Transcript Financial Statement Analysis and Security Valuation

Financial Statement Analysis
and Security Valuation
Stephen H. Penman
Prepared by
Peter D. Easton and Gregory A. Sommers
Fisher College of Business
The Ohio State University
With contributions by
Stephen H. Penman – Columbia University
Luis Palencia – University of Navarra, IESE Business School
McGraw-Hill/Irwin
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11 Student -1
The Analysis of Profitability
Chapter 11
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
11 Student -2
Recall:
We began by identifying a role for the residual income model
in valuation
E
V
B
V0E  B0   ρEt R Et  T T T
ρE
t 1
T
We identified the central role of ROCE in valuation
Since: earn   ρ  1B  ROCE   ρ  1 B
t
E
t-1
t
E
t-1
We reformatted the Income Statement to draw attention to the
components of Comprehensive Income (the numerator)
We reformatted the Balance Sheet to draw attention to the
components of CSE (the denominator)
We recognized that the component of earnings which adds value
is OI and the assets used to generate that value are NOA
The focus now is on the drivers of operating income
McGraw-Hill/Irwin
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11 Student -3
The Focus:
Accounting-Based Valuation
• The task is to determine premiums over book
value (or equivalently, the P/B ratio)
• What will future ROCE (residual earnings) be?
• Point of departure: Current ROCE
• How will future ROCE be different from current
ROCE?
McGraw-Hill/Irwin
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11 Student -4
Analysis of the Information
1. Future ROCE (residual earnings) is the forecast target
2. Establish the present: Financial statement analysis
Determine the current profitability (ROCE) and the factors that
influence the profitability
3. Determine transition from present to future: Projecting financial
statements
Determine factors that influence future profitability and describe
how the future will be different from the present
McGraw-Hill/Irwin
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11 Student -5
Chapter 11
Page 338
Figure 11.1
Cutting to the Core:
The Analysis of Profitability
ROCE  Comprehensive Income/Ave
rage CSE
 RNOA  [FLEV x SPREAD]
FLEV 
NFO
CSE
RNOA  OI/NOA
 ROOA  (OLLEVx OLSPREAD)
Level 1
RNOA
Level 2
Level 3
PM = OI / Sales
Sales PM
Gross Margin Ratio
McGraw-Hill/Irwin
SPREAD  RNOA - NBC
NBC 
NFE
NFO
ATO = Sales / NOA
Other Items PM
Expense Ratios
Other OI/Sales
Ratios
Individual Asset and
Liability Turnovers
© The McGraw-Hill Companies, Inc., 2001 All rights
Borrowing Cost
Drivers
11 Student -6
Cutting to the Core:
ROCE Drivers
ROCE is decomposed into drivers over three levels of
analysis:
1. Effects of Leverage
1. Analysis of Operating Profitability
1. Analysis of Net Borrowing Costs
McGraw-Hill/Irwin
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11 Student -7
First-Level Breakdown: Analysis of
Effects of Financial Leverage (FLEV)
ROCE 

Chapter 11
Page 339
Box 11.1
Comprehens ive Income
Average CSE
(OI - Net Financial Expense)
NOA  NFO
So, ROCE is a weighted return to operating activities and financing activities:
 NOA
  NFO

ROCE  
x RNOA  - 
x NBC 
 CSE
  CSE

or,
ROCE  RNOA  [FLEV x RNOA - NBC]
Spread
RNOA
FLEV
NBC
SPREAD
= OI (After tax) / NOA
= NFO / CSE
= NFE (after tax) / NFO
= RNOA – NBC
McGraw-Hill/Irwin
(Return on Net Operating Assets)
(Financial Leverage)
(Net Borrowing Cost)
(Operating Spread)
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11 Student -8
Chapter 11
Page 340
Figure 11.2
How Financial Leverage Explains the
Difference Between ROCE and RNOA
SPREAD = 6%
8%
SPREAD = 4%
Difference between ROCE and RNOA
(ROCE-RNOA)
6%
SPREAD = 2%
4%
SPREAD = 1%
2%
SPREAD = 0%
0%
SPREAD = -1%
-2 %
SPREAD = -2%
-4 %
0 .0 0
0 .2 5
0 .5 0
0 .7 5
1 .0 0
1 .2 5
1 .5 0
1 .7 5
2 .0 0
F LEV
RO C E = RN O A + [F LEV x S P REA D ]
Financial Leverage:
General Mills, Inc.
Chapter 11
Page 341
Box 11.2
General Mills, a large manufacturer of packaged foods, has had considerable stock
repurchases over the years. At the end of fiscal 1998 common shareholder equity was only
$190.2 million on net operating assets of $2.251 billion. Its financial leverage was a huge
5.745, based on average balance sheet amounts.
The firm’s ROCE for 1998 was 121.6%. Further analysis reveals that this very high
number is driven by the high leverage:
ROCE = RNOA + [FLEV x (RNOA  NBC)]
121.6% = 21.6% + [5.745 x (21.6%  4.2%)]
ROCE can exaggerate underlying operational profitability: RNOA is 21.6% but the high
financial leverage, combined with a SPREAD over a borrowing cost of 4.2%, yields a much
higher ROCE. Beware of firms boasting high ROCE: is it driven by financial leverage?
A What-If Question: What if the RNOA at General Mills fell to 3%? What would be the effect
on ROCE?
The answer is that the ROCE would fall to -3.9%:
-3.9% = 3.0% + [5.745 x (3.0%  4.2%)]
The unfavorable leverage would produce a negative ROCE on a positive RNOA.
McGraw-Hill/Irwin
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11 Student -10
Financial Leverage:
Microsoft, Corp.
Chapter 11
Page 342
Box 11.3
Microsoft Corp has been very profitable. For fiscal 1998 the firm reported an ROCE of 36.3% on
average common equity of $13.702 billion. But Microsoft had no financing debt other than $980 million
of convertible preferred stock. And it had considerable financial assets of $11.447 billion from cash
generated from its operations. The return on average net financial assets was 8.0% (a significant portion
from unrealized gains on financial assets).
The reported ROCE masks the profitability of operations:
 NFA

