ACCT 30001

Lecture 5: Analysing
Profitability
 Framework - Business A
The Context of Todays Lecture: Analysis of Profitability

·2·
 Learning Objectives

• To understand the economic drivers of firm value (ROIC) and return

to shareholders (ROE)

• To be able to attribute the firm into operational and financial

activities

• To under the impact of financial leverage on ROCE

• To use analysis (and ratios) to provide insight into the drivers of

firm profitability and how they aggregate to explain Return on
Common Equity and ROIC

• Understand the limitations of ratio and financial statement analysis12-3

 Lecture Structure

Framework for
Analysing the Attribute firm Competitive Use financial
Profitability of the between operating Evaluating Financial Evaluating ROIC Advantage and reports to improve
firm (ROIC) and the and financing Management and Operations Statistical the welfare of
Return to activities Properties of ROIC society
Shareholders (ROE)

4
 Reading (all on LMS)

• ReadingWeek5_Ratios (Chapter 8 “Return on Invested Capital and

Profitability Analysis from Financial Statement Analysis by K.R
Subramanyam)
• The Five Competitive Forces that Shape Competition by Michael Porter
(from Harvard Business Review)
• Excel Spreadsheet with template for ratio analysis to accompany
lecture (analysis of Woolworths)
• Woolworths 2021 Annual report
Woolworths Example using 30 June 2021
Framework for Analysing
the Profitability of the
Firm (ROIC) and the
Return to Shareholders
(ROE)
 Framework for Analyzing the Firm
growthhhhhhhhhhh

·8·
 Framework for analysing profitability of the
firm (ROIC) and return to Share Holders
(ROE)

Net Operating Assets Net Operating Profit

Source of Capital (CI) Financing Costs ROE
(IC= NOA) after Tax (NOPAT)
• Debt (NFO) • Net Working • Net Operating • Net Borrowing • Net Profit = NOPAT
• Shareholders Capital Profit before Costs on Debt less borrowing
Equity (SE) = • Long-Term financing expenses - (NBC) costs (NBC)
• Retained Resources: (NOPAT) • ROE = Net Profit/SE
Earnings • PPE • ROIC =NOPAT/IC
• Paid Capital • Intangibles
 Framework for Analyzing Firm(ROIC) and
Shareholder Profitability (ROE)
Return on common equity (ROE)

Return from operating activities Return from financing activities

Return on Invested Capital Financial leverage

(ROIC)

Profit margin Asset turnover X Financial leverage x spread

X

Gross margin and expense drivers Individual asset and liability drivers Net borrowing cost drivers
 Analysing the Firm (ROIC) and Return to
Shareholders (ROE
Ø ROE =ROIC +( Financial Leverage *Spread)

• ROE = Net Profit/Share Holders Equity

• ROIC (also referred to also referred to as RNOA) is the return

on capital (net operating assets) before financing costs

• Financial leverage is the ratio of debt financial obligations

(Debt) to shareholders equity (Debt/Shareholders Equity)

• Spread is the difference between ROIC and net borrowing

costs (NBC)
 Analysing the Firm (ROIC) and ROE
Ø ROE =ROIC +( Financial Leverage *Spread)
!"# $%"&'#()* +&,-(# .-#"& /'0 (!$+./)
• Return on Invested Capital (ROIC or RNOA)=
3'%(#'4 5)6"7#"8 (,& !"# $%"&'#()* '77"#7)

!"# 9":# (9":#)

• Financial Leverage =
;<'&"<,48"&7 =>?(#@ (;=)

!"# A()')B('4 =0%")7"7 (!A=)

• Net Borrowing Costs (NBC) =
!"# 9":# (9":#)

• Spread = ROIC – Net Borrowing Costs (NBC)

* Note that Total Capital Invested = Net operating assets (NOA) and therefore ROIC can also be referred to as Return on
!"# $%"&'#()* +&$,(# -,#"& .'/ (!1+-.)
Net Operating Assets ( RNOA) = !"# 1%"&'#()* -33"#3
 Woolworths: Return on Equity

