Ch_08

Chapter 08 - Return On Invested Capital and Profitability Analysis

Chapter 8 Return On Invested Capital And Profitability Profitability Analysis nalysis REVIEW Return on invested capital is important in our analysis of financial statements. inancial statement analysis involves our assessin! both ris" and return. #he prior three chapters focused primarily on ris"$ %hereas this chapter e&tends our analysis to return. Return on invested capital refers to a company's earnin!s relative to both the level and source of financin!. It is a measure of a company's success in usin! financin! to !enerate profits$ and is an e&cellent measure of operatin! operatin! performance. #his chapter describes return on inves invested ted capita capitall and its relev relevance ance to financ financial ial statem statement ent analys analysis. is. We also also e&plai e&plain n variations in measurement of return on invested capital and their interpretation. We also disa!!re!ate return on invested capital into important components for additional insi!hts insi!hts into company performance. #he role of financial levera!e and its importance for returns analysis analysis is e&amined. e&amined. #his chapter demonstr demonstrates ates each of these analysis analysis techni(ues techni(ues usin! financial statement data.

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O)#*I+E •

Importance of Return on Invested Capital ,easurin! ,ana!erial Effectiveness ,easurin! Profitability ,easurin! for Plannin! and Control

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Components of Return on Invested Capital -efinin! Invested Capital Adustments Adustments to Invested Capital and Income Computin! Return on Invested Capital

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Analy/in! Return on +et Operatin! Assets -isa!!re!atin! Return on +et Operatin! Assets Relation bet%een Profit ,ar!in and Asset #urnover Profit ,ar!in Analysis Asset #urnover Analysis

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Analy/in! Return on Common E(uity -isa!!re!atin! Return on Common E(uity inancial *evera!e and Return on Common E(uity Assessin! 0ro%th in Common E(uity

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O)#*I+E •

Importance of Return on Invested Capital ,easurin! ,ana!erial Effectiveness ,easurin! Profitability ,easurin! for Plannin! and Control

•

Components of Return on Invested Capital -efinin! Invested Capital Adustments Adustments to Invested Capital and Income Computin! Return on Invested Capital

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Analy/in! Return on +et Operatin! Assets -isa!!re!atin! Return on +et Operatin! Assets Relation bet%een Profit ,ar!in and Asset #urnover Profit ,ar!in Analysis Asset #urnover Analysis

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Analy/in! Return on Common E(uity -isa!!re!atin! Return on Common E(uity inancial *evera!e and Return on Common E(uity Assessin! 0ro%th in Common E(uity

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A+A*1 A+A*12I2 O34EC#IVE2 O34EC#IVE2 •

-escribe the usefulness of return measures in financial statement analysis.

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E&plain return on invested capital and variations in its computation.

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Analy/e Analy/e return on net operatin! assets and its relevance in our analysis.

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-escribe disa!!re!ation of return on net operatin! assets and the importance of its components.

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-escribe the relation bet%een profit mar!in and turnover.

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Analy/e Analy/e return on common shareholders' e(uity and its role in our analysis.

•

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-escribe disa!!re!ation of return on common shareholders' e(uity and the relevance of its components. E&plain financial levera!e and ho% to assess a company's success in tradin! on the e(uity across financin! sources.

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5)E2#IO+2 6. #he return that is achieved in any one period on the invested capital of a company consists of the returns 7and losses reali/ed by its various se!ments and divisions. In turn$ these returns are made up of the results achieved by individual product lines and proects. A %ell9mana!ed company e&ercises ri!orous control over the returns achieved by each of its profit centers$ and it re%ards the mana!ers on the basis of such results. 2pecifically$ %hen evaluatin! ne% investments in assets or proects$ mana!ement %ill compute the estimated returns it e&pects to achieve and use these estimates as a basis for its decision to invest or not. :. Profit !eneration is the first and foremost purpose of a company. #he effectiveness of operatin! performance determines the ability of the company to survive financially$ to attract suppliers of funds$ and to re%ard them ade(uately. Return on invested capital is the prime measure of company performance. #he analyst uses it as an indicator of mana!erial effectiveness$ and;or a measure of the company's ability to earn a satisfactory return on investment. <. If the investment base is defined as comprisin! net operatin! assets$ then net operatin! profit 7e.!.$ before interest after ta& 7+OPA# is the relevant income fi!ure to use. #he e&clusion of interest from income deductions is due to its bein! re!arded as a payment for the use of money from the suppliers of debt capital 7in the same %ay that dividends are re!arded as a payment to suppliers of e(uity capital. +OPA# is the appropriate amount to measure a!ainst net operatin! assets as both are considered to be operatin!. =. irst$ the motivation for e&cludin! nonproductive assets from invested capital is based on the idea that mana!ement is not responsible for earnin! a return on non9 operatin! invested capital. 2econd$ the e&clusion of intan!ible assets from the investment base is often due to s"epticism re!ardin! their value or their contribution to the earnin! po%er of the company. )nder 0AAP$ intan!ibles are carried at cost. >o%ever$ if their cost e&ceeds their future utility$ they are %ritten do%n 7or there %ill be an uncertainty e&ception re!ardin! their carryin! value in the auditor's opinion. #he e&clusion of intan!ible assets from the asset base must be based on more substantial evidence than a mere lac" of understandin! of %hat these assets represent or an unsupported suspicion re!ardin! their value. #his implies that intan!ible assets should !enerally not be e&cluded from invested capital. ?. #he basic formula for computin! the return on investment is net income divided by total invested capital. Whenever %e modify the definition of the investment base by$ say$ omittin! certain items 7liabilities$ idle assets$ intan!ibles$ etc. %e must also adust the correspondin! income fi!ure to ma"e it consistent %ith the modified asset base. @. #he relation of net income to sales is a measure of operatin! performance 7profit mar!in. #he relation of sales to total assets is a measure of asset utili/ation or turnovera means of determinin! ho% effectively 7in terms of sales !eneration the assets are utili/ed. 3oth of these measures$ profit mar!in as %ell as asset utili/ation$ determine the return reali/ed on a !iven investment base. 2ales are an important factor in both of these performance measures.