ROCE  RNOA  
x RNOA  RNFA
 CSE

36.3% 179.4%  [0.835x (179.4%  8.0%)].
The RNOA of 179.4% is weighted down by return on financing activities in the overall ROCE.
A What-If Question: Microsoft has regular stock repurchases. In fiscal 1998 the company used $2.796
billion of its financial assets to repurchase stock. What would the ROCE have been had it not undertaken
the stock repurchase?
The answer:
With $2.796 billion more in average financial assets and common equity, the NFA to CSE ratio would
have been 0.863 rather than 0.835, and the ROCE would have been:
31.5% = 179.4%  [0.863 x (179.4%  8.0%)]
Stock repurchases (and dividends) increase ROCE.
McGraw-Hill/Irwin
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11 Student -11
The Effects of Operating Liability
Leverage (OLLEV)
Chapter 11
Page 342
Operating liabilities lever the Return on Net Operating Assets
RNOA 
OI
OA - OL
What would be the operating profitability without operating liabilities?
Returnon OperatingAssetsROOA  
OI  Implicit Interest(AfterTax)
.
OperatingAssets
where
Implicit Interest on Operating Liabilities
= Short-term Borrowing Rate x Operating Liabilities
The Effect of OLLEV:
RNOA = ROOA + (OLLEV x OLSPREAD)
where
OLLEV
OL
NOA
OLSP READ ROOA  Short - termBorrowingRate
McGraw-Hill/Irwin
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11 Student -12
Operating Liability Leverage:
General Mills, Inc.
Chapter 11
Page 344
Box 11.4
General Mills had average net operating assets of $2.310 billion during fiscal 1998 of which $1.159
billion were in operating liabilities other than deferred taxes and pension liabilities. Thus its operating
liability leverage ratio was 0.50. Its borrowing rate on its short-term notes payable was 5.4%, or 3.4%
after tax. It reported operating income of $499.6 million, but applying the after-tax short-term
borrowing rate to operating liabilities other than deferred tax and pension liabilities, this operating
income includes implicit after-tax interest charges of $39.4 million. So,
ROOA 
499.6  39.4
 15.5%
3469.0
The effect of operating liability leverage is favorable:
RNOA  21.6%  15.5%  0.50 x 15.5%- 3.4%
A What-If Question: What-if suppliers were to charge the short-term borrowing rate of 5.4% explicitly
for the credit in accounts payable. What would be the effect on ROCE?
The answer: Probably no effect. The interest would be an additional expense. But, to stay competitive,
the supplier would have to reduce prices of goods sold to the firm by a corresponding amount so that the
total price charged (in implicit plus explicit interest) remains the same. But supplier markets may not
work as efficiently as this supposes, so firms can exploit operating liability leverage.
McGraw-Hill/Irwin
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11 Student -13
Return on Net Operating Assets
and Return on Assets
RNOA 
ROA 
Chapter 11
Page 343
OI
OA  OL
Net Income  Interest Expense (after tax)  Minority Interest
Total Assets
Problems with ROA:
• Financial assets in denominator
• Financial income in numerator
• Operating liabilities not in denominator
• Net income is not comprehensive income
Median ROA is 7.0%
Median RNOA is 10.3%
McGraw-Hill/Irwin
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11 Student -14
RNOA and ROA for
Selected Firms, 1996
Industry/ Firm
RNOA
ROA
Operating
Liability
Leverage
(OLLEV)
Chapter 11
Page 345
Table 11.1
Financial Assets
T otal Assets
Biotech
Genentech, Inc.
Amgen, Inc.
Chiron Corp.
11.2%
63.5%
6.2%
5.7%
26.2%
3.8%
0.37
0.51
0.31
52.8%
41.0%
10.3%
197.0%
68.4%
121.8%
25.4%
21.0%
32.5%
1.69
1.52
0.87
64.7%
26.5%
48.5%
12.7%
0.5%
39.7%
9.3%
0.4%
30.1%
0.35
0.35
0.56
1.0%
4.1%
24.1%
14.8%
13.9%
8.3%
8.2%
0.73
0.64
1.9%
