A major objective of Financial Statement Analysis is to
evaluate various drivers related to a firm’s risk and expected return. Profitability analysis of a firm’s recent
past provides relevant information to an analyst about the firm’s future
profitability and returns.
In the Financial Statement Analysis Module the sub branch
above, “Analyzing Profitability” is organized around three sub-sections:
Margins
Returns
Growth
Margins address the question, how profitable are the
operations of a firm?
Returns address the question, how profitable is the firm in
generating a return on capital invested as well as capital under the control of
management?
Growth addresses the question, how do the major firm
decisions impact upon profitability?
Combined these three dimensions provide a broader picture of
a firm’s profitability including raising flags regarding future profitability
when trends are negative versus reinforcing positive outlooks about future
profitability when comparisons and trends are positive.
In this topic we apply a
common convention for working with ratios involving a mixture of stocks and
flows. A flow variable is a variable
that is measured between two points in time.
A stock variable is a variable that is measured at a point in time. The convention for constructing ratios is:
Convention: Flow Variables /
Average Stock Variable or Average Stock Variables / Flow Variables
For example, the income
statement contains important flow variables such as sales, revenues and the
balance sheet contains important stock variables such as assets, stockholders’
equity. A ratio that relates earnings to
stockholders’ equity divides a flow variable (net income) by a stock variable
(stockholders’ equity). As a result,
applying the above convention requires that Net Income is divided by the
Average Stockholders’ Equity. Average
Stockholders’ Equity is defined as follows:
Average Stockholders’ Equity = (Beginning Period Stockholders’ Equity
+ Ending Period Stockholders’ Equity)/2
The SEC requires that
public companies file Balance Sheets that provide both the beginning and ending
period values.
Overview
Margins
immediately focusses on the Income Statement and Cash Flow Statements for a
firm. From the Income Statement three
bottom line profitability measures are calculated and expressed relative to
sales revenue:
Gross Profit Margin
Operating Profit Margin
Net Operating Profit after Tax Margin
From the Cash Flow Statement two major measures are
produced:
Cash Flow Margin
Free Cash Flow Margin
The above ratios are formally defined below and combined
provide immediate insights into how profitable the firm is relative to sales
revenue and how successful management is with respect to converting profits to cash .
Returns
immediately focus on measures of profitability defined relative to capital bases
derived from the balance sheet as follows:
Return on Shareholders’ Equity (ROE)
Return on Assets (ROA)
Return on Invested Capital (ROIC)
Return on Capital Employed (ROCE)
This set of performance measures provide immediate insights
into how profitable the firm is relative to the set of resources available to
management.
Growth focusses
on how the major decisions made by management, the investment, financing and
dividend decisions, drive profitability.
Fundamental Growth
DuPont Analysis
DuPont Burden Analysis
Fundamental growth results from the product of all three
major firm decisions (investing, financing and dividend) and the DuPont
analyses further decompose ROE into the impact of decisions at a finer level
(operating, financial leverage and tax).
.
Working with Profitability
Ratios
Gross Margin = Sales Revenue
less Cost of Sales
This is an important ratio for any firm reporting under the
merchant model for sales revenue recognition.
Sales Revenue equals the total amount the company ultimately expects to collect
from their customers. It is gross
revenue less discounts, and related items the company provides. Under the merchant model of accounting the
merchant bears all of the risk of the inventory and books the selling price as
revenue when sold (Gross Revenue Recognition) and accounts for the immediate
cost of the sales separately. Combined
this generates the Gross Margin.
Cost of sales can vary in nature under the “merchant model”
ranging from the traditional cost of sales as illustrated by Wal-Mart to
non-traditional as illustrated by Google.
Wal-Mart describes this in their 10-K report as follows:
“Cost of sales includes actual product cost, the cost of
transportation to the company’s warehouses, stores and clubs from suppliers,
the cost of transportation from the company’s warehouses to the stores and
clubs and the cost of warehousing for our Sam’s Club segment.”
