Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
© The McGraw−Hill
Companies, 2007
11. The Analysis of
Profitability
Chapter Eleven
LINKS
Link to previous chapters
Chapters 8, 9, and 10
reformulated the financial
statements to prepare them
for analysis.
The Analysis
of Profitability
This chapter
This chapter lays out the
analysis of profitability
that is necessary for
forecasting future
profitability and valuation.
What
Howare
arethe
financial
returns
calculated?
statement
drivers of
ROCE?
What are the
effects of
financial and
operating
liability
leverage on
ROCE?
How is
operating
profitability
analyzed?
How are
borrowing
costs
analyzed?
Link to next chapter
Chapter 12 lays out the
analysis of growth, to
complete the analysis of
the financial statements.
Link to Web page
The Web Site applies the
analysis in this chapter
to a wider range of firms
(www.mhhe.com/
penman3e).
The price-to-book valuation model of Chapter 5 directs us to forecast future residual
earnings to value equities. The price-earnings valuation model of Chapter 6 directs us to
forecast abnormal earnings growth. Residual earnings are determined by the profitability
of shareholders’ investment, ROCE, and the growth in investment. Earnings growth is also
determined by growth in investment and the profitability of that investment. So forecasting
involves forecasting profitability and growth. To forecast, we need to understand what drives
ROCE and growth. The analysis of the drivers of ROCE is called profitability analysis and
the analysis of growth is called growth analysis. This chapter covers profitability analysis.
The next chapter covers growth analysis.
The reformulation of financial statements in the preceding chapters readies the statements for profitability and growth 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 (as we will see
in Part Three of the book) by asking how future ROCE will be different from current
ROCE. She aims to forecast ROCE, and 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.
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. As you analyze the drivers, you learn more about the
business. Profitability analysis has a mechanical aspect, and the analysis here can be
transcribed to a spreadsheet program where the reformulated statements are fed in and
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
© The McGraw−Hill
Companies, 2007
11. The Analysis of
Profitability
Chapter 11 The Analysis of Profitability 371
The Analyst’s Checklist
After reading this chapter you should understand:
After reading this chapter you should be able to:
• How ratios aggregate to explain return on common
equity (ROCE).
• Calculate ratios that drive ROCE.
• How economic factors determine ratios.
• Perform a complete profitability analysis on reformulated financial statements.
• How financial leverage affects ROCE.
• Demonstrate how ratios combine to yield the ROCE.
• The difference between return on net operating assets
(RNOA) and return on assets (ROA).
• Prepare a spreadsheet program based on the design
in this chapter. See the BYOAP feature on the text’s
Web site.
• How profit margins, asset turnovers, and their composite ratios drive RNOA.
• Answer “what-if” questions about a firm using the
analysis in this chapter.
• How operating liability leverage affects ROCE.
• How borrowing costs are analyzed.
• How profitability analysis can be used to ask penetrating questions regarding the firm’s activities.
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.
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.
CUTTING TO THE CORE OF THE OPERATIONS:
THE ANALYSIS OF PROFITABILITY
As we have seen, the return on common stockholders’ equity (CSE) is calculated as
Return on common equity (ROCE) =
Comprehensive income
Average CSE
The ROCE is broken down into its drivers over three levels of analysis. These three levels
are depicted in Figure 11.1, so follow this figure as we go through the analysis. The abbreviations and acronyms used are defined in the figure key.
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
© The McGraw−Hill
Companies, 2007
11. The Analysis of
Profitability
372 Part Two The Analysis of Financial Statements
FIGURE 11.1 The Analysis of Profitability
Return on common equity is broken down into its drivers over three levels of analysis. The first level identifies the effect of
financing and operating liability leverage; the second level identifies the effect of profit margins and asset turnovers on
operating profitability; and the third level identifies the drivers of profit margins, asset turnovers, and the net borrowing cost.
ROCE = Earnings/CSE
= RNOA + (FLEV x SPREAD)
Level 1
FLEV = NFO
CSE
RNOA = OI/NOA
= ROOA + (OLLEV x OLSPREAD)
SPREAD = RNOA – NBC
NBC = NFE
NFO
Level 2
Level 3
PM = OI/Sales
Sales PM
Gross margin
ratios
ATO = Sales/NOA
Other items PM
Expense ratios
Other OI/Sales
ratios
Individual asset and
liability turnovers
Financial statement line items:
Ratios:
Earnings = Comprehensive income
CSE
= Common shareholders’ equity
OI
= Operating income (after tax)
NOA
= Net operating assets
NFE
= Net financial expense
NFO
= Net financial obligations
ROCE
RNOA
ROOA
NBC
OLLEV
OLSPREAD
FLEV
SPREAD
PM
ATO
Borrowing cost
drivers
= Return on common equity
= Return on net operating assets
= Return on operating assets
= Net borrowing cost
= Operating liability leverage
= Operating liability leverage spread
= Financial leverage
= Operating spread
= Operating profit margin
= Asset turnover
FIRST-LEVEL BREAKDOWN: DISTINGUISHING FINANCING
AND OPERATING ACTIVITIES AND THE EFFECT OF LEVERAGE
We have seen that both operating activities (which produce operating income) and
financing activities (which produce financial income or expense) affect the return to
common shareholders. The first breakdown of ROCE distinguishes the profitability of
these two activities. It also distinguishes 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) or by common equity. The measure FLEV = NFO/CSE, introduced in Chapter 9, captures financial leverage. To the extent that net operating assets are
financed by net financial obligations rather than equity, the return on the equity is affected.
The typical FLEV is about 0.4, but there is considerable variation among firms.
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
© The McGraw−Hill
Companies, 2007
11. The Analysis of
Profitability
ROCE Is Determined by Operating Profitability,
Financial Leverage, and the Operating Spread
11.1
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 =
OI – NFE
NOA – NFO
(Balance sheet amounts are often averages over the period.)
The operating income (OI) is generated by the net operating
assets (NOA), and the operating profitability measure, RNOA,
gives the percentage return on the net operating assets. The
net financial expense (NFE) is generated by the net financial
obligations (NFO), and the rate at which the NFE is incurred is
the net borrowing cost (NBC). So the ROCE can be expressed as
⎛ NOA
⎞ ⎛ NFO
⎞
ROCE = ⎜
× RNOA⎟ − ⎜
× NBC⎟
⎝ CSE
⎠ ⎝ CSE
⎠
where, to remind you, RNOA = OI/NOA and NBC = Net financial 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:
⎡ NFO
⎤
ROCE = RNOA + ⎢
× (RNOA – NBC)⎥
⎣ CSE
⎦
= RNOA + (Financial leverage × Operating spread)
= RNOA + (FLEV × SPREAD)
Financial leverage affects ROCE as follows (see Box 11.1):
Return on common equity = Return on net operating assets
+ (Financial leverage × Operating spread)
ROCE = RNOA + [FLEV × (RNOA − NBC)]
(11.1)
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 (FLEV = NFO/CSE).
3. Operating spread between the return on net operating assets and the net borrowing cost
(SPREAD = RNOA − NBC).
Both operating income and net financial expense must be after tax and comprehensive of
all components, as in the reformulated income statements of Chapter 9, 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 11.2 depicts how the difference between ROCE and RNOA changes with financial
leverage according to the formula. If a firm has zero financial leverage, equation (11.1) says
that ROCE equals RNOA. If the firm has financial leverage, then the difference between
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 leverage effect is unfavorable, as shown for General Mills in Box 11.2. This highlights the “good news/bad news”
nature of financial leverage: Financial leverage generates a higher return for shareholders if
373
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
© The McGraw−Hill
Companies, 2007
11. The Analysis of
Profitability
374 Part Two The Analysis of Financial Statements
FIGURE 11.2
SPREAD = 4%
6%
Difference between ROCE and RNOA
(ROCE – RNOA)
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.
SPREAD = 6%
8%
SPREAD = 2%
4%
SPREAD = 1%
2%
SPREAD = 0%
0%
SPREAD = –1%
–2%
SPREAD = –2%
–4%
0.00
0.25
0.50
0.75
1.00
1.25
1.50
1.75
ROCE = RNOA + (FLEV × SPREAD)
2.00
FLEV
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 13. 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 Microsoft (see Box 11.3) 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 (RNFA) rather than net borrowing costs. Return on common equity is related to
RNOA as follows:
⎡ NFA
⎤
ROCE = RNOA − ⎢
× (RNOA – RNFA)⎥
⎣ CSE
⎦
(11.2)
where (as in Chapter 9) 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.
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 liabilities are obligations incurred in the course of
operations and are distinct from financial obligations incurred to finance the operations.
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
© The McGraw−Hill
Companies, 2007
11. The Analysis of
Profitability
The Effect of Financial Leverage:
General Mills, Inc.
General Mills, a large manufacturer of packaged foods, has
had considerable stock repurchases over the years, leaving it
fairly highly leveraged. For fiscal 2004 its average common
shareholders’ equity was $4.712 billion on net operating assets of $12.578 billion. Its financial leverage was 1.670, based
on average balance sheet amounts.
The firm’s ROCE for 2004 was 26.5 percent. Further analysis reveals that this number was driven by the high leverage:
ROCE = RNOA + [FLEV × (RNOA − NBC)]
26.5% = 12.5% + [1.670 × (12.5% − 4.1%)]
ROCE can exaggerate underlying operating profitability: RNOA
is 12.5 percent but the high financial leverage, combined with
11.2
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 leverage rather than operations?
A What-If Question
What if the RNOA at General Mills fell to 2 percent? What
would be the effect on ROCE?
