Tutorial - Week6 Ans

BBF3034 – Analysis and Valuation of Financial Statements Semester 1 23/24
Tutorial Week 6 – Topic 4
Topic 4
Textbook Chapter 8
Questions – 8.2, 8.6, 8.8, 8.12
Q8.2. Why is return on invested capital one of the most relevant measures of company
performance? How do we use this measure in our analysis of financial statements?
Return on invested capital (ROIC) is considered one of the most relevant measures of
company performance because it provides insight into how efficiently a company
generates profits from its capital. ROIC is a key financial metric that evaluates the
profitability of a company by measuring the return it generates on the capital invested
in its operations. Here are some reasons why ROIC is important:
1. Efficiency Measurement: ROIC reflects how well a company utilizes its
capital to generate profits. A high ROIC indicates efficient use of capital,
while a low ROIC suggests that the company may not be utilizing its capital
effectively.
2. Comparative Analysis: ROIC allows for the comparison of companies within
the same industry. It helps investors and analysts assess which companies are
better at generating returns on their invested capital, providing a basis for
relative performance analysis.
3. Long-Term Performance: ROIC is particularly useful for assessing a
company's long-term performance. A consistently high ROIC over time
suggests that a company has a sustainable competitive advantage and is
effectively deploying its resources.
4. Investor Confidence: Investors often look at ROIC as a sign of a company's
ability to generate value. A higher ROIC can instill confidence in investors,
indicating that the company is capable of delivering strong returns on the
funds invested.
To use ROIC in the analysis of financial statements, follow these steps:

1. Calculate ROIC:
ROIC is calculated by dividing net operating profit after taxes (NOPAT) by the
average invested capital. The formula is:
Q8.6. What is the relation between return on net operating assets and sales? Consider
both NOPAT sales and sales to net operating assets in your response.
Return on Net Operating Assets (RNOA) is a financial metric that measures the
efficiency with which a company utilizes its net operating assets to generate profits.
The relationship between RNOA and sales involves understanding how effectively a
company's operating assets contribute to its overall revenue. Two key components in
SR 1
this relationship are NOPAT (Net Operating Profit After Taxes) sales and the ratio of
sales to net operating assets.
1. NOPAT Sales (Profit Margin):
 Definition: NOPAT Sales is essentially the profit margin, calculated
by dividing NOPAT by total sales.
 Formula:
 Interpretation: A higher NOPAT Sales indicates a higher profit
margin, meaning that the company is efficient in converting its sales
into operating profits.
 Relation to RNOA: RNOA is influenced by NOPAT, which includes
the operating profit earned on net operating assets. A higher NOPAT
Sales, in the context of RNOA, suggests that the company is
effectively converting its sales into operating profits in relation to its
net operating assets.
2. Sales to Net Operating Assets (Asset Turnover):

 Definition: Sales to Net Operating Assets is a measure of asset
turnover, indicating how efficiently a company uses its net operating
assets to generate sales.
 Formula:
 Interpretation: A higher Sales to Net Operating Assets ratio implies

