1. ASSET UTILIZATION ANALYSIS Chapter 13

2. CHAPTER 13 OBJECTIVES Explain how the definitions of investment, capital and assets affect asset utilization analysis. Explain how the definitions of investment, capital and assets affect asset utilization analysis. Indicate the significance of return on investment measures in the analysis of asset productivity. Indicate the significance of return on investment measures in the analysis of asset productivity. Compute return on assets and equity measures and their components. Compute return on assets and equity measures and their components.

3. CHAPTER 13 OBJECTIVES Discuss the need for technical adjustments to return on investment measures. Discuss the need for technical adjustments to return on investment measures. Present a preliminary asset utilization analysis for a company or industry. Present a preliminary asset utilization analysis for a company or industry.

4. OBJECTIVE FOR ANALYZING ASSET UTILIZATION An assessment of an entity’s wealth creating abilities An assessment of an entity’s wealth creating abilities Measures the relationship between inputs (assets) and output (income) Measures the relationship between inputs (assets) and output (income)

5. OBJECTIVE FOR ANALYZING ASSET UTILIZATION (CONT.) Asset utilization provides analysts with information about Asset utilization provides analysts with information about Managerial effectiveness Managerial effectiveness Shareholders’ earnings Shareholders’ earnings Future performance Future performance

6. INVESTMENT ACTIVITIES Return on investment is the primary means for measuring asset utilization Return on investment is the primary means for measuring asset utilization The term investment has multiple meanings The term investment has multiple meanings Its definition is context specific Its definition is context specific

7. INVESTMENT ACTIVITIES (CONT.) Asset Valuation Asset Valuation Most assets are measured on the basis of historical cost Most assets are measured on the basis of historical cost Trend toward more market based valuations Trend toward more market based valuations Revisions only occur when reliable market data exist Revisions only occur when reliable market data exist Examples include security investments and derivative instruments Examples include security investments and derivative instruments

8. INVESTMENT ACTIVITIES (CONT.) Reporting limitations affect asset valuation Reporting limitations affect asset valuation Underreported items—for example, research and development costs Underreported items—for example, research and development costs Unreported items—for example, human capital Unreported items—for example, human capital

9. INVESTMENT ACTIVITIES (CONT.) Capital is any form of wealth used to produce additional wealth Capital is any form of wealth used to produce additional wealth Assets are an entities’ capital as defined in its broadest sense Assets are an entities’ capital as defined in its broadest sense Shareholders’ equity is a narrower definition of capital Shareholders’ equity is a narrower definition of capital Legal equity is the regulatory view of capital; it is even more restrictive than shareholders’ equity definition Legal equity is the regulatory view of capital; it is even more restrictive than shareholders’ equity definition An analyst can modify GAAP-based investment disclosures to gain additional insights about asset utilization An analyst can modify GAAP-based investment disclosures to gain additional insights about asset utilization

10. INVESTMENT ACTIVITIES (CONT.) Asset utilization is a function of how capital is defined Asset utilization is a function of how capital is defined Return on assets (ROA) and return on equity (ROE) measure asset utilization Return on assets (ROA) and return on equity (ROE) measure asset utilization ROA is based on the total asset definition of capital ROA is based on the total asset definition of capital ROE is based on the shareholders’ equity definition of capital ROE is based on the shareholders’ equity definition of capital

11. RETURN ON ASSETS Reports the percentage of income earned for each dollar invested in an entity’s resources Reports the percentage of income earned for each dollar invested in an entity’s resources Computed as: net income / average total assets Computed as: net income / average total assets It is a measure of the productivity of an enterprise’s total resources It is a measure of the productivity of an enterprise’s total resources

12. RETURN ON ASSETS (CONT.) Managerial orientation Managerial orientation Analysts use ROA to assess managerial performance Analysts use ROA to assess managerial performance Measures manager’s ability to create wealth with its given store of value Measures manager’s ability to create wealth with its given store of value Reports their efficiency in creating that wealth Reports their efficiency in creating that wealth

13. RETURN ON ASSETS (CONT.) Components of return on assets Components of return on assets Analysts gain greater insight about ROA results by examining the measure’s components Analysts gain greater insight about ROA results by examining the measure’s components Profit margin measures the earnings per revenue dollar Profit margin measures the earnings per revenue dollar Computed as net income / revenues Computed as net income / revenues Asset turnover measures the revenues produced per dollar invested in assets Asset turnover measures the revenues produced per dollar invested in assets Computed as: revenues / average total assets Computed as: revenues / average total assets

14. RETURN ON ASSETS (CONT.) An infinite number of profit margins and asset turnover ratios produce an equivalent ROA (Exhibit 13-1B) An infinite number of profit margins and asset turnover ratios produce an equivalent ROA (Exhibit 13-1B) Increasing one ROA component to a greater extent than a decrease in the other one increases overall ROA (Exhibit 13-1C) Increasing one ROA component to a greater extent than a decrease in the other one increases overall ROA (Exhibit 13-1C)