The answer is that the ROCE would fall to –1.5 percent:
−1.5% = 2.0% + [1.670 × (2.0% − 4.1%)]
The unfavorable leverage would produce a negative ROCE on
a positive RNOA.
Chapter 9 gave a measure of the extent to which 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
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)
× Operating liabilities
Then calculate a return on operating assets, ROOA, as if there were no operating liabilities:
Return on operating assets (ROOA) =
OI + Implicit interest (after tax)
Operating assets
Then RNOA is driven by operating liability leverage as follows:
Return on net operating assets = Return on operating assets
(11.3)
+ (Operating liability leverage
× Operating liability leverage spread)
RNOA = ROOA + (OLLEV × 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)
375
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Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
© The McGraw−Hill
Companies, 2007
11. The Analysis of
Profitability
The Effect of Negative Financial Leverage:
Microsoft Corporation
Microsoft has been very profitable. Look at the firm’s reformulated statements for fiscal year 2002 in Exhibits 9.5 and
9.11 in Chapter 9. For fiscal 2002 the firm reported an ROCE
of 15.7 percent on average common equity of $49.735 billion. But Microsoft had no financing debt. Instead Microsoft
had considerable (average) financial assets of $36.906 billion
from cash generated from its operations, giving it an average
financial leverage that was negative: –0.742. The firm’s return
on average net financial assets was 4.2 percent.
The ROCE masks the profitability of operations of 48.9
percent:
ROCE = RNOA − [NFA/CSE × (RNOA − RNFA)]
11.3
The RNOA of 48.9 percent is weighted down by the lower return on financing activities in the overall ROCE.
A What-If Question
In 2004 the company used $33.0 billion of its financial assets
to pay a special dividend. What would the ROCE have been in
2002 had it paid the dividend then?
The answer is that with $33.0 billion more in average financial assets and common equity, the average financial leverage would have been −0.233 rather than −0.742, and the
ROCE would have been
38.5% = 48.9% − [0.233 × (48.9% − 4.2%)]
Stock repurchases (and dividends) increase ROCE.
15.7% = 48.9% − [0.742 × (48.9% − 4.2%)]
This leverage expression for RNOA is similar in form to the financial leverage equation (11.1) for ROCE: RNOA is driven by the rate of return on operating assets as if there
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—if ROOA
is greater than the short-term borrowing rate—or unfavorable—if ROOA is less than the
short-term borrowing rate.
In calculating operating liability leverage and the implicit interest, ignore any operating
liabilities, like pensions, where the accounting explicitly includes interest in operating expenses, and ignore liabilities for which there is no implicit interest. Deferred tax liabilities
are in the latter class because the government does not charge interest on the liabilities. See
Box 11.4.
Operating liability leverage can add value for shareholders, so it is important to identify
if the analyst is to discover the source of the value generation. A firm that carries $400 million in inventory but has $400 million in accounts 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). See Box 11.5.
Summing Financial Leverage and Operating Liability
Leverage Effects on Shareholder Profitability
Shareholder profitability, ROCE, is affected by both financial leverage and operating liability 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 11.2 and 11.4, the ROCE of 26.5 percent is
determined by:
26.5% = 10.4% + (12.5% − 10.4%) + (26.5% − 12.5%)
376
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
© The McGraw−Hill
Companies, 2007
11. The Analysis of
Profitability
The Effect of Operating Liability Leverage:
General Mills, Inc.
General Mills had average net operating assets of $12.578 billion during fiscal year 2004 of which $3.068 billion was in operating liabilities other than deferred taxes. Thus its operating
liability leverage ratio was 0.244. Its borrowing rate on its
short-term notes payable was 2.5 percent, or 1.6 percent after
tax. It reported operating income of $1,575 million, but applying the after-tax short-term borrowing rate to operating liabilities other than deferred tax liabilities, this operating income
includes implicit after-tax interest charges of $49.1 million. So
ROOA =
1, 575.0 + 49.1
= 10.4%
15, 646.0
11.4
A What-If Question
What if suppliers were to charge the short-term borrowing
rate of 2.5 percent explicitly for the credit in accounts
payable? What would be the effect on ROCE?
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 efficiently as this supposes, so firms can exploit operating liability leverage if they have power over their
suppliers. See Box 11.5.
The effect of operating liability leverage is favorable:
RNOA = 12.5% = 10.4% + [0.244 × (10.4% − 1.6%)]
Table 11.1 analyzes the effect of leverage on shareholder profitability for the two firms,
Nike and Reebok, for which we prepared reformulated statements in Chapter 9. The analysis, of course, uses the reformulated statements (the balance sheets are in Exhibits 9.3 and
9.4 and the income statements are in Exhibits 9.9 and 9.10). Table 11.1 compares the profitability of the two firms for 2004 and 2003 and gives examples of how their profitability
was affected by both financing and operating liability leverage. Nike had very little financial leverage in 2004, so its ROCE and RNOA are similar. But in 2003 Nike’s ROCE of
10.3% was levered up over its RNOA of 9.6% by net borrowing. The calculations show how
financial leverage of 0.117 worked in that year via the financing leverage equation. Reebok,
with net financial assets on its balance sheet, had negative leverage in both 2004 and 2003,
so its ROCE was less than its RNOA. Both Nike and Reebok levered up RNOA with operating liability leverage, and the calculations in Table 11.1 show how this was achieved for
Reebok in 2004 via the leveraging equation for operating liabilities.
A couple of complications can arise when analyzing leverage effects. First, the presence
of a minority interest calls for a modification. See Box 11.6. Second, if net borrowing is
close to zero, it can happen that firms report net interest expense (interest expense greater
than interest income) in the income statement but an average net financial asset position in
the balance sheet (or vice versa). You observe this with Reebok. Also, because of small average net financial obligations (in the denominator), you can sometimes calculate a very
high net borrowing cost. These problems arise because, strictly, average net borrowing
should be average of daily balances, not just the beginning and ending balances. An analyst
typically does not have access to these numbers, although using amounts from quarterly
reports alleviates the problem. The problem is not very important; for firms with net borrowing close to zero, the investigation of financing leverage effects is uninteresting.
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
377
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
11. The Analysis of
Profitability
A Case of Extreme Operating Liability
Leverage: Dell, Inc.
Dell, Inc. is recognized as an innovator in the process of producing and selling computers. Its direct-to-customer sales cut
out the retail distribution layer and the higher markup that retailing requires. Its just-in-time inventory system means it carries little inventory, so not only does Dell have less investment
in inventory but it also runs less risk of holding inventory as
computer prices fall and technology changes, making inventory obsolete. As production is outsourced, Dell has a relatively low investment in plant, as well. It exerts pressure on its
suppliers to carry inventory and delays payments to suppliers.
Accordingly it carries high accounts payable relative to its investment in inventories and plant.
A reformulation of Dell’s 2002 balance sheet (in Exhibit 2.1
in Chapter 2) gives the following composition of net operating assets (in millions of dollars):
© The McGraw−Hill
Companies, 2007
11.5
Dell has $7.742 billion invested in financial assets. But (remarkably for a manufacturer), shareholders have a negative investment in operations: Net operating assets are –$3.048 billion. On $31.168 billion in sales, Dell carries only $278 million
in inventories and has only $826 million in property, plant, and
equipment. With $5.075 billion in accounts payable and another $2.444 billion in accrued liabilities for services, operating liabilities exceed operating assets: The operating creditors
are providing the investment in operations rather than the
shareholders. Dell has extreme operating liability leverage.
Does this structure of the operations add value? Certainly,
yes, for Dell has considerable power over its suppliers. Dell
earned $1.284 billion from operations in 2002. Residual income
from operations, on a (negative) investment in operations of
–$3.048 billion (with a 9 percent required return), is
Residual income = $1.284 − (0.09 × −3.048) = $1.558 billion
Operating Assets
Operating cash
Accounts receivable
Inventories
Property, plant, and equipment
Other assets
Operating Liabilities
Accounts payable
Accrued liabilities
Other liabilities
Net Operating Assets
Net Financial Assets
Shareholders’ Equity
$
25
2,269
278
826
1,875
5,273
5,075
2,444
802
8,321
(3,048)
7,742
$4,694
The charge, at the required return, against a negative investment yields residual income greater than income. Effectively,
shareholders add value in two ways. First they get value from
the $1.284 billion in operating income and, second, they get
further value from investing the $3.048 billion they would
otherwise have had to put into the business had the suppliers
not supplied the investment. The suppliers are essentially providing a “float” that shareholders can invest elsewhere. The
residual income calculation captures both sources of value.
Note: You will notice that, because Dell has negative net operating
assets, an RNOA cannot be calculated. This happens rarely. But, from
a valuation point of view, this does not matter: Residual income from
the operations can be calculated, as above, and valuation involves
forecasting residual income.
(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 numerator. 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 operations. Operating liabilities
reduce the needed investment in operating assets, providing operating liability leverage, so
they are subtracted in the base.
