Chapter 2: Evaluating Financial Performance
Return on Equity
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦 = 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟'𝑠 𝐸𝑞𝑢𝑖𝑡𝑦
● It is not an exaggeration to say that the careers of many senior executives rise and fall with
their firms’ ROEs.
● ROE is accorded such importance because it is a measure of the efficiency with which a
company employs owners’ capital. It is a measure of earnings per dollar of invested equity
capital or, equivalently, of the percentage return to owners on their investment.
The Three Determinants of ROE
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝑆𝑎𝑙𝑒𝑠 𝐴𝑠𝑠𝑒𝑡𝑠
𝑅𝑂𝐸 = 𝑆𝑎𝑙𝑒𝑠
× 𝐴𝑠𝑠𝑒𝑡𝑠
× 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠' 𝐸𝑞𝑢𝑖𝑡𝑦
● Denoting the last three ratios as the profit margin, asset turnover and financial leverage,
respectively, the expression can be written as:
ROE = Profit margin x Asset turnover x Financial leverage
● This says that management has only three levers for controlling ROE: (1) the earnings
squeezed out of each dollar of sales, or the project margin; (2) the sales generated from each
dollar of assets employed, or the asset turnover; and (3) the amount of equity used to finance
the assets or the financial leverage.
● WIth few exceptions, whatever management does to increase these ratios increases ROE.
● The profit margin summarises the company’s income statement performance by showing
profit per dollar of sales.
● The asset turnover ratio summarises the company’s management of the asset side of the
balance sheet by showing the resources required to support sales.
● And the financial leverage ratio summarises the management of the liabilities side of the
balance sheet by showing the amount of shareholders’ equity used to finance the assets.
The Profit Margin
● The profit margin measures the fraction of each dollar of sales that trickles down through the
income statement to profits.
● This ratio is particularly important to operating managers because it reflects the company’s
pricing strategy and its ability to control operating costs.
● Note: profit margin and asset turnover tend to vary inversely.
● Companies with high profit margins tend to have low asset turns, and vice versa.
● A high profit margin is not necessarily better or worse than a low one - it all depends on the
combined effect of the profit margin and the asset turnover.
Return on Assets
● To look at the combined effect of margins and turns, we can calculate the return on assets
(ROA):
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
𝑅𝑂𝐴 = 𝑃𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 × 𝐴𝑠𝑠𝑒𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 = 𝐴𝑠𝑠𝑒𝑡𝑠
● ROA is a basic measure of the efficiency with which a company allocates and manages its
resources.
● It differs from ROE in that it measures profit as a percentage of money provided by the
owners and creditors as opposed to only the money provided by owners.
● A high profit margin and a high asset turnover are ideal, but can be expected to attract
considerable competition.
● Conversely a low profit margin combined with a low asset turnover will lead to bankruptcy.
Gross Margin
● When analysing profitability, it is often interesting to distinguish between variable costs and
fixed costs.
● Variable costs change as sales vary, while fixed costs remain constant.
● Companies with a high proportion of fixed costs are more vulnerable to sales declines than
other firms, because they cannot reduce fixed costs as sales fall.
, ● The accountant does not differentiate between fixed and variable costs when constructing an
income statement. However, it is usually safe to assume that most expenses in cost of goods
sold are variable, while most of the other operating costs are fixed.
● The gross margin enables us to distinguish, insofar as possible, between fixed and variable
costs. It is defined as:
𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡
𝐺𝑟𝑜𝑠𝑠 𝑚𝑎𝑟𝑔𝑖𝑛 = 𝑆𝑎𝑙𝑒𝑠
● Where gross profit equals net sales less cost of goods sold.
● One common use of the gross margin is to estimate a company’s breakeven sales volume.
Asset Turnover
𝑆𝑎𝑙𝑒𝑠
𝐴𝑠𝑠𝑒𝑡 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 = 𝐴𝑠𝑠𝑒𝑡𝑠
● Unless a company is about to go out of business, its value is in the income stream it
generates, and its assets are simply a means to this end.
● The ROE equation tells us that, other things constant, financial performance improves as asset
turnover rises.
● The asset turnover ratio measures the sales generated per dollar of assets.
● More specifically, it measures asset intensity, with a low asset turnover signifying an
asset-intensive business and a high turnover the reverse.
● The nature of a company’s products and its competitive strategy strongly influence asset
turnover.
● Management diligence and creativity in controlling assets are also vital determinants of a
company’s asset turnover.