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B. Profit mar!in$ althou!h important$ is only one aspect of the return on invested capital. #he other is asset turnover. Conse(uently$ %hile Company 3's profit mar!in is hi!h$ its asset turnover may have been sufficiently depressed so as to dra! do%n the overall return on invested capital$ leadin! to the shareholder's complaint. 8. #he asset turnover of Company  is <. #he profit mar!in of Company 1 is D.?. 2ince both companies are in the same industry$ it is clear that Company  must concentrate on improvin! its asset turnover. On the other hand$ Company 1 must concentrate on improvin! its profit mar!in. ,ore specific strate!ies depend on the product and industry. F. #he sales to total assets 7asset turnover component of the return on invested capital measure reflects the overall rate of asset utili/ation. It does not reflect the rate of utili/ation of individual asset cate!ories that enter into the overall asset turnover. #o better evaluate the reasons for the level of asset turnover or the reasons for chan!es in that level$ it is helpful to compute the rate of individual asset turnovers that ma"e up the overall turnover rate. 6D. #he evaluation of return on invested capital involves many factors. #he inclusion;e&clusion of e&traordinary !ains and losses$ the use;nonuse of trends$ the effect of ac(uisitions accounted for as poolin!s and their chance of recurrence$ the effect of discontinued operations$ and the possibility of avera!in! net income are ust a fe% of many such factors. ,oreover$ the analyst must ta"e into account the effects of price9level chan!es on return calculations. It also is important that the analyst bear in mind that return on invested capital is most commonly based on boo" values from financial statements rather than on mar"et values. And finally$ many assets either do not appear in the financial statements or are si!nificantly understated. E&les of such assets are intan!ibles such as patents$ trademar"s$ research and development activities$ advertisin! and trainin!$ and intellectual capital. 66. #he e(uity !ro%th rate is calculated as follo%sG H+et income  Preferred dividends  Common dividend payoutJ ; Avera!e common e(uity. #his is the !ro%th rate due to the retention of earnin!s and assumes a constant dividend payout over time. It indicates the possibilities of earnin!s !ro%th %ithout resort to e&ternal financin!. #he resultin! increase in e(uity can be e&pected to earn the rate of return that the company earns on its assets and$ thus$ further contribute to !ro%th in earnin!s. 6:. a. #he return on net operatin! assets and the return on common stoc"holders' e(uity differ by the capital investment base 7and its correspondin! effects on net income. R+OA reflects the return on the net operatin! assets of the company %hereas ROCE reflects the perspective of common shareholders. b. ROCE can be disa!!re!ated into the follo%in! components to facilitate analysisG ROCE K R+OA L *evera!e & 2pread. R+OA measures the return on net operatin! assets$ a measure of operatin! performance. #he second component 7*evera!e & 2pread measures the effects of financial levera!e. ROCE is increased by addin! financial levera!e so lon! as R+OAM%ei!hted avera!e cost of capital. #hat is$ if the firm can earn a return on operatin! assets that is !reater than the cost of the capital used to finance the purchase of those assets$ then shareholders are better off addin! debt to increase operatin! assets.

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6<. a. ROCE can be disa!!re!ated as follo%sG +et income 9 Preferred dividends 2ales

2ales Avera!e common e(uity

#his sho%s that Ne(uity turnover 7sales to avera!e common e(uity is one of the t%o components of the return on common shareholders' e(uity. Assumin! a stable profit mar!in$ the e(uity turnover can be used to determine the level and trend of ROCE. 2pecifically$ an increase in e(uity turnover %ill produce an increase in ROCE if the profit mar!in is stable or declines less than the increase in e(uity turnover. or e&le$ a common obective of discount stores is to lo%er prices by lo%erin! profit mar!ins$ but to offset this by increasin! e(uity turnover by more than the decrease in profit mar!in. b. E(uity turnover can be re%ritten as follo%sG 2ales +et operatin! assets

+et operatin! assets Avera!e common e(uity

#he first factor reflects ho% %ell net operatin! assets are bein! utili/ed. If the ratio is increasin!$ this can si!nal either a technolo!ical advanta!e or under9capacity and the need for e&pansion. #he second factor reflects the use of levera!e. *evera!e %ill be hi!her for those firms that have financed more of their assets throu!h debt. 3y considerin! these factors that comprise e(uity turnover$ it is apparent that EP2 cannot !ro% indefinitely from an increase in these factors. #his is because these factors cannot !ro% indefinitely. Even if there is a technolo!ical advanta!e in production$ the sales to net operatin! assets ratio cannot increase indefinitely. #his is because sooner or later the firm must e&pand its net operatin! asset base to meet risin! sales or else not meet sales and lose a share of the mar"et. Also$ financin! ne% assets %ith debt can increase the net operatin! assets to common e(uity ratio. >o%ever$ this can only be pursued to a pointat %hich time the e(uity base must e&pand 7%hich decreases the ratio. 6=. When convertible debt sells at a substantial premium above par and is clearly held by investors for its conversion feature$ there is ustification for treatin! it as the e(uivalent of e(uity capital. #his is particularly true %hen the company can choose at any time to force conversion of the debt by callin! it in.

