Profitability Analysis Flashcards
What are some of the inconsistent definitions under various return ratios where the numerator (“return”) can be adjusted?
Under various return ratios, the numerator (“return”) may be adjusted by:
- Subtracting preferred dividends to leave only income available to common stockholders
- Adding back minority interest in the income of a consolidated subsidiary (when invested capital is defined to include the minority interest)
- Adding back interest expense
- Adding back both interest expense and taxes so that the numerator is EBIT; this results in the basic earning power ratio, which enhances comparability of firms with different capital structures and tax planning strategies
Note: Inconsistent definitions complicate comparisons of ROI. The wide variety of definitions in use for the terms “return” and “investment” creates difficulties in comparability
What are some of the inconsistent definitions where the denominator (“equity” or “assets”) may be adjusted by?
The denominator (“equity” or “assets”) may be adjusted by:
- Excluding non-operating assets (such as investments, intangible assets and the other asset category)
- Excluding unproductive assets (such as idle plant, intangible assets and obsolete inventories)
- Excluding current liabilities to emphasize long-term capital
- Excluding debt and preferred stock to arrive at equity capital
- Stating invested capital at market value
Note: Inconsistent definitions complicate comparisons of ROI. The wide variety of definitions in use for the terms “return” and “investment” creates difficulties in comparability
What is the DuPont Model for return on assets (ROA)?
The DuPont model beings with the standard equation for ROA and breaks it down into two components ratios, one that focuses on the income statement and one that relates income to the balance sheet:
ROA = Net Income / Avg. total assets =
= (Net Income / Net sales) x (Net Sales / Avg. total assets)
= Net profit margin x Total asset turnover
Note: This breakdown emphasizes that shareholder return may be explained in terms of both profit margin and the efficiency of asset management
How are the two components of the DuPont equation interrelated?
The two components of the DuPont equation are interrelated since they both involve net sales
Profit margin on sales is another name for the net profit margin calculated in the DuPont model
Note: If net sales increase and all other factors remain the same, the net profit margin worsens because more sales are only generating the same bottom line
Total asset turnover measures the level of capital investment relative to sales volume
Note: If net sales increase and all other factors remain the same, the asset turnover ratio improves because more sales are being produced by the same amount of assets
What is the DuPont Model for return on equity (ROE)?
To examine the return on equity (ROE) ratio, it can be subdivided by the DuPont model into three different components:
ROE =
= (NI / Net sales) x (Net sales / Avg. TA) x (Avg. TA / Avg. TE)
= Net Profit margin x Asset turnover x Equity multiplier
The net profit margin component examines a company’s efficiency in generating earnings from sales. It measures the amount of earnings that the company makes from every $1 of sales
The assets turnover component examines how efficiently the company is deploying the totality of its resources to generate revenues. It measures how much sales a company generates from each $1 of assets
The equity multiplier measures a company’s financial leverage. High financial leverage means that the company relies more on debt to finance its assets
So, on the one hand, by raising capital with debt, the company can increase its equity multiplier and improve its return on equity
But, on the other hand, taking on additional debt may worsen the company’s solvency and increase the risk of going bankrupt
What is Return on common equity (ROCE)?
ROCE is a more conservative measure than return on total equity:
= (Net income - Preferred dividends) / Avg. common equity
Using only common equity in the denominator focuses attention on the equity stake provided by the common shareholders, who are the firm’s (residual) owners
What is the DuPont Model for return on common equity (ROCE)?
ROCE can be disaggregated into 3 components, similar to the DuPont model for ROE
Net income minus preferred dividends can be thought of as income available to common shareholders (IACS):
ROCE =
= (IACS / Net sales) x (Net sales / Avg. TA) x (Avg. TA / Avg. CE)
= Net profit margin x Total asset turnover x Common equity multiplier
IACS = NI - Pref. Divds
Note: The equity multiplier is also sometimes called leverage. This is consistent with the discussion of leverage because the equity multiplier indirectly measures the proportion of debt in the capital structure
What is the Sustainable equity growth rate?
The sustainable equity growth rate is the highest growth rate a company can sustain WITHOUT increasing leverage:
= ROCE x (1 - Dividend payout ratio)
ROCE = Return on common equity
What is the Plowback rate?
Plowback rate = 1 - Dividend payout ratio
It is the rate at which earnings are plowed back into the company rather than distributed to the shareholders
How can Net profit margin ratio be modified as another profitability measure?
Net profit margin on sales = Net income / Net sales
The numerator may also be stated in terms of the net income available to common shareholders
Another form of the ratio excludes non-recurring items from the numerator (i.e. unusual or infrequent items, discontinued operations, extraordinary items and effects of accounting changes)
This adjustment may be made for any ratio that includes net income
Still other numerator refinements are to exclude equity-based earnings and items in the other income and other expense categories
How can Operating profit margin ratio be modified as another profitability measure?
Operating profit margin = Operating income / Net sales
The ratio of net operating income to sales may also be defined as EBIT / net sales
Use of EBIT emphasizes operating results and more nearly approximates cash flows than other income measures
