18.How to Analyze and Improve Corporate Profitability and Shareholder Value

= Net profit margin × Total assets turnover The DuPont formula combines the income statementand balance sheet into this otherwise static measure ofperformance.. Total asset turnover, how-

C HAPTER 18

How do you measure managerial performance and the return to

stockholders?

The ability to measure performance is essential in oping incentives and controlling operations toward theachievement of organizational goals Perhaps the mostwidely used single measure of profitability of an organi-

devel-zation is the rate of return on investment (ROI) Related is the return to stockholders, known as the return on equity (ROE)

What is return on investment (ROI)?

ROI relates net income to invested capital (total assets) Itprovides a standard for evaluating how efficiently man-agement employs the average dollar invested in a firm’sassets, whether that dollar came from owners or credi-tors Furthermore, a better ROI can also translate directlyinto a higher return on the stockholders’ equity ROI iscalculated as:

Corporate Profitability and Shareholder Value 351

known as the DuPont formula, is expressed as a product of

these two factors, as shown next

= Net profit margin × Total assets turnover

The DuPont formula combines the income statementand balance sheet into this otherwise static measure ofperformance Net profit margin is a measure of profitabil-ity or operating efficiency It is the percentage of profitearned on sales This percentage shows how many centsattach to each dollar of sales Total asset turnover, how-ever, measures how well a company manages its assets It

is the number of times by which the investment in assetsturn over each year to generate sales

The breakdown of ROI is based on the thesis that theprofitability of a firm is directly related to management’sability to manage assets efficiently and to control expenseseffectively

The breakdown provides a lot of insights to CFOs

on how to improve the profitability of the companyand investment strategy (Note that net profit margin

and total asset turnover are called hereafter margin and turnover, respectively, for short.) Specifically, it

has at least four advantages over the original mula (i.e., net profit after taxes/total assets) for profitplanning They are:

for-1 Focusing on the breakdown of ROI provides thebasis for integrating many of the management con-cerns that influence a firm’s overall performance.This will help managers gain an advantage in thecompetitive environment

2 The importance of turnover as a key to overallreturn on investment is emphasized in the break-down In fact, turnover is just as important as profitmargin in enhancing overall return

3 The importance of sales is explicitly recognized,which is not there in the original formula

4 The breakdown stresses the possibility of tradingone off for the other in an attempt to improve acompany’s overall performance The margin andturnover complement each other In other words, alow turnover can be made up for by a high margin,and vice versa

E XAMPLE 18.3

The breakdown of ROI into its two componentsshows that a number of combinations of margin and

Corporate Profitability and Shareholder Value 353

Is there an optimal ROI?

Exhibit 18.1 can also be looked at as showing four panies that performed equally well (in terms of ROI), butwith varying income statements and balance sheets There

com-is no ROI that com-is satcom-isfactory for all companies turing firms in various industries will have low rates ofreturn Structure and size of the firm influence the rateconsiderably A company with a diversified product linemight have only a fair return rate when all products arepooled in the analysis In such cases, it seems advisable

Manufac-to establish separate objectives for each line as well as forthe total company

Sound and successful operation must point towardthe optimum combination of profits, sales, and capitalemployed The combination will necessarily vary depend-ing on the nature of the business and the characteristics

of the product An industry with products tailor-made tocustomers’ specifications will have different margins and

turnover ratios, compared with industries that mass duce highly competitive consumer goods For example,the combination (4) may describe a supermarket oper-ation that inherently works with low margin and highturnover, while the combination (1) may be a jewelrystore that typically has a low turnover and high margin.

pro-How do you use ROI for profit planning?

The breakdown of ROI into margin and turnover givesmanagement insight into planning for profit improvement

by revealing where weaknesses exist: margin or turnover,

or both Various actions can be taken to enhance ROI.Generally, management can employ three alternatives:

improv-❍ Use less costly inputs of materials

❍ Automate processes as much as possible to increaselabor productivity

❍ Bring the discretionary fixed costs under scrutiny,with various programs either curtailed or elimi-nated Discretionary fixed costs arise from annualbudgeting decisions by management Examplesinclude advertising, research and development,and management development programs Thecost-benefit analysis is called for in order to justifythe budgeted amount of each discretionary program