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EERCI2E2 E&ercise 896 7
+OPA# K @$DDD$DDD Q 6D K @DD$DDD +et income K @DD$DDD  H:$DDD$DDDQ6:J769.=D K =?@$DDD b. First alternative:

ROCE K ?:8$DDD ; ?$DDD$DDD K 6D.?@ Second alternative:

ROCE K =?@$DDD ; =$DDD$DDD K 66.=D c. First alternative:

Assets9to9E(uity K @$DDD$DDD ; ?$DDD$DDD K 6.: Second alternative:

Assets9to9E(uity K @$DDD$DDD ; =$DDD$DDD K 6.? d. irst$ lets compute return on assets 7R+OAG First alternative: @DD$DDD ; @$DDD$DDD K 6D Second alternative: @DD$DDD ; @$DDD$DDD K 6D 2econd$ notice that the interest rate is 6: on the debt 7bonds. ,ore importantly$ the after9ta& interest rate is B.: 76: & 769D.=D$ %hich is less than R+OA. >ence$ the company earns more on its assets than it pays for debt on an after9ta& basis. #hat is$ it can successfully trade on the e(uityuse bondholders funds to earn additional profits. inally$ since the second alternative uses more debt$ as reflected in the assets9to9e(uity ratio in c $ the second alternative is probably preferred. #he shareholders %ould ta"e on additional ris" %ith the second alternative$ but the e&pected returns are !reater as evidenced from computations in b.

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E&ercise 89: 7=D minutes a. +OPA# K +et income K 6D$DDD$DDD & 6D K 6$DDD$DDD b. First alternative: +OPA# K 6$DDD$DDD L @$DDD$DDDQ6D K 6$@DD$DDD +et income K 6$@DD$DDD  7:$DDD$DDD ? & H69.=DJ K 6$?=D$DDD Second alternative:

+OPA# K 6$DDD$DDD L @$DDD$DDDQ6D K 6$@DD$DDD +et income K 6$@DD$DDD  7@$DDD$DDD @ & H69.=DJ K 6$<8=$DDD c. First alternative: ROCE K 6$?=D$DDD ; 76D$DDD$DDD L =$DDD$DDD K 66 Second alternative: ROCE K 6$<8=$DDD ; 76D$DDD$DDD L D K 6<.8=

d. ROCE is hi!her under the second alternative due to successful use of levera!ethat is$ successfully tradin! on the e(uity. H+oteG Asset9to9E(uity is 6.6=K6@ mil.;6= mil. 76.@DK6@ mil.;6D mil. under the first 7second alternative.J #he company should pursue the second alternative in the interest of shareholders 7assumin! proected returns are consistent %ith current performance levels.

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E&ercise 89< 76? minutes a. R+OA K : & ? K 6D b. c.

ROCE K 6D L 6.B8@ & =.= K 6B.8@ R+OA *evera!e advanta!e Return on e(uity

6D.DD B.8@ 6B.8@

E&ercise 89= 7
Year 9

Pre9ta& profit mar!in........................................................... D.66: D.6DF Asset turnover..................................................................... D.=@ D.== Assets9to9e(uity.................................................................. <.:? <.=D After9ta& income retention Q............................................... D.?BD D.??@ ROCE 7product of above................................................... F.?= F.DB Q 69#a& rate. ROCE declines from 1ear ? to 1ear F becauseG 76 pre9ta& mar!in decreases by appro&imately <$ 7: asset turnover declines by rou!hly =.<$ and 7< the ta& rate increases by about <.8. #he combination of these factors drives the decline in ROCEthis is despite the sli!ht improvement in the assets9to9 e(uity ratio. b. #he main reason EP2 increases is that shareholders had a lar!e amount of assets and e(uity %or"in! for them. +amely$ the company !re% %hile return on assets and return on e(uity remained fairly stable. In addition$ the amount of preferred stoc" declined$ as did the amount of preferred dividends. With this decline in the cost of carryin! preferred stoc"$ earnin!s available to common stoc" increased. 7CA Adapted

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E&ercise 89? 76? minutes a. R+OA K < & B K :6 b. ROCE K R+OA L *EV & 2pread K :6 L 76.@@B & 8.= K
:6 6=
E&ercise 89@ 7
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E&ercise 89B 76D minutes 6. c :. a <. c E&ercise 898 7:D minutes 7Assessments of profit mar!in and asset turnover are relative to industry norms. a. >i!her profit mar!in and lo%er asset turnover. b. >i!her asset turnover and lo%er profit mar!in. c. >i!her profit mar!in and similar;lo%er asset turnover. d. >i!her asset turnover and similar;lo%er profit mar!in. e. >i!her asset turnover and lo%er;similar profit mar!in. f. >i!her asset turnover and similar;hi!her profit mar!in. !. >i!her asset turnover and lo%er profit mar!in.

E&ercise 89F 7:D minutes #he memorandum to Reliable Auto 2ales President %ould include the follo%in! pointsG 3oth Reliable and *e!end Auto 2ales are perpetually investin! 6DD$DDD in automobile inventory. *e!end Auto 2ales is able to !enerate more profit than Reliable because it is turnin! over its inventory 76D cars more often. 2pecifically$ *e!end is turnin! its inventory over 6D times per year %hile Reliable is turnin! its inventory over only ? times per year. >ence$ !iven the same investment in automobile inventory$ *e!end is t%ice as profitable as Reliable. Encoura!e Reliable to sacrifice some return on each sale to increase the inventory turnover. 3y sli!htly reducin! price$ relative to that char!ed by *e!end$ Reliable predictably %ill find that overall profitability increases. #his is because %hile profit per sale declines$ the number of units sold and$ therefore$ inventory turnover %ill increase. #hese factors predictably yield increased return on assets. •

