Chapter 3

Profitability

and

Risk Analysis

Which is more profitable?

Wal-MartHome Depot

May Company

Profitability Analysis

• Project future profitability based on an analysis of past performance

• Time series analysis • changes in financial ratios over time

• Cross-sectional analysis• examines company’s financial ratios in comparison

to - its competitors - industry averages

Profitability Analysis - Nuts & Bolts

• Rate of return on assets (ROA)• firm’s success in using assets to generate earnings• independent of financing considerations

N.I. + Interest Expense net of taxes + Minority Interest in Earnings

Average Total Assets

• Net Income - from continuing operations• Interest Expense net of taxes

(1 - marginal tax rate) (Interest Expense)

• Minority Interest - added back to obtain consistency between numerator and denominator

Nuts & Bolts, cont’d

• Dissaggregating ROA

ROA = Profit Margin X Assets Turnover

__Adj. NI_____ = Adj. NI X ____Sales________

Avg.Tot.Assets Sales Average Total Assets

Profit Margin Analysis

• Look at the components of net income as a percentage of sales• Other revenues• Cost of goods sold• Selling and administrative expenses• Income taxes

• Gives insight into how the company earned its income• “quality of earnings”

Analyzing Asset Turnover

• Looks at the relationship between operating revenues, expenses, and assets• Accounts receivable turnover

Net Sales on Account / Average Accounts Receivable

• Inventory turnover

Cost of Goods Sold / Average Inventories

• Fixed assets turnover

Sales / Average Fixed Assets

Chapter 3, cont’d

Risk Analysis

Case Assignment (due Monday, 3/1)

Case 3.1: Wal-Mart Profitability and Risk AnalysisGeneral guidelines for analysis are provided with the case. Simply answering the questions in a reasonably complete manner should garner a score of 80%. Additional points will be awarded based on thoroughness of analysis, presentation, and creativity.

In addition to the stated analysis requirements, you should also prepare a strategic analysis. This analysis should evaluate the market in which Wal-Mart operates (is it growing or shrinking, how intense is the competition, etc.) as well as evaluate Wal-Mart’s position relative to its competitors.

Financial Analysis Software

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

Profitability Analysis Summary

ROA = Profit Margin x Asset Turnover

ProfitMargin

Asset Turnover

A

B

C

D

ROAA=12%B=12%C=18%D=6%

Return on Common Equity

• Measures return not allocated to debt or preferred equity

ROCE = Net Income - Preferred Dividends*Avg. Common Equity

* also known as NI to Common

• Using lower-cost debt and preferred stock financing can increase the return to common shareholders• financial leverage

Disaggregating ROCE

• Allows us to interpret causes for differences between ROA and ROCE

ROCE = ROA x CEL x CSL

NI to common = __NI+I.E. X NI to common X Avg. Total Assets Avg. Common Avg. Total NI+I.E. Avg. Common Equity Assets Equity

Significance of ROA, CEL, and CSL• ROA tells us the return on all assets employed• CEL tells us about the relative cost of debt and preferred

stock• indicates the proportion of net income that is available to

common shareholders• the higher the cost of debt and preferred stock, the smaller the

ratio, the less income will remain for common shareholders

• CSL tells us about the degree to which a firm uses debt to increase its asset base• the more debt and preferred stock is used to finance assets, the

greater the multiplier effect on earnings • when the cost of debt and preferred is less than ROA, common

shareholders earnings are enhanced

• when the cost of debt and preferred is greater than ROA, common shareholders earnings are depressed

Putting numbers with the concepts

• Hi-debt Company has: Total Assets 2M Common Equity1MInterest Expense 100KTax rate 40%Year 1 N.I. 180K Year 2 N.I.

-0-

ROCE = ROA x CEL x CSLYR1 18% = 12% x 75 x 2

YR2 0% = 3% x 0 x 2

Putting numbers with the concepts

• No-debt Company has: Total Assets 2MCommon Equity 2MInterest Expense -0-Tax rate 40%Year 1 N.I. 240K Year 2 N.I.

60K

ROCE = ROA x CEL x CSL YR1 12% = 12% x 1 x 1

YR2 3% = 3% x 1 x 1

Financial Leverage and ROCE

3 -

9 -

15 -

18 -

12 -

6 -

Hi-Debt Co.

No-Debt Co.

Poor Neutral Good

Type of earnings year

ROCE

(%)

Leverage hurts

Leverage helps

0 -

Sources of Risk

Political Unrest

RecessionRecession

Technology

CompetitionDemographicsDemographics

Regulation

Short-term liquidity

• A firm’s ability to meet short-term commitments and the relative level of those commitments

• Ability to meet short-term commitments• Current ratio• Quick ratio• Operating cash flow to current liabilities ratio

• Amount of working capital required to support sales• A/R turnover & Days Receivables Outstanding• Inventory turnover & Days Inventory Held• A/P turnover & Days Payables Outstanding

Long-term solvency

• Measure the firm’s ability to meet interest and principal repayment on long-term debt

• Debt ratios - higher proportions indicate greater risk• Long-term Debt Ratio• Debt/Equity Ratio• Liabilities/Assets Ratio

• Coverage Ratios - lower ratios indicate greater risk• Interest Coverage Ratio• Operating Cash Flow to Total Liabilities Ratio• Operating Cash Flow to Total Capital Expenditures Ratio

Earnings per Common Share

• Simple capital structure (no convertible bonds, convertible preferred stock, or stock options)

Basic EPS = Net Income to Common Weighted Avg. Common Shares Outstanding

• Complex capital structure - EPS must reflect the ability of convertible securities to dilute common

Diluted EPS = NI to Common + Adj. For Dilutive Securities Weighted Avg.+ Wgtd. Avg. Shares from Common Outstanding Dilutive Securities

Problems with EPS measures

• Doesn’t reflect level of investment

• Therefore difficult to use in cross-sectional

analysis

• Mixes profitability measures (net income) with

capital structure decisions (# shares

outstanding)• can be manipulated by managing capital structure

TheEnd