A company with pricing power can raise selling pricesand retain profitability without losing business Pricingpower is the ability to raise prices even in poor economictimes when unit sales volume may be flat and capacitymay not be fully utilized It is also the ability to pass on costincreases to consumers without attracting domestic andimport competition, political opposition, regulation, newentrants, or threats of product substitution The companywith pricing power must have a unique economic position.Companies that offer unique, high-quality goods andservices (where the service is more important than thecost) have this economic position

Alternative 2 may be achieved by increasing sales whileholding the investment in assets relatively constant, or by

Corporate Profitability and Shareholder Value 355

reducing assets Some of the strategies to reduce assetsare:

❍ Dispose of obsolete and redundant inventory Thecomputer has been extremely helpful in this regard,making perpetual inventory methods more feasiblefor inventory control

❍ Devise various methods of speeding up the tion of receivables and also evaluate credit termsand policies

collec-❍ See if there are unused fixed assets

❍ Use the converted assets obtained from use of theprevious methods to repay outstanding debts orrepurchase outstanding issues of stock You mayrelease them elsewhere to get more profit, whichwill improve margin as well as turnover

Alternative 3 may be achieved by increasing sales or

by any combinations of alternatives 1 and 2

Exhibit 18.2 shows complete details of the ship of ROI to the underlying ratios—margin andturnover—and their components This will help iden-tify more detailed strategies to improve margin, turnover,

relation-or both

E XAMPLE 18.4

Assume that management sets a 20 percent ROI as

a profit target It is currently making an 18 percentreturn on its investment

Present situation:

The following alternatives are illustrative of thestrategies that might be used (Each strategy is inde-pendent of the other.)

Alternative 1: Increase the margin while ing turnover constant Pursuing this strategy wouldinvolve leaving selling prices as they are and mak-ing every effort to increase efficiency so as to reduceexpenses By doing so, expenses might be reduced by

hold-$2,000 without affecting sales and investment to yield

a 20 percent target ROI, as follows

E XAMPLE 18.4 (continued)

Alternative 2:Increase turnover by reducing ment in assets while holding net profit and salesconstant Working capital might be reduced or someland might be sold, reducing investment in assets by

invest-$10,000 without affecting sales and net income to yieldthe 20 percent target ROI, as follows

Alternative 3:Increase both margin and turnover

by disposing of obsolete and redundant inventories orthrough an active advertising campaign For example,trimming down $5,000 worth of investment in invento-ries would also reduce the inventory holding charge by

$1,000 This strategy would increase ROI to 20 percent

Excessive investment in assets is just as much of

a drag on profitability as excessive expenses In thiscase, cutting unnecessary inventories also helps cutdown the expenses of carrying those inventories, sothat both margin and turnover are improved at thesame time In practice, alternative 3 is much morecommon than alternative 1 or 2

What is the relationship between ROI and return on equity (ROE)?

Generally, a better management performance (i.e., ahigh or above-average ROI) produces a higher return

to investors (equity holders) However, even a poorlymanaged company that suffers from a below-average per-formance can generate an above-average return on the

stockholders’ equity, simply called the return on equity (ROE) This is because borrowed funds can magnify thereturns a company’s profits represent to its stockholders

Another version of the DuPont formula, called the ified DuPont formula, reflects this effect The formula tiestogether the ROI and the degree of financial leverage (use

mod-of borrowed funds) The financial leverage is measured

by the equity multiplier, which is the ratio of a company’stotal asset base to its equity investment, or, stated anotherway, the ratio of how many dollars of assets held perdollar of stockholders’ equity It is calculated by dividing

minus Total Cost

Net Profit after Taxes

Net Profit Margin

total assets by stockholders’ equity This measurementgives an indication of how much of a company’s assetsare financed by stockholders’ equity and how much withborrowed funds.

The return on equity (ROE) is calculated as:

= ROI × Equity multiplier

ROE measures the returns earned on the owners’ (bothpreferred and common stockholders’) investment Theuse of the equity multiplier to convert the ROI to theROE reflects the impact of the leverage (use of debt) onstockholders’ return:

If the company used only equity, the 18 percent ROIwould equal ROE However, 55 percent of the firm’scapital is supplied by creditors ($45,000/$100,000=45% is the equity-to-asset ratio; $55,000/$100,000=55% is the debt ratio) Since the 18 percent ROI allgoes to stockholders, who put up only 45 percent

of the capital, the ROE is higher than 18 percent.This example indicates that the company was usingleverage (debt) favorably

