3. Prepared by: Nir Yehuda With contributions by Stephen H. Penman – Columbia University Peter D. Easton and Gregory A. Sommers - Ohio State University Luis Palencia – University of Navarra, IESE Business School

4. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-3 What you will learn from this chapter How ratios aggregate to explain Return on Common Equity (ROCE) How economic factors determine ratios How financial leverage affects ROCE How operating liability leverage affects ROCE The difference between Return on Net Operating Assets (RNOA) and Return on Assets (ROA) How profit margins, asset turnovers and their composite ratios drive RNOA How borrowing costs are analyzed How profitability analysis can be used to ask penetrating questions regarding the firm’s activities

5. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-4 Steps in Fundamental Analysis 1.Specify the future payoffs to be forecasted 2.Identify information that forecasts payoffs Within financial statements Outside of financial statements 3.Prepare forecasts (pro forma analysis) 4.Determine the cost of capital 5.Infer price from pro forma analysis: combine pro forma with cost of capital An analyst’s competitive advantage lies in one or more of these steps

6. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-5 Analysis: Preamble to Forecasting and Valuation Analysis establishes where the firm is now Forecasting asks how it will be different in the future

7. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-6 Forecasting and the Analysis of Current Profitability 1.Future ROCE (residual earnings) is the forecast target 2.Establish the present: Analysis of profitability Determine the current profitability (ROCE) and the factors that influence the profitability 3.Determine transition from present to future: Projecting future profitability Determine factors that influence future profitability and describe how the future will be different from the present These correspond to steps 2 and 3 of fundamental analysis The reformulation of the balance sheet and income statement has put them into a form to carry out step 2 and to use them to forecast the future in step 3

8. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-7 Gross Margin RatioExpense RatiosOther OI/Sales Ratios Individual Asset and Liability Turnovers Borrowing Cost Drivers Level 3 Sales PMOther Items PM Cutting to the Core: The Analysis of Profitability PM = OI / SalesATO = Sales / NOA Level 2 Level 1

9. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-8 Cutting to the Core: ROCE Drivers ROCE is decomposed into drivers over three levels of analysis: 1.Analysis of Leverage 1.Analysis of Operating Profitability 1.Analysis of Net Borrowing Costs

10. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-9 First-Level Breakdown: Analysis of Effects of Financial Leverage (FLEV) So, ROCE is a weighted return to operating activities and financing activities: or, RNOA = OI (After tax) / NOA(Return on Net Operating Assets) FLEV = NFO / CSE(Financial Leverage) NBC= NFE (after tax) / NFO(Net Borrowing Cost) SPREAD= RNOA – NBC(Operating Spread) Spread

11. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-10 The Financial Leverage Equation ROCE = RNOA + FLEV x [RNOA – NBC] The equation says that ROCE is driven by three factors: 1.Profitability of Operations: RNOA 2.Financial Leverage: FLEV = NFO CSE 3.Operating Spread: RNOA - NBC

12. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-11 ROCE = RNOA + [FLEV x SPREAD] -4% -2% 0% 2% 4% 6% 8% 0.000.250.500.751.001.251.501.752.00 FLEV Difference between ROCE and RNOA (ROCE-RNOA) SPREAD = 6% SPREAD = 4% SPREAD = 2% SPREAD = 1% SPREAD = 0% SPREAD =-1% SPREAD =-2% How Financial Leverage Explains the Difference Between ROCE and RNOA

13. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-12 Financial Leverage: General Mills, Inc. General Mills, a large manufacturer of packaged foods, has had considerable stock repurchases over the years. At the end of fiscal 1998 common shareholder equity was only $190.2 million on net operating assets of $2.251 billion. Its financial leverage was a huge 5.745, based on average balance sheet amounts. The firm’s ROCE for 1998 was 121.6%. Further analysis reveals that this very high number is driven by the high leverage: ROCE = RNOA + [FLEV x (RNOA  NBC)] 121.6% = 21.6% + [5.745 x (21.6%  4.2%)] ROCE can exaggerate underlying operational profitability: RNOA is 21.6% but the high financial leverage, combined with a SPREAD over a borrowing cost of 4.2%, yields a much higher ROCE. Beware of firms boasting high ROCE: is it driven by financial leverage?

14. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-13 Financial Leverage: General Mills, Inc. A What-If Question: What if the RNOA at General Mills fell to 3%? What would be the effect on ROCE? The answer is that the ROCE would fall to -3.9%: -3.9% = 3.0% + [5.745 x (3.0%  4.2%)] The unfavorable leverage would produce a negative ROCE on a positive RNOA.

15. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-14 Microsoft Corp has been very profitable. For fiscal 1998 the firm reported an ROCE of 36.3% on average common equity of $13.702 billion. But Microsoft had no financing debt other than $980 million of convertible preferred stock. And it had considerable financial assets of $11.447 billion from cash generated from its operations. The return on average net financial assets was 8.0% (a significant portion from unrealized gains on financial assets). The reported ROCE masks the profitability of operations: The RNOA of 179.4% is weighted down by return on financing activities in the overall ROCE. Financial Leverage: Microsoft Corp.

16. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-15 Microsoft has regular stock repurchases. In fiscal 1998 the company used $2.796 billion of its financial assets to repurchase stock. What would the ROCE have been had it not undertaken the stock repurchase? The answer: With $2.796 billion more in average financial assets and common equity, the NFA to CSE ratio would have been 0.863 rather than 0.835, and the ROCE would have been: 31.5% = 179.4%  [0.863 x (179.4%  8.0%)] Stock repurchases (and dividends) increase ROCE. Financial Leverage: Microsoft Corp. A What-If Question:

17. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-16 The Effects of Operating Liability Leverage (OLLEV) Operating liabilities lever the Return on Net Operating Assets What would be the operating profitability without operating liabilities? where Implicit Interest on Operating Liabilities = Short-term Borrowing Rate x Operating Liabilities The Effect of OLLEV: where RNOA = ROOA + (OLLEV x OLSPREAD)

18. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-17 Operating Liability Leverage: General Mills, Inc. General Mills had average net operating assets of $2.310 billion during fiscal 1998 of which $1.159 billion were in operating liabilities other than deferred taxes and pension liabilities. Thus its operating liability leverage ratio was 0.50. Its borrowing rate on its short-term notes payable was 5.4%, or 3.4% after tax. It reported operating income of $499.6 million, but applying the after-tax short-term borrowing rate to operating liabilities other than deferred tax and pension liabilities, this operating income includes implicit after-tax interest charges of $39.4 million. So, The effect of operating liability leverage is favorable:

19. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-18 Operating Liability Leverage: General Mills, Inc. A What-If Question: What-if suppliers were to charge the short-term borrowing rate of 5.4% explicitly for the credit in accounts payable. What would be the effect on ROCE? The answer: Probably no effect. The interest would be an additional expense. But, to stay competitive, the supplier would have to reduce prices of goods sold to the firm by a corresponding amount so that the total price charged (in implicit plus explicit interest) remains the same. But supplier markets may not work as efficiently as this supposes, so firms can exploit operating liability leverage.

20. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-19 A Case of Extreme Operating Liability Leverage: Dell Computer Reformulated Balance Sheet, 2002 (millions) Net Operating Assets (NOA) are negative! Does this leverage add value? Yes! Residual income from operations = $ 1, 284 – (0.09 x -3,048) = $ 1,558 million

21. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-20 Summing Financial Leverage and Operating Liability Leverage Effects on ROCE ROCE = ROOA + (RNOA – ROOA) + (ROCE – RNOA) Return With no leverage Effect of Operating Liabilities Effect of Financing Liabilities For General Mills, 121.6% = 15.5% + (21.6% - 15.5%) + (121.6% - 21.6%)

22. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-21 Return on Net Operating Assets and Return on Assets Problems with ROA: Financial assets in denominator Financial income in numerator Operating liabilities not in denominator Net income is not comprehensive income Median ROA is 6.8% since 1962 for U.S firms Median RNOA is 10.1%

23. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-22 RNOA and ROA for Selected Firms, 1996

24. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-23 FLEV and Debt-to-Equity Ratios Problems with Debt-to-Equity ratio: Excludes financial assets (which effectively defease debt) Includes operating liabilities Median Debt-to-Equity is 1.21 Median FLEV is 0.42

25. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-24 Reformulated Financial Statements: Nike, Inc. Reformulated Statements of Common Stockholders’ Equity

26. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-25 Nike, Inc. 1 Cash and cash equivalents are split between operating cash and cash investments. 2 Some accounts payable are interest bearing but this cannot be discovered. 3 Other liabilities are primarily long-term deferred endorsement payments for promotions. 4 Notes payable are interest bearing. 5 Preferred stock is less than $0.5 million. Reformulated Balance Sheets

27. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-26 Nike, Inc. 1 Cash and cash equivalents are split between operating cash and cash investments. 2 Some accounts payable are interest bearing but this cannot be discovered. 3 Other liabilities are primarily long-term deferred endorsement payments for promotions. 4 Notes payable are interest bearing. 5 Preferred stock is less than $0.5 million. Reformulated Balance Sheets

28. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-27 Nike, Inc. 1 Broken out from selling and administrative expenses in published income statement. 2 Included in “other expense” in income statement. The nonrecurring changes in 1995 and 1994 relate to shutdown of certain facilities. 3 Marginal tax rate was 38.5%, 38.5% and 39.1% in 1996, 1995 and 1994, respectively. Reformulated Income Statements

29. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-28 Nike, Inc. 1 Broken out from selling and administrative expenses in published income statement. 2 Included in “other expense” in income statement. The nonrecurring changes in 1995 and 1994 relate to shutdown of certain facilities. 3 Marginal tax rate was 38.5%, 38.5% and 39.1% in 1996, 1995 and 1994, respectively. Reformulated Income Statements

30. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-29 Reformulated Financial Statements: Reebok International, Ltd. Reformulated Statements of Common Stockholders’ Equity

31. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-30 Reebok International, Ltd. 1 Cash and cash equivalents divided between operating cash and cash investments. 2 Excludes dividends payable which is included in stockholders’ equity. Reformulated Balance Sheets

32. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-31 Reebok International, Ltd. 1 Cash and cash equivalents divided between operating cash and cash investments. 2 Excludes dividends payable which is included in stockholders’ equity. Reformulated Balance Sheets

33. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-32 Reebok International, Ltd. 1 Broken out from selling and administrative expenses in published income statement. 2 The change in 1995 is due to consolidation and streamlining of facilities and to the sale of the Avia subsidiary. 3 Marginal tax rate was 35.4%, 36.2% and 36.9% for 1996, 1995 and 1994, respectively. Reformulated Income Statements

34. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-33 Reebok International, Ltd. 1 Broken out from selling and administrative expenses in published income statement. 2 The change in 1995 is due to consolidation and streamlining of facilities and to the sale of the Avia subsidiary. 3 Marginal tax rate was 35.4%, 36.2% and 36.9% for 1996, 1995 and 1994, respectively. Reformulated Income Statements

35. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-34 First Level Breakdown of ROCE: Nike, Inc. and Reebok International, Ltd.

36. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-35 Second-Level Breakdown of ROCE: Drivers of Operating Profitability 1.Operating profit margin: The profitability of each dollar of sales 2.Asset turnover: The ability to generate sales for a given asset base 3.Effect of financial leverage

37. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-36 Profit Margin and Asset Turnover Combinations for 238 Industries, 1963-96 Asset Turnover Profit Margin

38. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-37 Typical Levels for ROCE, FLEV, OLLEV, RNOA, PM and ATO Source: Standard & Poor’s COMPUSTAT ®

39. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-38 Third-Level Breakdown of ROCE: Profit Margin Drivers PM = Sales PM + Other operating income PM by product or line of business GM = Sales – Cost of Sales

40. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-39 Third-Level Breakdown of ROCE: Asset Turnover Drivers Some times other measures are used: Days in Acc. Receivable = Acc. Receivable/ Avg. Sales per day = 365 / Accounts receivable turnover Inventory Turnover = Cost of Sales / Avg. Inventories Acc. Payable Turnover = Purchases / Avg. Acc. Payable

41. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-40 Third-Level Breakdown: Nike, Inc. and Reebok International, Ltd.

42. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-41 Third-Level Breakdown: Nike, Inc. and Reebok International, Ltd.

43. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-42 What-If Questions: Nike, Inc. and Reebok International, Ltd

44. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-43 Third-Level Breakdown: Analysis of Net Borrowing Cost

45. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-44 Analysis of Net Borrowing Cost: Nike, Inc.

46. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-45 Tracking Profitability for Nike: BYOAP

47. Additional Presentation for Nike and Reebok

48. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-47 1996 1995 1994 Operating Income Revenues$6,471$4,761$3,790 Cost of sales 3,907 2,865 2,301 Gross margin 2,564 1,896 1,489 Operating expenses Administrative expenses$977$730$614 Advertising 643 495 373 Amortization of intangibles 22 1,642 13 1,238 8 995 Operating income from sales (before tax) 922 658 494 Taxes Tax as reported 346 250 192 Tax on other operating income - 4 3 Tax on financial items 9 355 (1) 253 (2) 193 Operating income from sales 567 405 301 Other operating income (expense) Nonrecurring change - (11) (7) Tax on other items - 4 3 - (7) (4) Currency translations (18) (18) 16 9 (7) (11) Operating income 549 414 290 Financing Expense (Income) Interest expense 39 24 15 Interest income (16) 23 (27) (3) (19) (4) Tax effect (9) 1 2 Net financing expense (income) 14 (2) (2) Comprehensive income to Common 535 416 292 Nike’s 1996 Reformulated Income Statements ROCE t = earn t / average CSE t = 535 / average CSE t or ROCE t = (OI t - NFE t ) / average (NOA t - NFO t ) = ( 549 - 14 ) / average (NOA t - NFO t )

49. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-48 1996 1995 1994 Net Operating Assets: Operating assets: Cash$ 27$ 20$ 15 Account receivable, net 1,346 1,053 704 Inventories 931 630 470 Prepaid expenses 94 74 40 Property, plant & equipment 643 555 406 Goodwill$328$330$182 Trademarks & other intangibles 210 209 12 Accumulated amortization (63) 475 (43) 496 (31) 163 Deferred income taxes & other assets 200 119 72 3,716 2,947 1,870 Operating liabilities: Accounts payable(455)(298)(211) Accrued liabilities(480)(345)(182) Income taxes payable (79) (36) (38) Deferred income taxes (2) (18) (18) Other liabilities (41)(1,057) (42) (739) (40) (489) 2,659 2,208 1,381 Net Financial Obligations: Cash equivalents(235)(196)(503) Current portion of long-term debt 7 32 4 Notes payable 446 397 127 Long-term debt 10 228 11 244 12 (360) Common Stockholders' Equity 2,431 1,964 1,741 ROCE t = earn t / average CSE t = 535 / [( 2,431 + 1,964 ) / 2] = 24.3% Nike’s 1996 Reformulated Balance Sheets orROCE t = (OI t - NFE t ) / average (NOA t - NFO t ) = (549 - 14) / [( 2,659 + 2,208 ) / 2 - ( 228+ 244 ) / 2] = 24.3%

50. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-49 First Level Breakdown: Reebok

51. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-50 First Level Breakdown: Reebok

52. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-51 First Level Breakdown: Reebok

53. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-52 What about Minority Interests? First Level Breakdown: Reebok

54. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-53 Cutting to the Core: ROCE Drivers Shorthand notation for average CSE RNOA t FLEV t NBC t First Level Breakdown: Distinguish operating and financial profitability and the effects of leverage

55. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-54 BreakingDownROCEDrivers Breaking Down ROCE Drivers for Nike:

56. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-55 BreakingDownROCEDrivers Breaking Down ROCE Drivers for Nike:

57. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-56 BreakingDownROCEDrivers Breaking Down ROCE Drivers for Nike:

58. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-57 BreakingDownROCEDrivers Breaking Down ROCE Drivers for Nike:

59. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-58 BreakingDownROCEDrivers Breaking Down ROCE Drivers for Nike:

60. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-59 Breaking Down ROCE Drivers for Nike:

61. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-60 Breaking Down ROCE Drivers for Nike:

62. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-61 Breaking Down ROCE Drivers for Nike:

63. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-62 Breaking Down ROCE Drivers for Nike: for Reebok:

64. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-63 Cutting to the Core: Drivers of Operating Profitability (1)Profit margin (PM): The profitability of each dollar of sales (2)Asset Turnover (ATO): The ability to generate sales for a given asset base. (3)Financial Leverage: Amount of leverage Spread Second Level Breakdown :

65. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-64 Third Level Breakdown Profit Margin DriversAsset Turnover Drivers

66. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-65 Cutting to the Core : Profit Margin Drivers Third level breakdown: by product or line of business benefit or expense?

67. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-66 1996 1995 1994 Operating Income Revenues$6,471$4,761$3,790 Cost of sales 3,907 2,865 2,301 Gross margin 2,564 1,896 1,489 Operating expenses Administrative expenses$977$730$614 Advertising 643 495 373 Amortization of intangibles 22 1,642 13 1,238 8 995 Operating income from sales (before tax) 922 658 494 Taxes Tax as reported 346 250 192 Tax on other operating income - 4 3 Tax on financial items 9 355 (1) 253 (2) 193 Operating income from sales 567 405 301 Other operating income (expense) Nonrecurring change - (11) (7) Tax on other items - 4 3 - (7) (4) Currency translations (18) (18) 16 9 (7) (11) Operating income 549 414 290 Financing Expense (Income) Interest expense 39 24 15 Interest income (16) 23 (27) (3) (19) (4) Tax effect (9) 1 2 Net financing expense (income) 14 (2) (2) Comprehensive income to Common 535 416 292 Nike’s 1996 Reformulated Income Statements

68. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-67 1996 1995 Second Level: Nike Reebok NikeReebok RNOA 22.6% 14.1% 23.1% 16.9% Profit Margin 8.5% 4.8% 8.7% 5.7% Asset Turnover 2.66 2.92 2.65 2.94 Third Level: Profit Margin Drivers (%): Gross margin ratio 39.6 38.4 39.8 39.3 Administrative expense ratio(15.1)(24.8)(15.3)(24.2) Advertising expense ratio (9.9) (5.8)(10.4) (4.5) Amortization expense ratio (0.3) (0.1) (0.3) (0.1) Sales PM before tax 14.2 7.6 13.8 10.4 Tax expense ratio (5.5) (2.7) (5.3) (3.8) Sales PM 8.8 4.9 8.5 6.7 Other items PM (0.3) (0.1) 0.2 (0.9) 8.5 4.8 8.7 5.7 Second and Third Level Breakdown: Nike and Reebok

69. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-68 1996 1995 Second Level: Nike Reebok NikeReebok RNOA 22.6% 14.1% 23.1% 16.9% Profit Margin 8.5% 4.8% 8.7% 5.7% Asset Turnover 2.66 2.92 2.65 2.94 Third Level: Profit Margin Drivers (%): Gross margin ratio 39.6 38.4 39.8 39.3 Administrative expense ratio(15.1)(24.8)(15.3)(24.2) Advertising expense ratio (9.9) (5.8)(10.4) (4.5) Amortization expense ratio (0.3) (0.1) (0.3) (0.1) Sales PM before tax 14.2 7.6 13.8 10.4 Tax expense ratio (5.5) (2.7) (5.3) (3.8) Sales PM 8.8 4.9 8.5 6.7 Other items PM (0.3) (0.1) 0.2 (0.9) 8.5 4.8 8.7 5.7 Second and Third Level Breakdown: Nike and Reebok

70. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-69 1996 1995 Second Level: Nike Reebok NikeReebok RNOA 22.6% 14.1% 23.1% 16.9% Profit Margin 8.5% 4.8% 8.7% 5.7% Asset Turnover 2.66 2.92 2.65 2.94 Third Level: Profit Margin Drivers (%): Gross margin ratio 39.6 38.4 39.8 39.3 Administrative expense ratio(15.1)(24.8)(15.3)(24.2) Advertising expense ratio (9.9) (5.8)(10.4) (4.5) Amortization expense ratio (0.3) (0.1) (0.3) (0.1) Sales PM before tax 14.2 7.6 13.8 10.4 Tax expense ratio (5.5) (2.7) (5.3) (3.8) Sales PM 8.8 4.9 8.5 6.7 Other items PM (0.3) (0.1) 0.2 (0.9) 8.5 4.8 8.7 5.7 Second and Third Level Breakdown: Nike and Reebok

71. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-70 Cutting to the Core : Asset Turnover Drivers Third level breakdown: Some times other measures are used: Days in Acc. Receivable = Acc. Receivable/ Avg. Sales per day Inventory Turnover = Cost of Sales / Avg. Inventories Acc. Payable Turnover = Purchases / Avg. Acc. Payable

72. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-71 1996 1995 Second Level: Nike Reebok NikeReebok RNOA 22.6% 14.1% 23.1% 16.9% Profit Margin 8.5% 4.8% 8.7% 5.7% Asset Turnover 2.66 2.92 2.65 2.94 Third Level: Cash turnover.004.003.004.002 Accounts receivable turnover.185.154.185.149 Inventory turnover.121.174.116.181 Prepayments turnover.013.011.012.011 PPE turnover.093.055.101.051 Intangibles turnover.075.019.069.023 Other assets turnover.025.038.020.035 Operating assets turnover.515.453.506.453 Accounts payable turnover (.058) (.051) (.053) (.048) Accrued expense turnover (.064) (.044) (.055) (.043) Taxes payable turnover (.008) - (.012) -.376.343.377.340 Second and Third Level Breakdown: Nike and Reebok

73. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-72 Other Operating Income Other operating income can sometimes be analyzed with specific operating ratios Question: Is the dividend return a good measure of the profitability of the investment ?

74. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2003 All rights reserved. 11-73 Gross Margin RatioExpense RatiosOther OI/Sales Ratios Individual Asset and Liability Turnovers Borrowing Cost Drivers Level 3 Sales PMOther Items PM Cutting to the Core: The Analysis of Profitability PM = OI / SalesATO = Sales / NOA Level 2 Level 1