4.4%
22.6%
14.1%
16.3%
9.8%
0.37
0.32
6.1%
7.2%
High Tech
Microsoft Corp.
Oracle Corp.
Cisco Systems, Inc.
Retailers
Wal-Mart Stores, Inc.
Kmart Corp.
The Gap, Inc.
Oil Producers and
Refiners
Exxon Corp.
Chevron Corp.
Footwear and Apparel
Manufacturers
Nike, Inc.
Reebok Int’l, Ltd.
McGraw-Hill/Irwin
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11 Student -15
FLEV and Debt-to-Equity Ratios
Chapter 11
Page 346
Debt - to - Equity  Total Debt
Equity
FLEV  NFO
CSE
Problems with Debt-to-Equity ratio:
• Excludes financial assets (which effectively
decrease debt)
• Includes operating liabilities
Median Debt-to-Equity is 1.17
Median FLEV is 0.40
McGraw-Hill/Irwin
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11 Student -16
Reformulated
Financial
Statements:
Nike, Inc.
Net dividends
Stock issues
Stock repurchases
Common dividends
Reformulated
Statements of
Comprehensive income
Stockholders’ Equity
Net income reported
Currency translations
Preferred dividends1
$ 33
(19)
(82)
553
(18)
0
Ending balance
1
Chapter 11
Page 349
Exhibit 11.1
McGraw-Hill/Irwin
(68)
$ 19
(143)
(69)
535
400
16
0
$2,431
$1,642
$1,741
$1,964
Beginning balance
1994
1995
1996
(193)
$ 6
(140)
(59)
(193)
416
299
(7)
0
292
1,964
1,741
Preferred dividends sere less than $0.5 million
© The McGraw-Hill Companies, Inc., 2001 All rights
11 Student -17
1996
1995
1994
Net Operating Assets
Operating Assets:
Cash1
Account receivable (less doubtful
accounts of $43, $33 and $28)
Inventories
Prepaid expenses
Property, plant and equipment (net)
Goodwill
Trademarks and other intangibles
Accumulated amortization
Deferred income taxes and other assets
Reformulated
Financial
Statements:
Nike, Inc.
Operating Liabilities:
Accounts payable2
Accrued liabilities
Income taxes payable
Deferred income taxes
Other liabilities3
Reformulated
Balance Sheets
$
27
$
1,346
931
94
643
$
328
210
(63)
(455)
(480)
(79)
(2)
(41)
475
200
3,716
(1,057)
2,659
20
$
1,053
630
74
555
$330
209
(43)
(298)
(345)
(36)
(18)
(42)
496
119
2,947
(739)
2,208
15
704
470
40
406
$182
12
(31)
(211)
(182)
(38)
(18)
(40)
163
72
1,870
(489)
1,381
Net Financial Obligations
Cash equivalents1
Current portion of long-term debt
Notes payable4
Long-term debt
Redeemable preferred stock5
Common Stockholders’ Equity
Chapter 11
Page 349
Exhibit 11.1
McGraw-Hill/Irwin
1
(235)
7
446
10
0
228
2,431
(196)
32
397
11
0
244
1,964
(503)
4
127
12
0
(360)
1,741
Cash and cash equivalents are split between operating cash and cash investments.
Some accounts payable are interest bearing but this cannot be discovered.
3 Other liabilities are primarily long-term deferred endorsement payments for promotions.
4 Notes payable are interest bearing.
5 Preferred
© Thestock
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Companies,
Inc., 2001 All rights
11 Student -18
is less than $0.5
million.
2
1996
1995
1994
Operating Income
Revenues
Cost of sales
Gross margin
Operating expenses
Administrative expenses
Advertising1
Amortization of intangibles2
Operating income from sales
(before tax)
Taxes
Tax as reported
Tax on other operating income
Tax on financial items
Operating income from sales
Other operating income (expense)
Nonrecurring change2
Tax on other items
Reformulated
Financial
Statements:
Nike, Inc.
Reformulated
Income Statements
Currency translations
$6,471
3,907
2,564
$977
643
22
1,642
922
346
9
(18)
Operating income
355
567
(18)
$4,761
2,865
1,896
$730
495
13
250
4
(1)
(11)
4
(7)
16
549
1,238
658
253
405
9
$3,790
2,301
1,489
$614
373
8
192
3
(2)
(7)
3
(4)
(7)
414
995
494
193
301
11)
290
Financing Expense (Income)
Interest expense
Interest income2
Tax effect3
Net interest expense
Preferred dividends
Comprehensive income to Common
Chapter 11
Page 350