However, Google describe their cost of sales as follows:
“Cost of revenues consists primarily of traffic acquisition
costs. Traffic acquisition costs consist of amounts ultimately paid to our
Google Network members under AdSense arrangements and to certain other partners
(our distribution partners) who distribute our toolbar and other products
(collectively referred to as access points) or otherwise direct search queries
to our website (collectively referred to as distribution arrangements). These
amounts are primarily based on the revenue share and fixed fee arrangements
with our Google Network Members and distribution partners.”
Technology has resulted in innovative business models that
push accounting revenue revenue recognition to the limits. For example, Groupon, provides an example of
a business model that they initially applied the merchant model for revenue
recognition until just prior to their IPO when they shifted to the Agent
Model. Under the agent model there is no
Gross Margin because only net revenue is reported.
Groupon Example: If Groupon sell a coupon for $25 that
promises $50 in services under the merchant model they would record $25 for
sales revenue whereas under the agent model this is recorded as $12.50 because
Groupon remits 50% (i.e., $12.50) to the merchant that actually provides the
goods or services. The difference is
clearly significant for recorded sales revenue on an income statement, depends
upon the extent to which Groupon bears the risks associated with the ultimate
goods and services being provided.
Operating Profit Margin = Operating
Income (EBIT) divided by Sales Revenue
The operating profit margin measures profitability relative
to a broader set of costs from operations than are included in a gross
margin. Many of these costs are
associated with the same accounting period for the company’s operations as
opposed to being directly associated with the goods and services provided
during the period. Profits generated
from a firm's continuing operations are referred to as “Operating Income” or departing
from US GAAP but more conventionally described as “Earnings Before Interest and
Taxes” (EBIT).
EBIT is computed by starting with Gross Margin or Sales
Revenue net of any remittances to the merchant who actually provides the goods
and or services. Additional operating
expenses are then subtracted away that result from supporting the frm’s ability
to generate revenues from their continuing
operations. These support activities
under EBIT do not include financing
activities and costs arising from discontinued operations. Major examples here are marketing costs, selling
costs, general and general administration.
Some operating costs arise from accounting principles that determine
whether a cost is expensed to the period or capitalized on the balance sheet in
the period in which they were incurred.
For example, research and development (R&D) fall into this latter
category under US GAAP. For most
industries R&D is expensed to the period in which it is incurred but an
exception is software development costs which can be capitalized on the balance
sheet as an asset and subsequently amortized over their economic life. As a result, operating costs arise from a
combination of the economics associated with the operations as well as GAAP.
Net Operating Profit after
Tax (NOPAT) = After tax profit from operations (EBIT * (1 – Effective Tax Rate)
NOPAT Margin = NOPAT
divided by Sales Revenue
This profitability measure further extends the concept of
operating profit margin to take into account corporate taxes. That is, the profitability measures such as
Operating Profit Margin and NOPAT margin are carefully teasing out the impact
of important firm decisions from their continuing operations. For the case of the Operating Profit Margin
the effects from the firm’s financing and tax decisions are excluded from
consideration. For the case of the NOPAT
margin only the impact of the financing decision is ignored.
Cash Flow Margin = Cash
flows from operating activities divided by Sales Revenue
An important function for management is not only to generate
profits from sales revenue but to convert these profits into cash. The cash flow related margins have the objective
of providing insight into how the firm is performing along this dimension. The cash flow from operations measure
provided on the Consolidated Cash Flow Statement in its indirect form starts
with net income and then “undoes” the effects of accounting accruals on net
income. What results, is an estimate of
the cash that was generated from operations over the accounting period in
question.
Free Cash Flow to the Firm
(FCFF) = Cash Flow from Operating Activities less Capital Expenditure plus
after tax net interest expense (FCFF).
