Web3ch11 - CHAPTER ELEVEN The Analysis of Profitability...

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CHAPTER ELEVEN The Analysis of Profitability Stephen H. Penman The web page for Chapter Eleven runs under the following headings: What this Chapter is Doing Financial Leverage: Risk and Return Analysis of Financial Leverage: Microsoft Corporation Return on Assets (ROA) and Return on Net Operating Assets (RNOA) for Dell Computer Corporation Operating Liability Leverage for an Insurance Company Profitability Analysis: Home Depot A Spreadsheet Engine for Profitability Analysis What this Chapter is Doing This chapter analyses the income statements and balance sheets that were reformulated in Chapter 9. Financial statements, remember, are the lens on the business. Reformulation sets up the financial statements in a form that reflects the business activities. The analysis in this chapter penetrates the business in order to understand the source of the profitability that is reported in the financial statements. Figure 11.1 summarizes the analysis of profitability. By the end of this chapter, you should have this scheme firmly in mind. The first task is to distinguish operating profitability from the effects of financing, for it is the operations that generate value. The next task is to understand the sources of the operating profitability. As you move through the chapter, you will begin to see the payoff to the reformulation exercise of earlier chapters: one gets clean measures of profitability and a clean separation of operating profitability from effects of financing. Understand why (for equity analysis) we calculate return on net operating assets (RNOA) rather than return on assets (ROA). Understand why we use the financial leverage measure, FLEV, rather than the traditional debt-to-equity ratio when evaluating leverage. Understand why we distinguish financial leverage (FLEV) from operating liability leverage (OLLEV); the Dell Corporation example is very instructive. 1
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The profitability analysis is the culmination of the analysis of the income statement and balance sheet in Chapter 9. But it is also the starting point for valuation in Part Three of the book. So you will appreciate that ultimate payoff to the analysis as you move into valuation in Chapters 13-15. Financial Leverage: Risk and Return The financing leverage equation indicates that there is a benefit to financial leverage: ROCE = RNOA + [ FLEV x SPREAD ] where the SPREAD = RNOA – NBC. If a firm adds financing leverage (FLEV), it increases its return to common shareholders, ROCE. But there is a proviso, of course: The return on net operating assets (RNOA) must be higher than the net borrowing cost (NBC) on the net financial obligations, that is, the SPREAD must be positive. There can never be additional return without additional risk, and here is the risk: If the SPREAD turns negative, ROCE is less than RNOA (the leverage is unfavorable). Financial leverage can increase ROCE but it also increases the risk that ROCE will be lower. In the
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Web3ch11 - CHAPTER ELEVEN The Analysis of Profitability...

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