12 Profitability analysis Magnanellidocenti.luiss.it/protected-uploads/1049/2016/10/...Proﬁtability+Analysis++ BarbaraSvevaMagnanelli+ 4 PROFITABILITY+ The+common+measures+of+proﬁtability+

Profitability Analysis

Lecture goals

Barbara Sveva Magnanelli 1

!  How ra;os aggregate to explain return on common equity (ROCE)

!  How financial leverage affects ROCE

!  How opera;ng liability leverage affects ROCE

!  The difference between return on net opera;ng assets (RNOA) and return on assets (ROA)

!  How profit margins, asset turnovers and their composite ra;os drives RNOA

!  Perform a complete profitability analysis on reformulated financial statements

Performance Analysis – Why?


FIRM PURPOSE

VALUE CREATION

Performance analysis

Type of Analysis


ANALYSIS

SOLVENCY PROFITABILITY

Financial equilibrium:

capabity to repay obliga;ons

Economic equilibrium:

capabity to generate profit



PROFITABILITY

The common measures of profitability are:

" Return on equity (ROE ≅ ROCE)

" Return on investments (ROI ≅ RNOA)

" Profit Margin ≅ Return on sales (ROS)

The Income Statement shows the final opera;ng result (Net profit/loss

for the period).

Net profit shall be distributed to shareholders, who will then decide if

this is sa;sfactory compared with costs.



PROFITABILITY

of the capital invested by stockholders

ROE

NET PROFIT / EQUITY

Return for Shareholders – Basic version



! Managers recognize that genera;ng higher profitability generates value and then they ask:

What drives value?

Return for Shareholders (investors) – Analysts’ version

ROCE = COMPREHENSIVE INCOME / EQUITY



i = return of risk-‐free investment Risk Premium= extra charge demanded by shareholders because they invested in a risky ac;vity

To establish if distributed profits are sa;sfactory or not, it is necessary to

evaluate risks and the return on risk-‐free assets.

Fair ROE = i (risk free) + Risk Premium

Fair ROE

ROE Breakdown


Net Profit Key Factors

Opera;ng ac;vi;es

ROE Key Factors

Return on opera;ng investments

Financial structure effect

Financial ac;vi;es

Analysts’ ROCE breakdown


Return'on'common'equity'

Return'from'opera1ng'ac1vi1es'

Return'on'net'opera1ng'asset'

Profit'margin' Asset'turnover'

Return'from'financial'ac1vi1es'

Financial'leverage'

Financial'leverage'x'spread'

Gross margin and expense drivers

Individual asset and liability drivers

Net borrowing cost drivers

(1)

(2)

(3)



!  In the profitability analysis ROCE is broken down into its drivers. The analysis proceeds over three levels:

(1)  THE EFFECT OF OPERATING AND FINANCING ACTIVITIES

(2)  EFFECT OF PROFIT MARGIN AND ASSET TURNOVERS ON OPERATING PROFITABILITY

(3)  DRIVERS FOR PROFIT MARGINS, ASSET TURNOVERS AND NET BORROWING COSTS

Profitability analysis – First level Breakdown


Ebit ROI (return on investments) =

Net opera;ng assets (NOA)

This raKo invesKgates the efficient usage of the capital invested in the business

Opera;ng Profitability Return – Basic version


This raKo invesKgates the efficient usage of the capital invested in the business

Opera;ng Profitability Return – Analysts’ version

OINOA

RNOA=

RNOA: Return on Net Opera;ng Assets OI: Opera;ng Income ajer taxes (NOPAT) NOA: Net Opera;ng Assets



Financial Leverage – Basic version

Cost of debt

Non Operating Debt /Equity

Tax rate

ROI-i > 0 POSITIVE FINANCIAL LEVERAGE

ROI-i < 0 NEGATIVE FINANCIAL LEVERAGE

[ ] )1(/)( tEDiROIROIROE −⋅⋅−+=




[ ] )1(/)( tEDiROIROIROE −⋅⋅−+=

Financial Leverage effect

The effect of debt increase on ROE is the so-called

FINANCIAL LEVERAGE EFFECT (or GEARING EFFECT)