This measure provides some additional refinements to Cash
Flows from Operating Activities in order to account for the effects of Capital
Expenditure (expenditures required for maintaining the physical capacity for
generating cash from operations. In
addition, the impact of accounting standards mixing operating and financing
activities upon the measurement of cash flows from operations is also
eliminated. In particular, the tax
benefit from interest expense is subtracted out.
Return on Total Assets (ROA)
= Net Income attributable to shareholders’ divided by the average Total Assets
The average total assets is used to reflect the fact that
net income was generated over the entire accounting period and the denominator
should also reflect this. This
profitability measure provides insight into how well the total resources under
control of management are used to generate income independently of how they are
financed. By considering the fundamental
accounting equation Total Assets equals Total Equities, alternatively, ROA can
be viewed as the return generated to the Total Equities or the total providers
of capital to the firm. From this
perspective one variation of ROA is to add back Interest Expense net of
tax. That is, net income is an after tax
number that treats interest paid to debt-holders as an expense but not
dividends paid to shareholders. So the
above adjustment treats each class of equity holder equal.
Adjusted Return on Total
Assets (ROA) = (Net Income attributable to shareholders’ + Interest Expense (1
– tax rate)) divided by the Average Total Assets
The Return on Equity measures the return provided to the
shareholders’ over the time period.
Return on Shareholders’
Equity (ROE) = Net Income attributable to shareholders divided by Average
Shareholders’ Equity for the period
The average shareholders’ equity is used to reflect the fact
that net income is generated over the entire accounting period and so the
denominator should also reflect this.
This is a bottom line measure of overall performance that results from
the firm’s investment and financing decisions.
The investment decision is the primary driver of the numerator, net
income attributable to shareholders, and the financing decision is the primary
driver of the average shareholders’ equity.
Shareholders’ Equity equals Total Assets minus Total Liabilities plus
Non-Controlling Interests. As a result,
the more successful investing activities have been the higher is net income and
the more financial leverage employed the smaller average shareholders’ equity
will be relative to the available total assets. The performance measure is
useful for comparing companies within the same or similar industries because
significant cross sectional differences arise when working across
industries. One cause of this is the
nature of technology applied within an industry. For example, some industries are capital
intensive which will result in a larger fixed asset base while other industries
are human capital and talent driven which usually implies a smaller fixed asset
base.
The definition of ROE implies a positive relationship
between financial leverage and ROE if net income increases with total
assets. Whether or not this relationship
translates into the same predicted relationship in the capital markets between
leverage and returns, is subject to much controversy. That is, higher leverage is predicted to be
associated with higher expected returns but empirical evidence is mixed with respect
to leverage and returns.
From the fundamental accounting equation shareholders’
equity equal Total Assets minus the sum of Total Liabilities and other equity
classes. As a result, again some common
adjustments are to subtract out distributions to these classes. As noted earlier, Net Income already accounts
fr Debt-holders but Net Income does not account for preferred
stockholders. As a result, a common
adjustment is to subtract out Preferred Dividends from Net Income.
Adjusted Return on
Shareholders’ Equity (ROE) = (Net Income attributable to shareholders –
Preferred Dividends) divided by Average Shareholders’ Equity for the period
Another important question asked of profitability measures
is whether or not management is adding value?
The answer to this question depends upon whether the return generated
for the firm exceeds the weighted average cost of capital taking into account
the various classes of equity holders. A
popular measure for assessing whether management is adding value is the Return
on Invested Capital (ROIC).
Return on Invested Capital
(ROIC) = Net Income attributable to shareholders’ minus Dividends divided by
the sum of Average Debt, Average Lease Obligations and Average Shareholders’
Equity
The Return On Invested Capital (ROIC) measure provides a
profitability measure relative to the invested capital in a firm. If this measure is less than the firm’s after
tax Weighted Average Cost of Capital (WACC) then management’s investment
decisions are failing to add value. This
is because the discount rate is greater than the returns generated from the
investment.
