P2A.3 Profitability Analysis

Question 1

Inconsistent Definitions of the Elements of ROA & ROE

Answer 1

1. Assets: could include or exclude idle assets from total assets.
2. Equity: could include or exclude preferred equity, retained earnings, etc.
3. Return: could be net income, EBT, EBITDA, etc.

Question 2

ROA Ratio Formula

Answer 2

= Net income / Average Assets

Question 3

ROA Ratio Alternative Formulas

Answer 3

DuPont Model
= Net Profit Margin * Asset Turnover Ratio
Net Profit Margin = Net income / Sales
Asset Turnover Ratio = Sales / Average Assets

= ROE * (1 - Debt Ratio)
Debt Ratio = Total Liabilities / Total Assets

Question 4

Effect of a Change of a Financial Statement Element on Return on Total Assets (ROA)

Answer 4

Numerator:
Increase = Increase on ROA
Decrease = Decrease on ROA

Denominator
Increase = Decrease on ROA
Decrease = Increase on ROA

Example: ROA = A * B. If A & B are both 5, ROA is 25. If you lower A or B, ROA will be less than 25.

Question 5

Return on Investment (ROI)

Answer 5

Performance measure for evaluating the efficiency of an investment

= Business Unit Income / Business Unit Assets

For ROA, income defined:
= Net income + [Interest * (1 - Tax rate)]

For ROE, income defined:
= Net income - preferred dividends

*Note: if BV or FV are both given, use BV to solve.

Question 6

Financial Leverage AKA Equity Multiplier

Answer 6

1. Measures how many times company resources are available to shareholders.
2. A low equity multiplier indicates company is using more equity than debt to finance purchase of assets.

= Average Total Assets / Average Equity

Question 7

Return on Equity (ROE)

Answer 7

= Net Income / Average Equity

Question 8

ROE - DuPont Method

Answer 8

= ROA * Equity Multiplier

= Profit Margin * Asset Turnover * Financial Leverage
Profit Margin = Net income/Sales
Asset Turnover = Sales/Avg Assets
Financial Leverage (AKA Equity Multiplier) = Asset/Equity

Question 9

Return on Common Equity (ROCE)

Answer 9

= (Net Income - Preferred Dividends) / (Average Equity - Average Preferred Equity)

Question 10

Income Measurement Considerations

Answer 10

1. Estimates: Allowance for bad debts, useful life of fixed assets, etc.
2. Accounting Methods: FIFO vs LIFO, Depreciation methods, etc.
3. Disclosure Incentives: SEC requirements
4. Different Needs of Users: Classification and presentation

Question 11

Characteristics of Sales (Revenue)

Answer 11

1. Source: revenue from operations (lifeblood of business)
2. Stability: consistency of the amount of revenue over time (surviving amidst competitive environment)
3. Trend: sustainable growth - increasing, decreasing or constant

Question 12

Relationship of Revenue to Receivables & Inventory

Answer 12

1. Increases in Revenue = Increases in receivables & inventory
2. Decreases in Revenue = Decreases in receivables & inventory
3. Higher receivables = higher risk of non-collection
4. Higher inventory = higher risk of obsolescence or loss

Question 13

Variation Analysis (% change over time)

Answer 13

Presentation and interpretation of financial statements over a period of time using a base year as a point of comparison.

Question 14

Sustainable Equity Growth

Answer 14

Maximum growth rate of sales that can be sustained by a company before issuing new shares or debt.

The key to sustainable growth is to reinvest available funds and not increase dividend payouts.

Question 15

Sustainable Growth Rate Formula

Answer 15

= (1 - Dividend Payout Ratio) * ROE
Dividend Payout = Common Dividend/EPS

= Plowback ratio * ROE
Plowback = Retained Earnings / Net Income