Chapter 4 : Profitability Analysis
Exercises and Solutions
[4.10, 4.12. 4.13, 4.15, 4.16, 4.22, 4.28]
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4.10 Calculating ROA and Its Components.
Exercise 4.10:
Nucor, a steel manufacturer, reported net income for 2008 of $1,831 million on sales of
$23,663 million. Interest expense for 2008 was $135 million, and noncontrolling
interest was $314 million for 2008. The income tax rate is 35%. Total assets were
$9,826 million at the beginning of 2008 and $13,874 million at the end of 2008.
Compute the rate of ROA for 2008 and disaggregate ROA into profit margin for ROA
and assets turnover components.
2
Solution: 4.10
Return on Assets:
Net Income + (1- Tax Rate)(Interest Expense)+ MinorityInterest in Earnings
Average Total Assets
ROA = Profit Margin for ROA x Asse ts Turnover
Where :
Adjusted Net Income
Profit Margin =
Sales
Sales
Assets Turnover =
Average Total Assets
3
Ex4.12
Basic EPS
Net Income - Preferred Stock Dividends
Weighted Average Number of
Common Shares Outstandin g
Diluted EPS:
NetIncome- Preferred
StockDividends
+ AdjustmentsforDilutiveSecurities
WeightedAverage Weig htedAverage Number
Numberof Common+ of Shares Issuablefrom
SharesOutstanding DilutiveSecurities
4
Net Income - Preferred Stock Dividends
Weighted Average Number of
Common Shares Outstandin g
Solution: 4.12
Calculating Basic and Diluted EPS (amounts in
thousands).
1. Basic EPS:
$609,699/488,809 = $1.25
2. Diluted EPS:
NetIncome- Preferred
StockDividends
+ AdjustmentsforDilutiveSecurities
WeightedAverage Weig htedAverage Number
Numberof Common+ of Shares Issuablefrom
SharesOutstanding DilutiveSecurities
($609,699 + $4,482)/ (488,809 + 16,905 + 6,935) = $1.20
5
4.13 Relating ROA and ROCE.
Boston Scientific, a medical device manufacturer, reported net income (amounts in
millions) of $1,062 on sales of $5,624 during Year 4. Interest expense totaled $64.
The income tax rate was 35%. Average total assets were $6,934.5, and average
common shareholders’ equity was $3,443.5. The firm did not have preferred stock
outstanding or noncontrolling interest in its equity.
a. Compute the rate of ROA. Disaggregate ROA into profit margin for ROA and
assets turnover components.
b. Compute the rate of ROCE. Disaggregate ROCE into profit margin for ROCE,
assets turnover, and capital structure leverage ratio components.
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Solution: 4.13
(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.
Capital Structure Leverage Ratio: $6,934.5/$3,443.5 = 2.0
P4.15
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P4.15 (continued)
NetIncome
+(1- TaxRate)(Inte
restExpense)
+Minority
Interest
inEarnings
Average TotalAssets
ROA = Profit Margin for ROA x Asse ts Turnover
Where :
Adjusted Net Income
Profit Margin =
Sales
Sales
Assets Turnover =
Average Total Assets
9
10
Macy’s performed poorly, reporting a large net loss. It also has the slowest assets
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.
11
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 combination 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.
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 nonperishable 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 similar 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.
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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, especially compared to Macy’s.
Supervalu’s rapid inventory turnover also results from the perishable nature of
many of its products. The rapid inventory turnover increases 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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P4.16
14
Account Receivable Turnover = Sales/ Avg Accounts Receivables
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Solution: 4.16:
[A]
[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
management 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. 16
[C]
The accounts receivable turnover of Microsoft was relatively steady during the
three years. Microsoft appears to manage its accounts receivable well, with
collection 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.However, 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.Growing sales while contracting credit granted to customers would
lead to an increase in accounts receivable turnover.
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P4.22
Solution: 4.22:
Exercise: 4.28
Solution: 4.28:
1. Analyzing the Profitability of Two Rental Car Companies.
Computed ratios are as follows:
Avis Budget Hertz Global
Group Holdings
2012 2012
Profit Margin for ROA 6.3% 7.4%
Profit Margin for ROCE 3.9% 2.7%
Assets Turnover 0.523 0.440
Leverage 24.065 8.638
ROA 3.3% 3.2%
ROCE 49.6% 10.2%
Interpretation:
The ROA of the two companies is very similar, just above 3.0%. ROA measures the
overall profitability of the company’s operations, regardless of financial structure.
Given the competitiveness of the rental car industry, it is not surprising that the
overall profitability of the firms’ operations is similar. ROCE provides a different
story, however. Avis reports ROCE approximately five times as large as Hertz. ROCE
reflects the strategic use of debt financing to increase returns to equity holders.
Thus, Avis must be engaging in strategic use of debt financing relative to their
overall capital structure. Indeed, the leverage of Avis is approximately three times
the level for Hertz. The use of leverage is the primary difference between ROCE for
each company. There is also a slight difference in the assets turnover, with Avis
showing a turnover of 0.523 relative to Hertz’s turnover of 0.440. There is
insufficient information available to explain this, but possible explanations could be
that Avis uses cars that are older or leased rather than owned (both reducing asset
values) or that Avis is able to command a price premium relative to Hertz.
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