Analyzing and Interpreting
Return on investment measures profitability in relation to the amount of investment that has been made in the business. A company can always increase dollar profit by increasing the amount of investment (assuming it is a profitable investment). So, dollar profits are not necessarily a meaningful way to look at financial performance. Using return on investment in our analysis, whether as investors or business managers, requires us to focus not only on the income statement, but also on the balance sheet.
Increasing leverage increases ROE as long as the assets earn a greater operating return than the cost of the additional debt. Financial leverage is also related to risk: the risk of potential bankruptcy and the risk of increased variability of profits. Companies must, therefore, balance the positive effects of financial leverage against their potential negative consequences. It is for this reason that we do not witness companies entirely financed with debt.
Gross profit margins can decline because 1) the industry has become more competitive, and/or the firm’s products have lost their competitive advantage so that the company has reduced selling prices or is selling fewer units or 2) product costs have increased, or 3) the sales mix has changed from higher-margin/slowly turning products to lower-margin/higher turning products. Declining gross profit margins are usually viewed negatively. On the other hand, cost increases that reflect broader economic events or certain strategic product mix changes might not be viewed as negatively. Q4-4.
Reducing advertising or R&D expenditures can increase current operating profit at the expense of the long-term competitive position of the firm. Expenditures on advertising or R&D often create long-term economic benefits.
Asset turnover measures the amount of revenue compared with the investment in an asset. Generally speaking, we want turnover to be higher rather than lower. Turnover measures productivity and an important company objective is to make assets as productive as possible. Because turnover is one of the components of ROE (via RNOA), increasing turnover increases shareholder value. Turnover is, therefore, viewed as a value driver.
ROE>RNOA implies a positive return on nonoperating activities. This results from borrowed funds being invested in operating assets whose return (RNOA) exceeds the cost of borrowing. In this case, borrowing money increases ROE.
Once a business segment has been sold or designated for sale, it is classified as a discontinued operation. Consequently, sales and expenses related to the business segment are reported separately, Thus, the income statement reports income from continuing operations, discontinued operations, and net income (which includes both continuing and discontinued operations). On the balance sheet, the business segment’s assets and liabilities are similarly segregated. Because the business segment was or will be sold, it no longer contributes to the operating activities of the company. One of the primary uses of financial information is to project future financial results so that investors and others can properly price the company’s securities and evaluate strategic plans. The discontinued operations will not affect future results (other than via investment of the proceeds from the sale), and, therefore, should not be considered as a component of operating activities. Q4-8.
The interest tax shield arises because interest expense is deductible for tax purposes. Thus, interest expense “shields” income from taxes by reducing taxable income. The after-tax cost of interest is, therefore, the pretax cost multiplied by 1 minus the appropriate tax rate (typically the sum of the federal and state tax rates).
The “net” in net operating assets, means operating assets “net” of operating...
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