• Return on Equity (ROE) is the final return to

ordinary shareholders on capital invested

!"# +&,-(# (!+) C"77 +&"-"&")B" 9(6(8")87

• 𝑅𝑂𝐸 =
.6"&'*" ;<'&"<,48"&7 =>?(#@

$EF,HIJ
• 𝑅𝑂𝐸 = = 39.71%
$EK,ILM
 Analysing the Firm (ROIC)

• ROE (39.71%) =ROIC +( Financial Leverage *Spread)

!"# $%"&'#()* +&,-(# .-#"& /'0 (!$+./)
• Return on Invested Capital (ROIC or RNOA)=
3'%(#'4 5)6"7#"8 (,& !"# $%"&'#()* '77"#7)
Woolworths: Source of Capital
Sources Of Capital
2021A 2020A Average
$m $m $m
Net Debt Obligations
Current
Borrowings 119 2,027
Lease Liabilities 1,495 1,826
1,614 3,853
Non-Current
Borrowings 2,753 1,904
Lease Liabilities 10,521 12,902
13,274 14,806

Total Debt 14,888 18,659 16,774

Shareholders Equity (SE) 1,739 9,032 5,386
Total Capital Invested (CI) 16,627 27,691 22,159

Leverage Debt/SE 856% 207% 311%

Net Operating Profit After Tax (NOPAT): Attribute
Net Profit (NP) between Operating (NOPAT) and
Financing (NFE)
Net Profit (NP) and Net Operating Profit After Tax (NOPAT)
2021A 2020A
$m $m

Net Profit 2,139 1209

Add Back Net Financial Expenses (NFE)

Interest Expense (note 2.3 =528+102-10) 620 856
Tax Benefit (assume 30%) (186) (257)
NFE# 434 599

Net Operating Profit After Tax (NOPAT) 2,573 1,808

# Can be computed as gross Financial Expenses * (1-Tax rate)

 Woolworths: Return on Invested Capital
(ROIC also referred to as RNOA)

!"#$% !"#$%
• 𝑅𝑂𝐼𝐶 = 𝑅𝑁𝑂𝐴 = =
!"$ &'()*'+ ,-./0*/1

$34,678
• 𝑅𝑂𝐼𝐶 = = 11.61%
$344,96:
 Benchmark for evaluating ROIC
(RNOA)

• Two possible benchmarks:

― An appropriate benchmark for evaluating operating
ROIC is the weighted average cost of (debt and
equity) capital (WACC)
― Average for large Australian firms over long term is 8
to 10%
― Woolworths current WACC = 6.01%
― Competitor Companies
― Benchmark Coles ROIC = 10.12%
― Benchmark Consumer Staples ROIC =16.1%
· 18 ·
 ROIC: Variations on Computation in Practice

• While ROIC is one of the most important performance metrics there

is significant variation in practice as to how computed
• These variations could be motivated by providing a more informative
or precise metric but could also be motivated by opportunistic
incentives to increase reported ROIC
• The two main choices and variations are:
― The numerator (Profit). Adjusting for non-recurring items
― The denominator (Capital). Adjusting and removing investments that are
considered non-operating such as investments in financial assets
 Woolworths: Return on Invested Capital
(ROIC) adjusted for non-recurring

!"#$%;/<=>/ -=-?>/@A>>)-B
• 𝑅𝑂𝐼𝐶 = 𝑅𝑁𝑂𝐴 =
&'()*'+ ,-./0*/1

$34,CDC Net Operating Profit After Tax (NOPAT) before non-recurring

• 𝑅𝑂𝐼𝐶 = = 9.2% 2021A
$344,96: $m

Net Profit before Non-Recurring 1,606

Add Back Net Financial Expenses (NFE)

Interest Expense (note 2.3 =528+102-10) 620
Tax Benefit (assume 30%) (186)
NFE# 434

NOPAT before non-recurring 2,040

Woolworths: Capital Invested in Net Operating
Assets (CI= NOA)

Net Operating Assets

2021A 2020A Average
$m $m $m
Current Working Capital
Current Operating Assets 15,786 8,125
Current Operating Liabilities* (21,503) (9,604)
Working Capital (5,717) (1,479)
Long-Term Resources
Property, plant and equipment 17,030 20,804
Intangible assets 4,671 7,717
Long Term Resources 21,701 28,521
Other Net Financial Assets
Non-Current Assets 1,749 1,826
Non-Current Finnacial Libilities (1,106) (1,177)
Other 643 649