Exhibit 11.1
McGraw-Hill/Irwin
39
(16)
23
(9)
14
(0)
14
535
24
(27)
(3)
1
(2)
(0)
(2)
416
15
(19)
(4)
2
(2)
(0)
(2)
292
1
Broken out from selling and administrative expenses in published income statement.
Included in “other expense” in income statement. The nonrecurring changes in 1995
and 1994 relate to shutdown of certain facilities.
3 Marginal
© tax
Therate
McGraw-Hill
Companies,
All1994,
rights
was 38.5%, 38.5%
and 39.1% inInc.,
1996,2001
1995 and
respectively.
2
11 Student -19
Reformulated
Financial
Statements:
Reebok
International,
Ltd.
Reformulated
Statements of
Stockholders’ Equity
1996
Beginning balance1
Net dividends
Stock issues
Stock repurchases
Common dividends2
$
$ 15
(687)
(21)
1995
941
$
(693)
$ 11
(225)
(24)
133
165
12
3
1994
999
$
856
(238)
$ 15
(113)
(25)
(123)
180
254
12
0
266
Comprehensive income
Net income reported
Currency translations
Preferred dividends1
139
(6)
0
Ending balance3
$
381
$
941
$
999
1
Balances exclude unearned compensation (treated as an operating asset) and include dividends payable (treated as a
liability in annual report). The 1995 balance excludes a charge for put options issued; this has been netted out against a
put option liability, and the 1996 expiration of the option has been excluded from the 1996 statement (to simplify the
example).
2
Dividends include changes in dividends payable.
3
The stock repurchase in 1996 was completed at the end of August and was financed by the issue of long-term debt (see
balance sheet).
Chapter 11
Page 351
Exhibit 11.2
McGraw-Hill/Irwin
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11 Student -20
1996
1995
1994
Net Operating Assets
Operating Assets:
Cash 1
Account receivable (less doubtful
Accounts of $44, $46 and $45)
Inventory
Deferred taxes
Prepaid expenses
Property, plant and equipment
Goodwill
Trademarks and other intangibles
Accumulated amortization
Other assets
Operating assets
Reformulated
Financial
Statements:
Reebok
International,
Ltd.
Operating Liabilities:
Accounts payable
Accrued expenses
Income taxes payable
Reformulated
Balance Sheets
$
12
$
591
545
77
26
185
$
34
116
(80)
(196
(169)
(66)
70
60
1,566
(431)
1,135
$152
116
(204)
(166)
(145)
(48)
8
$
8
507
635
71
45
192
532
625
69
30
165
64
57
1,579
96
48
1,573
(359)
1,220
(171)
(157)
(101)
(429)
1,144
Net Financial Obligations 2
Cash equivalents 1
Notes payable
Current portion of long-term debt
Long-term debt
CSE and Minority Interest
Minority Interest
Chapter 11
Page 351
Exhibit 11.2
McGraw-Hill/Irwin
Common Stockholders’ Equity
(220)
33
53
854
720
(72)
67
1
252
248
(76)
64
5
131
124
415
972
1020
34
31
21
381
941
999
1
Cash and cash equivalents divided between operating cash and cash investments.
2
Excludes
payable whichCompanies,
is included in stockholders’
© dividends
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Inc., 2001 equity.
All rights
11 Student -21
1996
1995
1994
Operating Income
Reformulated
Financial
Statements:
Reebok
International,
Ltd.
Reformulated
Income Statements
Sales
Cost of sales
Gross margin
Operating expenses
Administrative expenses
Advertising1
Amortization of intangibles
Operating income from sales
(before tax)
Taxes
Tax as reported
Tax on other operating income
Tax on financial items
Operating income from sales
Other operating income (expense)
Other income
Nonrecurring change2
Tax on other items
Currency translations
$3,479
2,144
1,355
$864
202
4
84
(2)
11
4
____
4
(2)
2
(6)
Operating income
1,070
265
93
172
(4)
$3,481
2,114
1,367
$842
158
4
99
25
7
3
(72)
(69)
25
(44)
12
168
1,004
363
131
232
(32)
$3,280
1,966
1,314
$727
163
3
154
(3)
4
7
___
7
(3)
4
12
200
893
421
155
266
16
282
Financing Expense (Income)
Interest expense
Interest income
Tax effect3
