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CHAPTER 4

PROFITABILITY ANALYSIS

Solutions to Questions, Exercises, Problems, and Teaching Notes to Cases

4.1 Common-Size Analysis. Restating income statement line items as a percentage of

sales and balance sheets as a percentage of total assets enables the analyst to com-

pare different firms regardless of size. However, at least three possible limitations

could impact the benefits of common-size analysis. First, firms often categorize or

group expenses in different line items, which can make it difficult to force dissimi-

lar financial statements into a standardized format. Second, firms do not always

share the same fiscal year-ends; so balance sheets and income statements may be

misaligned in time, which could matter in rapidly changing economic environ-

ments. Third, firms may use or be subject to different accounting practices that may

affect the comparability of common-size financial statements.

4.2 Earnings per Share. Firms can be identical in all respects but report different earn-

ings per share due simply to different decisions regarding the number of shares out-

standing. Furthermore, one firm could have higher earnings per share than another

firm, but without knowledge about the relative levels of assets invested, it is difficult

to draw any inferences about relative performance. The ubiquity of earnings per share

in the financial press is due to the comparability of earnings per share with price per

share, the ultimate concern of investors in common stock. The inevitable use of earn-

ings per share is the computation of price-to-earnings ratios, which signal information

about the way investors, on average, are valuing the firm’s earnings series.

4.3 Pro Forma Earnings. Analysts often want managers to highlight any unusual or

nonrecurring components of reported income because the analyst is interested in

drawing inferences from the current performance for future performance, which will

be an input into valuation estimates and buy/sell decisions. Thus, managers who

proactively carve out special items are attempting to respond to the informational

demands of analysts and investors. However, unscrupulous managers may seize this

opportunity to carve out expenses that are not unusual or nonrecurring in an attempt

to artificially inflate the perceived level of current “core” earnings. Thus, analysts

and investors should be healthily skeptical of attempts to ignore certain charges or

expenses if those items are likely to recur.

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in whole or in part.

4.4 Profit Margin for ROA versus ROCE. The profit margin for ROA excludes

subtractions for the cost of debt and equity financing, whereas the profit margin for

ROCE makes subtractions for the cost of all financing senior to the common share-

holders (that is, debt and preferred stock financing). The purpose of ROA is to pro-

vide a measure of how well a firm has used assets to generate earnings without

considering how the firm financed those assets. Excluding the cost of all financing

in the numerator provides this measure of return. The purpose of ROCE is to pro-

vide a measure of how well a firm has used the capital (contributed capital plus re-

tained earnings) to generate earnings for the common shareholders. Subtracting

interest expense on borrowing and preferred dividends provides this measure of

return.

4.5 Concept and Measurement of Financial Leverage. Financial leverage involves

using assets financed with debt and preferred equity and earning a higher return on

those assets (that is, ROA) than the cost of these sources of capital. The excess of

ROA over the cost of debt and preferred equity financing belongs to the common

shareholders. Thus, the purpose of financial leverage is to increase the return to

common shareholders over the return it would realize without financial leverage.

All earnings generated by a firm before subtracting financing costs (that is, the nu-

merator of ROA) belong to the various provides of capital. All assets used to gener-

ate a return (that is, the denominator of ROA) are financed by the various providers

of capital. If the cost of debt and preferred shareholders’ capital are less than ROA,

ROCE must exceed ROA for the equalities in the preceding two sentences to hold.

4.6 Advantages of Financial Leverage. For financial leverage to work effectively,

ROA must exceed the after-tax cost of debt and preferred stock financing. One in-

terpretation of the president’s remark is that the firm is earning such a small ROA

that it barely exceeds the cost of debt and preferred stock financing. Another inter-

pretation is that the firm has very little capacity to carry debt, except at a very high

cost. For example, the firm’s products may have very short product life cycles (as

with technology firms) or the firm may have few assets that can serve as collateral

for borrowing (as with intangibles-based companies). Here again, ROA will just

barely exceed the cost of debt financing.

4.7 Disadvantages of Financial Leverage. The cost of borrowing increases as a firm

becomes more levered. Thus, although a firm’s ROA may exceed its cost of

borrowing currently, additional borrowings could carry interest rates that approach

or exceed the current ROA. On the other hand, ignoring the change in interest cost

as firms borrow more, the crucial assumption behind strategically using financial

leverage is that the firm can instantaneously deploy assets financed with the

borrowed funds and those assets will immediately generate returns commensurate

with current levels. First, there are typically lags between securing financing,

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in whole or in part.

deploying assets, getting operations up and running, and realizing returns from

investments. In the meantime, firms are saddled with costs of borrowing. Second,

there are diminishing returns to scale. Many growth firms that generate high ROA

tend to overinvest, only to realize that there are limits to their ability to scale up

operations. For example, a restaurant may find that additional restaurants merely

cannibalize sales from nearby restaurants rather than satisfy unlimited demand.