Net Operating Assets (NOA) 16,627 27,691 22,159

Total Capital Invested 16,627 27,691 22,159

*Current liabilities less current borrowings

 Woolworth: Financial Leverage

!/* E/;* F)-'-@)'+ ";+)B'*)=-0(!F")

• Financial Leverage =
IJ'>/K=+1/>0 /LA)*M (IN)

$39O,77D (!F")
• Financial Leverage =
$36,8PO (IN)

• Financial Leverage = 311%

• Benchmark (Consumer Staples)=43%
 Woolworth: Spread

• Spread = ROIC – Net Borrowing Costs (NBC)

!/* F)-'-@)'+ NQ(/-0/0 (!FN)

• Net Borrowing Costs (NBC) =
!/* E/;* F)-'-@)'+ ";+)B'*)=-0 (!F")

$3D8D
• Net Borrowing Costs (NBC) = = 2.6%
$39O,77D

• Spread = 11.61% - 2.6% = 9.01%

 Decomposing Woolworths ROE between Operating
and Financing

$!/* #>=<)* $34,98:

• 𝑅𝑂𝐸 = = = 39.7%
$$./>'B/ 0J'>/J=+1/>0 NLA)*M $36,8PO

• ROE =ROIC +( Financial Leverage *Spread)

• ROE = 11.61% + (3.11 * 9.01%) = 39.7%

• ROE = 11.61% + (28.02%) = 39.7%

Evaluating Financial
Management
 Financing Costs and Leverage

• Higher leverage increases (decreases) ROCE when spread is

positive (negative)
― ROE can be made larger than ROIC by leveraging assets
• Why not increase ROE by increasing leverage?
― Risk
― Lower Spread
― As debt increases, interest will increase and this will lower NPM

• In general capital structure stay reasonably constant and

determined by industry effects
― Woolworths Leverage = 311%
― Coles Leverage = 388%
Evaluating Operations
and ROIC
 What explains the level and changes in
ROIC?

• Most economic production in our society is conducted through firms

• Analysis of drivers of firm performance is important for:

• As a consultant and as a manager in order to identify areas for business

improvement
• For stewardship and corporate governance over a firms
• For investment and valuation by fund managers, analyst and individual
investors
• As an auditor to identify business risk
• For economic policy
 Lecture Structure for Analysing ROIC

Some Noisy (Some) Sustainability

The Primary Some
Ratio Primary and Sources
Economic empirical Stewardship
Measures of Economic of
Determinants properties of and Valuation
the Drivers of the Competitive
of ROIC ROIC
Determinants Determinants Advantage

29
 The Primary Determinants of ROIC and Firm
Value (Volume, Price and Cost)

Level and Growth in Sales

Volume
Price Premium
(example customers willing to pay a
premium for a real or perceived
ROIC

difference in quality)

Profit Margins (net profit per dollar Cost of Inputs

of sales)

Cost Structure and Efficiency Cost Efficiencies

Capital and Investment Efficiency
(example a lower investment in
working capital improves ROIC)
Operating Leverage
 Some Ratios: Decomposing ROIC

• ROE =ROIC +( Financial Leverage *Spread)

• ROIC = Net profit margin * Asset turnover

$"#$ %&#'($)*+,'-.)$ $"#$ %&#'($)*+ ,'-.)$ ("%,78) $/(1#4

• ROIC = /0(&)$(12*3#4$#5
= /(1#4
* $0(&)$(1 2*3#4$#5("%7)

• Net profit margin measures margins and thus how much the company is able to
keep as profits for each dollar of sales and measures price premiums and
operating efficiency and thus reflects both:
― Price premiums
― Operating costs
• Asset turnover indicates how many dollars of sales the firm is able to generate
for each dollar of operating assets and reflects:
― The efficiency and productivity of the capital investment (asset use efficiency)
 Some Ratios: Decomposing ROIC

!"#$% $34,678
• 𝑅𝑂𝐼𝐶 = = = 11.61% (from prior slides)
!"$ $344,96:

• ROIC = Net profit margin * Asset turnover

$!/* "(/>'*)-B #>=<)* (!"#$%) $I'+/0

• ROIC = *
I'+/0 $!/* "(/>'*)-B $00/*0(!"$)

$34,678 $366,O:D
• ROIC = *
$366,O:D $44,96:

• ROIC = 4.6% *2.51 = 11.61%

Woolworths ROIC across time? Why has
ROIC increased from 8.76% to 11.61%

2015 2016 2017 2018 2019 2020 2021

ROIC 15.18% -14.96% 13.32% 14.40% 20.93% 8.76% 11.61%
 The Primary Determinants of ROIC and Firm
Value (Volume, Price and Cost)

Level and Growth in Sales

Volume
Price Premium
(example customers willing to pay a
premium for a real or perceived
ROIC

difference in quality)

Profit Margins (net profit per dollar Cost of Inputs

of sales)

Cost Structure and Efficiency Cost Efficiencies

Capital and Investment Efficiency
(example a lower investment in
working capital improves ROIC)
Operating Leverage
 Woolworths ROIC: Analyzing Sales Growth

2015 2016 2017 2018 2019 2020 2021

ROIC 15.18% -14.96% 13.32% 14.40% 20.93% 8.76% 11.61%

Sales Growth and Level

Sales ($m) 59,001 53,664 55,034 56,965 59,984 63,675 55,694
NOA ($m) 15,369 14,500 13,025 13,279 13,633 20,652 22,159

Perc Growth in Sales -9.05% 2.55% 3.51% 5.30% 6.15% -12.53%

Perc Growth in NOA -5.65% -10.18% 1.95% 2.66% 51.49% 7.30%

Some Measures of Premiums, Operating cost and Capital Efficiency RNOA=PMxAT

PM 0.0396 -0.0404 0.0315 0.0336 0.0476 0.0284 0.0462
ATO 3.84 3.70 4.23 4.29 4.40 3.08 2.51
 The Sales Growth Volume Lever

• Level and Growth in Sales is the most important driver of firm value

• What is the total size of the potential market and economic conditions?
• What is the firm’s share of the market?
― At what point in the product life cycle is the firm/industry?
― What is the competitive advantage of the firms that will determine sales growth?

• High growth is unlikely to persist due to demand saturation and intra-

industry competition
Evidence:
Sales growth rates tend to be ‘mean reverting’: firms with above or below average rates of sale growth
tend to revert to the mean
 The Sales Volume Lever: Size of Market and
Cyclicality of Sales
• Cyclicality of Sales refers to the sensitivity of sales to
economic conditions on the economy
• Some goods are highly sensitive to good/bad economic
states (e.g. luxury goods, cars, digital equipment). Other
goods are less sensitive to economic states (e.g. food,
electric utilities)
• Firms with more cyclical patterns incur more risk than
firms with noncyclical sales and will have more variable
ROIC
 The Sales Volume Lever: Share of Market -Product
Life Cycle

• The stage and length of a firm’s product life cycle affect Sales
and thus ROIC
- Introduction = Low Sales and Negative ROIC
- Growth = Growing Sales and Positive ROIC
- Maturity = Stable Sales and Growing ROIC
- Decline = Declining sales and Positive or Declining ROIC
 The Primary Determinants of ROIC and Firm
Value (Volume, Price and Cost)

Level and Growth in Sales

Volume
Price Premium and Pricing Powr
(example customers willing to pay a
premium for a real or perceived
ROIC

difference in quality) Cost of Inputs

Profit Margins (net profit per dollar

of sales)

Provision for Stock Loss

Cost Structure and Efficiency

Capital and Investment Efficiency
(example a lower investment in Cost efficiencies
working capital improves ROIC)

Operating Leverage
 Woolworths ROIC: Analyzing Profit Margins

2015 2016 2017 2018 2019 2020 2021

ROIC 15.18% -14.96% 13.32% 14.40% 20.93% 8.76% 11.61%

Sales Growth and Level

Sales ($m) 59,001 53,664 55,034 56,965 59,984 63,675 55,694
NOA ($m) 15,369 14,500 13,025 13,279 13,633 20,652 22,159