Thus ROA typically measures a lower rate of return than RNOA. The median ROA for
all U.S. nonfinancial firms from 1963 to 2004 was 6.8 percent. This is below what we would
378
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Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
© The McGraw−Hill
Companies, 2007
11. The Analysis of
Profitability
Chapter 11 The Analysis of Profitability 379
TABLE 11.1 First Level Breakdown: Nike and Reebok
2004
ROCE
ROCE before minority interest
RNOA
2003
Nike
Reebok
Nike
Reebok
23.0%
18.9%
19.2
24.4
10.3%
18.1%
18.5
27.9
23.3
9.6
Analysis of Financial Leverage: Nike 2003
ROCE =
Earnings
405
=
= 10.29%
Ave CSE
3, 936
RNOA =
OI
423
=
= 9.62%
Ave NOA
4,395
⎛
Ave NFO ⎞
459
Financial Leverage ⎜ FLEV =
=
= 0.117
Ave CSE ⎟⎠ 3, 936
⎝
⎛
NFE ⎞
18
Net Borrowing Cost ⎜ NBC =
=
= 3.92%
Ave NFO ⎟⎠
459
⎝
SPREAD = RNOA − NBC = 9.62% − 3.92% = 5.70%
ROCE = RNOA + (FLEV × SPREAD)
10.29% = 9.62% + (0.117 × 5.70%)
Analysis of Operating Liability Leverage: Reebok 2004
OI
237
=
= 24.40%
Ave NOA
971.5
Short-term borrowing rate (after tax) = 3.2%1
Implicit borrowing cost on $636 million of operating liabilities = $636 × 0.032 = $20.4
RNOA =
ROOA =
OI + $20.4
237 + 20.4
=
= 16.01%
Ave OA
971.5 + 636.0
Operating liability leverage (OLLEV ) =
Ave OL
636
=
= 0.655
Ave NOA
971.5
Operating liability leverage spread = ROOA − Short-term borrowing rate
= 16.01% − 3.2%
= 12.81%
RNOA = ROOA + (OLLEV × OLSPREAD)
24.40% = 16.01% + (0.655 × 12.81%)
The short-term borrowing rate is based on a before-tax rate of 5%. The after-tax rate is 5% × (1 − 0.36) = 3.2%.
1
expect for a return to risky business investment: It looks more like a bond rate. The median
RNOA was 10.4 percent, more in line with what we expect as a typical return from running
businesses. ROA is a poor measure of operating profitability.
Table 11.2 compares ROA and RNOA for selected firms for 1996. That year was a very
good profit year for many corporations and the high fliers included the high-tech firms you
see in the table. In good profit years we expect the differences between RNOA and ROA to
be higher because of favorable operating liability leverage, as it is for all firms in the table.
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Dealing with Minority Interests
The presence of minority 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 different equity
claimants. The minority, like the majority common, shares the
costs and benefits of leverage. So the additional step with minority interest (MI) is to distinguish ROCE for all common
claimants from that for the (majority) common owners of the
parent corporation in the consolidation:
ROCE = ROCE before MI × MI sharing ratio
where ROCE is the return on common equity to the shareholders of the parent company (the majority) and
ROCE before MI =
11.6
The first ratio here gives the return to total common equity,
minority and majority, as reported for Reebok in Table 11.1.
The second ratio gives the sharing of the return. Use ROCE before minority interest when applying the financing leveraging
equation 11.1.
This calculation is cumbersome. It can be avoided if the minority interests’ shares of operating and financing assets, liabilities, and income in subsidiaries can be identified and then
subtracted from the relevant categories in the reformulated
balance sheet. Minority interests are typically small in the
United States, and one can (as an approximation) then treat
minority interest as a reduction in consolidated operating
income and net operating assets.
Comprehensive income before MI
CSE + MI
Comprehensive income /
Minority interest
Comprehensive income before MI
=
sharing ratio
CSE /(CSE + MI)
Indeed you can see that ROA understates operating profitability. As a case in point, look at
Exxon and Chevron. The ROAs for these firms look lackluster, to say the least. They are
below what we would expect their cost of capital to be. The RNOAs, on the other hand, look
respectable. And the RNOA measures identify Microsoft, Oracle, and Cisco Systems as the
exceptional companies they indeed are.
TABLE 11.2
Return on Net
Operating Assets
(RNOA) and Return
on Assets (ROA) for
Selected Firms for
1996 Fiscal Year
ROA typically
understates operating
profitability because it
fails to incorporate
operating liability
leverage and includes
the profitability of
financial assets.
380
Industry and Firm
Biotech
Genentech, Inc.
Amgen, Inc.
Chiron Corp.
High-tech
Microsoft Corp.
Oracle Corp.
Cisco Systems, Inc.
Retailers
Wal-Mart Stores, Inc.
Kmart Corp.
The Gap, Inc.
Oil producers and refiners
Exxon Corp.
Chevron Corp.
Footwear and apparel
manufacturers
Nike, Inc.
Reebok Intl., Ltd.
RNOA, % ROA, %
11.2%
63.5
6.2
Operating Liability Financial Assets/
Leverage (OLLEV) Total Assets, %
5.7%
26.2
3.8
0.37
0.51
0.31
52.8%
41.0
10.3
197.0
68.4
121.8
25.4
21.0
32.5
1.69
1.52
0.87
64.7
26.5
48.5
12.7
0.5
39.7
9.3
0.4
30.1
0.35
0.35
0.56
1.0
4.1
24.1
14.8
13.9
8.3
8.2
0.73
0.64
1.9
4.4
22.6
14.1
16.3
9.8
0.37
0.32
6.1
7.2
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Operating liability leverage (OLLEV) and the amount of financial assets relative to total
assets explain the difference between RNOA and ROA, and you can see in the table that
firms with the largest differences have high numbers for these ratios. Microsoft had an
RNOA of 197.0 percent in 1996, but inclusion of financial assets (64.7 percent of total
assets) in the ROA measure and the omission of the operating liability leverage of 1.69
reduces the profitability measure to 25.4 percent.
These observations reinforce two points. To analyze profitability effectively, two procedures 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 debt-to-equity ratio, calculated as total debt
divided by equity. This measure is useful in credit analysis (see Chapter 19) but, for the
analysis of profitability, it confuses operating liabilities (which create operating liability
leverage) with financial liabilities (which create financial leverage). And, as usually defined,
it does not net out financial 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 60.0 percent of its assets in financial assets at the end 2002 and, with an operating liability leverage of 0.428,
had no financial obligations. Its debt-to-equity ratio was 0.22, but all the debt in the debtto-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 –0.742.
SECOND-LEVEL BREAKDOWN: DRIVERS
OF OPERATING PROFITABILITY
In the first-level breakdown, RNOA is isolated as an important driver of the ROCE. RNOA
can be broken down further into its drivers so that
ROCE = RNOA + [FLEV × (RNOA − NBC)]
(11.4)
= (PM × ATO) + [FLEV × (RNOA − NBC)]
The two drivers of RNOA are
1. Operating profit margin (PM):
PM = OI (after tax)/Sales
This we calculated as a common-size ratio in Chapter 9. The profit margin reveals the
profitability of each dollar of sales.
2. Asset turnover (ATO):
ATO = Sales/NOA
The asset turnover reveals the 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
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its inverse, 1/ATO = NOA/Sales, which indicates the amount of NOA 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.
This decomposition of operating profitability is known as the Du Pont 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; second, RNOA is higher the more sales are
generated from the net operating assets. The first is a profitability measure; the second is an
efficiency 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 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 of RNOA with a relatively high
profit margin but low turnover, or with a relatively high turnover but a low margin. Figure 11.3 plots median PM and ATO for 238 industries from 1963 to 1996. You see from the
figure that industries with low asset turnovers tend to have high profit margins, and industries with high asset turnovers tend to have low profit margins. One could draw a curve—
sloping down to the right—that connects dots with the same RNOA but different PMs and
ATOs. An industry with a 10 percent margin and an ATO of 1.0 has the same 10 percent
RNOA as a firm with a 3.33 percent margin and an ATO of 3.0.
Table 11.3 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 operating liability leverage (OLLEV). This table will give 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
FIGURE 11.3
Source: D. Nissim and S. H.
Penman, “Ratio Analysis and
Equity Valuation: From
Research to Practice,” Review
of Accounting Studies, March
2001, p. 137.
0.3
0.25
0.2
Profit margin
Profit Margin and
Asset Turnover
Combinations for 238
Industries, 1963–1996
Industries with high
profit margins tend
to have low asset
turnovers, and
industries with low
profit margins tend to
have high asset
turnovers.
0.15
0.1
0.05
0
0
1
2
3
4
–0.05
Asset turnover
5
6
7
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Chapter 11 The Analysis of Profitability 383
TABLE 11.3
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
Data: Compustat® data.