Return on Capital Employed is a popular performance measure
among value investors. It assesses
profitability from the perspective of re-investing profits into the
business. It is defined as follows:
Return on Capital Employed
(ROCE) = Net Operating Profit After Tax (NOPAT) divided by Capital Employed
Capital Employed = Average
Total Assets – (Average Short Term plus Average Long Term Security Investments)
– Average Current Liabilities or equivalently,
Capital Employed = Average
Fixed Assets + Average Working Capital - (Average Short Term plus Average Long
Term Security Investments)
ROCE provides insight into what income is earned from
reinvesting in the firm’s normal operations.
If this is too low then the company will have less available for future
investments and shareholders would prefer that the income be paid out as a
dividend. What is too low again depends
upon the opportunity cost of capital for the firm which is measured as the
firm’s after tax weighted average cost of capital. As a result, from the perspective of the
accounting equation, Assets equal Equities, ROIC provides insight into
profitability from the perspective of equity holders and ROCE provides insight
into profitability and future profitability, from the perspective of total
assets or capital employed for productive purposes.
Fundamental Growth
An important dimension to understanding the profitability of
a firm is forecasting future profitability in terms of how profits grow over
time. In particular, when viewed from
the perspective of current stockholders it is profits retained in a business that
drive the growth of stockholders’ equity over time. As a result, fundamental growth is defined
from the perspective of growth in stockholders’ equity defined relative to
income retained times the return on equity generated:
Fundamental Growth = ROE *
RR where ROE equals the return on shareholders’ equity and RR equals the
retention ratio (= 1 – Dividend Payout Ratio)
In the above we are assuming that there have not been any
additional contributions or distributions of capital from or to owners.
Fundamental growth is an important relationship because it
represents the outcome from three major decisions management make for a
firm. These are the Investment Decision,
the Financing Decision and the Dividend Decision. That is, RR captures the effects from the
Dividend decision and ROE captures the effects from both the investment and
financing decisions. To see why this is
the case for ROE we need to introduce a powerful concept in ration analysis
which is referred to as “decomposition analysis.”
For example, return on equity can be viewed as the outcome
of two major firm decisions, the investment and financing decisions. Consider multiplying ROE by Total
Assets/Total Assets or 1. Clearly, ROE
times 1 equals ROE. However, the
advantage of doing this is that we can rearrange the terms as follows:
ROE * Average Total
Assets/Average Total Assets = Net Income/Average Total Assets * Average Total
Assets/Average Stockholders’ Equity
The above has re-expressed ROE into two components, ROA
(Return on Assets) and Financial Leverage.
The ROA term results from the investment decision, and the financial
leverage term results from the financing decision. As a result, ROE can be viewed as the outcome
from the product of two major firm decisions and Fundamental Growth results
from the product of three major firm decisions.
The major advantage of decomposing ratios is to understand
how major firm decisions affect a firm’s profitability. Motivations along these lines gave rise to a
major decomposition which has become known as the DuPont Decomposition.
DuPont
Decompositions
Among the stocks that currently make up the Dow Jones
Industrial Index the oldest is E. I. du Pont de Nemours And Company more
commonly referred to simply as DuPont.
DuPont was originally a gunpowder mill founded in July 1802 by Eleuthère
Irénée du Pont and today is one of the largest chemical companies in the world.
DuPont was a pioneer with respect to management accounting systems, including
devising the accounting ratio Return on Investment (ROI). Around 1912 their ROI approach was extended
by one of their financial officers, Donaldson Brown, who decomposed the ROI
calculation into a product of the sales turnover ratio and the profit margin
ratio. In 1914 DuPont invested in General
Motors (GM) to assist the struggling automobile company. In 1920, Pierre DuPont became chairman of GM,
and during his tenure implemented a pioneering management accounting system
that focused sharply on understanding the drivers of return on investment. By organizing resources around this system GM
grew to be the largest automobile company in the world. In 1957 DuPont had to divest itself of
General Motors because of the Clayton Antitrust Act. The DuPont decomposition became popular after
its successful use at GM and DuPont.