● When product technology is similar among competitors, control of assets is often the margin
between success and failure.
● With current assets, especially accounts receivable and inventory, if sales decline
unexpectedly, customers delay payment, or a critical part fails to arrive, a company’s
investment in current assets can balloon very rapidly.
● Unlike fixed assets, current assets can become a source of cash during business downturns. A
sales decline, a company’s investment in accounts receivable and inventory should fall as well,
thereby freeing cash for other uses.
Inventory turnover
Inventory turnover is expressed as:
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 = 𝐸𝑛𝑑𝑖𝑛𝑔 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
● Several alternative definitions of the inventory turnover ratio exist. Including sales divided by
ending inventory and cost of goods sold divided by average inventory.
● Cost of goods sold is a more appropriate numerator than sales because sales include a profit
markup that is absent from inventory.
● Days inventory outstanding (or days’ sales in inventory) = 365/Inventory turnover
The Collection period
The collection period highlights a company’s management of accounts receivable.
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒
𝐶𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛 𝑝𝑒𝑟𝑖𝑜𝑑 = 𝐶𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠 𝑝𝑒𝑟 𝑑𝑎𝑦
● Credit sales appear here rather than net sales because only credit sales generate accounts
receivable.
● Credit sales per day is defined as credit sales for the accounting period divided by the number
of days in the accounting period, which for annual statements is 365.
Days’ Sales in Cash
𝐶𝑎𝑠ℎ 𝑎𝑛𝑑 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠
𝐷𝑎𝑦𝑠' 𝑆𝑎𝑙𝑒𝑠 𝑖𝑛 𝐶𝑎𝑠ℎ = 𝑆𝑎𝑙𝑒𝑠 𝑝𝑒𝑟 𝑑𝑎𝑦
● On one hand, cash balances should not be too low. Companies require modest amounts of
cash to facilitate transactions and are sometimes required to carry substantially larger
amounts as compensating balances for bank loans.
● In addition, cash and marketable securities can be an important source of liquidity for a firm
in an emergency.
● On the other hand, if cash balances are too high, shareholders may become disappointed that
the firm’s assets are not put to more productive and profitable uses.
Return on Equity
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦 = 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟'𝑠 𝐸𝑞𝑢𝑖𝑡𝑦
● It is not an exaggeration to say that the careers of many senior executives rise and fall with
their firms’ ROEs.
● ROE is accorded such importance because it is a measure of the efficiency with which a
company employs owners’ capital. It is a measure of earnings per dollar of invested equity
capital or, equivalently, of the percentage return to owners on their investment.
The Three Determinants of ROE
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝑆𝑎𝑙𝑒𝑠 𝐴𝑠𝑠𝑒𝑡𝑠
𝑅𝑂𝐸 = 𝑆𝑎𝑙𝑒𝑠
× 𝐴𝑠𝑠𝑒𝑡𝑠
× 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠' 𝐸𝑞𝑢𝑖𝑡𝑦
● Denoting the last three ratios as the profit margin, asset turnover and financial leverage,
respectively, the expression can be written as:
ROE = Profit margin x Asset turnover x Financial leverage
● This says that management has only three levers for controlling ROE: (1) the earnings
squeezed out of each dollar of sales, or the project margin; (2) the sales generated from each
dollar of assets employed, or the asset turnover; and (3) the amount of equity used to finance
the assets or the financial leverage.
● WIth few exceptions, whatever management does to increase these ratios increases ROE.
● The profit margin summarises the company’s income statement performance by showing
profit per dollar of sales.
● The asset turnover ratio summarises the company’s management of the asset side of the
balance sheet by showing the resources required to support sales.
● And the financial leverage ratio summarises the management of the liabilities side of the
balance sheet by showing the amount of shareholders’ equity used to finance the assets.
The Profit Margin
● The profit margin measures the fraction of each dollar of sales that trickles down through the
income statement to profits.
● This ratio is particularly important to operating managers because it reflects the company’s
pricing strategy and its ability to control operating costs.
● Note: profit margin and asset turnover tend to vary inversely.
● Companies with high profit margins tend to have low asset turns, and vice versa.
● A high profit margin is not necessarily better or worse than a low one - it all depends on the
combined effect of the profit margin and the asset turnover.