Premium from put options
Minority Interest
Chapter 11
Page 352
Exhibit 11.2
Comprehensive income to Common
1
42
(11)
31
11
26
(7)
19
7
17
(6)
11
4
_____
3
_____
(15)
(11)
(9)
133
180
266
Broken out from selling and administrative expenses in published income statement.
The change in 1995 is due to consolidation and streamlining of facilities and to the sale of the Avia subsidiary.
3 Marginal tax©
McGraw-Hill/Irwin
The
McGraw-Hill
Companies,
Inc.,
2001
All rights
11 Student -22
rate
was
35.4%, 36.2% and
36.9% for 1996,
1995
and 1994,
respectively.
2
First Level Breakdown of ROCE:
Nike, Inc. and Reebok Int’l, Ltd.
1996
ROCE
ROCE Before Minority Interest
RNOA
Financial Leverage Drivers
NBC
SPREAD
FLEV
1995
Nike
Reebok1
Nike
Reebok
24.3%
22.5%
22.6%
17.6%
18.8%
14.1%
23.1%
18.6%
19.2%
16.9%
6.0%
16.6%
0.107
4.9%
9.2%
0.515
–3.4%
19.7%
–0.031
4.8%
12.1%
0.187
17.3%
14.1%
0.369
11.5%
8.3%
0.321
18.0%
14.8%
0.342
13.5%
10.3%
0.333
Operating Liability Leverage Drivers
ROOA
OLSPREAD
OLLEV
2
Nike:
Reebok:
McGraw-Hill/Irwin
Nike:
Reebok:
ROCE
=
RNOA
+
[FLEV x SPREAD]
24.3%
18.8%
=
=
22.6%
14.1%
+
+
[0.107 x 16.6%]
[0.515 x 9.2%]
RNOA
=
ROOA
+
[OLLEV x OLSPREAD]
22.6%
14.1%
=
=
17.3%
11.5%
+
+
[0.369 x 14.1%]
[0.321 x 8.3%]
© The McGraw-Hill Companies, Inc., 2001 All rights
11 Student -23
1996
Nike’s 1996
Reformulated
Income
Statements
Operating Income
Revenues
Cost of sales
Gross margin
Operating expenses
Administrative expenses
Advertising
Amortization of intangibles
Operating income from sales
(before tax)
Taxes
Tax as reported
Tax on other operating income
Tax on financial items
Operating income from sales
Other operating income (expense)
Nonrecurring change
Tax on other items
Currency translations
Operating income
Chapter 11
Page 350
Exhibit 11.1
Financing Expense (Income)
Interest expense
Interest income
Tax effect
Net financing expense (income)
Comprehensive income to Common
1995
$6,471
3,907
2,564
$977
643
22
1,642
1994
$4,761
2,865
1,896
$730
495
13
1,238
922
346
9
(18)
39
(16)
355
567
(18)
549
23
(9)
14
535
$3,790
2,301
1,489
$614
373
8
658
250
4
(1)
(11)
4
(7)
16
253
405
9
414
24
(27)
(3)
1
(2)
416
995
494
192
3
(2)
(7)
3
(4)
(7)
15
(19)
193
301
(11)
290
(4)
2
(2)
292
ROCEt = earnt / average CSEt or ROCEt = (OIt - NFEt) / average (NOAt - NFOt)
= 535 / average CSEt
= ( 549 - 14 ) / average (NOAt - NFOt)
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
11 Student -24
1996
Nike’s 1996
Reformulated
Balance
Sheets
Net Operating Assets:
Operating assets:
Cash
Account receivable, net
Inventories
Prepaid expenses
94
Property, plant & equipment
Goodwill
$328
Trademarks & other intangibles
210
Accumulated amortization
(63)
Deferred income taxes & other assets
Operating liabilities:
Accounts payable
Accrued liabilities
Income taxes payable
Deferred income taxes
Other liabilities
Net Financial Obligations:
Cash equivalents
Current portion of long-term debt
Notes payable
Long-term debt
(455)
(480)
(79)
(2)
(41)
(235)
7
446
10
Common Stockholders' Equity
1995
$
27
1,346
931
1994
$
20
1,053
630
74
(1,057)
2,659
228
2,431
555
$330
209
(43)
(298)
(345)
(36)
(18)
(42)
15
704
470
40
643
475
200
3,716
$
496
119
2,947
(739)
2,208
(196)
32
397
11
244
1,964
406
$182
12
(31)
(211)
(182)
(38)
(18)
(40)
(503)
4
127
12
163
72
1,870
(489)
1,381
(360)
1,741
ROCEt = earnt / average CSEt
= 535 / [( 2,431 + 1,964 ) / 2] = 24.3%
Chapter 11
Page 349
Exhibit 11.1
McGraw-Hill/Irwin
or ROCEt = (OIt - NFEt) / average (NOAt - NFOt)
= (549 - 14) / [( 2,659 + 2,208 ) / 2 - ( 228+ 244 ) / 2] = 24.3%
© The McGraw-Hill Companies, Inc., 2001 All rights
11 Student -25
First Level Breakdown: Reebok
Chapter 11
Page 353
Box 11.7
OI t  NFEt
ROCE t 
NOAt  NOAt 1   NFOt  NFOt 1 / 2
168  35

