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CHAPTER 5 Revenue Recognition and Profitability Analysis 271 What is considered to be a desirable profit margin is highly sensitive to the nature of the business activity. For instance, you would expect a specialty shop to have a higher profit margin than, say, Walmart. A low profit margin can be compensated for by a high asset turnover rate, and vice versa, which brings us to considering the trade-offs inherent in generating return on assets. RETURN ON ASSETS. The return on assets (ROA) ratio expresses income as a percentage of the average total assets available to generate that income. Because total assets are partially financed with debt and partially by equity funds, this is an inclusive way of measuring earning power that ignores specific sources of financing. A company’s return on assets is related to both profit margin and asset turnover. Specifically, profitability can be achieved by either a high profit margin, high turnover, or a combination of the two. In fact, the return on assets can be calculated by multiplying the profit margin and the asset turnover. Return on assets 5 Profit margin 3 Asset turnover ____N__e_t _in_c_o_m__e_ ___ 5 _ N_e_t_ i_n_c_o_m_e_ Average total assets 3 _ ____N__ e_t _s _al_e_s_ ____Net sales Average total assets Industry standards are particularly important when evaluating asset turnover and profit margin. Some industries are characterized by low turnover but typically make up for it with higher profit margins. Others have low profit margins but compensate with high turnover. Grocery stores typically have relatively low profit margins but relatively high asset turnover. In comparison, a manufacturer of specialized equipment will have a higher profit margin but a lower asset turnover ratio. Additional Consideration The return on assets ratio often is computed as follows: Net income 1 Interest expense (1 2 Tax rate) _________ ________ _____ ____ ______ __ ________ Return on assets 5 Average total assets The reason for adding back interest expense (net of tax) is that interest represents a return to suppliers of debt capital and should not be deducted in the computation of net income when computing the return on total assets. In other words, the numerator is the total amount of income available to both debt and equity capital. RETURN ON SHAREHOLDERS’ EQUITY. Equity investors typically are concerned about the amount of profit that management can generate from the resources that owners provide. A closely watched measure that captures this concern is return on equity (ROE), calculated by dividing net income by average shareholders’ equity. In addition to monitoring return on equity, investors want to understand how that return can be improved. The D uPont framework provides a convenient basis for analysis that breaks return on equity into three key components: 32 • Profitability, measured by the profit margin (Net income  4  Sales). As discussed already, a higher profit margin indicates that a company is generating more profit from each dollar of sales. • Activity, measured by asset turnover (Sales  4  Average total assets). As discussed already, higher asset turnover indicates that a company is using its assets efficiently to generate more sales from each dollar of assets. • Financial Leverage, measured by the equity multiplier (Average total assets  4  Average total equity). A high equity multiplier indicates that relatively more of the company’s assets have been financed with debt. As indicated in Chapter 3, leverage can provide additional return to the company’s equity holders. The return on shareholders’ equity measures the return to suppliers of equity capital. The DuPont framework shows that return on equity depends on profitability, activity, and financial leverage. 32 DuPont analysis is so named because the basic model was developed by F. Donaldson Brown, an electrical engineer who worked for DuPont in the early part of the 20th century. Profit margin and asset turnover combine to yield return on assets, which measures the return generated by a company’s assets.


Spiceland_Inter_Accounting8e_Ch05
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