Q5-1. 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.
Q5-2. ROE is the sum of return on assets (ROA) and the return that results from the effective use of financial leverage (ROFL). Increasing leverage increases ROE as long as ROA exceeds the after-tax interest rate. 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.
Q5-3. 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 had to reduce 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 negatively.
Q5-4. 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 are more asset-like and create long-term economic benefits.
Q5-5. Asset turnover measures the amount of revenue volume 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. Since turnover is one of the components of ROE (via ROA), increasing turnover increases shareholder value. Turnover is, therefore, viewed as a value driver.
Q5-6. ROE>ROA implies a positive return on financial leverage. This results from borrowed funds being invested in operating assets whose return (ROA) exceeds the cost of borrowing. In this case, borrowing money increases ROE.
Q5-7. Common-size financial statements express balance sheet and income statement items in ratio form. Common-size balance sheets express each asset, liability and equity item as a percentage of total assets and common-size income statements express each line item as a percentage of sales. The ratio form facilitates comparison among firms of different sizes as well as across time for the same firm. Q5-8. The asset turnover ratio (AT) is the ratio of sales revenue to average total assets. The ratio is increased by increasing sales while holding assets constant, or by reducing assets without reducing sales. The most effective means of improving the ratio is to increase the efficient utilization of operating assets. This is done by improving inventory management practices, improving accounts receivable collection, and improving the efficient use of PP&E.
Q5-9. The “net” in net operating assets, means operating assets “net” of operating liabilities. This netting recognizes that a portion of the costs