Peter D. Easton Mary Lea McAnally Greg Sommers Xiao-Jun Zhang ©Cambridge Business Publishers, 2015 M ODULE 3 Profitability Analysis and Interpretation

©Cambridge Business Publishers, Learning Objective 1 Compute return on equity (ROE) and disaggregate it into components of operating and nonoperating returns.

Analysis Structure 3 ©Cambridge Business Publishers, 2015

Return on Equity Return on equity (ROE) is computed as: 4 ©Cambridge Business Publishers, 2015

Operating Return (RNOA)  The income statement reflects operating activities through revenues, costs of goods sold (COGS), selling, general and administrative expenses (SG&A) and other expenses.  Net operating assets typically include current assets other than cash and marketable securities (cash is typically comprised mostly of short-term investments, called cash equivalents) and noncurrent assets like PPE, less current liabilities other than short-term debt, and less long-term operating liabilities like pension obligations and deferred taxes. ©Cambridge Business Publishers,

Operating Items in the Income Statement 6 ©Cambridge Business Publishers, 2015

Walmart’s Operating Items 7 ©Cambridge Business Publishers, 2015

Computing Tax on Operating Profit For Walmart: 8 ©Cambridge Business Publishers, 2015

Treatment of Noncontrolling Interests in Tax Shield Computation  Our computation of NOPAT adjusts reported tax expense for the tax shield on net nonoperating expense (NNE).  Should noncontrolling interest be included in NNE?  While noncontrolling interests are treated as nonoperating, they represent an allocation of net income to the parent company and the noncontrolling shareholders.  The allocation of consolidated net income to noncontrolling interests is not an expense that is deductible for tax purposes.  Thus, noncontrolling interest should not be included in the tax shield computation. ©Cambridge Business Publishers,

Net Operating Assets (NOA) 10 ©Cambridge Business Publishers, 2015

Walmart: Operating Assets & Liabilities 11 ©Cambridge Business Publishers, 2015

Walmart: NOA 12 ©Cambridge Business Publishers, 2015

Walmart: RNOA and ROE 13 ©Cambridge Business Publishers, 2015

Key Definitions 14 ©Cambridge Business Publishers, 2015

15 Learning Objective 2 Disaggregate operating return (RNOA) into components of profitability and asset turnover.

Disaggregation of RNOA 16 ©Cambridge Business Publishers, 2015

Net Operating Profit Margin (NOPM)  Reveals how much operating profit the company earns from each sales dollar.  NOPM is affected by  The level of gross profit  The level of operating expenses  The level of competition and the company’s willingness and ability to control costs ©Cambridge Business Publishers,

Walmart: NOPM  This result means that for each dollar of sales at Walmart, the company earns just over 4¢ profit after all operating expenses and tax.  As a reference, the median NOPM for all publicly traded firms is about 8¢. ©Cambridge Business Publishers,

Net Operating Asset Turnover (NOAT)  Measures the productivity of the company’s net operating assets.  This metric reveals the level of sales the company realizes from each dollar invested in net operating assets.  All things equal, a higher NOAT is preferable. ©Cambridge Business Publishers,

Walmart: NOAT  This result means that for each dollar of net operating assets, Walmart realizes $3.73 in sales.  As a reference, the median for all publicly traded companies is $1.30. ©Cambridge Business Publishers,

Margin vs. Turnover 21 ©Cambridge Business Publishers, 2015

22 Learning Objective 3 Explain nonoperating return and compute it from return on equity and the operating return.

Nonoperating Return Component of ROE  Assume that a company has $1,000 in average assets for the current year in which it earns a 20% RNOA. It finances those assets entirely with equity investment (no debt).  Its ROE is computed as follows: ©Cambridge Business Publishers,

Effect of Financial Leverage  Next, assume that this company borrows $500 at 7% interest and uses those funds to acquire additional assets yielding the same operating return.  Its net operating assets for the year now total $1,500 and its profit is $265. ©Cambridge Business Publishers,

Effect of Financial Leverage on ROE  Next, We see that this company has increased its profit to $265 (up from $200) with the addition of debt, and its ROE is now 26.5% ($265 / $1,000).  The reason for the increased ROE is that the company borrowed $500 at 7% and invested those funds in assets earning 20%.  The difference of 13% accrues to shareholders. ©Cambridge Business Publishers,

