Operating Profitability

Question 1

What are some key ratios for Profitability?

Answer 1

• Profit
• Profit margin
• Return on Assets
• Return on Capital Employed
• Return on Equity

Alternative for certain industries, for example:
- Profit per employee

Question 2

How can we related stakeholders to the income statement?

Answer 2

• Operating income = customers
• External purchases = suppliers
• Personnel expenses = employees
• Interest expenses = Lenders
• Tax expenses = State
• Net profit = Owners

Question 3

What is value added in the income statement?

Answer 3

Sales - Purchases

Question 4

What is a typical depreciation for a manufacturing company (Atlas Copco)?

Answer 4

around 4-5% of sales

Question 5

What is often a large item for telecommunications companies?

Answer 5

High depreciation/amortization/writedowns (impairment of goodwill)

Question 6

What are characteristics of food retailers?

Answer 6

Low value added and low personnel expenses

Question 7

What are characteristics of service companies?

Answer 7

Low purchases and high personnel expense

Question 8

What is the net margin?

Answer 8

Net profit / Revenues

Question 9

What is a margin?

Answer 9

A measure of how efficiently resources are used to make revenues (income statement)

Does not include investments/capital.Two firms can have the same profit margin but have differences in financing.

Question 10

What is the formula for Return on Assets?

Answer 10

ROA = EBIE / Total Assets

Question 11

What is the formula for Return on Capital Employed?

Answer 11

ROCE = EBIE / Capital employed

Question 12

Why do we use EBIE as a profit measure in ROA and ROCE?

Answer 12

The returns should not be affected by how capital is financed

Question 13

What are similarities between ROA and ROCE?

Answer 13

• They measure operating profitability
• The profit number is EBIE, unaffected by compensation to capital providers
• The capital measure in the denominator should be opening capital in this course

Question 14

What is the formula for EBIE?

Answer 14

EBIE = Operating profit + Financial income

Question 15

What are differences between ROA and ROCE?

Answer 15

The capital measure is different:
- ROA: capital measure includes all assets used in operations to generate profits
- ROCE: only assets that are financed by owners and lenders are included

Question 16

What is the final formula for ROA in the DuPont analysis?

Answer 16

ROA = PM * TOA

Question 17

What is the formula for the profit margin?

Answer 17

PM = EBIE / Sales

Question 18

What is the formula for Turnover of Assets?

Answer 18

TOA = Sales / Total assets

Question 19

What is the formula for Turnover of Capital Employed?

Answer 19

TOCE = Sales / Capital employed

Question 20

What are on the axes of the DuPont graph?

Answer 20

Vertical: Profit margin

Horizontal: Asset turnover

Question 21

What does the position in the DuPont analysis/graph indicate?

Answer 21

• industry
• strategy
• value creation

Question 22

What does movements in the DuPont analysis/graph indicate?

Answer 22

• Changed efficiency (cost savings, capital efficiency)
• Change in strategy (new product mix, outsourcing, divestments)
• Change in business cycle (demand, prices, exchange rate)
• New competition situation (new entrants, deregulations)
• Accounting based reasons (goodwill, accounting changed, asset age)

Question 23

What does business risk depend on?

Answer 23

Uncertainty on the earnings capacity. More movement in the dupont graph implies more business risk

If the firm has enough equity, they may live with it. If not, may do something about it, for example increase the proportion of variable costs).

Question 24

Which firms tend to be on the left side of the DuPont graph?

Answer 24

Those in capital intensive industries (energy companies)

Question 25

Which firms tend to be on the right side of the DuPont graph?

Answer 25

Retailers / organically growing service&consulting companies

Question 26

What does the movements of a steel company typically look like in the DuPont graph?

Answer 26

Like a circle

Question 27

How can a firm improve its profit margin?

Answer 27

• Growth = increase in sales (new markets, products, services, distribution channels, customer segments, market share increase, acquisition, change prices)
• Margin improvements (purchase from low cost suppliers, close unprofitable businesses, decrease number of products, outsource, everyday efficiency improvements)

Question 28

How can a firm increase its turnover of capital (employed)?

Answer 28

• Non-current assets (internal efficient use, external cooperation with customers/suppliers, sharing with competitors)
• Working capital management (inventory, acc rec and acc pay)

Question 29

What are changes in ROA/ROCE most often linked to?

Answer 29

Changes in profit margin (why it is in focus in media)

Question 30

Which companies tend to be in the middle of the DuPont graph?

Answer 30

Manufacturing industrial companies

Question 31

What is capital intensity?

Answer 31

The inverse of capital turnover:

Assets / Sales

Question 32

How are interest-bearing liabilities incurred?

Answer 32

As a consequence of purely financial decisions and negotiations with lenders on the terms of the payment of interest, amortization, etc.

Question 33

How do non-interest-bearing liabilities normally arise?

Answer 33

As a consequence of decisions in the ongoing activity of buying materials and services, employing personnel, etc, in combination with the traditional payment terms which apply to various types of resource acquisition.

Question 34

How can a firm decrease business risk?

Answer 34

By shifting to more variable costs