Industry
Pipelines
Tobacco
Restaurants
Printing and publishing
Business services
Chemicals
Food stores
Trucking
Food products
Communications
General stores
Petroleum refining
Transportation equipment
Airlines
Utilities
Wholesalers, nondurable goods
Paper products
Lumber
Apparel
Hotels
Shipping
Amusements and recreation
Building and construction
Wholesalers, durable goods
Textiles
Primary metals
Oil and gas extraction
Railroads
ROCE, %
FLEV
OLLEV RNOA, % PM, % ATO
17.1%
15.8
15.6
14.6
14.6
14.3
13.8
13.8
13.7
13.4
13.2
12.6
12.5
12.4
12.4
12.2
11.8
11.7
11.6
11.5
11.4
11.4
11.4
11.2
10.4
9.9
9.1
7.3
1.093
0.307
0.313
0.154
0.056
0.198
0.364
0.641
0.414
0.743
0.389
0.359
0.369
0.841
1.434
0.584
0.436
0.312
0.408
1.054
0.793
0.598
0.439
0.448
0.423
0.424
0.395
0.556
0.154
0.272
0.306
0.374
0.488
0.352
0.559
0.419
0.350
0.284
0.457
0.487
0.422
0.516
0.272
0.461
0.296
0.384
0.317
0.201
0.205
0.203
0.409
0.354
0.266
0.338
0.263
0.362
12.0%
14.0
14.2
13.6
13.5
13.4
12.0
10.1
12.1
9.1
11.3
11.2
11.2
9.0
8.2
10.2
10.2
10.4
10.1
8.5
9.1
10.1
10.6
9.9
9.3
9.4
8.3
7.1
27.8%
9.3
5.0
6.5
5.2
7.1
1.7
3.8
4.4
12.5
3.5
6.0
4.5
4.3
14.5
2.3
5.9
4.0
4.0
8.2
12.6
9.5
4.5
3.4
4.3
5.0
13.0
9.7
0.40
1.70
2.83
2.20
2.95
1.91
7.39
2.88
2.74
0.76
3.55
1.96
2.47
1.99
0.59
3.72
1.74
2.60
2.55
1.04
0.61
1.10
2.06
2.84
2.09
1.80
0.57
0.78
variation, particularly in financial leverage. 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 generated 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
high margins. Firms that generate customers with advertising—like apparel makers—
typically have lower margins (after advertising expense) but, as a result of the advertising,
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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
The common-size analysis of the income statement in Chapter 9 broke the profit margin
into two components:
PM = Sales PM + Other items PM
(11.5)
Other items in the income statement include shares of subsidiary income, special
items, and gains and losses. These sources of income are not a result of sales revenue at
the top of the income statement. So calculating a PM that includes these items distorts
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
=
(11.6)
Gross margin Administrative expense Selling expense
−
−
Sales
Sales
Sales
−
R&D Operating taxes
−
Sales
Sales
Other operating items PM =
Subsidiary income Other equity income
+
Sales
Sales
+
(11.7)
Special items Other gains and losses
+
Sales
Sales
These component ratios are known as profit margin drivers. A good part of managerial
accounting and cost accounting texts is devoted to an analysis of these drivers. The drivers
should be analyzed further by segment if segment disclosures are available. Clearly, profit
margins are increased by adding to gross margins (reducing cost of sales), by adding other
items income, 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
=
+
+
+L+
ATO Sales
Sales
Sales
Sales
+L–
(11.8)
Accounts payable Pension obligations
−
−L
Sales
Sales
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 support
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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,
Accounts receivable turnover =
Sales
Accounts receivable (net)
and
PPE turnover =
Sales
Property, plant, and equipment (net)
(This is sometimes called the fixed asset turnover.)
A firm increases its turnover (and thus RNOA) by maintaining operating assets at a minimum 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,
Days in accounts receivable =
365
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. The inventory
turnover ratio is sometimes measured as
Inventory turnover =
Cost of goods sold
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:
Days in inventory =
365
Inventory turnover
This ratio is best applied in wholesaling or retailing concerns where there is just one type
of inventory, finished goods inventory. 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 goods inventory can be calculated.
A metric that assesses the ability to get operating liability leverage by extending credit
from suppliers is
Days in accounts payable =
365 × Accounts payable
Purchases
where
Purchases = Cost of goods sold + Change in inventory
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The turnover drivers can be reduced to two summary drivers, the operating working capital driver and the long-term net operating asset driver:
1
Operating working capital Long-term NOA
=
+
ATO
Sales
Sales
Working capital is often defined as current assets minus current liabilities, but these may
include financial items not involved in generating sales. So Operating working capital =
Current assets – Current liabilities – Current financial assets + Current financial liabilities.
The long-term NOA of course also exclude financial items and are usually made up of
property, plant, and equipment, intangibles, and investments in equities.
The profit margins and turnovers for Nike and Reebok are given in Table 11.4, 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, as laid out in equations (11.5),
(11.6), and (11.8). Then look at sources of the differences in RNOA for the two firms.
TABLE 11.4 Second- and Third-Level Breakdown: Nike and Reebok
2004
Second Level
RNOA
Profit Margin
Asset Turnover
Third Level
Profit Margin drivers (%)
Gross margin ratio
42.9
Administrative expense ratio (18.9)
Advertising expense ratio
(11.2)
Amortization expense ratio
(0.7)
Sales PM before tax
12.0
Tax expense ratio
(4.2)
Sales PM
7.8
Other items PM
0.6
Asset Turnover drivers (inverse)
Cash turnover
0.005
Accounts receivable turnover
0.172
Inventory turnover
0.128
Prepayment turnover
0.029
PPE turnover
0.131
Intangibles turnover
0.028
Other asset turnover
0.037
Operating asset turnover
0.529
Accounts payable turnover
(0.051)
Accrued expenses turnover
(0.078)
Taxes payable turnover
(0.010)
Other liability turnover
(0.028)
Note: Columns may not add precisely due to rounding error.
2003
Nike
Reebok
Nike
Reebok
23.31%
8.45%
2.759
24.40%
6.26%
3.896
9.62%
3.95%
2.434
27.88%
5.48%
5.088
8.45
0.362
39.6
(28.2)
(3.6)
(0.1)
7.6
(1.9)
5.7
0.6
0.005
0.158
0.107
0.015
0.044
0.051
0.049
0.425
(0.045)
(0.101)
(0.013)
(0.009)
6.26
0.257
41.0
(18.5)
(10.9)
(0.8)
10.8
(3.7)
7.1
(3.1)
0.005
0.182
0.136
0.075
0.151
0.029
0.039
0.568
(0.046)
(0.083)
(0.010)
(0.019)
3.95
0.411
38.4
(26.9)
(4.3)
(0.0)
7.2
(2.2)
5.0
0.5
0.005
0.137
0.108
0.012
0.041
0.019
0.042
0.366
(0.046)
(0.104)
(0.010)
(0.009)
5.48
0.197
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What-If Questions: Nike and Reebok
What if Nike increased its accounts receivable turnover from
5.83 to Reebok’s level of 6.35 while maintaining the current
level of sales? How would RNOA change?
Answer: The increase would reduce average accounts receivable by $172 million to $1,930 million, increase the overall asset turnover from 2.76 to 2.87, and increase RNOA from
23.31 percent to 24.25 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.
What if Nike’s gross margin ratio of 42.9 percent in 2004 is
likely to decline to the 41.0 percent in 2003 due to higher production costs?
Answer: A reduction in the gross margin ratio of 1.9 percent is an after-tax reduction of 1.20 percent at Nike’s 37.1
percent tax rate. This results in a drop in the (after-tax) overall
11.7
profit margin from 8.45 percent to 7.25 percent and a drop
on RNOA from 23.31 percent to 20.0 percent.
What if Reebok increased its annual advertising expenditures
by $100 million to $1,167 million, resulting in $500 million in
additional sales at the same gross margin percentage?
Answer: The increased advertising would result in an extra
$198 million of gross margin at the current gross margin ratio
of 39.6 percent. Net of the $100 million in additional advertising expenses, the additional pretax income would be $98 million, or $62.8 million after tax. Accordingly, the profit margin
ratio would increase to 7.0 percent. If receivables, inventory,
and other net assets increase proportionally to support the
sales, the ATO remains the same, so RNOA increases to
7.0 percent × 3.896 = 27.27 percent. Clearly, if the increased
sales that the advertising draws were lower margin sales, the
RNOA would be less.
Reebok’s higher RNOA for both 2004 and 2003 is due to a higher asset turnover, not the
profit margin. Indeed, Nike has a higher gross margin ratio (lower production costs) and
a lower administrative expense ratio, indicating that, with respect to the main operating
expenses, Nike is more efficient in squeezing income from sales. Nike’s advertising expense ratio is higher than Reebok’s, but the higher advertising outlays deliver sales with
higher gross margin. In 2003, Nike’s lower profit margin is due to “other items,” not the
profitability of sales. Reebok’s higher asset turnovers are due to its carrying lower receivables and inventory per dollar of sales and significantly lower carrying amounts for
property, plant, and equipment to support sales. Nike, on the other hand, maintains
higher accounts payable per dollar of sales, though overall has a lower operating liability
leverage than Reebok.
Bear in mind one caveat in interpreting these numbers. Asset turnover calculations are
affected by the accounting for net assets. So, for example, a firm using LIFO methods for
inventory will report a higher inventory turnover than one using FIFO, all else constant.
Rapid depreciation methods produce higher PPE turnovers. So one must ask whether
Reebok’s higher asset turnovers are due to its accounting policies, not the efficiency with
which it deploys assets and optimizes operating liabilities. In fact, both Nike and Reebok
use FIFO inventory valuation methods, so the inventory turnover ratios are comparable.
Part Four of the book examines accounting issues and their effect on profitability analysis
and valuation.
Analysis does not end with the calculation of ratios. Indeed the calculations are the tools
of analysis. The analyst takes these tools and asks what-if questions—and gets answers. See
Box 11.7.
Borrowing Cost Drivers
The final component of ROCE is the operating spread, RNOA – NBC. As the RNOA component 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.
387
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11. The Analysis of
Profitability
© The McGraw−Hill
Companies, 2007
388 Part Two The Analysis of Financial Statements
The net borrowing cost is a weighted average of the costs for the different sources of net
financing. It can be calculated as
⎡ FO
After-tax interest on financial obligations (FO) ⎤
NBC = ⎢
×
⎥
NFO
FO
⎣
⎦
⎡ FA
After-tax interest on financial assets (FA) ⎤
−⎢
×
⎥
FA
⎣ NFO
⎦
⎛ FA
Unrealized gains on FA ⎞ ⎛ Preferred stock Preferred dividend ⎞
−⎜
×
×
⎟ +⎜
⎟ +L
FA
NFO
Preferred stock ⎠
⎝ NFO
⎠ ⎝
Nike’s 2003 after-tax net borrowing cost of 3.92 percent, calculated in Table 11.1, is made
up of interest expense and interest income components, weighted as follows. Refer again to
the reformulated statements in Exhibits 9.3 and 9.9 (the very small preferred dividend is
not material).