Formally, the Return on Equity (ROE) equals Net Income for
the period divided by the Average Shareholders Equity. Under the DuPont decomposition ROE is
decomposed into Return on Assets (ROA) and Financial Leverage by multiplying
and dividing by the average total assets for the period. ROE measures the rate at which shareholder
wealth is increasing. ROA measures the
productivity of the assets in generating income, and therefore measures the
efficiency of the investment decision and financial leverage measures the
extent to which the firm is using debt.
In the traditional DuPont formula ROA is further decomposed by
multiplying ROA by Sales/Sales and recombining the terms into Net Income/Sales
and Sales/Average Total Assets. This
breaks the investment decision outcome into two components, operating
efficiency (i.e., profitability) and asset turnover efficiency (i.e.,
utilization).
Formally, the DuPont formula is:
ROE = (Net Income/Sales) *
(Sales/Average Total Assets) * (Average Total Assets/Average Shareholders’
Equity)
Each term in the decomposition has a specific meaning:
Profit Margin Ratio = Net Income/Sales
Asset Turnover Ratio or Asset Use Efficiency = Sales/Average
Total Assets
Financial Leverage Ratio= Average Total Assets/Average Shareholders’
Equity
The first two terms provide important insights into the
investment decision and how it affects ROA whereas the latter provides insights
into the role played by financial leverage to boost ROE relative to ROA.
For the case of ROA the profit margin ratio provides insight
into the effectiveness of managing costs.
That is, how profitable is a dollar of sales? When contrasted with immediate competitors a
relatively low margin implies higher costs and a relatively higher margin
implies lower costs compared to the competitors. This of course may be a result of the
business strategy employed (e.g., full service firm versus a discounter) or it
may be the result of poor managerial cost controls. The numbers raise questions that guide the
further analysis of ratios, some of which go beyond just profitability analysis
and some considered next.
Extended DuPont
Analysis
The objective of extending the DuPont analysis is to provide
a finer decomposition of the major firm decisions into the Investment,
Financing and Tax decisions. The
Extended DuPont analysis provides this by conducting an additional
decomposition of the Profit Margin Ratio (Net Income/Sales) into two burden
components, Tax and Interest, times the Operating Profit Margin. This provides a refinement of the profit
margin ratio into the operating profit margin ratio by taking out the effects
arising from taxes and interest expense.
As a result, it provides both management and the financial analyst with
finer information about a company and its immediate competitors.
Formally, the Extended DuPont formula is:
ROE = (Net Income/EBT) *
(EBT/EBIT) * (EBIT/Sales) * (Sales/Average Total Assets) * (Average Total
Assets/Average Shareholders’ Equity)
Each term in the decomposition has a specific meaning:
Profit Margin Ratio =Net Income/Sales now decomposes into:
Net Income/Earnings Before Taxes = Tax Burden Ratio
Earnings Before Taxes/Earnings Before Interest and Taxes =
Interest Burden Ratio
Earnings Before Interest and Taxes/Sales = Operating Profit
Margin
Asset Turnover Ratio or Asset Use Efficiency = Sales/Average
Total Assets
Financial Leverage Ratio= Average Total Assets/Average Shareholders’
Equity
Net Income is measured after taxes. So if taxes are zero the tax burden equals
one and so the lower this number, the higher the tax burden. Similarly, if Interest Expense is zero then
interest burden ratio equals one and therefore the higher the financial
leverage, the lower is this number. The
advantage of adjusting for taxes and interest is to gain better insight into
the firm’s profit margin by focusing upon the operating profit margin.
Note that the product of the first four terms is now
ROA. This is driven by operations,
financing and the management of taxes. A
nice property of the Extended DuPont formula is that one can examine the
breakdown of ROA from the perspective of major firm decisions --- investment,
financing and tax decisions.
The remainder of this decomposition is as before. That is, the fifth term is again related to
the financing decision; a highly leveraged firm has low Shareholders Equity
compared to Assets.