As ROI increases ROE increases As ROI decreases ROE decreases

As i increases ROE decreases As i decreases ROE increases

As D/E increases (ROI-‐i)>0 ROE increases (ROI-‐i)<0 ROE decreases

As D/E decreases (ROI-‐i)>0 ROE decreases

(ROI-‐i)<0 ROE increases

All other conditions being equal:




The effect of financing ac;vi;es on ROE depends on:

i & FINANCIAL DEBT/

EQUITY

Cost of financial debt Debt/equity ratio

Limit value = 1, 1.5



NFOCSE

ROCE= RNOA *+ x(RNOA.NBC)

Financial Leverage – Analysts’ version

The analists’ version of the financial leverage instead of considering D/E, it takes into account the Net Financial Posi;on and the Common Shareholders Equity to ca lcu late the mul;plicator of the spread.

ATTENTION!!! Net Financial Posi;on can be posi;ve (NFO) or nega;ve (NFA), if in this last case financial assets are higher than financial obliga;ons!



! Financial Leverage is defined as the degree to which Net Opera;ng Assets (NOA) are financed by borrowings (NET FINANCIAL OBLIGATION, NFO)

! The measure of financial leverage is:

NFOCSE

FLEV=

where, NFO: Net Financial Obliga;on CSE: Common Shareholders Equity

Financial Leverage – Analysts’ version


Typical FLEV = 0.4


NFOCSE

ROCE= RNOA *+ x(RNOA.NBC)

ROCE= RNOA (+ (RNOA+NBC) x FLEV

Previous expression says that ROCE can be broken down into three drivers: 1.  Return on Opera;ng Assets,

2.  Financial Leverage,

3.  Opera;ng spread between return on net opera;ng assets and net borrowing cost,

NFOCSE

FLEV=

OINOA

RNOA=

SPREAD=(RNOA(+(NBC



! ROCE is levered up over the return from opera;on (RNOA) if the company has financial leverage and the return from opera;on is higher than net borrowing cost (RNOA > NBC)

! So, the company increase equity return if net opera;ng assets are

financed by debts and those assets provide a return higher than the cost of debt


Both OI (Opera)ng Income) and NBC (net borrowing costs) must be ajer tax and comprehensive of all components, as in the reformulated income statements; otherwise the breakdown doesn’t work!


! So the difference between ROCE e RNOA changes with financial leverage according to the SPREAD

! We can have: #  If FLEV = 0 $ ROCE = RNOA

#  if the company has financial leverage, the difference between ROCE e RNOA is determined by the amount of leverage (FLEV) and opera;ng spread (RNOA – NBC). Par;cularly:

RNOA > NBC POSITIVE (or FAVORABLE) FIN. LEV.

RNOA < NBC NEGATIVE (or UNFAVORABLE) FIN. LEV



!  If a company has Net Financial Assets (NFA) rather than Net Financial Obliga;ons (NFO) – or in other terms, the firm has a nega;ve Net Financial Posi;on – the financial leverage formula becomes:

Where: RNFA = Net Financial Income / NFA


ROCE = RNOA – [(RNOA – RNFA) * NFA/CSE]

The second factor of the equa;on is subtracted because NFA is mathema;cally a nega;ve number (nega;ve Net Financial Posi;on)


! Two situa;ons could occur:

1.  Financial income greater than financial expenses ! RNFA>0, and RNFA higher than RNOA – most common situa;on

! The ROCE is higher than RNOA

2.  Financial income greater than financial expenses ! RNFA>0, but lower than RNOA – less common situa;on

! The ROCE is lower than RNOA The ROCE is lower than RNOA, because the spread is posi;ve and thus, as a result, ROCE decreases.


ROCE = RNOA – [(RNOA – RNFA) * NFA/CSE]

The effect of financial leverage First level break down


Is the effect of financial leverage always real?

Can a company always increase its equity value by increasing ROCE through financial leverage, or it will reduce equity value because of

increasing in risk?



