Week 5 – Assignment: Interpret Research on

Decomposition Analysis

Research the decomposition analysis of performance ratio and then be able to apply the ratios. You will need to respond to and explain the following:

1. Define,      describe and illustrate the decomposition of ROI and ROE. Form numerical      illustrations to clarify your discussion.
2. Extend      the basic analysis to show the connection of this decomposition analysis      to the common-size income statement. Explain and illustrate clearly the      connection and the value of the analysis,
3. Using      the decomposition of ROI and ROE, form this analysis on a study company      and a comparison company using the most recent three years of financial      data. Some potential companies could be: Lowes and Home Depot, Toyota and      Honda, PepsiCo and Coca Cola. Review the referenced paper by Prendergast      (2006). Describe the research question being addressed. Discuss the      methods used and the conclusions reached by the study.

Support your paper with a minimum of five (5) external resources In addition to these specified resources, other appropriate scholarly resources, including older articles, may be included.
 

Length: 5-7 pages not including title and reference pages
 

Your paper should demonstrate thoughtful consideration of the ideas and concepts presented in the course and provide new thoughts and insights relating directly to this topic. Your response should reflect scholarly writing and current APA standards.

Decomposition Analysis

This week in the course studies the decomposition analysis. This analysis is aimed at understanding the drivers to some of the more important performance ratios, i.e. the return on investment (ROI) and the return on equity (ROE). The analysis offers insight to the value and risk associated with financial leverage. The analysis is also directly connected to the common-size income statement through the profit margin.

Review the resources listed in the Books and Resources area below to prepare for this week’s assignments.

Week 5 – Assignment: Interpret Research on

Decomposition Analysis

Research the decomposition analysis of performance ratio and then be able to apply the ratios. You will need to respond to and explain the following:

1. Define, describe and illustrate the decomposition of ROI and ROE. Form numerical illustrations to clarify your discussion.

2. Extend the basic analysis to show the connection of this decomposition analysis to the common-size income statement. Explain and illustrate clearly the connection and the value of the analysis,

3. Using the decomposition of ROI and ROE, form this analysis on a study company and a comparison company using the most recent three years of financial data. Some potential companies could be: Lowes and Home Depot, Toyota and Honda, PepsiCo and Coca Cola. Review the referenced paper by Prendergast (2006). Describe the research question being addressed. Discuss the methods used and the conclusions reached by the study.

Support your paper with a minimum of five (5) external resources In addition to these specified resources, other appropriate scholarly resources, including older articles, may be included.
Length: 5-7 pages not including title and reference pages
Your paper should demonstrate thoughtful consideration of the ideas and concepts presented in the course and provide new thoughts and insights relating directly to this topic. Your response should reflect scholarly writing and current APA standards.

Decomposition Analysis

This week in the course studies the decomposition analysis. This analysis is aimed at understanding the drivers to some of the more important performance ratios, i.e. the return on investment (ROI) and the return on equity (ROE). The analysis offers insight to the value and risk associated with financial leverage. The analysis is also directly connected to the common-size income statement through the profit margin.

Review the resources listed in the Books and Resources area below to prepare for this week’s assignments.

Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.

Financial Analysis
Prendergast, Paul
Financial Management; May 2006; ProQuest
pg. 48

Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.

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Chapter 8
Profitability

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The primary financial analysis of profit ratios should include only those items of income arising from normal operations
Excludes
Discontinued operations
Extraordinary items
Profitability Measures

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Also referred to as return on sales
Reflects net income dollars generated by each dollar of sales
Potential distortion can be caused by “other income” and “other expense” items from net income, as these do not relate to net sales
Net Profit Margin

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Measures the activity of the assets and the ability of the firm to generate sales through the use of the assets
Potential distortion
Investments
Construction in progress
Other assets that do not relate to net sales
Total Asset Turnover

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Measures the ability to utilize assets to create profits
Average total assets
For internal analysis use month-end amounts
For external analysis use beginning and ending amounts
If necessary, consistent use of end-of-year amounts, instead of averages
Return on Assets

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DuPont analysis separates return on assets into net profit margin and total asset turnover
Separating the ratio into the two elements allows for improved analysis of the causes for the change in the percentage of return on assets
DuPont Return on Assets

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DuPont Return on Assets—Continued

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Consider only operating assets and income
Operating assets exclude
Construction in progress
Long-term investments
Intangibles
‘Other’ assets
Operating income includes only
Net sales less the cost of sales
Operating expenses
May give significantly different results
Reflective of ROA from primary business
DuPont Analysis Variation

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Includes only operating income in the numerator
Operating Income Margin

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Measures the ability of operating assets to generate sales dollars
Operating Asset Turnover

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Measures the ability of operating assets to generate operating income
Return on Operating Assets

DuPont analysis of the return on operating assets:

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Measures the ability to make productive use of property, plant, and equipment by generating sales dollars
Exclude construction in progress from net fixed assets
Possible distortions
Old fixed assets
Labor-intensive industry
Sales to Fixed Assets

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Measures income earned on invested capital and how well the firm utilizes its asset base
Evaluates enterprise performance without regard to financing sources
Return on Investment (ROI)

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Measures the return to common and preferred stockholders
Return on Total Equity
Adjustments for redeemable preferred stock
Deduct dividends from net income (numerator)
Deduct stock value from total equity (denominator)

