ASSET UTILIZATION ANALYSIS

1. ASSET UTILIZATION ANALYSIS Chapter 13

2. CHAPTER 13 OBJECTIVES • 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. • 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. • 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 • Measures the relationship between inputs (assets) and output (income)

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

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

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

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

9. INVESTMENT ACTIVITIES (CONT.) • Capital is any form of wealth used to produce additional wealth • Assets are an entities’ capital as defined in its broadest sense • 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 • 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 • Return on assets (ROA) and return on equity (ROE) measure asset utilization • ROA is based on the total asset 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 • Computed as: net income / average total assets • It is a measure of the productivity of an enterprise’s total resources

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

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

16. RETURN ON ASSETS (CONT.) • Technical adjustments to return on assets • Debt Cost • 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

17. RETURN ON ASSETS (CONT.) • Computational procedure for interest adjustment • 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

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

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

20. RETURN ON EQUITY (CONT.) • Financial structure leverage ratio • A component of the ROE ratio • 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

21. RETURN ON EQUITY (CONT.) • 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 • 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 decreases ROE if the profit margin is negative

23. eSTUFF’S ASSET UTILIZATION RATIOS

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

25. ADDITIONAL ASSET UTILIZATION CONSIDERATIONS (CONT.) • Asset impairment • 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 • Judgment is required in determining if and when an asset is impaired • Some entities attempt to bury impaired assets as part of restructuring charges

26. ADDITIONAL ASSET UTILIZATION CONSIDERATIONS (CONT.) • Segment returns • Companies report revenues, income, and assets of their business divisions • 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 • Segment ROA can be computed • 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 and information increasingly produce value and wealth • Such items are more difficult to measure than traditional resources • 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

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

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

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

34. ANALYSIS OF THE PC INDUSTRY (CONT.) • ROA components reflected overall ROA results • 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) • 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)

37. ANALYSIS OF THE PC INDUSTRY (CONT.) • Return on Equity • None of the four firms were highly leveraged, due to • Small fixed asset bases • A history of venture equity capital • Substantial retention of earned income • 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) • It can produce returns on equity that are greater than returns on assets • For example, the equity returns earned by Dell and Gateway • It can produce ROE that are less than ROA • 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) • 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 • Apple performed poorly in the domestic market • Compaq’s segments could not be analyzed because they did not disclose segment information