As RNOA increases ROCE increases As RNOA decreases ROCE decreases

As NBC increases ROCE decreases As NBC decreases ROCE Increases

As NFO/CSE increases (RNOA-‐NBC)>0 ROCE increases (RNOA –NBC)<0 ROCE decreases

As NFO/CSE decreases (RNOA-‐NBC)>0 ROCE decreases

(RNOA –NBC)<0 ROCE increases

ROCE= RNOA (+ (RNOA+NBC) x FLEVAll other condiKons being equal:



!  CONCLUSIONS: #  High financial leverage business (with high NFO/CSE) have higher sensi;vity

of ROCE in changes in RNOA and NBC

#  Hence, financial leverage degree is at the same ;me a measure of financial Risk (ROCE vola;lity) meaning a higher shareholders returns genera;ng capacity in high opera;ng profitability context, but also higher ROCE reduc;on when the spread RNOA –NBC decreases

#  This means that good financial manager must choose appropriate level of financial leverage. Excessive financial leverage is never healthy for the company, because: 1.  The company can never be sure that their RNOA will keep above their NBC

2.  High financial risk bring to higher Fair ROCE expected by shareholders. Making it possible to have higher ROCE but, at the same ;me lower value crea;on for shareholders.

Summary of first level breakdown for profitability analysis


Comprehensive,IncomeAverage,CSE

ROCE=,

OINOA

RNOA=

NFENFO

NBC=

NOA$=$NFO$'$CSE

where, ROCE: Return on Common Equity RNOA: Return on Net Opera;ng Assets OI: Opera;ng Income ajer taxes NFE: Net Financial Expenses NOA: Net Opera;ng Assets NFO: Net Financial Obliga;on NBC: Net Borrowing Costs CSE: Common Shareholders’ Equity

We know that:

OI-NFENOA-NFO

ROCE=

The effect of opera;ng leverage liability First level break down


!  Also opera;ng liability can lever up the return on net opera;ng asset (RNOA)

!  Levering up the RNOA, as from previous rela;onship, we subsequently increase ROCE

!  The measure for operaKng liability leverage is: OL#

NOAOLLEV=

where, OL: Opera;ng Liabili;es NOA: Net Financial Assets The typical OLLEV is 0.4



!  To compute the leverage effect we follow these steps (how opera;ng liabili;es impact on RNOA):

1.  Es;mate the implicit rate that a supplier would charge for credit

2.  Calculate the return on opera;ng assets (ROOA) as if there is no opera;ng liabili;es

OI#+#Implicit#InterestOperating#Asset

ROOA=

Implicitinterestonoperatingliabilities

= Short-termborrowingrate

x Operatingliabilities



!  To compute the leverage effect we follow these steps (how opera;ng liabili;es impact on RNOA):

3.  Calculate the Opera;ng Liabili;es SPREAD:

4.  Compute the effect of opera;ng liabili;es on RNOA with the

operaKng leverage equaKon:

OLSPREAD = ROOA – Short-‐term borrowing rate

RNOA=&ROOA&+&(OLLEV&x&&OLSPREAD)Opera)ng Leverage Effect



ROOA > Short-‐term borrowing rate RNOA increases ROCE increases

POSITIVE (or FAVORABLE) OPERATING LIABILITIES LEVERAGE

ROOA < Short-‐term borrowing rate RNOA decreases ROCE decreases

NEGATIVE (or UNFAVORABLE) OPERATING LIABILITIES LEVERAGE

RNOA vs ROA


!  A common measure of the profitability of opera;ons is:

Net$Income$+$Interest$expensesTotal$Assets

ROA=

!  The numerator considers net income rather than comprehensive income;

!  Total asset is composed by opera;ng and financial asset

!  So, this measure mixes up the return on opera;ons with the return from inves;ng excess cash in financial assets

!  RNOA calcula;on appropriately dis;nguishes opera;ng and financial items

Drivers of opera;ng profitability Second level break down


ROCE= RNOA (+ (RNOA+NBC) x FLEV

Profit Margin Asset turnover

Operating*IncomeSales

SalesNOA

X

≅ ROS

Where: Opera;ng Income is always NOPAT

Drivers of opera;ng profitability Second level break down


!  The decomposi;on of opera;ng profitability is known as the DuPont Model. It says that high profitability opera;on comes from two sources:

1.  RNOA will be higher the more of each dollar of sales ends up in opera;ng income

2.  RNOA will be higher the more sales are generated from the net opera;ng assets.

Third-‐level breakdown


!  Finally, we move to the final step of profitability analysis. The third-‐level considers drivers to affect RNOA. Improving RNOA increases ROCE, all other condi;ons being equal. So we proceed the following analysis:

# Profit Margin drivers (Break-‐Even Point Analysis)

#  Individual asset and liability drivers (Asset Turnover Analysis) # Net borrowing cost drivers

Internal analysis $ Managerial Accoun;ng

Asset Turnover drivers Third level break down


!  Star;ng from the following rela;onship:

1 NOAATO Sales

+=SalesNOA

ATO*=

!  Breaking down NOA, we have:

1 Cash Accounts,receivable Inventory PPEATO Sales Sales Sales Sales

Accounts,payable Pension,obligationsSales, Sales

,<,,<,

… + +,= ,+ ,+, ,+,

Asset Turnover drivers, Inventory Third level break down


SalesInventory

Inventory-turnover -=

Cost%of%good%soldInventory

Inventory%turnover %=

365Inventory,turnover

Days,in,inventory ,=

or

and

Or, in other terms:

Inventory turnover expressed in days = (Average Inventory/ Cost of good sold) * 365

Asset Turnover drivers, Accounts receivable Third level break down


SalesAccounts,receivable

Accounts,receivable,turnover ,=

365Accounts+receivable+turnover

Days+in+accounts+receivable

+=

and

Or, in other terms:

Accounts receivable turnover expressed in days = (Average Accounts Receivable / Sales) * 365

Asset Turnover drivers, Accounts payable Third level break down


PurchasesAccounts-payable

Accounts-payable-turnover

-=

365Accounts+payable+turnover

Days+in++accounts+payable

+=

and

where, Purchases = Cost of good sold + Changes in inventory

Or, in other terms:

Accounts payable turnover expressed in days = (Average Accounts Payable / Purchases) * 365

Asset Turnover drivers – working capital cycle Third level break down


The Working Capital Cycle corresponds to the average ;me elapsed between cash

payments to purchase produc;on factors and cash takings generated by the sales of

goods or services.

Average stock period

Average credit period

Average debt period

+

-‐

€

ACC.RECEIVABLESSALES

× 360

INVENTORIESCOSTOFGOODSSOLD

×360

360.×

PURCHASESPAYABLEACC

This index is useful to assess crises or

liquidity problems due to mismatches

between cash inflow and ouulow.

DURATION OF THE WORKING CAPITAL CYCLE

=



Avg. inventory period 90 days

Avg. collec;on period

granted to

customers 60 days

Avg. suppliers payment period 45 days

Dura;on of the working capital

cycle 105 days

Avg. inventory period 120 days

Avg. collec;on period

granted to

customers 60 days

Avg. suppliers payment period

210 days

Dura;on of the working capital

cycle -‐30 days

Purchase of materials

Sales

Clients collection

Suppliers payment

Purchase of materials

Debt collection

Debt collection

Sales

EXAMPLE A EXAMPLE B

Low Working Capital Investments. Low Financial needs

High Working Capital Investment, High Financial needs



A long Working Capital Cycle (example A) can have two different nega;ve effects:

A PROBLEM OF PROFITABILITY

A PROBLEM OF LIQUIDITY Failing clients collec;on, increasing financial

needs to pay suppliers

INCREASING FINANCIAL DEBT BURDEN

High working capital: Capital invested at low returns

Documents

12 Profitability analysis Magnanellidocenti.luiss.it/protected-uploads/1049/2016/10/...Proﬁtability+Analysis++ BarbaraSvevaMagnanelli+ 4 PROFITABILITY+ The+common+measures+of+proﬁtability+