Profitability

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Chapter 3
Profitability and Risk Analysis
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Which is more profitable?

• Wal-Mart

Home Depot
May Company
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Profitability Analysis

• Project future profitability based on an analysis
  of past performance
• Time series analysis
• changes in financial ratios over time
• Cross-sectional analysis
• examines companys financial ratios in
  comparison to - its competitors - industry
  averages

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Profitability Analysis - Nuts Bolts

• Rate of return on assets (ROA)
• firms success in using assets to generate
  earnings
• independent of financing considerations
• N.I. Interest Expense net of taxes Minority
  Interest in Earnings
• Average Total Assets
• Net Income - from continuing operations
• Interest Expense net of taxes
• (1 - marginal tax rate) (Interest Expense)
• Minority Interest - added back to obtain
  consistency between numerator and denominator

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Nuts Bolts, contd

• Dissaggregating ROA
• ROA Profit Margin X Assets Turnover
• __Adj. NI_____ Adj. NI X ____Sales________
• Avg.Tot.Assets Sales Average Total
  Assets

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Profit Margin Analysis

• Look at the components of net income as a
  percentage of sales
• Other revenues
• Cost of goods sold
• Selling and administrative expenses
• Income taxes
• Gives insight into how the company earned its
  income
• quality of earnings

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Analyzing Asset Turnover

• Looks at the relationship between operating
  revenues, expenses, and assets
• Accounts receivable turnover
• Net Sales on Account / Average Accounts
  Receivable
• Inventory turnover
• Cost of Goods Sold / Average Inventories
• Fixed assets turnover
• Sales / Average Fixed Assets

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Chapter 3, contd
Risk Analysis
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Case Assignment (due Monday, 3/1)

• Case 3.1 Wal-Mart Profitability and Risk
  Analysis
• General guidelines for analysis are provided
  with the case. Simply answering the questions in
  a reasonably complete manner should garner a
  score of 80. Additional points will be awarded
  based on thoroughness of analysis, presentation,
  and creativity.
• In addition to the stated analysis requirements,
  you should also prepare a strategic analysis.
  This analysis should evaluate the market in which
  Wal-Mart operates (is it growing or shrinking,
  how intense is the competition, etc.) as well as
  evaluate Wal-Marts position relative to its
  competitors.

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Financial Analysis Software

• Program and documentation available on the class
  web page
• documentation is in a self-extracting file

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Profitability Analysis Summary
A
ROAA12B12C18D6
ProfitMargin
C
B
D
Asset Turnover

• ROA Profit Margin x Asset Turnover

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Return on Common Equity

• Measures return not allocated to debt or
  preferred equity
• ROCE Net Income - Preferred DividendsAvg.
  Common Equity also known as NI to Common
• Using lower-cost debt and preferred stock
  financing can increase the return to common
  shareholders
• financial leverage

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Disaggregating ROCE

• Allows us to interpret causes for differences
  between ROA and ROCE
• ROCE ROA x CEL x CSL
• NI to common __NII.E. X NI to common
  X Avg. Total Assets Avg. Common Avg.
  Total NII.E. Avg.
  Common Equity Assets
  Equity

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Significance of ROA, CEL, and CSL

• ROA tells us the return on all assets employed
• CEL tells us about the relative cost of debt and
  preferred stock
• indicates the proportion of net income that is
  available to common shareholders
• the higher the cost of debt and preferred stock,
  the smaller the ratio, the less income will
  remain for common shareholders
• CSL tells us about the degree to which a firm
  uses debt to increase its asset base
• the more debt and preferred stock is used to
  finance assets, the greater the multiplier effect
  on earnings
• when the cost of debt and preferred is less than
  ROA, common shareholders earnings are enhanced
• when the cost of debt and preferred is greater
  than ROA, common shareholders earnings are
  depressed

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Putting numbers with the concepts

• Hi-debt Company has Total Assets 2M Common
  Equity 1MInterest Expense 100K Tax
  rate 40Year 1 N.I. 180K Year 2 N.I. -0-
• ROCE ROA x CEL x CSLYR1 18
  12 x 75 x 2
• YR2 0 3 x 0 x 2

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Putting numbers with the concepts

• No-debt Company has Total Assets 2M Common
  Equity 2MInterest Expense -0- Tax
  rate 40Year 1 N.I. 240K Year 2 N.I. 60K
• ROCE ROA x CEL x CSL YR1 12
  12 x 1 x 1
• YR2 3 3 x 1 x 1

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Financial Leverage and ROCE
Hi-Debt Co.
18 -
Leverage helps
15 -
R O C E ()
No-Debt Co.
12 -
9 -
6 -
3 -
Leverage hurts
0 -
Poor
Neutral
Good
Type of earnings year
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Sources of Risk
Regulation
Technology
Recession
Competition
Demographics
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Short-term liquidity

• A firms ability to meet short-term commitments
  and the relative level of those commitments
• Ability to meet short-term commitments
• Current ratio
• Quick ratio
• Operating cash flow to current liabilities ratio
• Amount of working capital required to support
  sales
• A/R turnover Days Receivables Outstanding
• Inventory turnover Days Inventory Held
• A/P turnover Days Payables Outstanding

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Long-term solvency

• Measure the firms ability to meet interest and
  principal repayment on long-term debt
• Debt ratios - higher proportions indicate greater
  risk
• Long-term Debt Ratio
• Debt/Equity Ratio
• Liabilities/Assets Ratio
• Coverage Ratios - lower ratios indicate greater
  risk
• Interest Coverage Ratio
• Operating Cash Flow to Total Liabilities Ratio
• Operating Cash Flow to Total Capital Expenditures
  Ratio

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Earnings per Common Share

• Simple capital structure (no convertible bonds,
  convertible preferred stock, or stock options)
• Basic EPS Net Income to Common
  Weighted Avg. Common Shares
  Outstanding
• Complex capital structure - EPS must reflect the
  ability of convertible securities to dilute
  common
• Diluted EPS NI to Common Adj. For Dilutive
  Securities Weighted Avg.
  Wgtd. Avg. Shares from Common
  Outstanding Dilutive Securities

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Problems with EPS measures

• Doesnt reflect level of investment
• Therefore difficult to use in cross-sectional
  analysis
• Mixes profitability measures (net income) with
  capital structure decisions ( shares
  outstanding)
• can be manipulated by managing capital structure

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TheEnd