•

•

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E&ercise 896D 7:D minutes Computation of Asset 7PPSE #urnover Hcomputed as 2ales ; PPSE 7netJG +orthernG 6:$DDD ; :D$DDD K D.@D 2outhernG @$DDD ; :D$DDD K D.
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PRO3*E,2 Problem 896 7o%ever$ if %e use the be!innin! price of =8 per share$ %e !et closer to the company's <= returnG K H6.?@ L 6=J ; =8 K <:.= :. #he return on common e(uity is based on the relation bet%een net income and the boo" value of the e(uity capital. In contrast$ 5ua"er Oats Nreturn to shareholders uses dividends plus mar"et value chan!e in relation to the mar"et price per share 7cost of investment to shareholders. b. #he company must have derived the <.@ from price$ mar"et$ and other factors that are not disclosed. Conceptually$ this <.@ should reflect the added ris" of an investment in 5ua"er Oats stoc" vis9T9vis a ris"9free security such as a ).2. #reasury bond. c. 5ua"er does not reveal its computations. It may disclose a variety of interest rates on lon!9term debt that it carries in the notes to financial statements. 3ased on data available to it$ but not to the financial statement reader$ it probably computed a %ei!hted9avera!e interest rate from %hich it deducted the ta& benefit in arrivin! at the @.= cost of debt.

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Problem 89: 7?D minutes a. Computation of Return on Invested Capital ,easuresG As a first step$ %e construct the companys income statement. 2ales 7?DD$DDD units U 6D................................................ i&ed costs...................................................................... Variable costs 7?DD$DDD units U =.............................. *abor costs 7:D employees & 
?$DDD$DDD 6$?DD$DDD :$DDD$DDD BDD$DDD 8DD$DDD =DD$DDD  =DD$DDD

76 R+OA K H=DD$DDD L 7:$DDD$DDD & B.?769D.?DJ ; 78$DDD$DDD9:$DD$DDD K =B?$DDD ; @$DDD$DDD K B.F: 7: ROCE K H=DD$DDD 9 76$DDD$DDD & @J ; <$DDD$DDD K 66.<< b. Wa!e Rate Analysis to meet a #ar!et Return on Invested CapitalG Estimated Fiscal Year 9 Operations:

2ales 7??D$DDD units U 6D..............................................................?$?DD$DDD i&ed costs 76$?DD$DDD & 6.D@..........................................................6$?FD$DDD Variable costs 7??D$DDD units U =............................................... :$:DD$DDD Income before labor costs and ta&es..............................................6$B6D$DDD #o obtain a 6D return on lon!9term debt and e(uity capital$ ear %ill need a numerator of @DD$DDD !iven an invested capital base of @$DDD$DDD. #he re(uired operatin! income to yield this @DD$DDD amount is computed asG +et income L Interest e&pense & 76 9 D.?D K @DD$DDD +et income L 7:$DDD$DDD & B.? & 769D.?D K @DD$DDD +et income K ?:?$DDD Assumin! ta&es at a ?D rate$ ear needs pre9ta& income of 6$D?D$DDD$ computed asG Income before labor and ta&es.............6$B6D$DDD *abor costs............................................  Pre9ta& income.......................................6$D?D$DDD #his impliesG *abor costs K @@D$DDD or Avera!e %a!e per %or"er K @@D$DDD ; :: employees K 
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Problem 89< 7
D.<@

+et income to sales

D.:<

2ales;current assets

6.=B

2ales ; fi&ed assets

:.FB

2ales ; total assets

D.F8

#otal liabilities ; e(uity

D.88

*9# liabilities ; e(uity

D.D<

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Problem 89= 7@D minutes a. 6. R+OA K +OPA# Av!. +OA +OPA# K H68@$DDD L :$DDD 9 6:D$DDD 9 
+OA 1ear @ K 6<8$DDD 9 :F$DDD 9 BDDD 9 <$@DD K F8$=DD +OA 1ear ? K 6D?$DDD 9 :<$DDD 9 :$DDD 9 :$DDD K B8$DDD R+OA K 6@$DDD ; 7HF8$=DD L B8$DDDJ;: K 68.6= :. ROCE K +et income 9 Preferred dividends Avera!e common e(uity ROCE K 76D$DDD D ;H7??$=DDQ L =B$8DDQ;:J

K 6F.<8

Q+oteG minority interest is treated as e(uity. If ,inority interest is i!nored$ the ROCE is 6F.8

b. +O K +OA 9 E(uity 1ear @G =<$DDDX 1ear ?G 
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Problem 89? 7=D minutes a. ROCE K H+et income  preferred dividendsJ ; stoc"holders e(uityQ Qend of year in this problem ROCE 1ear ?G H6=  DJ ; 6:? K 66.: ROCE 1ear FG H<= 9 DJ ; ::D K 6?.? R+OA 1ear ? K 7
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Problem 89@ 7B? minutes 3ac"!round InformationG Product A Yr 7 Yr 

+umber of units sold..................... 6D$DDD 2ellin! price per unit...................... @.DD )nit cost.......................................... ?.DD

B$DDD ?.DD =.DD

Product B Yr 7 Yr 

@DD ?D.DD <:.?D

FDD ?D.DD 
4ohnson Corporation Analysis 2tatement of Chan!es in 0ross ,ar!in 1ear : versus 1ear 6 Analysis of Variation in Product A 2ales

Increased (uantity at 1r @ prices 7<$DDD & ?......................... Price increase at 1r @ (uantity 7B$DDD & 6 ............................ 5uantity increase & price increase 7<$DDD & 6 .....................

 6?$DDD B$DDD <$DDD

Analysis of Variation in Product A Cost of 2ales

Increased (uantity at 1r @ cost 7<$DDD & = ........................... Increased cost at 1r @ (uantity 7B$DDD & 6 ........................... Cost increase & (uantity increase 7<$DDD & 6 ...................... +et Variation 7Increase in 0ross ,ar!in for Product A..............