15. RETURN ON ASSETS (CONT.) Technical adjustments to return on assets Technical adjustments to return on assets Financial leverage Financial leverage Substitution of fixed-charged financing for common equity financing Substitution of fixed-charged financing for common equity financing Financial leverage can either increase or decrease ROA, depending on its cost and the return on assets Financial leverage can either increase or decrease ROA, depending on its cost and the return on assets

16. RETURN ON ASSETS (CONT.) Technical adjustments to return on assets Technical adjustments to return on assets Debt Cost Debt Cost Interest expense affects net income (Exhibit 13-2) Interest expense affects net income (Exhibit 13-2) The actual cost of debt is less than the effective rate of borrowing because interest expense is tax deductible The actual cost of debt is less than the effective rate of borrowing because interest expense is tax deductible

17. RETURN ON ASSETS (CONT.) Computational procedure for interest adjustment Computational procedure for interest adjustment Undertaken to eliminate bias in assessing managerial effectiveness Undertaken to eliminate bias in assessing managerial effectiveness Adds net interest expense back to net income in computing overall return on assets and the profit margin component to ROA Adds net interest expense back to net income in computing overall return on assets and the profit margin component to ROA

18. RETURN ON EQUITY Reports the percentage of income earned for each dollar invested by the owners of an entity Reports the percentage of income earned for each dollar invested by the owners of an entity Common shareholder orientation Common shareholder orientation Analysts use ROE to determine the rate of earnings produced by the owners’ investment Analysts use ROE to determine the rate of earnings produced by the owners’ investment Measures wealth creation accruing to risk capital Measures wealth creation accruing to risk capital

19. RETURN ON EQUITY (CONT.) Return on Equity (ROE) Ratio Return on Equity (ROE) Ratio Computed as: net income / average common shareholders’ equity Computed as: net income / average common shareholders’ equity Disaggregating the ratio into its components produces more information Disaggregating the ratio into its components produces more information

20. RETURN ON EQUITY (CONT.) Financial structure leverage ratio Financial structure leverage ratio A component of the ROE ratio A component of the ROE ratio Computed as: average total assets / average common shareholders’ equity Computed as: average total assets / average common shareholders’ equity It is multiplied by profit margin and asset turnover (the components of ROA) to produce ROE It is multiplied by profit margin and asset turnover (the components of ROA) to produce ROE

21. RETURN ON EQUITY (CONT.) Components of return on equity Components of return on equity The profit margin and asset turnover (the components of ROA) are multiplied by the financial structure leverage ratio to yield ROE The profit margin and asset turnover (the components of ROA) are multiplied by the financial structure leverage ratio to yield ROE Computed as: ROE = profit margin * asset turnover * financial structure leverage ratio Computed as: ROE = profit margin * asset turnover * financial structure leverage ratio

22. RETURN ON EQUITY (CONT.) The multiplicative nature of the financial structure leverage ratio increases ROE if the profit margin and asset turnover ratios are positive The multiplicative nature of the financial structure leverage ratio increases ROE if the profit margin and asset turnover ratios are positive The multiplicative nature of the financial structure leverage ratio decreases ROE if the profit margin is negative The multiplicative nature of the financial structure leverage ratio decreases ROE if the profit margin is negative

23. eSTUFF’S ASSET UTILIZATION RATIOS

24. ADDITIONAL ASSET UTILIZATION CONSIDERATIONS Fixed asset turnover Fixed asset turnover Subset of asset turnover ratio Subset of asset turnover ratio Measures the revenue produced per dollar of fixed investment Measures the revenue produced per dollar of fixed investment Gauges the productivity of an entity’s long-term resources Gauges the productivity of an entity’s long-term resources Computed as: revenues / average fixed assets Computed as: revenues / average fixed assets The denominator often includes intangible assets to reflect their contributions to generating revenues The denominator often includes intangible assets to reflect their contributions to generating revenues

25. ADDITIONAL ASSET UTILIZATION CONSIDERATIONS (CONT.) Asset impairment Asset impairment Exists when an asset’s expected cash flow is less than its book value Exists when an asset’s expected cash flow is less than its book value Losses on impaired assets are reported as part of other gains and losses Losses on impaired assets are reported as part of other gains and losses Judgment is required in determining if and when an asset is impaired Judgment is required in determining if and when an asset is impaired Some entities attempt to bury impaired assets as part of restructuring charges Some entities attempt to bury impaired assets as part of restructuring charges

26. ADDITIONAL ASSET UTILIZATION CONSIDERATIONS (CONT.) Segment returns Segment returns Companies report revenues, income, and assets of their business divisions Companies report revenues, income, and assets of their business divisions Management determines what its segments are and reports on them accordingly Management determines what its segments are and reports on them accordingly Analysts use segment disclosures to determine how well various aspects of the enterprise have fared Analysts use segment disclosures to determine how well various aspects of the enterprise have fared Segment ROA can be computed Segment ROA can be computed Segment ROE cannot be calculated, due to an inability to divide shareholders’ equity into segments Segment ROE cannot be calculated, due to an inability to divide shareholders’ equity into segments