Perc Growth in Sales -9.05% 2.55% 3.51% 5.30% 6.15% -12.53%

Perc Growth in NOA -5.65% -10.18% 1.95% 2.66% 51.49% 7.30%

Some Measures of Premiums, Operating cost and Capital Efficiency RNOA=PMxAT

PM 0.0396 -0.0404 0.0315 0.0336 0.0476 0.0284 0.0462
ATO 3.84 3.70 4.23 4.29 4.40 3.08 2.51
 The Profit Margin Lever: Gross (and Net) Profit Margin

• Possible explanations for past and future increases

(decreases) in gross profit margin
- An increase (decrease) in price
- due to increase (decrease) in demand
- due to price premium
- An increase (decrease) in unit costs due to:
- Changes in input prices of labour and raw material
- Change in production cost efficiency
- Changes in sales volume resulting in lower (higher) unit costs as fixed
costs allocated over a greater number of units (operating leverage)
- An increase (decrease) in both price and unit costs;
- Lower price to gain market share an increased volume sold gives rise to
lower unit cost
- Change in product mix sold
 Profit Margin Lever: Prices Premiums and
Pricing Power

• Price Premiums (the level of prices)

― Can a firm sell their product at a price premium compared to competitors?
(next slide)

• Pricing Power (the changes in prices)

― Can a firm pass on cost increases?
― This is a function of price elasticity of demand (see microeconomics)
― Determinants of price inelasticity:
― No or little Availability of substitutes
― Small Percentage of income
― Necessity
Pricing Power and Passing Costs On
 Profit Margin Lever: Sources of Price
Premiums
To sell a product at a price premium, a company must find a way to
differentiate its products from those of competitors:

1. Unique Products through Innovation: Innovative good and

services yield high returns on capital if they are protected by patents,
difficult to copy, or both.
2. Real (or perceived) Quality: Quality refers to any real or perceived
difference between one product or service and another for which
consumers are willing to pay a higher price.
− In the car business, for example, BMW enjoys a price premium because customers perceive
that its cars handle and drive better than comparable products that cost less
 Profit Margin Lever: Sources of Price Premium

3. Brand: A factor highly correlated and difficult to distinguish with

“Quality,” Brand is especially important when no particular quality
difference is present and customer loyalty to brands in a particular
industry allows companies to charge higher prices for their products

4. Customer Lock-In: Making the replacement costs expensive or

impractical for consumers is an ideal way to lock-in customers and keep
ROIC high for a particular company
 The Primary Determinants of ROIC and Firm
Value (Volume, Price and Cost)

Level and Growth in Sales

Volume
Price Premium and Pricing Power
(example customers willing to pay a
premium for a real or perceived
ROIC

difference in quality) Cost of Inputs

Profit Margins (net profit per dollar

of sales)

Provision for Stock Loss

Cost Structure and Efficiency

Capital and Investment Efficiency
(example a lower investment in Cost efficiencies
working capital improves ROIC)

Operating Leverage
 Profit Margin Lever: Cost of Inputs and
Provision for Stock Loss

• Cost of inputs being costs of raw materials and labour is a primary

fundamental determinant of costs and thus margins

• Provision for stock loss is included as part of the costs of goods sold
― AASB 102 Inventories requires stock to be written down to NRV
― This write-down is included in COGS
 Profit Margin Lever: Cost Efficiency

Cost efficiency is the ability to sell products and services at a

lower cost than the competition

• Innovative Business Method includes a combination of a

company’s production, logistics, and pattern of interaction
with customers.