76:$DDD 7B$DDD 7<$DDD  <$DDD

Analysis of Variation in Product 3 2ales

-ecreased (uantity at 1r @ prices 7

 76?$DDD

Analysis of Variation in Product 3 Cost of 2alesG

-ecreased (uantity at 1r @ cost 7

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



F$DDD 7:$:?D B?D 7B$?DD

<$DDD 7B$?DD  7=$?DD


Problem 89B 7@D minutes a. 2P1RE2 ,A+)AC#)RI+0 CO,PA+1 Comparative Common92i/e Income 2tatements 1ear Ended -ecember <6 1ear F 1ear 8

Increase 7-ecrease

+et sales..............................

6DD.D

6DD.D

:D.D

Cost of !oods sold.............

86.B

[email protected]

6=.D

0ross mar!in on sales.......

68.<

6=.D

?B.6

Operatin! e&penses...........

[email protected]

6D.:

F8.D

Income before ta&es...........

6.?

<.8

7?:.@

Income ta&es.......................

D.=

6.D

7?:.D

+et income..........................

6.6

:.8

7?:.F

b. Performance in 1ear F is poor %hen compared %ith 1ear 8. One bri!ht spot is the percenta!e of Cost of 0oods 2old to 2ales$ %hich decreased in 1ear F. >o%ever$ Operatin! E&penses climbed sharply. #his sharp climb in operatin! e&penses is une&pected since there is usually a lar!er fi&ed cost component comprisin! these costs compared %ith that for Cost of 0oods 2old.

,ana!ement should further chec" operatin! e&penses. If operatin! e&penses had remained at the 1ear 8 level of 6D.:$ income %ould have been up favorably for 1ear F. Operatin! e&penses may have included a future9directed component such as advertisin! or trainin! costs. Also$ mana!ement %ould %ant to follo% up on the chan!e in !ross mar!in. #he sharp improvement in !ross mar!in may have been due to factors such as the li(uidation *IO inventory layers or$ alternatively$ to somethin! more fundamental %ith the activities of the firm.

8-1#


Problem 898 7B? minutes E#A CORPORA#IO+ 2tatement of Variations in Income and Income Components 1ear @ versus 1ear ? !tems tendin" to increase net income:

Increase in net salesG +et sales$ 1ear @........................................ 68@$DDD +et sales$ 1ear ?........................................ 6??$DDD :D.D -educt increase in cost of !oods soldG Cost of !oods sold$ 1ear @....................... 6:D$DDD Cost of !oods sold$ 1ear ?....................... FF$DDD +et increase in !ross mar!in on salesG 0ross mar!in$ 1ear @................................ @@$DDD 0ross mar!in$ 1ear ?................................ ?@$DDD Increase in e(uity in income 7loss of assoc. co.G E(uity in income$ 1ear @........................... :$DDD E(uity in loss$ 1ear ?................................. 76$DDD -ecrease in loss of discont. oper. 7net of ta&esG *oss on disc. oper.$ 1ear @........................ 6$6DD *oss on disc. oper.$ 1ear ?........................ 6$:DD Increase in cum. effect of accountin! chan!eG Cumulative effect$ 1ear @.......................... 6$DDD Cumulative effect$ 1ear ?.......................... D #otal of items tendin! to increase income. . .

<6$DDD

:6$DDD

:6.:

6D$DDD

6B.F

<$DDD

6DD

8.<

6$DDD 6=$6DD



=$DDD

6:.6

=$DDD

@@.B

:$:DD

:8.:

:DD



BDD 66$6DD



!tems tendin" to decrease net income:

Increase in 2SA e&penseG 2SA$ 1ear @................................................
8-20

6D$DDD B$DDD

<$DDD

=:.F


Problem 898continued Anal#sis and !nterpretation:

76 E#A has t%o Ybelo% the lineY items99discontinued operations and a chan!e in accountin! principle. While net income increased by =:.F$ income from continuin! operations increased by <6.B. 7Per note 6$ the increase in 1ear @ income from operations due to the chan!e in inventory accountin! is only =DD. 7: Per note <$ E#A ac(uired most of #RO Company effective -ecember <6$ 1ear @. As the ac(uisition %as accounted for as a purchase$ the 1ear ? and @ income statements do not reflect the results of #RO. Certain pro forma information is included in note <. 7< #he :6.: increase in CO02 sli!htly e&ceeds the :D increase in sales$ leadin! to a lo%er !ross profit mar!in despite the accountin! chan!e. 7= #he increase in e(uity in income of associated companies helped increase net income. #he analyst should assess %hether a dollar of income for associated companies is e(uivalent to a dollar of income for E#A. 7? 2SA e&penses rose less than sales$ contributin! to increased income. 7@ #he increase in interest e&pense is matched by an increase in lon!9term debt.

8-21


Problem 89F 7B? minutes a. 6. -ata communications............................. #ime recordin! devices.......................... >ard%are for electronics........................ >ome se%in! products.......................... Corporate total........................................

Inventory9to92ales 6$8FB;@$8FD K :B.? :$B:8;=$6DD K @@.? :8B;6$8?D K 6?.? ?:@;6$:@? K =6.@ ?$=<8;6=$6D? K <8.@

:. Inventory9to9Contribution -ata communications............................. 6$8FB;6$?6D K 6.:@ #ime recordin! devices.......................... :$B:8;=6: K @.@: >ard%are for electronics........................ :8B;F6F K D.<6 >ome se%in! products.......................... ?:@;<=: K 6.?= Corporate total........................................ ?$=<8;<$68< K 6.B6 b. -ata communications............ #ime recordin! devices......... >ard%are for electronics....... >ome se%in! products.......... #otal.........................................