4.8 Concept of Residual Income. Residual income can be viewed as income after

inserting an additional line item on the income statement for the cost of equity capi-

tal. Net income available to the common shareholders includes subtractions from

net income for the costs of financing from sources that are senior to the common

shareholders (that is, interest expense on debt and dividends on preferred stock).

Residual income (and other similar measures such as economic value added) in-

cludes an additional subtraction for the cost of common shareholders’ equity fi-

nancing. Thus, residual income and economic value added reflect the earnings after

subtracting the required return by all providers of capital, including common equity

shareholders.

4.9 Return on Common Shareholders’ Equity versus Basic Earnings per Common

Share. The statement is correct that both ROCE and basic earnings per share use

net income available to the common shareholders in the numerator; so the reason

for the difference in comparability must relate to the denominator. The denominator

of ROCE measures the historical amount of capital provided by common share-

holders plus the capital reinvested in the form of retained earnings. This capital

finances assets that provide the base for the return in the numerator. Other things

being equal, larger amounts of capital should result in larger amounts of earnings.

On the other hand, the denominator of earnings per common share is the weighted-

average number of common shares outstanding. The number of shares outstanding

is not a meaningful measure of the capital provided by the common shareholders.

Firms tend to change the number of common shares outstanding by way of stock

dividends, stock splits, reverse stock splits, repurchases of treasury stock, and other

transactions and events. The purposes of these transactions and events include guid-

ing the market price of the firm’s stock to a desirable trading range and avoiding di-

lution. Thus, firms with larger numbers of shares outstanding do not necessarily

have more capital to finance assets than do firms with fewer shares outstanding.

The number of shares outstanding does not represent a common denominator across

firms, whereas the dollar amount of capital provided by the common shareholders

does provide a common denominator to permit inter-firm comparisons.

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in whole or in part.

4.10 Calculating ROA and Its Components.

Return on Assets = Profit Margin × Assets

for ROA Turnover

)826,9$874,0.5($13

314)$135)(35.00.1(831,$1

+−+

= 663$23,

314+135))($35.00.1(831,$1 −+

× $9,826)3,87410.5($

663,$23

18.8% = 9.4% × 2.0

4.11 Calculating ROCE and Its Components.

Return on Common Shareholders’ Equity:

($58,615 – $21,122)/[0.5($296,157 + $364,026)] = 11.4%

Profit Margin for ROCE:

($58,615 – $21,122)/($1,460,235) = 2.6%

Assets Turnover:

$1,460,235/[0.5($1,439,283 + $1,549,582)] = 0.98

Capital Structure Leverage Ratio:

[0.5($1,439,283 + $1,549,582)]/[0.5($296,157 + $364,026)] = 4.5

4.12 Calculating Basic and Diluted EPS.

Basic EPS: $609,699/488,809 = $1.25

Diluted EPS: ($609,699 + $4,482)/(488,809 + 16,905 + 6,935) = $1.20

4.13 Relating ROA and ROCE.

a. Return on Assets: [$1,062 + (1 – 0.35)($64)]/$6,934.5 = 15.9%

Profit Margin for ROA: [$1,062 + (1 – 0.35)($64)]/$5,624 = 19.6%

Assets Turnover: $5,624/$6,934.5 = 0.8

b. Return on Common Shareholders’ Equity: $1,062/$3,443.5 = 30.8%

Profit Margin for ROCE: $1,062/$5,624 = 18.9%

Assets Turnover: $5,624/$6,934.5 = 0.8

Capital Structure Leverage Ratio: $6,934.5/$3,443.5 = 2.0

c. Average total liabilities equal $3,491 ($6,934.5 – $3,443.5). Boston Scientific

earned $555 (0.159 × $3,491) on assets financed by liabilities (calculations

taken to more decimal places than shown), while the liabilities cost $42 [(1 –

0.35)($64)]. Therefore, the excess return generated for the common sharehold-

ers on assets financed with liabilities is $513 ($555 – $42). The assets financed

by common shareholders’ capital generated a return for the common sharehold-

ers of $548 (0.159 × $3,443.5). Thus, net income available to the common

shareholders equals $1,061 ($513 + $548). Almost one-half of the return to the

common shareholders results from the successful use of financial leverage.