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Measures the return to the common stockholder
Return on Common Equity

Common equity = Total Stockholders’ Equity
− Preferred Capital − Noncontrolling Interest

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Includes the return to all suppliers of funds, both long- and short-term, by both creditors and investors
Return on Total Asset Variation
Differs from the return on assets ratio and return on investment
It does not lend itself to DuPont Analysis

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Rate of
return on Measures
return to providers of Typical result
Assets All funds Lowest (includes all assets)
Investment Long-term funds Higher than ROA (relative small amount of short-term funds)
Total equity Equity Higher than ROI (measures return only to shareholders)

The Relationship Between Profitability Ratios

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The Relationship Between Profitability Ratios—Continued
Rate of
return on Measures
return to providers of Typical result
Common equity Common equity Highest
Common shareholders absorb greatest degree of risk
Requires that return to preferred shareholders exceed funds paid to preferred shareholders

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Comparing gross profit with net sales is termed the gross profit margin
Gross Profit Margin
Net Sales Revenue
− Cost of Goods Sold
= Gross Profit
Beginning Inventory
+ Purchases of Inventory
− Ending Inventory

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Analysis helps the following ways:
Managers budget gross profit levels into their predictions of profitability
Used in cost control
Estimate inventory levels for interim financial statements and insured losses in merchandising industries
Used by auditor and Internal Revenue Service to judge accuracy of accounting systems

Gross Profit Margin Analysis

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Operating segments
Separate financial information is available
Evaluated by the chief operating decision maker
Requires information about
Countries in which the firm earns revenues and holds assets
Major customers
Segment Reporting

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Disclosures
The way the operating segments are determined
Products and services by the operating segments
Differences between the measurements used in reporting segment and firm’s general-purpose financial information
Profitability trends can also be shown as revenues by major product lines
Segment Reporting—Continued

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Charged directly to retained earnings
Changes in accounting principles
Realization of income tax benefits of preacquisition operating loss carryforwards of purchased subsidiaries
Changes in accounting entity
Correction of errors in prior periods
Gains and Losses from Prior Period Adjustments

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Items not included in net income
Reported as a separate component of shareholders’ equity
Foreign currency translation adjustments
Unrealized holding gains and losses from available-for-sale marketable securities
Changes to stockholders’ equity resulting from additional minimum pension liability adjustments
Unrealized gains and losses from derivative instruments
Comprehensive Income

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Traditional profitability analysis includes items related to net income
Items of accumulated other comprehensive income are excluded from analysis
Consider supplemental analysis including other comprehensive income items for
Return on assets
Return on investment
Return on total equity
Return on common equity
Comprehensive Income—Continued

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It is a hypothetical or projected amount
Release timed to coincide with release of GAAP financial results
Sarbanes-Oxley Act of 2002 requires
Reconciling of pro forma data to GAAP financial condition and results of operations
Pro-Forma Financial Information

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Unaudited financial reports covering fiscal periods of less than one year
SEC requires limited financial data be provided on Form 10-Q
Certain quarterly information is disclosed in notes to the annual report
Interim reports are an integral part of the annual report
Less reliable than annual reports as contain more estimates
Interim Reports

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Net Income Before Noncontrolling Interes
t,
Equity Income, and Nonrecurring Items
Net Profit Margin =
Net Sales
Net Sales
Total Asset Turnover =
Average Total Assets
Net Income Before Noncontrolling
Interest and Nonrecurring Items
Return on Assets =
Average Total Assets
Return on Assets = Net Profit Margin To
tal Asset Turnover
´
Return on Net Profit Total Asset
Assets = Margin × Turnover
Firm A
Year 1 10% = 4.0% × 2.5
Year 2 8% = 4.0% × 2.0

Firm B
Year 1 10% = 4.0% × 2.5
Year 2 8% = 3.2% × 2.5

Net Income BeforeNet Income Before
Noncontrolling InterestNoncontrolling In
terest
and Nonrecurring Itemsand Nonrecurring I
temsNet Sales
= ×
Average Total AssetsNet salesAverage Tot
al Assets

Return on
Net Profit
Total Asset

Assets
=
Margin
×
Turnover

Firm A
Year 1
10%
=
4.0%
×
2.5
Year 2
8%
=
4.0%
×
2.0
Firm B
Year 1
10%
=
4.0%
×
2.5
Year 2
8%
=
3.2%
×
2.5
Operating Income
Operating Income Margin =
Net Sales
Net Sales
Operating Asset Turnover =
Average Operating Assets
Return on Operating assets =
Operating Income
Average Operating Assets
DuPont ReturnOperatingOperating
On = Income × Asset
Operating AssetsMarginTurnover
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Net Sales
Sales to Fixed Assets =
Average Net Fixed Assets
(Exclude Construction in Progress)
Net Income Before Noncontrolling
Interest and Nonrecurring Items +
[(Interest Expense) × (1 Tax Rate)]
Return on Investment =
Average (Long-Term Liabilities + Equity)
–
Net Income Before Nonrecurring Items
Dividends on Redeemable Preferred Stock
Return on Equity =
Average Total Equity
–
Net income Before Nonrecurring
Items Preferred Dividends
Return on Common Equity =
Average Common Equity
–
Net Income + Interest Expense
Return on Total Asset Variation =
Average Total Assets
Gross Profit
Gross Profit Margin =
Net Sales