⎡ 1, 013 43 × (1 − 0.375) ⎤ ⎡ 554 14 × (1 − 0.375) ⎤
×
NBC = ⎢
×
⎥
⎥−⎢
1, 013
554
⎦
⎣ 459
⎦ ⎣ 459
⎡ 1, 013
⎤ ⎡ 554
⎤
=⎢
× 2.65%⎥ − ⎢
× 1.58%⎥
459
459
⎣
⎦ ⎣
⎦
= 3.92% (allow for rounding error).
The weights are calculated from average NFO ($459 million), average financial obligations
($1,013 million), and average financial assets ($554 million). This calculation separates the
after-tax borrowing cost for the obligations (2.65 percent) from the return on financial
assets (1.58 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 (3.92 percent versus
2.65 percent). The difference in the rates for the two components is called the spread
between lending and borrowing rates (–1.07 percent here). Banks make money with
higher lending than borrowing rates and thus (if they are successful) their overall net rate,
their RNFA, is higher than the borrowing rate. Nike has a negative lending and borrowing
rate spread (typical of nonfinancial firms) and the overall contribution of financing activities to ROCE could be improved by selling off the financial assets and using the proceeds
to reduce the financial obligations. Alternatively, Nike may wish to buy operating assets
by selling off its financial assets and improve the ROCE through the RNOA driver.
The profitability analysis for Nike is continued on the BYOAP feature on the book’s
Web site. See Box 11.8.
As with all calculations, these numbers should be checked for their reasonableness.
Footnotes give rates for some borrowings as a benchmark. If your calculated borrowing
costs seem “out of line,” it may be that you 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 if the averaging
of balance sheet amounts does not reflect the timing of changes in those amounts during the
period.
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
© The McGraw−Hill
Companies, 2007
11. The Analysis of
Profitability
Tracking Nike’s Profitability: 1996–2004
Web site, which provides a full analysis of the firm from
1996–2004. Here are some of the salient numbers:
The profitability analysis for Nike is continued on the Build
Your Own Analysis Product (BYOAP) feature on the book’s
Sales revenue ($ billions)
Profitability:
Return on common equity (%)
Return on net operating assets (%)
Profit margin (%)
Asset turnover
Net borrowing cost (%)
Leverage:
Financial leverage
Operating liability leverage
1996
1997
1998
1999
2000
2001
6.5
9.2
9.6
8.8
9.0
24.3
22.6
8.5
2.7
5.9
27.8
25.0
8.7
2.9
5.1
12.0
10.6
4.3
2.5
4.1
13.0
11.2
5.1
2.2
2.6
16.6
13.3
6.2
2.1
2.1
0.107
0.369
0.140
0.369
0.202
0.315
You see that Nike’s return on common equity (ROCE) declined subsequent to 1996, even though financial leverage
increased and net borrowing cost declined (as interest rates
generally declined). The reason, of course, was a decline in
operating profitability (RNOA), due to a decline in profit margins, assets turnovers, and operating liability leverage.
11.8
0.218
0.277
0.295
0.290
2002
2003
2004
9.5
9.9
10.7
12.3
16.5
12.9
6.1
2.1
2.5
17.0
14.4
6.5
2.2
2.7
10.3
9.6
4.0
2.4
3.9
23.0
23.3
8.5
2.8
—
0.342
0.258
0.216
0.283
0.117
0.384
0.001
0.46
The next chapter analyzes the growth or decline in profitability in more depth. Chapter 12 also shows how changes in
profitability combine with growth in investment to determine
growth in earnings and residual earnings.
The Web Connection
Find the following on the Web page for this chapter:
• Further exploration of the effects of financial leverage,
with consideration of both risk and profitability effects.
• Discussion of RNOA vs. ROA for Dell Computer
Corporation (Dell, Inc.).
Summary
• Further exploration of operating liability leverage and
how it is particularly pertinent for an insurance company.
• Profitability analysis for more firms, including a comprehensive analysis of Home Depot, Inc.
• A spreadsheet engine to carry out profitability analysis.
This chapter has laid out the analysis of profitability. The analysis is summarized in Figure 11.1. 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 statement and balance sheet are entered into
a spreadsheet program and the template in Figure 11.1 overlaid, the analysis proceeds at the
press of a button.
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. But it is also a way of organizing your knowledge
of the business and understanding the effects of business activities 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
389
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Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
© The McGraw−Hill
Companies, 2007
11. The Analysis of
Profitability
390 Part Two The Analysis of Financial Statements
earnings and the value of the business. So, for example, the analyst understands 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.
The chapter has provided numbers for typical levels of ROCE, RNOA, financial leverage (FLEV), operating liability leverage (OLLEV), profit margins, asset turnovers, and
more. Keep these numbers in mind, for they will provide useful benchmarks for what to
expect when forecasting.
Key Concepts
favorable financial leverage (or favorable
gearing) is an increase in ROCE over
RNOA, induced by borrowing. 373
favorable operating liability leverage is
an increase in return on net operating
assets over return on operating assets,
induced by operating liabilities. 376
growth analysis is the analysis of the
determinants of growth in residual
earnings. 370
operating liability leverage spread is
the difference between the return on
operating assets and the implicit
borrowing rate for operating
liabilities. 375
operating spread is the difference
between operating profitability and the
net borrowing cost. 373
profitability analysis is the analysis of the
determinants of return on common equity
(ROCE). 370
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. 373
spread between borrowing and lending
rates is the difference between the return
on financial obligations and the return on
financial assets. 388
The Analyst’s Toolkit
Analysis Tools
The analysis of financial
leverage
equations 11.1, 11.2
The analysis of operating
liability leverage
equation 11.3
Du Pont analysis of return on
net operating assets
equation 11.4
Analysis of profit margin
equations 11.6, 11.7
Analysis of asset turnovers
equation 11.7
Analysis of borrowing costs
What-if analysis
Page
373
375
381
384
384
387
387
Key Measures
Probability ratios (a full set,
including those introduced
in previous chapters)
Return on common equity
(ROCE)
Return on net operating
assets (RNOA)
Net borrowing cost (NBC)
Return on net financial
assets (RNFA)
Financial leverage (FLEV)
Operating liability leverage
(OLLEV)
The operating spread
(SPREAD)
Operating liability leverage
spread (OLSPREAD)
Return on operating assets
(ROOA)
Page
371
373
373
374
373
375
373
373
375
Acronyms to Remember
ATO asset turnover = sales/NOA
CSE common shareholders’
equity
FLEV financial leverage =
NFO/CSE
NBC net borrowing cost =
NFE/NFO
NFA net financial assets
NFE net financial expenses
NFI net financial income
NOA net operating assets
OA operating assets
OI operating income
OL operating liabilities
OLLEV operating liability leverage
= OL/NOA
OLSPREAD operating liability
leverage spread = ROOA − shortterm borrowing rate
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
© The McGraw−Hill
Companies, 2007
11. The Analysis of
Profitability
Chapter 11 The Analysis of Profitability 391
The Analyst’s Toolkit (concluded)
Analysis Tools
Page
Key Measures
Minority interest sharing
ratio
Operating profit margin
(PM)
Asset turnover (ATO)
Sales profit margin
Other operating items
profit margin
Gross margin
Expense ratios
Individual asset turnover
ratios
Days in accounts receivable
Days in inventory
Days in accounts payable
Borrowing cost drivers
Spread between lending
and borrowing rates
Page
381
381
381
384
384
384
384
384
385
385
385
387
Acronyms to Remember
PM profit margin = OI/sales
PPE property, plant, and
equipment
RNFA return on net financial
assets = NFI/NFA
RNOA return on net operating
assets = OI/RNOA
ROA return on assets
= net income + interest expense
(after tax)/total assets
ROOA return on operating
assets = OI + implicit interest on
OL/OA
SPREAD operating spread =
RNOA − NBC
388
A Continuing Case: Kimberly-Clark Corporation
A Self-Study Exercise
In the Continuing Case for Chapter 9, you reformulated Kimberly Clark’s balance sheets
and income statements. The reformulation prepares the statements for analysis, which you
will carry out here.
PROFITABILITY ANALYSIS FOR KMB
Proceed with a comprehensive profitability analysis of Kimberly Clark for 2004 and 2003.
Let Figure 11.1 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 3.5 percent.
WHAT DOES THE ANALYSIS MEAN?
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
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Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
11. The Analysis of
Profitability
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Companies, 2007
392 Part Two The Analysis of Financial Statements
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 statements into a spreadsheet in Chapter 9, 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.
Concept
Questions
C11.1. Under what conditions would a firm’s return on common equity (ROCE) be equal
to its return on net operating assets (RNOA)?
C11.2. Under what conditions would a firm’s return on net operating assets (RNOA) be
equal to its return on operating assets (ROOA)?
C11.3. 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.
C11.4. Explain why borrowing might lever up the return on common equity.
C11.5. Explain why operating liabilities might lever up the return on net operating assets.
C11.6. A firm should always purchase inventory and supplies on credit rather than paying
cash. Correct?
C11.7. A reduction in the advertising expense ratio increases return on common equity
and share value. Correct?
C11.8. 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?
C11.9. Why might operating losses increase after-tax borrowing cost?