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in whole or in part.

4.14 Relating ROA and ROCE.

a. Return on Assets: [$1,803.8 + (1 – 0.35)($359.7)]/$17,527.9 = 11.6%

Profit Margin for ROA: [$1,803.8 + (1 – 0.35)($359.7)]/$54,618.6 = 3.7%

Assets Turnover: $54,618.6/$17,527.9 = 3.1

b. Return on Common Shareholders’ Equity: ($1,803.8 – $12.5)/$6,562.3 = 27.3%

Profit Margin for ROCE: ($1,803.8 – $12.5)/$54,618.6 = 3.3%

Assets Turnover: $54,618.6/$17,527.9 = 3.1

Capital Structure Leverage Ratio: $17,527.9/$6,562.3 = 2.7

c. Average total liabilities equal $10,761.3 ($17,527.9 – $204.3 – $6,562.3).

Valero Energy earned $1,251.0 (0.116 × $10,761.3; allow for rounding) on as-

sets financed by liabilities (calculations taken to more decimal places than

shown), while the liabilities cost $233.8 [(1 – 0.35)($359.7)]. Therefore, the

excess return generated for the common shareholders on assets financed with

liabilities is $1,017.2 ($1,251.0 – $233.8). Valero Energy earned $23.7 (0.116 ×

$204.3) on assets financed by preferred shareholders’ equity, while this capital

costs $12.5. Therefore, the excess return generated for the common sharehold-

ers on assets financed with preferred shareholders’ capital is $11.2 ($23.7 –

$12.5). The assets financed by common shareholders’ capital generated a return

for the common shareholders of $762.9 (0.116 × $6,562.3) (calculations taken

to more decimal places than shown). Thus net income available to the common

shareholders equals $1,791.3 ($1,017.2 + $11.2 + $762.9 = $1,803.8 – $12.5 of

net income available to the common shareholders). Valero Energy generated

over one-half of the net income available to the common shareholders from the

successful use of financial leverage.

4.15 Analyzing Operating Profitability.

a. Return on Assets = Profit Margin × Assets

for ROA Turnover

Macy’s:

967,$24

)$588)(35.00.1($(4,803) −+ = 892,$24

)$588)(35.00.1($(4,803) −+ × $24,892

$24,967

(17.7)% = (17.7)% × 1.00

Home Depot:

744,$42

)$624)(35.00.1(260,$2 −+ = 288,1$7

)$624)(35.00.1(260,$2 −+ ×

$71,288

$42,744

6.2% = 3.7% × 1.67

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in whole or in part.

Supervalu:

333,19$

)$633)(35.00.1(($2,855) −+ = 564,44$

)$633)(35.00.1(($2,855) −+ × $44,564

$19,333

(12.6)% = (5.5)% × 2.31

The following additional ratios help in interpreting the profit margin for ROA

and assets turnover of these companies:

Cost of Goods Sold Inventory Fixed Asset

÷ Sales Turnover Turnover

Macy’s 32.2

$10,717

$24,892

05.3

$4,915

$15,009

%3.60

892,$24

009,$15 ===

Home Depot 65.2

$26,855

$71,288

22.4

$11,202

$47,298

%3.66

288,71$

298,47$ ===

Supervalu 92.5

$7,531

$44,564

56.12

$2,743

4,4513$

%3.77

564,44$

451,34$ ===

b. Macy’s performed poorly, reporting a large net loss. It also has the slowest as-

sets turnover of the three companies. Its product line is less commodity-like

than either Supervalu’s or Home Depot’s. Its clothing has a higher fashion

orientation, allowing it normally to achieve a high profit margin (lower cost of

goods sold to sales percentage). One would expect Macy’s to have the highest

profit margin. The greater use of sales personnel in stores increases its selling

expenses. Each store tends to be unique in terms of design and construction,

which increases building costs and lowers the fixed asset turnover. However,

margin is masked by the overall net loss for the year. As Macy’s reports in its

10-K, “In recent periods, consumer spending levels have been adversely

affected by a number of factors, including substantial declines in the level of

general economic activity and real estate and investment values, substantial in-

creases in consumer pessimism, unemployment and the costs of basic necessi-

ties, and a significant tightening of consumer credit. These conditions have

reduced the amount of funds that consumers are willing and able to spend for

discretionary purchases, including purchases of some of the merchandise

offered by the Company.” Its inventory turnover is, not surprisingly, the lowest

of the three companies because it uses low prices as a strategy less frequently.

As a result, its total asset turnover is the lowest of the three companies.

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in whole or in part.