1ear 6 == <= 99 :: 6DD

1ear : 1ear < 1ear = ?F =8 :6 : 99
=B 6< :F 66 6DD

c. -esirability of Investment for Each Product *ine 7ran"edG $ata communications e%uipment seems to be the best candidate for investment. Its !ro%th has been steady %hile the amount of inventory;sales 7:B.? and inventory;income contribution 76.:@ is relatively lo%. #he trend of income contribution of hard&are 'or electronics is stable and both the amount of inventory;sales 76?.? and inventory;income contribution 7D.<6 compares very %ell %ith others. (ome se&in" products also sho%s a stable income contribution trendX ho%ever$

it should be noted that the amount of sales is decreasin! every year and the inventory;sales 7=6.@ and inventory;income contribution 76.?= do not compare favorably %ith others. #he least desirable candidate for investment is time recordin" devices %hose data compare very poorly %ith others in all the respects mentioned above.

8-22


CA2E2 Case 896 76:D minutes a. Computation of Return on Invested Capital ,easuresG :DD? 76 Return on net operatin! assets HaJ.............. B<.F 7: -isa!!re!ated R+OAG Oper. Profit mar!in HaJ............................. ?.F +OA turnover HaJ....................................... 6:.=F 7< Return on common e(uity HbJ...................... =B.B 7= -isa!!re!ated ROCE HcJG R+OA .................................................. B<.F *EV .................................................. 9<8.< 2pread....................................................... @8.@ Computation notesG HaJ +OPA# Avera!e net operatin! assets ) 7=$:?= & 769H6$=D:;=$==?J ; 776$F
:DD?G :<$:6? 9 ?$D@D 9 6=$6<@ 9 :$D8F K 6$F
:

$isa""re"ated: *++5 pro'it mar"in: 7=$:?= & 769H6$=D:;=$==?J ; =F$:D? K ?.F *++5 net operatin" asset turnover: =F$:D? ; 776$F
HbJ +et income H66J 9 Preferred dividends Avera!e common e(uity *++5: H<$D=< 9 DJ ; H7@$=8? L @$:8D;:J K =B.B

HcJ :DD? +O K ?D? 9 ?$D@D K 9=$??? :DD= +O K ?D? 9 8
K

79=$??? 9 <
K

9<8.<

+E K +OPA# 9 +et income K :$F6: 9 <$D=< K 96<6 +R K +E ; Av!. +O K 96<6 ; 79=$??? 9 <
8-23


Case 896continued b. Computation of Asset #urnover RatiosG :DD? 76 Accounts receivable turnover.................................

6:.:<

Avera!e collection period........................................

:F.8?

7: Inventory turnover...................................................

6D:.:@

Avera!e inventory days outstandin!......................

<.?B

7< *on!9term operatin! asset turnover......................

@.?@

7= Accounts payable turnover.....................................

=.F@

Avera!e payables days outstandin!.......................

B<.@6

c. -ell achieves e&traordinary returns 7both on net operatin! assets and e(uity due to its hi!h turnover of net operatin! assets. -ells %or"in! capital mana!ement is le!endary. #he Accounts receivable turnover rate has decreased in recent years as the company e&panded into more corporate sales$ but remains hi!h %ith an avera!e collection period of only :F.F days. -ells ability to operatin! %ith very little inventory and lon!9term operatin! assets$ ho%ever$ is the primary driver of its profitability. Inventories turn 6D: times a year$ %ith an avera!e inventory days outstandin! of only <.?B. #his is e&traordinary. urthermore$ the company turns its lon!9term operatin! assets @.?@ times a year$ si!nificantly !reater than nearly every other publicly traded company. inally$ -ell is able to use its mar"et po%er to delay payment to suppliers. Its accounts payable turnover rate is =.F@ times a year$ for an avera!e payable days outstandin! of B<.@6. -ell is$ therefore$ collectin! cash in :8.8? days and payin! its suppliers in B<.@6 days. #he cash !enerated by this relation is invested in mar"etable securities$ ? billion in :DD?$ resultin! in a ne!ative +O. #he fact that ROCE is lo%er than R+OA results from the use of relatively hi!h cost e(uity capital to finance investment in mar"etable securities. #he company could eliminate this Nproblem by repurchasin! stoc" %ith its mar"etable investments$ and has$ indeed$ repurchased a considerable amount of stoc" over the past < years. 2ince it operates in a fast chan!in! industry$ the additional li(uidity is probably %arranted. -ells ROE of =B.B is still considerably !reater than the 6: median for publicly traded companies.

8-24


Case 89: 7B? minutes a. +i"es ROCE$ currently at :6.@$ has been steadily increasin! over the ? year period$ %hile Reebo"s has remained at a constant level for the past < years$ and is currently 6?.B. ROCE K R+OA L *EV & 2pread. #he computation of ROCE$ based on its disa!!re!ated components is as follo%sG +IZEG 6F.: L D.6== & 6@.@ K :6.@ Reebo"G 6:.B L D.<@B & 8.: K 6?.B #he recent ?9year trend in the ROCE components is as follo%sG +IZE 7+ZE Reebo" 7R3Z 2ales !ro%th

+ZEs sales !ro%th has increased si!nificantly in the past : years

After sufferin! sales declines ? and = years a!o$ R3Zs !ro%th has improved and is si!nificant in the current year

0ross Profit

+ZEs !ross profit mar!in has increased by <.? percenta!e points in the past < years and is currently =.? percenta!e points hi!her than R3Zs.

R3Zs !ross profit mar!in increased by 6.@ percenta!e points in year = and has leveled off.

20SA e&p 

+ZEs 20SA percenta!e has increased by :.6 percenta!e points from its trou!h and is currently D.? percenta!e points hi!her than R3Zs.

R3Zs 20SA percenta!e is < percenta!e points lo%er than ? years a!o and has leveled off in the recent : years.