C11.10. Some retail analysts use a measure called “inventory yield,” calculated as gross
profit-to-inventory. What does this measure tell you?
C11.11. Return on total assets (ROA) is a common measure of profitability. The historical
average is about 6.8 percent. The historical yield on corporate bonds is about
6 percent. Why is the ROA so low? Would not investors expect more than a
0.8 percent higher return on risky operations?
C11.12. Low profit margins always imply low return on net operating assets. True or false?
Exercises
Drill Exercises
E11.1.
Leveraging Equations (Easy)
The following information is from reformulated financial statements (in millions of dollars):
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
© The McGraw−Hill
Companies, 2007
11. The Analysis of
Profitability
Chapter 11 The Analysis of Profitability 393
Operating assets
Marketable debt securities
Operating liabilities
Bonds payable
Book value (net)
2005
2006
$2,000
400
(100)
(1,400)
$ 900
$2,700
100
(300)
(1,300)
1,200
Sales
Operating expenses
Interest revenue
Interest expense
Tax expense (rate = 34%)
Earnings (net)
2,100
(1,677)
27
(137)
(106)
$ 207
a. (1) Calculate the dividends, net of capital contributions, for 2006.
(2) Calculate ROCE for 2006; use average net book value in the denominator.
(3) Calculate RNOA for 2006; use the average net operating assets in the denominator.
(4) Supply the numbers for the formula
ROCE = PM × ATO + [Financial leverage × (RNOA − Borrowing cost)]
b. The firm’s short-term borrowing rate is 4.5 percent after tax. Supply the numbers for
the formula
RNOA = ROOA + (OLLEV × OLSPREAD)
c. Repeat the exercise in part (a) using the following information:
2005
Operating assets
Marketable debt securities
Operating liabilities
Book value (net)
Sales
Operating expenses
Interest revenue
Tax expense (rate = 34%)
Earnings
E11.2.
$2,000
800
(100)
$2,700
2006
$2,700
1,000
(300)
3,400
2,100
(1,677)
90
(174)
$ 339
First-Level Analysis of Financial Statements (Easy)
A firm whose shares traded at three times their book value on December 31, 2005, 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 balance sheet.
a. The firm paid no dividends and issued no shares during 2005, but it repurchased some
stock. Calculate the amount of stock repurchase.
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
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
© The McGraw−Hill
Companies, 2007
11. The Analysis of
Profitability
394 Part Two The Analysis of Financial Statements
c. Does it make sense that this firm’s shares should trade at three times book value?
Balance Sheet, December 31, 2005
Assets
2005
Operating cash
Short-term investments
Accounts receivable
Inventories
Property and plant (net)
$
50
150
300
420
840
$1,760
2004
Liabilities and
Shareholders’ Equity 2005
$
20
150
250
470
790
$1,680
Accounts payable
Long-term debt
Common equity
2004
$ 215
450
$ 205
450
1,095
1,025
$1,760
$1,680
Income Statement, Year Ended December 31, 2005
Sales
Interest income
Operating expenses
Interest expense
Tax expense
Net income
E11.3.
$3,295
9
$3,048
36
61
(3,145)
$ 159
Reformulation and Analysis of Financial Statements (Medium)
This exercise continues Exercise 9.5 in Chapter 9. The following financial statements were
reported for a firm for fiscal year 2006 (in millions of dollars):
Balance Sheet
Operating cash
Short-term investments (at market)
Accounts receivable
Inventory
Property and plant
2006
2005
60
550
940
910
2,840
5,300
50
500
790
840
2,710
4,890
2006
2005
Accounts payable
Accrued liabilities
Long-term debt
1,200
390
1,840
1,040
450
1,970
Common equity
1,870
5,300
1,430
4,890
Statement of Shareholders’ Equity
Balance, end of fiscal year 2005
Share issues
Repurchase of 24 million shares
Cash dividend
Unrealized gain on debt investments
Net income
Balance, end of fiscal year 2006
1,430
822
(720)
(180)
50
468
1,870
The firm’s income tax rate is 35%. The firm reported $15 million in interest income and $98
million in interest expense for 2006. Sales revenue was $3,726 million.
a. Prepare a reformulated balance sheet and comprehensive income statement (as required in Exercise 9.5).
b. Calculate free cash flow for 2006.
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
11. The Analysis of
Profitability
© The McGraw−Hill
Companies, 2007
Chapter 11 The Analysis of Profitability 395
c. Calculate the operating profit margin, asset turnover, and return on net operating
assets for 2006. (For simplicity, use beginning-of-period balance sheet amounts in
denominators.)
d. Calculate individual net 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 × 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 × (RNOA – 3.0%)]
E11.4.
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.
E11.5.
Profit Margins, Asset Turnovers, and Return on Net Operating Assets:
A What-If Question (Medium)
A firm earns a profit margin of 3.8 percent on sales of $435 million and employs net operating assets of $150 million to do so. It considers adding another product line that will earn
a 4.8 percent profit margin with an asset turnover of 2.3.
What would be the effect on the firm’s return on net operating assets of adding the new
product line?
Applications
E11.6.
Profitability and Leverage: Intel Corporation (Medium)
Refer to the income statement and balance sheets for Intel in Exercise 9.8 in Chapter 9,
along with the other information supplied there.
a. Reformulate those statements in a way that prepares them for profitability analysis.
b. Carry out a comprehensive analysis of Intel’s return on common equity (ROCE) for
2004, distinguishing between profitability that arises from operations and that from financing activities.
c. Calculate the traditional return on assets (ROA) and compare it to Intel’s return on net
operating assets (RNOA). What explains the difference?
d. Calculate the standard debt-to-equity ratio and compare it to the financial leverage
measure that distinguishes operating profitability from financing profitability. When
might an analyst rely on the standard debt-to-equity ratio?
Real World Connection
See Exercise E4.12 in Chapter 4, Exercise E8.9 in Chapter 8, Exercise E9.8 in Chapter 9,
and Exercise E17.15 in Chapter 17.
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
© The McGraw−Hill
Companies, 2007
11. The Analysis of
Profitability
396 Part Two The Analysis of Financial Statements
E11.7.
E11.8.
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 ponders
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?
Operating Profitability Analysis: Home Depot, Inc. (Medium)
Comparative balance sheets and income statements for fiscal year ended 2005 are given below
for the warehouse retailer, Home Depot. Amounts are in millions, except per-share data.
a. Reformulate the 2005 and 2004 income statements and the 2005, 2004, and 2003 balance sheets. In addition to net income, Home Depot reported other comprehensive income of $137 million in currency translation gains in 2005 and $172 million of translation gains in 2004. Details of Home Depot’s taxes are given in the tax footnote
included in Exercise 9.10 in Chapter 9. For the reformulation of the balance sheets, include $50 million as operating cash.
b. Carry out a comprehensive analysis of operating profitability for 2005 and 2004.
Real World Connection
See Exercises E9.10 and E12.9 and Minicases M4.2 and M14.2.
THE HOME DEPOT, INC. AND SUBSIDIARIES
Consolidated Statements of Earnings
Fiscal Year Ended
Net Sales
Cost of Merchandise Sold
Gross profit
Operating expenses:
Selling and store operating
General and administrative
Total operating expenses
Operating income
Interest income (expense):
Interest and Investment Income
Interest Expense
Interest, net
Earnings before provision for income taxes
Provision for income taxes
Net earnings
Weighted–average common shares
Basic earnings per share
Diluted weighted-average common shares
Diluted earnings per share
January 30, 2005
February 1, 2004
$73,094
48,664
24,430
$64,816
44,236
20,580
15,105
1,399
16,504
7,926
12,588
1,146
13,734
6,846
56
(70)
(14)
7,912
2,911
$ 5,001
2,207
$ 2.27
2,216
$ 2.26
59
(62)
(3)
6,843
2,539
$ 4,304
2,283
$ 1.88
2,289
$ 1.88
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
© The McGraw−Hill
Companies, 2007
11. The Analysis of
Profitability
Chapter 11 The Analysis of Profitability 397
THE HOME DEPOT, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
January 30, February 1, February 2,
2005
2004
2003
Assets
Current assets:
Cash and Cash Equivalents
Short-Term Investments
Receivables, net
Merchandise Inventories
Other Current Assets
Total current assets
$
Property and equipment, at cost:
Land
Buildings
Furniture, fixtures, and equipment
Leasehold improvements
Construction in progress
Capital leases
Less accumulated depreciation and amortization
Net property and equipment
Notes Receivable
Cost in excess of the fair value of net assets
acquired, net of accumulated amortization
Other assets
Total assets
506
1,659
1,499
10,076
450
14,190
$ 1,103
1,749
1,097
9,076
303
13,328
$ 2,188
65
1,072
8,338
254
11,917
6,932
12,325
6,195
1,191
1,404
390
28,437
5,711
22,726
369
6,397
10,920
5,163
942
820
352
24,594
4,531
20,063
84
5,560
9,197
4,074
872
724
306
20,733
3,565
17,168
107
1,394
228
$38,907
833
129
$34,437
575
244
$30, 011
$ 5,159
801
419
1,281
175
509
1,210
9,554
856
653
967
$ 4,560
809
307
998
227
7
1,127
8,035
1,321
491
362
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts Payable
Accrued salaries and related expenses
Sales taxes payable
Deferred revenue
Income taxes payable
Current installments of long-term debt
Other accrued expenses
Total current liabilities
Long-term debt, excluding current installments
Other long-term liabilities
Deferred income taxes
$ 5,766
1,055
412
1,546
161
11
1,578
10,529
2,148
763
1,309
(continued)
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
© The McGraw−Hill
Companies, 2007
11. The Analysis of
Profitability
398 Part Two The Analysis of Financial Statements
January 30, February 1, February 2,
2005
2004
2003
Stockholders’ Equity
Common Stock, per value $0.05; authorized:
10,000 shares; issued 2,385 shares
at January 30, 2005, and 2,373 shares at
February 1, 2004; outstanding 2,185
shares at January 30, 2005, and 2,257 shares
at February 1, 2004
Paid-in capital
Retained earnings
Accumulated other comprehensive income
Unearned compensation
Treasury stock, at cost, 200 shares at January
30, 2005, and 116 shares at February 1, 2004
Total stockholders’ equity
Total liabilities and stockholders’ equity
119
6,650
23,962
227
(108)
119
6,184
19,680
90
(76)
118
5,858
15,971
(82)
(63)
(6,692)
24,158
(3,590)
22,407
(2,000)
19,802
$38,907
$34,437
$ 30,011
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
© The McGraw−Hill
Companies, 2007
11. The Analysis of
Profitability
Chapter 11 The Analysis of Profitability 399
Minicases
M11.1
Analysis of Profitability: Electronic Data
Systems (EDS)
Electronic Data Systems (EDS) is a technology services company providing information
technology and business process outsourcing services to corporate and government clients
throughout the world. The company offers infrastructure services, such as hosting, workplace (desktop) services, managed storage services, mobile information protection, security
and privacy, and communication services. It also is involved in applications development
and management, and develops enterprise and industry-specific information technology
and outsourcing solutions with clients working with shared services. The Company owns
A.T. Kearney, a value management consultancy. A.T. Kearney operates as a separate
subsidiary of EDS.