• Benefits of Size and Scale include buying power and thus

capacity to buy at a lower price from suppliers and capacity
to buy raw materials in bulk and get a discount
 Example Impact of Cost Efficiency on Margins

“Supermarket giant Coles Group had a pandemic like few others, with
lockdowns causing an unimaginable spike in demand. Yet chief executive
Steve Cain’s Smarter Selling cost program has remained on course. The
initiative, which in the December half included supply chain
improvements, technology enhancements and data-driven changes to
pricing, helped lift gross margin in the supermarkets division by 71 basis
points to 25.8 per cent” Australian Financial Review February 2021
 The Profit Margin Lever: Operating
Leverage

• Firms operate with a mixture of fixed and variable

costs
• Firms with a high proportion of fixed costs to total
costs are referred to as having high operating
leverage
• Firms with high proportion of fixed costs
experience significant increases (decreases) in
operating income as sales increase (decrease)
 Measuring Operating Leverage

• Fixed and Variable cost are not disclosed and thus measuring
operating leverage is difficult
• Some insight into the degree of operating leverage (DOL) can be
obtained by computing

• DOL = %∆EBIT/%∆Sales

• A DOL > 1 implies a firm has some operating leverage

• The greater the DOL then the greater the operating leverage
Why Have Woolworths Margins Increased?
 The Primary Determinants of ROIC and Firm
Value (volume, Price and Cost)

Level and Growth in Sales

Volume
Price Premium
(example customers willing to pay a
premium for a real or perceived
ROIC

difference in quality)

Profit Margins (net profit per dollar Operating Leverage

of sales)

Cost Structure and Efficiency Economies of Scale

Capital and Investment Efficiency
(example a lower investment in
working capital improves ROIC)
Cost Efficiencies
 The Investment Efficiency Lever and ATO

• Investment (or Capital) efficiency is selling more products per dollar

of invested capital than competitors

• The sales to NOA (invested capital) ratio can provide an indication of

investment efficiency, with higher sales to capital ratios reflecting
more efficiency.

$I'+/0
• ATO = = 2.51 (Woolworths 2021)
$!/* "(/>'*)-B $00/*0(!"$)
 Evaluating Investment Efficiency
(Asset Turnover)

• The Overall Asset turnover can be attributed into two

main components:

− Management of long-term assets (Sales to Long-Term

Assets)
− PPE Turnover = Sales/Average Net PPE

− Working capital management (Sales to Working

Capital)

· 55 ·
 Working Capital Asset Turnover

• Ideally a firm would like to generate sales with minimum

investment in working capital. This involves trade-offs
− Can minimize inventory but then customers do not have choice
or fast delivery
− Would like to collect sales early and pay accounts payable late
but customers prefer delayed payments and suppliers give
incentives to pay early
 Working Capital Asset Turnover

• The most significant working capital account and associated

standard turnover ratios are:

− Accounts Receivable Turnover

o Receivable Turnover = Sales / Average Accounts receivable
o Days in Acc. Receivable = 365 / Accounts Receivable Turnover
− Inventory Turnover
o Inventory Turnover = Cost of Sales / Avg. Inventories
o Days in Inventory = 365 / Inventory Turnover

− Accounts Payable Turnover

o Acc. Payable Turnover = Purchases / Avg. Acc. Payable
 Days-in-Inventory (Inventory Turnover)

• The interpretation of the level and changes in days-in-

inventory involves opposing considerations:
• Low and decreasing days-in-inventory could be:
− good as implies an efficient inventory system, liquid stock and thus involves
lower cost for financing to carrying inventory and lower risk of obsolescence
− bad as firm is carrying too little inventory and misses sales
• High and increasing days-in-inventory could be:
― good as it suggests management is anticipating an increase in sales
― bad as company has experienced a negative demand shock and/or
management has overstocked
 Days-in-Receivable (Accounts Receivable Turnover)

• Increases (decreases) in Days-in-Receivable could

be a negative or positive signal. It could reflect:
− Decreases (increases) in credit worthiness of customers; and/or
− Changes in a firms credit extension policies to stimulate sales
 Forecasting and the Investment Efficiency Lever
and ATO
• To grow, companies have to invest in production capacity
– What assets (e.g. plant, intangibles) and working capital need to be
invested in to generate the forecasted sales?

