LectureWeek5 ProfitabilityAnalysis-5
LectureWeek5 ProfitabilityAnalysis-5
LectureWeek5 ProfitabilityAnalysis-5
Lecture 5: Analysing
Profitability
Framework - Business A
The Context of Todays Lecture: Analysis of Profitability
·2·
Learning Objectives
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)
·8·
Framework for analysing profitability of the
firm (ROIC) and return to Share Holders
(ROE)
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)
* 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
$EF,HIJ
• 𝑅𝑂𝐸 = = 39.71%
$EK,ILM
Analysing the Firm (ROIC)
!"#$% !"#$%
• 𝑅𝑂𝐼𝐶 = 𝑅𝑁𝑂𝐴 = =
!"$ &'()*'+ ,-./0*/1
$34,678
• 𝑅𝑂𝐼𝐶 = = 11.61%
$344,96:
Benchmark for evaluating ROIC
(RNOA)
!"#$%;/<=>/ -=-?>/@A>>)-B
• 𝑅𝑂𝐼𝐶 = 𝑅𝑁𝑂𝐴 =
&'()*'+ ,-./0*/1
$39O,77D (!F")
• Financial Leverage =
$36,8PO (IN)
$3D8D
• Net Borrowing Costs (NBC) = = 2.6%
$39O,77D
29
The Primary Determinants of ROIC and Firm
Value (Volume, Price and Cost)
difference in quality)
• Net profit margin measures margins and thus how much the company is able to
keep as profits for each dollar of sales and measures price premiums and
operating efficiency and thus reflects both:
― Price premiums
― Operating costs
• Asset turnover indicates how many dollars of sales the firm is able to generate
for each dollar of operating assets and reflects:
― The efficiency and productivity of the capital investment (asset use efficiency)
Some Ratios: Decomposing ROIC
!"#$% $34,678
• 𝑅𝑂𝐼𝐶 = = = 11.61% (from prior slides)
!"$ $344,96:
$34,678 $366,O:D
• ROIC = *
$366,O:D $44,96:
difference in quality)
• 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?
• 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)
Operating Leverage
Woolworths ROIC: Analyzing Profit Margins
Operating Leverage
Profit Margin Lever: Cost of Inputs and
Provision for Stock Loss
• 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
“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
• 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
• 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)
difference in quality)
$I'+/0
• ATO = = 2.51 (Woolworths 2021)
$!/* "(/>'*)-B $00/*0(!"$)
Evaluating Investment Efficiency
(Asset Turnover)
· 55 ·
Working Capital Asset Turnover
• 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
· 64 ·
Porter Five Sources of Competitive Advantage
(see reading)
• Total asset turnover ratio and the total leverage ratios are stable
– These ratios are determined by industry structure
· 66 ·
Trade-off between Asset Turnover and Profit
Margin
– 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
12-70
Limitations of Ratio
Analysis
Limitations of Ratio Analysis