(1,135  2(1,220))  (754  2(279))/ 3
 17.6%
What about Minority Interests?
168  20
ROCE t 
(1,135  2(1,220))  (720  2(248))/ 3
 18.8%
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
11 Student -26
Cutting to the Core: ROCE Drivers
Chapter 11
Page 339
• First Level Breakdown: Distinguish operating and
financial profitability and the effects of leverage
OI t  NFEt
ROCE t 
Shorthand notation
CSEt
for average CSE
OI t
NFEt
ROCE t 

CSEt CSEt
ROCE t 
NOAt OI t
NFOt NFEt



CSEt NOAt CSEt NFOt
CSEt  NFOt
1  FLEVt
CSEt
RNOAt
FLEVt
NBCt
ROCE t  RNOAt  FLEVt RNOAt  NBCt 
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
11 Student -27
Breaking Down ROCE Drivers
Chapter 11
Pages 352-353
Table 11.2
ROCE t  RNOAt  FLEVt RNOAt  NBCt 
for Nike:


549
(228  244) 2 
549
14



2,659  2,208 / 2 (2,431  1,964) 2  (2,659  2,208) 2 (228  244) / 2 
 0.226  0.107  0.226  0.060  24.3%
for Reebok:
 0.141  0.515  0.141  0.049  18.8%
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
11 Student -28
Cutting to the Core:
Drivers of Operating Profitability
• Second Level Breakdown:
(3)
Financial Leverage:
•
Amount of leverage
•
Spread
Chapter 11
Page 354
ROCE t  RNOAt  FLEVt  RNOAt  NBCt 
OI t
OI t Salest


NOAt Salest NOAt
(1)
Operating profit margin:
The profitability of each
dollar of sales
McGraw-Hill/Irwin
(2)
Asset Turnover:
The ability to generate sales
for a given asset base.
© The McGraw-Hill Companies, Inc., 2001 All rights
11 Student -29
Profit Margin and Asset Turnover
Combinations for 238 Industries, 1963-96
1
2
3
4
5
6
Chapter 11
Page 355
Figure 11.3
7
Asset Turnover
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
11 Student -30
Typical Levels for
ROCE, FLEV,
OLLEV, RNOA,
PM and ATO
Chapter 11
Page 356
Table 11.3
McGraw-Hill/Irwin
ROCE(%)
FLEV
OLLEV
Pipelines
17.1
1.093
0.154
Tobacco
15.8
0.307
Restaurants
15.6
Printing and publishing
RNOA(%)
PM(%)
ATO
12.0
27.8
0.40
0.272
14.0
9.3
1.70
0.313
0.306
14.2
5.0
2.83
14.6
0.154
0.374
13.6
6.5
2.20
Business services
14.6
0.056
0.488
13.5
5.2
2.95
Chemicals
14.3
0.198
0.352
13.4
7.1
1.91
Food stores
13.8
0.364
0.559
12.0
1.7
7.39
Trucking
13.8
0.641
0.419
10.1
3.8
2.88
Food products
13.7
0.414
0.350
12.1
4.4
2.74
Communications
13.4
0.743
0.284
9.1
12.5
0.76
General stores
13.2
0.389
0.457
11.3
3.5
3.55
Petroleum refining
12.6
0.359
0.487
11.2
6.0
1.96
Transportation equipment
12.5
0.369
0.422
11.2
4.5
2.47
Airlines
12.4
0.841
0.516
9.0
4.3
1.99
Utilities
12.4
1.434
0.272
8.2
14.5
0.59
Wholesalers, non-durable goods
12.2
0.584
0.461
10.2
2.3
3.72
Paper products
11.8
0.436
0.296
10.2
5.9
1.74
Lumber
11.7
0.312
0.384
10.4
4.0
2.60
Apparel
11.6
0.408
0.317
10.1
4.0
2.55
Hotels
11.5
1.054
0.201
8.5
8.2
1.04
Shipping
11.4
0.793
0.205
9.1
12.6
0.61
Amusements and recreation
11.4
0.598
0.203
10.1
9.5
1.10
Building and construction
11.4
0.439
0.409
10.6
4.5
2.06
Wholesalers, durable goods
11.2
0.448
0.354
9.9
3.4
2.84
Textiles
10.4
0.423
0.266
9.3
4.3
2.09
Primary metals
9.9
0.424
0.338
9.4
5.0
1.80
Oil and gas extraction
9.1
0.395
0.263
8.3
13.0
0.57
Railroads
7.3
0.556
0.362
7.1
9.7
0.78
© TheStandard
McGraw-Hill
Companies,® Inc., 2001 All rights
Source:
& Poor’s COMPUSTAT
11 Student -31
Breaking Down ROCE Drivers
Chapter 11
Page 359
Table 11.4
ROCE t  PM t  ATOt  FLEVt RNOAt  NBCt 
for Nike:
549 6,471