Home Depot was the only profitable company, so it is the only company

showing a positive profit margin for ROA. Combined with total assets turnover

between the other two companies, Home Depot reported a respectable 6.2%

ROA when many other companies reported losses. Perhaps this reflects a com-

bination of efficient operations combined with continued demand for do-it-

yourself products, which persist during economic downturns, as homeowners

perform work that they would otherwise pay professionals to do. Nevertheless,

Home Depot’s performance deteriorated from prior years, and the 10-K states,

“… the housing, residential construction and home improvement markets have

deteriorated dramatically and more severely than was previously anticipated.”

Home Depot has the second highest COGS/Sales percentage, which falls

between the branded items sold by Macy’s and commodity items sold by

Supervalu. Home Depot’s overall asset turnover also lies between Macy’s and

Supervalu, but individual asset turnover ratios lie closer to Macy’s than to

Supervalu, which is not surprising given Home Depot’s inventory of non-

perishable products. Overall, Home Depot’s profitability likely resulted from

lower selling and administrative expenses as a percentage of sales. Home Depot

probably offers less sales help in its stores than Macy’s does. Home Depot also

holds down administrative expenses by building similar stores and spreading

such costs over a larger number of stores. Its mid-range assets turnover reflects

mid-range inventory and fixed asset turnovers. Its building costs are likely simi-

lar to those of Supervalu, but Home Depot does not turn over its inventory as

rapidly. The slower inventory turnover decreases sales and therefore decreases

the fixed asset turnover.

Supervalu sells grocery products, which are essentially commodities. There

also is extensive competition in the grocery products business. Thus, one would

expect it to have the lowest profit margin for ROA, but this was a year in which

many companies reported losses, and the grocery industry was no different. The

10-K reports, “The unprecedented decline in the economy and credit market

turmoil during fiscal 2009 combined with high food inflation and energy costs

negatively impacted consumer confidence and spending.” [Supervalu’s fiscal

year ended February 28, 2009, which management refers to as their 2009 year,

but we adopt the common treatment of describing this fiscal year as 2008

because 10/12ths of their fiscal year is in calendar 2008.] Note that it has the

highest cost of goods sold to sales percentage of the three companies, indicating

the commodity nature of its products and the relatively small markup of selling

prices over costs. Supervalu also has the highest assets turnover, the result of a

rapid inventory turnover and relatively low investment in fixed assets, especial-

ly compared to Macy’s. Supervalu’s rapid inventory turnover also results from

the perishable nature of many of its products. The rapid inventory turnover in-

creases sales and thereby the fixed asset turnover as well. Its stores are less

complicated to build and thus are less costly than those of department stores.

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in whole or in part.

4.16 Calculating and Interpreting Accounts Receivable Turnover Ratios.

a. Year 3 Year 2 Year 1

Microsoft: 0.5

$10,327

$51,122

8.4

$12,464

$60,420

7.4

391,12$

437,58$ ===

Oracle: 9.3

$4,589

$17,996

9.3

$5,799

$22,430

2.5

430,4$

252,23$ ===

b. The accounts receivable turnover of Microsoft is steady, ranging between 4.8

and 5.0. Until Year 3, Microsoft’s accounts receivable was consistently larger

than that of Oracle. One possible explanation is that Microsoft’s larger size

permits it to demand quicker payment from its customers. Another possibility is

that Microsoft distributes a higher proportion of its more standardized software

to computer hardware manufacturers and retailers. The customers of Oracle are

businesses that must install and adapt the software to their information man-

agement systems. These customers might stretch out their payments to Oracle

until installation is completed. A third possibility is that Oracle might give more

attractive credit terms as a means of stimulating sales.

c. The accounts receivable turnover of Microsoft was relatively steady during the

three years. Microsoft appears to manage its accounts receivable well, with col-

lection in approximately 73–78 days from the date of sale regardless of the

growth rate in sales. The sales growth of Oracle was large for Year 1 and Year

2, approximately 25% in each year, but sales growth dropped sharply in Year 3.

Microsoft also showed strong sales growth for Year 1 and Year 2, although

somewhat lower than that of Oracle, and suffered a sales decline in Year 3. Both

Microsoft and Oracle were subject to the economic contraction in Year 3. How-

ever, it is possible that the contraction led Oracle to tighten credit to a greater

extent, given the larger per-customer cost than that faced by Microsoft. Grow-

ing sales while contracting credit granted to customers would lead to an

increase in accounts receivable turnover.