The year 2002 was not a good one for EDS shareholders. The stock price fell from $73
in January to $22 in November upon news that revenue from projects would be lower than
expected, both in the current year and subsequent years. But the drop in price was not
entirely due to the revenue news.
The firm’s statement of shareholders’ equity, income statement, and balance sheet for
2002 are provided below. If you worked Minicase M8.1 in Chapter 8, you will have reformulated the 2002 statement of shareholders’ equity to identify income reported in the income
statement and also some hidden expenses associated with share transactions. If you worked
Minicase M9.1 in Chapter 9, you will have also reformulated the 2002 income statement on
a comprehensive income basis. If not, reformulate these statements and also the balance
sheets for 2002 and 2001 below. Be sure to present all aspects of the business on an after-tax
basis. The additional information at the foot of the statements will help you in your task.
ELECTRONIC DATA SYSTEMS CORPORATION
Statement of Shareholders’ Equity
(in millions of dollars; format modified slightly from 10-K)
Balance at December 31, 2001
Net income
Currency translation gain
Change in minimum pension
liability
Unrealized gain on debt securities
Comprehensive income
Issue of stock for acquisition
Employee stock awards
Issue of stock purchase contracts
Purchase of treasury shares
Common dividends
Balance at December 31, 2002
Paid-In
Capital
Retained
Earnings
967
7,122
1,116
Other
Comprehensive
Income
Treasury
Stock
Shareholders’
Equity
(560)
(1,083)
6,446
1,116
288
288
(423)
6
85
232
(72)
11
(380)
906
(287)
7,951
(689)
(1,146)
(423)
6
987
85
160
11
(380)
(287)
7,022
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
© The McGraw−Hill
Companies, 2007
11. The Analysis of
Profitability
400 Part Two The Analysis of Financial Statements
After carrying out these reformulations, perform a comprehensive analysis of the profitability of the business activities for the shareholders during 2002, along the lines of this
chapter. Perform all necessary calculations, but also discuss what the calculations reveal.
Real World Connection
Exercises on EDS are E12.10 and E17.11. Minicases M8.1 and M9.1 also cover EDS.
Notes to Statement of Shareholders’ Equity
1. The issue of stock awards to employees includes issues under stock purchase plans and
issues under stock option plans. With respect to the latter, 0.7 million nonqualifying options were exercised during 2002 at an exercise price of $44. A resultant tax benefit of
$5.75 million was netted into the proceeds from the share issues. The firm’s tax rate is
35 percent.
2. Proceeds from the issue of stock purchase contracts were paid by parties signing forward stock purchase agreements. Stock purchase contracts were also written in 2001,
with EDS recognizing a charge of $118 million to paid-in capital for the right to repurchase its stock at a set price. In both cases, the parties exercised their purchase rights
during 2002.
3. A total of 5.4 million shares were repurchased during for $340 million stock in settlement of forward purchase agreements. At the time of the repurchase, EDS shares traded
at $20. The $340 million is included in the $380 million of stock repurchases in the
statement of shareholders’ equity.
Consolidated Statements of Income
(in millions)
Years Ended December 31,
Revenues
Costs and expenses
Cost of revenues
Selling, general, and administrative
Acquired in-process R&D and other
acquisition-related costs
Restructuring and other charges
Total costs and expenses
Operating income
Other income (expense)
Interest expense and other, net
Reclassification of investment gain from equity
Total other income (expense)
Income from continuing operations before
income taxes
Provision for income taxes
Income from continuing operations
Income from discontinued operations, net
of income taxes (including net gain of
$87 in 2002, net of income taxes)
2002
2001
2000
$21,502
$21,141
$18,856
17,744
1,889
17,086
1,880
144
15,289
1,776
24
(3)
19,630
(15)
19,095
(22)
17,067
1,872
2,046
1,789
(347)
(27)
(347)
(213)
315
102
(27)
1,525
518
1,007
2,148
794
1,354
1,762
643
1,119
109
33
24
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
© The McGraw−Hill
Companies, 2007
11. The Analysis of
Profitability
Chapter 11 The Analysis of Profitability 401
Income before cumulative effect of a
change in accounting principle
Cumulative effect on prior years of a
change in accounting for derivatives,
net of income taxes
Net income
1,116
1,387
1,143
$ 1,116
(24)
$ 1,363
$ 1,143
Notes to Income Statement
1. Interest expense and other for 2002 is made up of the following:
Interest expense
Interest income
Losses on investments
$(258)
30
(119)
$(347)
The investment losses arose from write-downs of lease receivables as a result of the US
Airways and United Airlines bankruptcies.
2. The firm’s statutory tax rate is 35 percent.
Consolidated Balance Sheets
(in millions, except share and per share amounts)
December 31,
2002
2001
Assets
Current assets:
Cash and cash equivalents
Marketable securities
Accounts receivable and unbilled revenue, net
(including pledged receivables of $406 in 2002)
Prepaids and other
Total current assets
Property and equipment, net
Investments and other assets
Goodwill
Other intangible assets, net
Total assets
$ 1,642
248
6,435
$
521
318
5,642
1,060
9,385
3,023
986
4,077
1,409
$18,880
893
7,374
3,082
911
3,692
1,294
$16,353
$ 3,674
830
386
1,239
6,129
51
1,113
4,148
417
$ 3,298
488
190
36
4,012
234
325
4,692
644
Liabilities and Shareholders’ Equity
Current liabilities:
Accounts payable and accrued liabilities
Deferred revenue
Income taxes
Current portion of long-term and secured revolving debt
Total current liabilities
Deferred income taxes
Pension benefit liability
Long-term debt, less current portion
Minority interests and other long-term liabilities
(continued)
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
© The McGraw−Hill
Companies, 2007
11. The Analysis of
Profitability
402 Part Two The Analysis of Financial Statements
December 31,
2002
Shareholders’ equity
Preferred stock, $.01 per value;
authorized 200,000,000 shares; none issued
Common stock, $.01 per value; authorized
2,000,000,000 shares;
495,604,217 shares issued at December 31, 2002;
495,593,044 shares issued at December 31, 2001
Additional paid-in capital
Retained earnings
Accumulated other comprehensive income
Treasury stock, at cost, 18,731,311 and 18,277,672
shares at December 31, 2002 and 2001, respectively
Total shareholders’ equity
Total liabilities and shareholders equity
2001
5
901
7,951
(689)
5
962
7,122
(560)
(1,146)
7,022
$18,880
(1,083)
6,446
$16,353
Notes to Balance Sheet
1. The operating cash component of cash and cash equivalents is $35 million, in all years.
2. Noncurrent investments and other assets consist of lease receivables, contract receivables, and deposits arising from the firm’s operations.
M11.2
Analysis of a Press Release: Nike, Inc., 2005
Analysts eagerly await press releases from the firms that they cover. They usually know the
approximate date of earnings releases and plan their work schedules around them so they
can digest the release and immediately advise clients on any revision they may have on the
firm’s prospects. They also attend the subsequent conference call that management conducts with analysts (usually over the Internet), and a thorough analysis of the press release
is necessary to prepare questions for management.
In July 2005, Nike issued a press release with its results for fiscal year ending May 31,
2005. The press release is in Exhibit 11.1. It does not contain the full information that one
would find in a 10K—that is filed some time later with the SEC. But it gives enough detail
to discover how Nike’s profitability changed in the year. To the extent that the information
allows, carry out a thorough analysis of Nike’s profitability for 2005. Compare it with the
analysis for 2004 in this chapter and find out how Nike’s profitability changed in 2005. Get
down to the level of the drivers that determine the change in profitability.
What questions would you ask at the conference call?
Real World Connection
Follow Nike through Chapters 7–15 and in the BYOAP feature on the book’s Web site.
Exercises E2.13, E6.6, E8.8, E8.11, E13.16, E14.11, E15.10, and E18.5 also deal with
Nike, as does Minicases M2.1 and M7.1.