• A “benchmark” ATO (=Sales/NOA) for example from similar

companies, or the firms past history, can be used to provide some
insight into required investment in assets:
– The forecast Net Operating Assets (NOA) = Forecast Sales/BenchmarkATO
Sustainable Competitive
Advantage, Industry
Structure and Statistical
Properties of ROIC
 The Economics of Competition

• One of the most important principles in a market economy and

thus business is that competition will drive ROIC to ‘normal’
levels over time (reversion to the mean)
• Firms with abnormally high (low) ROIC tend to experience
earnings declines (increases)
― Highly profitable firms attract competition
― Poorly performing firms are made more productive or capital is reallocated

• However some firms may have ROIC above or below normal for long
periods of time due to a sustainable competitive advantage or below
because lack of market discipline
 ROIC and Reversion to the Mean

• The graph reports the subsequent ROIC for 5

portfolios of companies based on the level of
ROIC in year 0 ranked from low to high.

• The ROIC of both high and low performing

companies tends to the median, but does not
fully decay and reach the aggregate median
level

• This suggests that successful businesses can

sustain competitive advantages in their
businesses, though it also might mean that
unsuccessful business struggle to ever
establish any sort of competitive advantage
 Sustainable Competitive Advantage

• The efficient use of capital will improve

short-term ROICs, but to maintain long-
term ROICs above the cost of capital, the
company also needs a sustainable
competitive advantage

• For instance, pharmaceutical companies

tend to have high ROICs (ranging between
20-30% ) because cost of production is low
and barriers to entry (R&D and patent
protection) are high.

• See Porter (2008) reading for sources of

competitive advantage

· 64 ·
 Porter Five Sources of Competitive Advantage
(see reading)

• Rivalry amongst existing competitors

• Threat of new entrants
• Bargaining power of buyers
• Bargaining power of suppliers
• Threats of substitute products/services
 Some Empirical Properties of Profit Margins and
Asset Turnover (to discuss in workshops)
• Profit margin reverts to the mean
– due to price competition

• Total asset turnover ratio and the total leverage ratios are stable
– These ratios are determined by industry structure

• Trade-off between asset turnover and profit margin

· 66 ·
 Trade-off between Asset Turnover and Profit
Margin

• We can characterize different firms and industries by

the different trade-offs required between margins and
turnover. Determined by:

– Industry Structure
– Firms Strategy

· 67 ·
 Industry Structure: Trade-off between asset
turnover and profit margin y Structure: Trade-off
between asset turnover and profit margin

• Industry Structure
– Capital-intensive industries (which can be a barrier to
entry), such as construction and heavy equipment
manufacturing, have low turnovers and therefore charge
higher margins to get a competitive return on their
assets.
– Commodity-like industries (Discount retailers and fast
food chains) with intense competition have low margins
and therefore must have high-asset turnovers to get a
competitive return on their assets

· 68 ·
 Business Strategy: Trade-off between asset
turnover and profit margin ss Strategy:
Trade-off between asset turnover and profit margin

• Business Strategy
– A cost leadership strategy of producing at lowest cost
will have low prices and thus low margins and high
turnover.
– A product differentiation strategy with a premium
product gives rise to market pricing power and thus high
margins and low turnover

· 69 ·
12-70

Profit Margin and Asset Turnover Combinations for

238 Industries: 1963-2000

12-70
Limitations of Ratio
Analysis
 Limitations of Ratio Analysis

• Biases and Random Errors in GAAP and Reported Accounting

Numbers
– Non-Recognition of Assets and Liabilities
– Random and Biased Measurement

• Effects of Scale in the Denominator

― Given the wide variation in firm size we need to scale and this is the benefit of ratios
― The problem with scaled variables and thus ratios is that the denominator is often a noisy proxy for the
true scale of the variable of interest such as size
 Limitations of Ratio Analysis

• Aggregation of non-homogenous divisions and subsidiaries

– Financial ratios based on aggregated information may not be representative of divisions and individual
companies within the group (mask poor performance)
– There may be lack of uniformity in measurement of transactions (for example fair and HC) making them
non-additive

• Computed ratios may be biased because management is aware ratios

will be computed and may try to make them look good
Conclusion
 Conclusions

• The economic determinants of firm value (ROIC) is sales,

margins and efficiency of capital utilization
• The return to shareholders (ROE) will differ from ROIC due to
leverage
• Financial statement and ratio analysis can provide some
insight into the value of the economic drivers
• These returns are driven by competitive advantages that
enable companies to realize price premiums, cost and capital
efficiencies, or some combination of these.
• CAVEATS
― Ratios are only a guide they don’t provide answers