4.17 Calculating and Interpreting Inventory Turnover Ratios.

a. Year 3 Year 2 Year 1

Dell: 8.76

$618

$47,433

1.53

$920

$48,855

2.48

024,1$

375,49$ ===

Sun

Microsystems: $5,948

$623

=9.5 $6,639

$602

=11.0 $6,778

$532

=12.7

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in whole or in part.

b. The faster inventory turnover ratio for Dell reflects its made-to-order business

strategy. It has virtually no raw materials or finished goods inventory. Across

these three years (where the average turnover ratio is 59.4 [{48.2 + 53.1 +

76.8}/3]), its work-in-process inventory is on hand for only six days (365/59.4 =

6 days). Sun Microsystems builds more complex computers to specific custom-

er specifications and likely assists in installation. Although Sun probably con-

tracts out the manufacture of some of the components of its computers, its

production cycle is longer than that of Dell; hence, Sun has a lower inventory

turnover.

c. In contrast to rapid growth experienced in the past, sales growth at Dell has

been in the low single digits over the last three years and has been slowing. Sun

has had low or decreasing sales growth over the three years. Both firms have

been experiencing declining inventory turnover, consistent with maturity of the

computer hardware market. Consumers are gradually viewing a PC as a com-

modity, and Dell’s previous advantage of being the made-to-order manufacturer

is diminishing in necessity among consumers, who can run to the local electron-

ics store and find a suitable computer. Sun’s performance has been deteriorating

through time, which triggered the acquisition attempt by Oracle (a software

provider).

4.18 Calculating and Interpreting Accounts Receivable and Inventory Turnover

Ratios.

a. Year 2 Year 1

Nucor: 12.4

$1,340

$16,593

16.7

$1,420

$23,663 ==

AK Steel: 10.2

$686

$7,003

13.4

$572

$7,644 ==

b. The faster accounts receivable turnover for Nucor reflects its sales to steel ser-

vice centers and distributors, which in turn sell to various end users. Given the

wide uses of its steel, Nucor does not depend on a single customer or even a few

major customers. Thus, it need not provide liberal credit terms. AK Steel relies

on the automobile, appliance, and construction industries and may need to pro-

vide more liberal credit terms.

c. The accounts receivable turnover of both Nucor and AK Steel increased across

years, but that of Nucor increased significantly. The growth rate in sales of

Nucor was considerably higher than that of AK Steel. Perhaps Nucor offered

less liberal credit terms during this time of increased sales or customers were

willing to pay more quickly to have access to Nucor’s steel products.

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in whole or in part.

d. Year 1 Year 2

AK Steel: 5.9

$1,371

$13,035

8.9

$2,005

$19,612 ==

Nucor: 9.7

$752

$5,904

7.10

$607

$6,479 ==

e. Nucor had higher inventory turnover than AK Steel in Year 1, but lower inven-

tory turnover in Year 2. Nucor is not an integrated steel producer. It ships rolled

steel products directly to steel service centers and distributors. AK Steel is an

integrated steel producer. It transforms raw steel into various steel products, re-

sulting in a longer production process. More detail on the composition of the

sales increases for both companies is required to understand these flips in rela-

tive inventory turnovers.

f. The inventory turnover of AK Steel increased significantly between Year 1 and

Year 2 as a result of a moderate increase in sales coupled with a decline in in-

ventories. The firm was able to sell its inventory more quickly. The inventory

turnover of Nucor was relatively stable between Year 1 and Year 2 despite the

rapid increase in sales. Nucor appears to maintain effective control systems over

its inventories regardless of the growth rate in sales. Nucor can likely change

production capacity quickly, given that it is not an integrated producer, and

manufactures more standardized products, thereby maintaining its inventory

turnover. The cost of goods sold to sales percentages in Year 1 were 78.6%

($13,035/$16,593) for Nucor and 84.3% ($5,904/$7,003) for AK Steel. The cor-

responding percentages for Year 2 were 82.9% ($19,612/$23,663) for Nucor

and 84.8% ($6,479/$7,644) for AK Steel. The significantly increased percen-

tages likely result from a combination of lower selling prices and slightly in-

creased in put prices. The increase for Nucor is surprising given the expected

economies of scale in spreading high fixed costs over a rapidly growing sales

base.

4.19 Calculating and Interpreting Fixed Assets Turnover Ratios.

a. Year 3 Year 2 Year 1

Texas Instruments: 6.3

$3,925

$14,255

7.3

$3,780

$13,835

6.3

,4573$

501,12$ ===

Hewlett-Packard: 2.14

$7,331

$104,286

7.12

$9,318

$118,364

4.10

050,11$

552,114$ ===