 0.107  0.226  0.059
6,471 2,433.5
 0.084  2.659  0.107  0.226  0.059

for Reebok:
 0.048  2.919  0.515  0.141  0.049
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
11 Student -32
Third Level Breakdown
Chapter 11
Page 357
ROCE t  PM t  ATOt  FLEVt  Spread t
Profit Margin Drivers
McGraw-Hill/Irwin
Asset Turnover Drivers
© The McGraw-Hill Companies, Inc., 2001 All rights
11 Student -33
Cutting to the Core :
Profit Margin Drivers
Chapter 11
Page 357
• Third level breakdown:
PM  Sales PM + Other operating income PM
Sales PM =
GM Admin Exp Selling Exp R & D Taxes





Sales
Sales
Sales
Sales
Sales
by product
or line of business
benefit
or expense?
GM  Sales  Cost of Sales
Other OI PM = Other Operating Income/Sal es
=
McGraw-Hill/Irwin
Subsidiary Income Equity Dividends


Sales
Sales
Special Items Other Net Gain & Losses
+


Sales
Sales
© The McGraw-Hill Companies, Inc., 2001 All rights
11 Student -34
1996
Nike’s 1996
Reformulated
Income
Statements
Operating Income
Revenues
Cost of sales
Gross margin
Operating expenses
Administrative expenses
Advertising
Amortization of intangibles
Operating income from sales
(before tax)
Taxes
Tax as reported
Tax on other operating income
Tax on financial items
Operating income from sales
Other operating income (expense)
Nonrecurring change
Tax on other items
Currency translations
Operating income
Financing Expense (Income)
Interest expense
Interest income
Tax effect
Net financing expense (income)
Comprehensive income to Common
Chapter 11
Page 359
Table 11.4
McGraw-Hill/Irwin
1995
$6,471
3,907
2,564
$977
643
22
1,642
1994
$4,761
2,865
1,896
$730
495
13
1,238
922
346
9
(18)
39
(16)
355
567
(18)
549
23
(9)
14
$3,790
2,301
1,489
$614
373
8
658
250
4
(1)
(11)
4
(7)
16
253
405
9
414
24
(27)
535
(3)
1
(2)
416
995
494
192
3
(2)
(7)
3
(4)
(7)
15
(19)
193
301
(11)
290
(4)
2
(2)
292
GM Admin Exp Selling Exp R & D Taxes




Sales
Sales
Sales
Sales
Sales
2,564 977
643
22
355
=




6,471 6,471 6,471 6,471 6,471
Sales PM =
=39
.6 15.1  9.9  0.3Companies,
 5.5
© The
McGraw-Hill
Inc., 2001 All rights
11 Student -35
Chapter 11
Page 359
Table 11.4
Second and Third Level
Breakdown: Nike and Reebok
1996
Second Level:
RNOA
Profit Margin
Asset Turnover
Third Level:
Profit Margin Drivers (%):
Gross margin ratio
Administrative expense ratio
Advertising expense ratio
Amortization expense ratio
Sales PM before tax
Tax expense ratio
Sales PM
Other items PM
Sales PM =
McGraw-Hill/Irwin
Nike
22.6%
8.5%
2.66
Reebok
14.1%
4.8%
2.92
1995
Nike
Reebok
23.1%
16.9%
8.7%
5.7%
2.65
2.94
39.6
(15.1)
(9.9)
(0.3)
14.2
(5.5)
8.8
(0.3)
8.5
38.4
(24.8)
(5.8)
(0.1)
7.6
(2.7)
4.9
(0.1)
4.8
39.8
(15.3)
(10.4)
(0.3)
13.8
(5.3)
8.5
0.2
8.7
39.3
(24.2)
(4.5)
(0.1)
10.4
(3.8)
6.7
(0.9)
5.7
GM Admin Exp Selling Exp R & D Taxes




Sales
Sales
Sales
Sales
Sales
© The McGraw-Hill Companies, Inc., 2001 All rights
11 Student -36
Cutting to the Core :
Asset Turnover Drivers
Chapter 11
Pages 357-358
• Third level breakdown:
1
Cash Acc. Rec. Inventory
PPE
=




ATO Sales
Sales
Sales
Sales
Subsidiar y Inv.
Payables Pension Oblig.




