long as its ROIC exceeds its cost of debt
• Should refrain from borrowing whenever its ROIC
  is lower than its cost of debt

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Two Related Caveats Risk And The Ability To
Create Value

• The above conclusion suggesting that financial
  leverage enhances the firms overall
  profitability (its ROE) as long as the firm
  achieves ROIC that exceeds the borrowing rate has
  two caveats
• Managers do not know their firms future ROIC
• High expected ROE does not necessarily mean that
  the firm is creating value for its owners

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Managing Growth

• Growing too fast Puts considerable strain on a
  companys resources.
• Almost as many companies go bankrupt from
  excessive growth as from too slow of growth.

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• Growing too slow Presents a different set of
  problems.
• What to do with excess cash
• Chrysler

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• The Sustainable Growth Cycle
• Assume
• The company wants to grow as rapidly as market
  conditions permit
• Management is unable or unwilling to sell new
  equity
• The company has a target capital structure and a
  target dividend policy that it wants to maintain
• The company wants to maintain current debt
  proportions
• A company is operating at full capacity.

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Sustainable Growth
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Self-Sustainable Growth

• As sales increase, the related growth in assets
  will have to be financed with
• Debt
• Equity
• A combination of these two sources of funds
• Self-sustainable growth rate (SSGR)
• Maximum rate of growth in sales a firm can
  achieve without issuing new shares or changing
  either its operating or its financing policy
• SSGR Retention rate x ROE
• SSGR Retention rate x PM x AT x Leverage
• SSGR RR x ROIC x Capital Turn x FCR x FSR x Tax
  Effect Ratio
• If the five factors comprising ROE stay fixed, a
  firm cannot grow its sales faster than its
  self-sustainable growth rate unless it issues new
  shares

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• Sustainable growth is the rate at which a company
  could grow while MAINTAINING the values of these
  four important ratios
• To grow faster than g at least one of these
  ratios must give.
• g is positively related to a firms ROE

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Too Much Growth

• Too Much Growth
• To grow faster than the sustainable growth rate a
  company must.
• Improve operating efficiency
• ? PM ? ? RE
• ? AT ? ? RE
• Alter Financial Policies
• ? R ? reduce dividends ? ? RE
• ? LEV ? ? debt financing and growth capacity
• Many small firms view growth maximization as
  their goal.
• Must be aware of sustainable growth or risk
  losing control.

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TSP Revisited

• Sustainable Growth
• How has TSP maintained growth above its
  sustainable growth?

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What to Do When Actual Growth Exceeds Sustainable
Growth

• Is the growth temporary
• Solve problem with S-T borrowing
• When growth decreases use excess cash to payoff
  loans.
• If it isnt temporary
• Sell equity
• Increase leverage
• Reduce the payout
• Sourcing
• Pricing
• Merger

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Too Little Growth

•  Example The Deb Shop (Philadelphia)
• What has Deb shop done?

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• What did they do?
• By 1990 had paid off all interest bearing debt
  LEV?
• Built up cash reserves AT ?
• By 1990 56 of assets were either cash or
  securities
• What to do when sustainable growth exceeds actual
  growth
• Ignore the problem
• Return money to shareholders
• Buy growth