+OPA#;2ales

+ZEs +OPA# has increased by 6 percenta!e point form ? years a!o and is currently :.8 percenta!e points hi!her than R3Zs.

R3Zs +OPA# has also increased over the ? year period$ and is currently 6.8 percenta!e points hi!her than in year 6. It is currently si!nificantly lo%er than +ZEs.

#A e&p. 

+ZEs ta& e&pense has been increasin! and is currently hi!her than R3Zs.

R3Zs ta& e&pense has been decreasin! over the ? year period.

+OA turnover

+ZEs +OA turnover has increased si!nificantly over the ? year period$ but is currently lo%er than R3Zs.

R3Zs +OA turnover has decreased form its hi!h in 1ear <$ but has leveled off in the past : years.

Receivables turnover

+ZEs receivables turn has fluctuated %ithin a constant band over the past ? years and the avera!e collection period currently stands at @< days.

R3Zs receivable turn is si!nificantly hi!her than +ZEs$ and has remained fairly constant durin! the past < years. Its avera!e collections period is ?D days.

Inventory turnover

+ZE turns its inventories =.=? times a year$ for an avera!e inventory days outstandin! of 8: days.

R3Z turns its inventories ?.B6 times a year for an avera!e inventory days outstandin! of @= days.

*9# oper. asset turn

+ZE has been turnin! its lon!9term operations assets more (uic"ly over the past ? years$ but only half as fast as R3Z does.

R3Zs lon!9term operatin! asset turnover rate is t%ice that of +ZE and has been increasin! steadily over the past ? years.

Accts. Pay turn

+ZEs accounts payable turnover rate has slo%ed over the past < years$ increasin! its avera!e payable days outstandin! to
R3Zs accounts payable turnover has increased over the past < years$ reducin! its avera!e payable days outstandin! to :B days.

8-2


Case 89:concluded b. +ZEs operatin! performance is better than R3Zs. Its +OPA# mar!in is :.8 percenta!e points hi!her$ driven by a si!nificantly hi!her !ross profit mar!in. It appears that +ZE is able to use its brand reco!nition and effective advertisin! to command hi!her unit sellin! prices for its products. #he +OA turnover is rou!hly comparable to the t%o companies. ,ost of the assets are current and +ZE %or"in! capital turnover rate 7not listed is <.8F times$ compared %ith R3Zs of <.6=. #he hi!her turnover of the more si!nificant %or"in! capital accounts more than offsets +ZEs slo%er lon!9 term operatin! assets turnover rate. 3ased on this analysis$ +ZE appears to e&hibit superior operatin! performance. Whether the stoc" is a Nbuy depends on t%o factorsG 6. is +ZEs hi!her profit mar!in sustainable$ and :. has the mar"et already impounded the superior operatin! performance into +ZE stoc" price.

8-2!


Case 89< 7B? minutes a. Computation and -isa!!re!ation of ROCE 1ear 6<

1ear F

6<.<= ?$?:B =FB ?$D
:<.DF <$:=< 6FF <$D==

*EV3

D.6D

D.DB

+OPA# +EC +et income

@?= 6B @B6

@BB :@ BD<

66.8: 9<.?: 6?.<=

:D.8B 96<.6B <=.D=

ROCE +OA +OA E(uity

R+OA +R2preadE A

+OA 9 E(uity +O;E(uity C +et income9+OPA# +e!ative amount indicates net income vs. e&pense E R+OA9+R 3

Computations ROCE +OA +OPA#

1ear 6< @B6;?$D
1ear F BD<;<$D==K.:<6 <86L::=LLFDFL<$
6

Endin! assets are used because information is unavailable to compute avera!e assets.

b. -isneys profit mar!in on sales decreased substantially from 1ear F to 1ear 6<. 2ome reasons for this chan!e includeG -isney e&perienced above avera!e !ro%th in the film entertainment business$ %hich has the lo%est operatin! mar!in of any of its business se!ments. -isney e&perienced deterioration in consumer product mar!ins as the business mi& shifted a%ay from licensin! and royalty income. Euro -isney losses and reserve provision 7%rite9off hurt 1ear 6< results$ as compared %ith no effect in 1ear F. -isney e&perienced deterioration in the theme par" mar!ins because of lo%er attendancethis$ in turn$ stemmed from a slo%er economy and more e&pensive admission prices. #he profit mar!in on sales is offset$ to some e&tent$ by the favorable effects of financial levera!e as the return on financial assets 7other current assets e&ceeds borro%in! costs. •

•

•

•

•

8-2"


Case 89= 7?? minutes a. #he level of sales %ould be affected by many factors$ includin! the follo%in!G 7i the (uality and popularity of products for the particular fashion season$ 7ii the number of customers reached via the catalo! or the internet$ 7iii the prices at %hich !oods are offered$ and 7iv the state of the economy. #he !ross profit level %ould be affected byG 7i the (uality of materials used in production$ 7ii the costs of manufacturin! products$ 7iii the price of !oods purchased for resale$ and 7iv the prices at %hich !oods are sold. b. In simple terms$ the !ross profit percent !ives you a measure of ho% much of each dollar sold is available to cover the non9product costs. or *and's End in 1ear F$ the !ross profit percent indicates that for every 6 of sales$ there %as D.=? to cover sellin!$ !eneral$ and administrative e&penses$ and all other e&penses. c. #he sellin!$ !eneral$ and administrative e&penses %ould be determined by all of the follo%in!G 7i the cost of paper$ 7ii the cost of posta!e to mail the catalo!s$ 7iii the cost of the photo!raphy and catalo! production$ 7iv the number of pa!es per catalo!$ and 7v the number of catalo!s mailed. #he cost of paper is most li"ely directly related to the (uality of the paper used. #he (uality of the paper used can impact sales by influencin! the customer's opinion of the (uality of the products 7that is$ if cheap paper is used$ the products may be perceived as cheaply made$ but if the catalo! is made of heavy$ !lossy paper$ the products may be e&pected to be of similar hi!h (uality. *imitin! the si/e and %ei!ht of each catalo! can control the cost of posta!e. >o%ever$ limitin! the si/e and %ei!ht of each catalo! may mean lo%er sales because customers may not !et enou!h information about the products available. 3y choosin! a hi!her or lo%er (uality production$ the cost of the photo!raphy and the catalo! production can be controlled. #he e&pected impact on the sales level %ould be similar to the impact of the paper (uality. #he number of pa!es can be easily controlled. #here is probably an optimum number of pa!es to ma&imi/e sales levels 7that is$ more is probably not absolutely better. #he number of catalo!s mailed can easily be controlled %ith proper address trac"in! 7to avoid doublin! or triplin! up on some customers. A!ain$ there is probably an optimum number of different addresses to tar!et.