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
© The McGraw−Hill
Companies, 2007
11. The Analysis of
Profitability
Chapter 11 The Analysis of Profitability 403
EXHIBIT 11.1
Excerpts from the
Press Release
Announcing 2005
Fiscal Year Results
for Nike, Inc.
FOR IMMEDIATE RELEASE
Global strength of Nike portfolio drives record financial performance
Nike, Inc. reports double-digit revenue growth for fiscal 2005;
EPS up 28 percent to $4.48
Worldwide futures orders increase 9.5 percent
Highlights:
• Fiscal 2005 revenues up 12 percent to $13.7 billion, earnings per diluted share up 28 percent to $4.48
• Fourth quarter revenues up 7 percent; earnings per diluted share up 15 percent to $1.30
• Full-year revenue growth across all Nike brand regions and product lines; All regions post
record revenues and profits
• Nike, Inc. Other business full-year revenues grew 22 percent, exceeding $1.7 billion
• Full-year gross margin percentage grew 160 basis points to 44.5 percent
• Balance sheet strengthens as cash and short term investments rise to $1.8 billion
Beaverton, OR (June 27, 2005)—Nike, Inc. (NYSE:NKE) today reported record financial
results for the 2005 fiscal year, ended May 31, 2005. Earnings per diluted share for the year
grew 28 percent to $4.48, supported by double digit revenue growth and record gross
margins.
For the fiscal year ended May 31, 2005, revenues increased 12 percent to $13.7 billion,
compared to $12.3 billion in fiscal year 2004. Changes in currency exchange rates contributed three percentage points of this growth, while the acquisition of Converse and
Starter added one point. Full year net income was up 28 percent to $1.2 billion, or $4.48
per diluted share, versus $945.6 million, or $3.51 per diluted share, in 2004.
Fourth quarter revenues increased seven percent to $3.7 billion, versus $3.5 billion for the
same period last year. Three percentage points of this growth were the result of changes in
currency exchange rates. Fourth quarter net income was up 15 percent to $349.5 million,
or $1.30 per diluted share, compared to $305.0 million, or $1.13 per diluted share in the
prior year.
Commenting on the company’s results, William D. Perez, Nike, Inc. President and Chief
Executive Officer said, “Fiscal 2005 was a great year. The strength of the Nike brand around
the world, the breadth of our Nike, Inc. portfolio, and the quality of our management team
contributed to another year of consistent, profitable growth for our shareholders. The Nike
brand is exceptionally strong, driving full-year revenue gains across all regions and product
lines, while Converse and Cole Haan led the growth in our portfolio of other businesses.
Today’s record earnings were driven by healthy revenue growth and the highest gross
margin in the company’s history.”
Perez continued, “Looking ahead, our worldwide futures orders for athletic footwear and
apparel are strong, up 9.5 percent, with all regions posting increases and U.S. footwear
remaining particularly healthy. We’re very pleased with the brand strength reflected in these
futures results and we see continued potential for profitable expansion across our portfolio
of businesses.”*
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
11. The Analysis of
Profitability
© The McGraw−Hill
Companies, 2007
404 Part Two The Analysis of Financial Statements
Futures Orders
The Company reported worldwide futures orders for athletic footwear and apparel, scheduled for delivery from June through November 2005, totaling $6.3 billion, 9.5 percent
higher than such orders reported for the same period last year. Approximately one point
of this growth was due to changes in currency exchange rates.*
By region, U.S. futures were up nine percent; Europe increased seven percent; Asia Pacific
grew 11 percent; and the Americas increased 25 percent. Changes in currency exchange
rates had a favorable impact of two percentage points in Europe and Asia Pacific. Changes
in currency exchange rates had no impact on futures orders growth for the Americas.*
Income Statement Review
In the fourth quarter, gross margins were 45.2 percent of revenue compared to 43.8 percent last year. For the full year, gross margins were 44.5 percent compared to 42.9 percent
last year. Selling and administrative expenses were 30.6 percent of fourth quarter revenues,
compared to 29.8 percent last year. For the full year, selling and administrative expenses
were 30.7 percent of full year revenues versus 30.2 percent last year. The effective tax rate
was 35.0 percent for the fourth quarter and 34.9 percent for the full year. The tax provision
for the fourth quarter reflected a charge related to the Company’s decision to repatriate
$500 million of foreign earnings under the American Jobs Creation Act during fiscal 2006.
The net impact of this charge was not material to our effective tax rate for the quarter or
the full year.
Balance Sheet Review
At fiscal year-end, global inventories stood at $1.8 billion, an increase of 10 percent from
last year. Cash and short-term investments were $1.8 billion at fiscal year-end, compared
to $1.2 billion last year.
Share Repurchase
During the quarter, the Company purchased a total of 1,853,500 shares for approximately
$152.7 million in conjunction with the Company’s four-year, $1.5 billion share repurchase
program that was approved by the Board of Directors in June 2004. To date, the Company
has repurchased a total of 6,924,400 shares under this program.
NIKE, Inc. based in Beaverton, Oregon, is the world’s leading designer, marketer and distributor of authentic athletic footwear, apparel, equipment and accessories for a wide variety
of sports and fitness activities. Wholly owned Nike subsidiaries include Converse Inc., which
designs, markets and distributes athletic footwear, apparel and accessories; Bauer NIKE
Hockey, Inc., a leading designer and distributor of hockey equipment; Cole Haan, a leading
designer and marketer of luxury shoes, handbags, accessories and coats; Hurley International LLC, which designs, markets and distributes action sports and youth lifestyle
footwear, apparel and accessories and Exeter Brands Group LLC, which designs and
markets athletic footwear and apparel for the value retail channel.
NIKE’s earnings releases and other financial information are available on the Internet at
www.NikeBiz.com/invest.
*The marked paragraphs contain forward-looking statements that involve risks and uncertainties that could cause actual results to differ
materially. These risks and uncertainties are detailed from time to time in reports filed by NIKE with the S.E.C., including Forms 8-K,
10-Q, and 10-K. Some forward-looking statements in this release concern changes in futures orders that are not necessarily indicative of
changes in total revenues for subsequent periods due to exchange rate fluctuations as well as the mix of futures and “at once” orders,
which may vary significantly from quarter to quarter.
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
© The McGraw−Hill
Companies, 2007
11. The Analysis of
Profitability
Chapter 11 The Analysis of Profitability 405
NIKE, INC.
Consolidated Financial Statements
For the Period Ended May 31, 2005
(In millions, except per share data)
Quarter Ending
Income Statement
Revenues
Cost of sales
Gross margin
SG&A
Interest (income) expense, net
Other expense, net
Income before income taxes
Income taxes
Net income
Diluted EPS
Basic EPS
Year Ending
05/31/2005 05/31/2004 % Chg 05/31/2005 05/31/2004 % Chg
$3,721.4
2,038.7
1,682.7
45.2%
1,139.2
30.6%
(3.6)
9.2
537.9
188.4
35.0%
$ 349.5
$
1.30
$
1.34
$3,487.1
7%
1,958.4
4%
1,528.7
10%
43.8%
1,037.9
10%
29.8%
3.9
—
19.4
(53%)
467.5
15%
162.5
16%
34.8%
$ 305.0
15%
$
1.13 15%
$
1.16 16%
Weighted-average common shares outstanding:
Diluted
268.5
270.8
Basic
261.1
263.2
Dividends declared
$
0.25
$
0.20
Balance sheet*
$13,739.7
7,624.3
6,115.4
44.5%
4,221.7
30.7%
4.8
29.1
1,859.8
648.2
34.9%
$ 1,211.6
$
4.48
$
4.61
$
270.3
262.6
0.95
$12,253.1
7,001.4
5,251.7
42.9%
3,702.0
30.2%
25.0
74.7
1,450.0
504.4
34.8%
$ 945.6
$
3.51
$
3.59
$
12%
9%
16%
14%
(81%)
(61%)
28%
29%
28%
28%
28%
269.7
263.2
0.74
05/31/2005
05/31/2004
$1,388.1
436.6
2,262.1
1,811.1
110.2
343.0
6,351.1
3,179.2
1,573.4
1,605.8
$ 828.0
400.8
2,120.2
1,650.2
165.0
364.4
5,528.6
3,183.4
1,571.6
1,611.8
541.5
295.2
$8,793.6
501.7
266.6
$7,908.7
Assets
Cash and equivalents
Short-term investments
Accounts receivable
Inventory
Deferred taxes
Prepaid expenses and other current assets
Current assets
Fixed assets
Depreciation
Net fixed assets
Identifiable intangible
assets and goodwill
Other assets
Total assets
(continued)
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
© The McGraw−Hill
Companies, 2007
11. The Analysis of
Profitability
406 Part Two The Analysis of Financial Statements
Balance sheet*
05/31/2005
05/31/2004
Liabilities and Equity
Current long-term debt
Payable to banks
Accounts payable
Accrued liabilities
Income Taxes Payable
Current liabilities
Long-term debt
Def Inc taxes and other liabilities
Preferred stock
Common equity
Total liabilities and equity
$
6.2
69.8
843.9
984.3
95.0
1,999.2
687.3
462.6
0.3
5,644.2
$8,793.6
$
6.6
146.0
780.4
979.3
118.2
2,030.5
682.4
413.8
0.3
4,781.7
$7,908.7
*Certain prior year amounts have been reclassified to conform to fiscal year 2005 presentation. These changes had no impact on
previously reported results of operations or shareholders’ equity.