that the company is generating more sales for every dollar invested in
net operating assets.
 Relation to RNOA: RNOA is calculated as the product of NOPAT
Sales and Sales to Net Operating Assets. Therefore, a higher Sales to
Net Operating Assets ratio contributes to a higher RNOA, as the
company is generating more sales per unit of net operating assets.
Overall Relationship:
 Positive Correlation: There is a positive correlation between RNOA and
sales. A company with a higher RNOA is generally efficient in utilizing its net
operating assets to generate profits, and this efficiency is reflected in the
relationship with sales.
 Combined Impact: Both components, NOPAT Sales and Sales to Net
Operating Assets, contribute to the overall efficiency of a company in terms of
converting sales into operating profits relative to its net operating assets. A
favorable relationship in both components enhances the overall effectiveness
of a company's operations.
Q8.8. Company X's NOPAT margin is 2% of sales. Company Y has a net operating
asset turnover of 12. Both companies' RNOA are 6% and are considered
unsatisfactory by industry norms. What is the net operating asset turnover of
Company X? What is the NOPAT margin for Company Y? What strategic actions do
you recommend to the managements of the respective companies?
SR 2
Strategic Recommendations:
Since both companies have RNOA below industry norms (6%), they need to improve
their performance. Recommendations:
1. Company X:
 Increase NOPAT Margin: Implement cost-cutting measures or revenue
enhancement strategies to improve profitability.
 Improve Efficiency: Focus on optimizing the utilization of net
operating assets.
2. Company Y:
 Enhance Net Operating Asset Turnover: Streamline operations, reduce
excess assets, and improve asset utilization.
 Evaluate Profitability: Examine the NOPAT Margin to identify areas
for improvement.
Q8.12.a. How do return on net operating assets and return on common equity differ?
b. What are the components of return on common share holders’ equity? What do the
components measure?
1. Scope:
Return on Net Operating Assets (RNOA): Focuses specifically on
the return generated from the company's net operating assets,
excluding non-operating items.
 Return on Common Equity (ROCE): Encompasses the overall
return to common shareholders, considering all sources of funding,
including both operating and non-operating assets.
2. Components Included:
 RNOA: Considers only assets and liabilities directly related to the core
operating activities of the business.
SR 3
ROCE: Includes all assets and liabilities, providing a more

comprehensive view of the overall return on the equity invested by
common shareholders.
3. Purpose:
 RNOA: Offers insights into the efficiency and profitability of the
company's core operations.
 ROCE: Provides a broader perspective on how effectively all assets
(both operating and non-operating) are employed to generate returns
for common shareholders.
b. Components of Return on Common Shareholders' Equity (ROCE):
1. Adjusted Profit Margin (APM):
 Measures the profitability of the company after accounting for taxes.

2. Asset Turnover (AT):
 Reflects how efficiently the company generates sales from its assets.
3. Leverage:
 Examines the use of debt and equity to finance assets.
What the Components Measure:

 Adjusted Profit Margin (APM):
 Indicates the proportion of sales revenue converted into profit after
taxes.
 Asset Turnover (AT):
 Shows how efficiently the company utilizes its assets to generate sales.
 Leverage:
 Measures the degree to which the company relies on debt to finance its
assets.
Problem – 8.3 (calculate the RNOA and ROCE only), 8.5 (calculate the RNOA and
ROCE only)
Problem 8.3
Selected income statement and balance sheet data from Merck & Co. for Year 9 are
reproduced below:
SR 4
MERCK & COMPANY, INC.

Year 9 Selected Financial Data ($ millions)
Income Statement Data
Sales revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $7,120
Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Pretax income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,550
Income taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 900
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,650
Balance Sheet Data

Current assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,850
Fixed assets, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,400
Total assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,250
Current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,290
Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
Shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,860
Total liabilities & shareholders’ equity . . . . . . . . . . . . . . . . 7,250
Assume tax rate is 35% and no preferred dividend. Calculate Merck’s RNOA and
ROCE. (assume all assets and current liabilities are operating).
Problem 8.5
Selected financial statement data from Texas Telecom, Inc., for Years 5 and 9 are
reproduced below ($ millions):
SR 5
Assume tax rate is 50%. Calculate Texas Telecom’s RNOA and ROCE. (assume fixed
assets and working capital are operating).
SR 6
SR 7
Questions are from Subramanyam, K. R., Financial Statement Analysis, 11th Edition,
McGraw Hill
SR 8

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BBF3034 – Analysis and Valuation of Financial Statements Semester 1 23/24

Tutorial Week 6 – Topic 4

Questions – 8.2, 8.6, 8.8, 8.12

To use ROIC in the analysis of financial statements, follow these steps:

2. Sales to Net Operating Assets (Asset Turnover):

 Interpretation: A higher Sales to Net Operating Assets ratio implies

ROCE: Includes all assets and liabilities, providing a more

1. Adjusted Profit Margin (APM):

 Measures the profitability of the company after accounting for taxes.

 Examines the use of debt and equity to finance assets.

What the Components Measure:

MERCK & COMPANY, INC.

Balance Sheet Data

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