Median Liabilities to Equity for Selected Industries 26 ©Cambridge Business Publishers, 2015

GAAP Limitations of Ratio Analysis 1.Measurability – Financial statements reflect what can be reliably measured. This results in nonrecognition of certain assets, often internally developed assets, the very assets that are most likely to confer a competitive advantage and create value. Examples are brand name, a superior management team, employee skills, and a reliable supply chain. 2.Non-capitalized costs – Related to the concept of measurability is the expensing of costs relating to “assets” that cannot be identified with enough precision to warrant capitalization. Examples are brand equity costs from advertising and other promotional activities, and research and development costs relating to future products. 3.Historical costs – Assets and liabilities are usually recorded at original acquisition or issuance costs. Subsequent increases in value are not recorded until realized, and declines in value are only recognized if deemed permanent. ©Cambridge Business Publishers,

Global Accounting  IFRS companies routinely report “financial assets” or “financial liabilities” on the balance sheet.  IFRS defines financial assets to include receivables (operating item), loans to affiliates or associates (can be operating or nonoperating depending on the nature of the transactions), securities held as investments (nonoperating), and derivatives (nonoperating).  IFRS notes to financial statements usually detail what financial assets and liabilities consist of. ©Cambridge Business Publishers,

Global Accounting 29 ©Cambridge Business Publishers, 2015

30 Appendix 3A Nonoperating Return Component of ROE

Nonoperating Return Framework 31 ©Cambridge Business Publishers, 2015

Nonoperating Return with Debt Financing and No Nonoperating Assets 32 ©Cambridge Business Publishers, 2015 $500 / $1,00020% - 7%

Nonoperating Return with Debt Financing and No Nonoperating Assets - Target - 33 ©Cambridge Business Publishers, 2015

Nonoperating Return without Debt Financing and with Nonoperating Assets - Intel  Intel’s excessive liquidity is penalizing its return on equity.  Intel’s operating assets are providing an outstanding return (27.17%), much higher than the return on its marketable securities (1.72%).  Holding liquid assets that are less productive means that Intel’s shareholders are funding a sizeable level of liquidity, and sacrificing returns in the process.  This is the cost of gaining financial flexibility. ©Cambridge Business Publishers,

Nonoperating Return with Debt Financing, Nonoperating Assets, and Noncontrolling Interest 35 ©Cambridge Business Publishers, 2015

Nonoperating Return with Debt Financing, Nonoperating Assets, and Noncontrolling Interest - Walmart 36 ©Cambridge Business Publishers, 2015

Special Topics: Discontinued Operations  Discontinued operations are subsidiaries or business segments that the board of directors has formally decided to divest.  Companies must report discontinued operations on a separate line, below income from continuing operations.  The net assets of discontinued operations should be considered to be nonoperating (they represent an investment once they have been classified as discontinued) and their after-tax profit (loss) should be treated as nonoperating as well.  Although the ROE computation is unaffected, the nonoperating portion of that return will include the contribution of discontinued operations. ©Cambridge Business Publishers,

Special Topics: Preferred Stock  The ROE formula takes the perspective of the common shareholder in that it relates the income available to pay common dividends to the average common shareholder investment.  Thus, the presence of preferred stock requires two adjustments to the ROE formula (called ROCE). 1.Preferred dividends must be subtracted from net income in the numerator. 2.Preferred stock must be subtracted from stockholders’ equity in the denominator. ©Cambridge Business Publishers,

©Cambridge Business Publishers, Learning Objective 4 Appendix 3B Describe and illustrate traditional DuPont disaggregation of ROE.

DuPont Disaggregation Analysis  Profit margin is the amount of profit that the company earns from each dollar of sales.  Asset turnover is a productivity measure that reflects the volume of sales that a company generates from each dollar invested in assets.  Financial leverage measures the degree to which the company finances its assets with debt rather than equity. ©Cambridge Business Publishers,

Return on Assets 41 ©Cambridge Business Publishers, 2015

Return on Assets Adjustment The adjusted numerator better reflects the company’s operating profit as it measures return on assets exclusive of financing costs (independent of the capital structure decision). 42 ©Cambridge Business Publishers, 2015

DuPont Disaggregation for Walmart 43 ©Cambridge Business Publishers, 2015

The End