Sales
Sales
Sales
Some times other measures are used:
Days in Acc. Receivable = Acc. Receivable/ Avg. Sales per day
Inventory Turnover = Cost of Sales / Avg. Inventories
Acc. Payable Turnover = Purchases / Avg. Acc. Payable
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
11 Student -37
Chapter 11
Page 359
Table 11.4
Second and Third Level
Breakdown: Nike and Reebok
1996
Second Level:
RNOA
Profit Margin
Asset Turnover
Third Level:
Cash turnover
Accounts receivable turnover
Inventory turnover
Prepayments turnover
PPE turnover
Intangibles turnover
Other assets turnover
Operating assets turnover
Accounts payable turnover
Accrued expense turnover
Taxes payable turnover
Nike
22.6%
8.5%
2.66
Reebok
14.1%
4.8%
2.92
1995
Nike
Reebok
23.1%
16.9%
8.7%
5.7%
2.65
2.94
.004
.185
.121
.013
.093
.075
.025
.515
(.058)
(.064)
(.008)
.376
.003
.154
.174
.011
.055
.019
.038
.453
(.051)
(.044)
.343
.004
.185
.116
.012
.101
.069
.020
.506
(.053)
(.055)
(.012)
.377
.002
.149
.181
.011
.051
.023
.035
.453
(.048)
(.043)
.340
1
Cash Acc. Rec. Inventory
PPE
=




ATO Sales
Sales
Sales
Sales
Subsidiar y Inv.
Payables Pension Oblig.




Sales
Sales
Sales
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
11 Student -38
Other Operating Income
• Other operating income can sometimes be analyzed
with specific operating ratios
Subsidiary income
Return on subsidiary investment =
Subsidiary investment
Dividend income
Dividend Return =
Equity investment at lower of cost or market
Question: Is the dividend return a good measure of the
profitability of the investment ?
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
11 Student -39
Chapter 11
Page 5
Cutting to the Core:
The Analysis of Profitability
ROCE  Comprehensive Income/Ave
rage CSE
 RNOA  [FLEV x SPREAD]
FLEV 
NFO
CSE
RNOA  OI/NOA
 ROOA  (OLLEVx OLSPREAD)
Level 1
RNOA
Level 2
Level 3
PM = OI / Sales
Sales PM
Gross Margin Ratio
McGraw-Hill/Irwin
SPREAD  RNOA - NBC
NBC 
NFE
NFO
ATO = Sales / NOA
Other Items PM
Expense Ratios
Other OI/Sales
Ratios
Individual Asset and
Liability Turnovers
© The McGraw-Hill Companies, Inc., 2001 All rights
Borrowing Cost
Drivers
11 Student -40
What-If Questions:
Nike and Reebok
Chapter 11
Page 361
Box 11.8
• What-If Nike increased its accounts receivable turnover from 5.4 to
Reebok’s 6.5 in 1996? How would RNOA change?
• The Answer: The increase would result in a reduction of average
accounts receivable by $204 million to $996 million. If this reduction
had no effect on sales (and it might!), overall ATO would increase
from 2.66 to 2.90 and RNOA from 22.6% to 24.6%.
• What-If Nike’s gross margin ratio had declined to Reebok’s 38.4% in
1996? How would RNOA change?
• The Answer: A reduction in gross margin of 1.2% is a reduction of
0.738% after tax at a rate of 38.5%. This results in a drop of operating
PM after tax from 8.48% to 7.75% and a drop in RNOA to 20.6%.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
11 Student -41
What-If Questions:
Nike and Reebok
Chapter 11
Page 361
Box 11.8
• What-If Reebok increased its annual advertising expenditures by $50
million from their 1996 level, resulting in $300 million of additional
sales at the same gross margin percentage?
• The Answer: The increased advertising would result in an additional
$115.2 million in gross margin and, after the increase in adverting
expenses, an additional $42.1 million in after-tax operating income,
yielding a profit margin of 5.56%. The advertising expense ratio
would increase from 5.8% to 6.7% of sales, but this increase produces
an increased profit margin. If no further investment is needed to
generate the sales, ATO also increases and the RNOA would increase
from 14.1% to 17.6%. But, if inventories and receivables and assets
increase proportionally to support the sales, so that ATO remains
unchanged, RNOA would increase to only 16.2%.
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
11 Student -42
Third-Level Breakdown: Analysis
of Net Borrowing Cost
Chapter 11
Page 360
 FO After- tax Intereston FinancialObligations 
NBC  
x

NFO
FO

 FA After- tax Intereston FinancialAssets

x

FA
 NFO
 FA UnrealizedGains on FA 

x

NFO
FA

 P referredStock
P ref.Divs. 

x
  --NFO
P
r
eferred
Stock


McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
11 Student -43
Analysis of Net Borrowing Cost:
Nike, Inc.
Chapter 11
Page 361
 452 39 x 1  .385  216 16 x 1  .385
NBC  
x
 
x


452
216
 236
  236
 452
  216


x 5.31%  
x 4.56%
 236
  236

 6.0%
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., 2001 All rights
11 Student -44