8-28


Case 89? 7F? minutes a. Petersen Corporation 76  of #otal Consolidated Revenue

,anuf. en!in. products..............

6

=

6

:

<

=

6

:

<

En!ineerin! e(uipment.............. :8.6 68.< [email protected] 6B.D

99

99

99

99

99

99

99

Other e(uipment.........................

:.F

99

99

99

99

99

99

99

Parts$ supplies S services.......... :B.? 68.= 6B.< 6B.:

99

99

99

99

99

99

99

#otal.............................................. @6.6 =D.=
?.B

?.?

En!in. S erectin! services......... International operations.............

99 99

: <.B

<

7:  of -ivisional 7< -ivisional Income Income to #otal Income as  of Revenue

<.?

99

@.< 6=.<

99

99

99

99

99

<6.= 6B.@

?.8 6:.D F.@

8.8

@.D 6:.@

99 6D.D

8.B

99

99

99

F.:

F.? 6=.@

?.B

B.:

F.D

99

@.F

8.6

?.? 76.8

@.6

@.=

@.F

8.D

#otal Environmental 2ystems 0roup............................ @6.6 =D.= =<.F ?6.= 8<.F =8.< ?8.F @6.? ...............................................6:.< 0raphics 0roup rye Copy 2ystems..................... :<.@ 6B.< [email protected] 6?.< :D.: 6?.@ 6<.: 6<.@ F.: 2inclair and Valentine................. 8.=

99 <<.D : F.? : <.B

A. C. 0arber................................. 6?.< ?.F

F.< 6D.?

99 :8.F :6.8 6F.=

F.@ 7=.6

B.:

@.6

#otal 0raphics 0roup ................. <8.F ?F.@ [email protected] =8.@ [email protected] ?6.B =6.6 <8.? 8.: #otal rev. or div. income.............. 6DD.D 6DD.D 6DD.D 6DD.D 6DD.D 6DD.D 6DD.D 6DD.D

8-2#

:.8

99


Case 89?concluded b. #he Environmental 2ystems 0roup has !enerally declined in its contribution to total consolidated revenue. #he e&ception is in 1ear < %hen the decline %as reversed due to a stron! increase in the revenue of the en!ineerin! and erection services division. #he 0raphics 0roup mar"edly increased its dollar revenue share in 1ear :. #his increase is lar!ely due to the ac(uisition of 2inclair and Valentine in 1ear :. Accordin!ly$ this increase has lar!ely leveled off. +ote that only income9related data are reported for international operations. In such a case$ the analyst must carefully e&amine the related te&tual disclosures. In the case of Petersen Corp.$ these fi!ures consist of royalty income and the Company's e(uity participation in the income before ta&es of the international subsidiaries and affiliates of the !roup$ neither of %hich are included in revenue. While the Environmental 2ystems 0roup has declined overall in its contribution to sales$ it has !ro%n in its contribution to income. Its income share is much lar!er than its share of revenuesthis is due to !reater profitability by the Environmental 2ystems 0roup and$ particularly$ the ,anufactured En!ineerin! Products %here profitability 7as measured by divisional income as a percent of revenues has been !ro%in!. While this profitability has declined some%hat from 1ear : to 1ear <$ it remains at a level considerably hi!her than the company as a %hole.

8-30


Case 89@ 76?D minutes 6. 2ears and Wal9,art9Recast Income 2tatement 2ears 6FFF OR

Operatin! Revenue 2ales and 2ervice Other Income Credit Revenues

<@B:8 @ =<=<

6FF8 <@F?B :8 =@68

=6DBB OE

*ess Operatin! E&penses Cost of 2ales 2ellin! S 0eneral Admin Provision for )ncollectible Accounts -epreciation S Amorti/ation Restructurin! and Impairment Cumulative Effect of Acct! Chan!e

:B:6: 8=68 8B6 8=8 =6

*ess #a& E&pense Reported Provision Interest #a& 2hield

OI

Operatin! Income

+E

*ess +et inancial E&pense Interest E&pense Interest Interest on Capital *ease E&traordinary *oss on -ebt E&tin!uishment *ess Interest Income *ess Int. #a& 2hield 7U
,I+

*ess ,inority Interest

+I

+et Income

6FFF 6@?D6< 6BF@

=6@D< :B=== 8<8= 6:8B 8
6FF8 6
6@@8DF 6:F@@= :BD=D

6
6F8
#E

Wal9,art

FD= ===

<8:FB B@@ =F8

6?@FD: <<<8
6<6D88 :B=D :BF

6<=8

6:@=

<@F@

:<
:D=:

@:66

?6D6

6:@8

6=:<

B?@ :@@

?:F :@8

:= 6:@8

6==B

6D::

BFB

===

=F8

:BF

8-31

8:=

F=F

@@=

?68

@:

=?

6BD

6?<

6=?<

6D=8

?
==

Ch_08

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