27. ADDITIONAL ASSET UTILIZATION CONSIDERATIONS (CONT.) Knowledge-based assets Knowledge-based assets Knowledge and information increasingly produce value and wealth Knowledge and information increasingly produce value and wealth Such items are more difficult to measure than traditional resources Such items are more difficult to measure than traditional resources They are often underreported or unreported on the balance sheet They are often underreported or unreported on the balance sheet Their existence limits the usefulness of return on investment measures, especially for new economy firms Their existence limits the usefulness of return on investment measures, especially for new economy firms

28. ANALYSIS OF THE PC INDUSTRY Intellectual Asset Factors Intellectual Asset Factors Property, plant, and equipment compose a very small proportion of industry resources Property, plant, and equipment compose a very small proportion of industry resources Financial reporting requirements reduced asset disclosures on the balance sheet Financial reporting requirements reduced asset disclosures on the balance sheet Underreported assets, such as research and development Underreported assets, such as research and development Aggressive elimination of other intangibles, such as goodwill and in-process research and development Aggressive elimination of other intangibles, such as goodwill and in-process research and development Unreported assets, such as human capital Unreported assets, such as human capital

29. ANALYSIS OF THE PC INDUSTRY (CONT.) Component purchases and out sourcing reduce fixed asset requirements Component purchases and out sourcing reduce fixed asset requirements Knowledge-based, relatively small sized products also decrease demand for fixed assets Knowledge-based, relatively small sized products also decrease demand for fixed assets Industry emerged toward product creation and distribution from product manufacturing Industry emerged toward product creation and distribution from product manufacturing

30. ANALYSIS OF THE PC INDUSTRY (CONT.) Return on assets--data indicated diverse results Return on assets--data indicated diverse results Dell provided the highest rate of return on assets in the industry (Exhibit 13-6) Dell provided the highest rate of return on assets in the industry (Exhibit 13-6) Gateway demonstrated steady improvement, except for 1997 Gateway demonstrated steady improvement, except for 1997 Compaq’s poor ROA in 1998 offset an otherwise steady rate of return Compaq’s poor ROA in 1998 offset an otherwise steady rate of return Apple lagged its competition, even in its profitable years Apple lagged its competition, even in its profitable years

32. ANALYSIS OF THE PC INDUSTRY (CONT.) The cumulative rates of direct computer sellers (Dell and Gateway) far surpassed those of the indirect sellers (Compaq and Apple), as evidenced by Exhibit 13-8 The cumulative rates of direct computer sellers (Dell and Gateway) far surpassed those of the indirect sellers (Compaq and Apple), as evidenced by Exhibit 13-8

34. ANALYSIS OF THE PC INDUSTRY (CONT.) ROA components reflected overall ROA results ROA components reflected overall ROA results Dell increased its profit margin and asset turnover throughout the period analyzed (Exhibit 13-7A) Dell increased its profit margin and asset turnover throughout the period analyzed (Exhibit 13-7A) The asset turnovers for Gateway, Compaq, and Apple decreased over time (Exhibit 13-7B) The asset turnovers for Gateway, Compaq, and Apple decreased over time (Exhibit 13-7B) Apple’s profit margin and asset turn lagged those of the other firms Apple’s profit margin and asset turn lagged those of the other firms Lack of debt financing precluded the need to adjust ROA and profit margin for the effect of interest expense on net income (Exhibit 13-9) Lack of debt financing precluded the need to adjust ROA and profit margin for the effect of interest expense on net income (Exhibit 13-9)

37. ANALYSIS OF THE PC INDUSTRY (CONT.) Return on Equity Return on Equity None of the four firms were highly leveraged, due to None of the four firms were highly leveraged, due to Small fixed asset bases Small fixed asset bases A history of venture equity capital A history of venture equity capital Substantial retention of earned income Substantial retention of earned income Dell earned substantially higher returns on common shareholders’ equity than its competition Dell earned substantially higher returns on common shareholders’ equity than its competition

38. ANALYSIS OF THE PC INDUSTRY (CONT.) The PC industry illustrates the dual nature of financial leverage (Exhibit 13-11A and 13- 11B) The PC industry illustrates the dual nature of financial leverage (Exhibit 13-11A and 13- 11B) It can produce returns on equity that are greater than returns on assets It can produce returns on equity that are greater than returns on assets For example, the equity returns earned by Dell and Gateway For example, the equity returns earned by Dell and Gateway It can produce ROE that are less than ROA It can produce ROE that are less than ROA For example, the negative equity returns earned by Apple in 1996 and 1997 For example, the negative equity returns earned by Apple in 1996 and 1997

40. ANALYSIS OF THE PC INDUSTRY (CONT.) Segment returns (Exhibit 13-12A, 13-12B, and 13-12C) Segment returns (Exhibit 13-12A, 13-12B, and 13-12C) The American market is the largest market for PC companies The American market is the largest market for PC companies Dell’s return on assets in the American market exceeded those of its competition and contributed to its improver investment returns Dell’s return on assets in the American market exceeded those of its competition and contributed to its improver investment returns Apple performed poorly in the domestic market Apple performed poorly in the domestic market Compaq’s segments could not be analyzed because they did not disclose segment information Compaq’s segments could not be analyzed because they did not disclose segment information