Return on Assets
● To look at the combined effect of margins and turns, we can calculate the return on assets
(ROA):
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
𝑅𝑂𝐴 = 𝑃𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 × 𝐴𝑠𝑠𝑒𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 = 𝐴𝑠𝑠𝑒𝑡𝑠
● ROA is a basic measure of the efficiency with which a company allocates and manages its
resources.
● It differs from ROE in that it measures profit as a percentage of money provided by the
owners and creditors as opposed to only the money provided by owners.
● A high profit margin and a high asset turnover are ideal, but can be expected to attract
considerable competition.
● Conversely a low profit margin combined with a low asset turnover will lead to bankruptcy.
Gross Margin
● When analysing profitability, it is often interesting to distinguish between variable costs and
fixed costs.
● Variable costs change as sales vary, while fixed costs remain constant.
● Companies with a high proportion of fixed costs are more vulnerable to sales declines than
other firms, because they cannot reduce fixed costs as sales fall.
, ● The accountant does not differentiate between fixed and variable costs when constructing an
income statement. However, it is usually safe to assume that most expenses in cost of goods
sold are variable, while most of the other operating costs are fixed.
● The gross margin enables us to distinguish, insofar as possible, between fixed and variable
costs. It is defined as:
𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡
𝐺𝑟𝑜𝑠𝑠 𝑚𝑎𝑟𝑔𝑖𝑛 = 𝑆𝑎𝑙𝑒𝑠
● Where gross profit equals net sales less cost of goods sold.
● One common use of the gross margin is to estimate a company’s breakeven sales volume.
Asset Turnover
𝑆𝑎𝑙𝑒𝑠
𝐴𝑠𝑠𝑒𝑡 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 = 𝐴𝑠𝑠𝑒𝑡𝑠
● Unless a company is about to go out of business, its value is in the income stream it
generates, and its assets are simply a means to this end.
● The ROE equation tells us that, other things constant, financial performance improves as asset
turnover rises.
● The asset turnover ratio measures the sales generated per dollar of assets.
● More specifically, it measures asset intensity, with a low asset turnover signifying an
asset-intensive business and a high turnover the reverse.
● The nature of a company’s products and its competitive strategy strongly influence asset
turnover.
● Management diligence and creativity in controlling assets are also vital determinants of a
company’s asset turnover.
● When product technology is similar among competitors, control of assets is often the margin
between success and failure.
● With current assets, especially accounts receivable and inventory, if sales decline
unexpectedly, customers delay payment, or a critical part fails to arrive, a company’s
investment in current assets can balloon very rapidly.
● Unlike fixed assets, current assets can become a source of cash during business downturns. A
sales decline, a company’s investment in accounts receivable and inventory should fall as well,
thereby freeing cash for other uses.
Inventory turnover
Inventory turnover is expressed as:
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 = 𝐸𝑛𝑑𝑖𝑛𝑔 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
● Several alternative definitions of the inventory turnover ratio exist. Including sales divided by
ending inventory and cost of goods sold divided by average inventory.
● Cost of goods sold is a more appropriate numerator than sales because sales include a profit
markup that is absent from inventory.
● Days inventory outstanding (or days’ sales in inventory) = 365/Inventory turnover
The Collection period
The collection period highlights a company’s management of accounts receivable.
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒
𝐶𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛 𝑝𝑒𝑟𝑖𝑜𝑑 = 𝐶𝑟𝑒𝑑𝑖𝑡 𝑠𝑎𝑙𝑒𝑠 𝑝𝑒𝑟 𝑑𝑎𝑦
● Credit sales appear here rather than net sales because only credit sales generate accounts
receivable.
● Credit sales per day is defined as credit sales for the accounting period divided by the number
of days in the accounting period, which for annual statements is 365.
Days’ Sales in Cash
𝐶𝑎𝑠ℎ 𝑎𝑛𝑑 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠
𝐷𝑎𝑦𝑠' 𝑆𝑎𝑙𝑒𝑠 𝑖𝑛 𝐶𝑎𝑠ℎ = 𝑆𝑎𝑙𝑒𝑠 𝑝𝑒𝑟 𝑑𝑎𝑦
● On one hand, cash balances should not be too low. Companies require modest amounts of
cash to facilitate transactions and are sometimes required to carry substantially larger
amounts as compensating balances for bank loans.
● In addition, cash and marketable securities can be an important source of liquidity for a firm
in an emergency.
● On the other hand, if cash balances are too high, shareholders may become disappointed that
the firm’s assets are not put to more productive and profitable uses.