Net profit margin

Total asset turnover

Measures the returns earned on the owners’ (both preferred and common stockholders’) investment

Measures overall effectiveness in generating profits with available assets

Measures profitability with respect to sales generated

Measures efficiency in using assets to generate sales

Debt Ratio

Total liabilities Total assets

Measures the proportion of total assets provided by the firm’s creditors

Net profit after taxes Stockholders’ equity

E XAMPLE 18.6

To further demonstrate the interrelationship between

a firm’s financial structure and the return it generates

on the stockholders’ investments, let us compare twofirms that generate $300,000 in operating income Bothfirms employ $800,000 in total assets, but they havedifferent capital structures One firm employs no debt,whereas the other uses $400,000 in borrowed funds.The comparative capital structures are shown as:

Total assets $800,000 $800,000 Total liabilities — 400,000 Stockholders’ equity (a) 800,000 400,000 Total liabilities and stockholders’ equity $800,000 $800,000

Firm B pays 10 percent interest for borrowed funds.The comparative income statements and ROEs forfirms A and B would look like this:

Operating income $300,000 $300,000

Profit before taxes $300,000 $260,000 Taxes (30% assumed) (90,000) (78,000) Net profit after taxes (b) $210,000 $182,000

The absence of debt allows firm A to register higherprofits after taxes Yet the owners in firm B enjoy asignificantly higher return on their investments Thisprovides an important view of the positive contribu-tion debt can make to a business, but within a certainlimit Too much debt can increase the firm’s financialrisk and thus the cost of financing

If the assets in which the funds are invested are able

to earn a return greater than the fixed rate of returnrequired by the creditors, the leverage is positive andthe common stockholders benefit The advantage ofthis formula is that it enables the company to breakits ROE into a profit margin portion (net profit mar-gin), an efficiency-of-asset-utilization portion (totalasset turnover), and a use-of-leverage portion (equitymultiplier) It shows that the company can raiseshareholder return by employing leverage—taking

on larger amounts of debt to help finance growth.Since financial leverage affects net profit marginthrough the added interest costs, management mustlook at the various pieces of this ROE equation, within

Balanced Scorecard 361

E XAMPLE 18.6 (continued)

the context of the whole, to earn the highest returnfor stockholders CFOs have the task of determiningjust what combination of asset return and leveragewill work best in its competitive environment Mostcompanies try to keep at least a level equal to what isconsidered to be ‘‘normal’’ within the industry

BALANCED SCORECARD

How does a balanced scorecard

to evaluate performance work?

A problem with just assessing performance with financialmeasures like profit, ROI, and economic value added(EVA) is that the financial measures are backward looking

In other words, today’s financial measures tell you aboutthe accomplishments and failures of the past An approach

to performance measurement that also focuses on whatmanagers are doing today to create future shareholdervalue is the balanced scorecard

Essentially, a balanced scorecard is a set of performance

measures constructed for four dimensions of performance

As indicated in Exhibit 18.4, the dimensions are financial,customer, internal processes, and learning and growth.Having financial measures is critical even if they are back-ward looking After all, they have a great effect on theevaluation of the company by shareholders and credi-tors Customer measures examine the company’s success

in meeting customer expectations Internal process sures examine the company’s success in improving criticalbusiness processes And learning and growth measuresexamine the company’s success in improving its ability

mea-to adapt, innovate, and grow The cusmea-tomer, internal cesses, and learning and growth measures are generallythought to be predictive of future success (i.e., they arenot backward looking)

pro-How is balance achieved

in a balanced scorecard?

A variety of potential measures for each dimension

of a balanced scorecard are indicated in Exhibit 18.4.After reviewing these measures, note how ‘‘balance’’ isachieved:

achieving its financial goals?

Operating income Return on assets Sales growth Cash flow from operations Reduction of administrative expense

meeting customer expectations?

Customer satisfaction Customer retention New customer acquisition Market share On-time delivery Time to fill orders

Internal

Processes

Is the company

improving critical internal processes?

Defect rate Lead time Number of suppliers Material turnover Percent of practical capacity

Exhibit 18.4 B ALANCED S CORECARD

❍ Performance is assessed across a balanced set of sions (financial, customer, internal processes, andinnovation)

dimen-❍ Quantitativemeasures (e.g., number of defects) arebalanced with qualitative measures (e.g., ratings ofcustomer satisfaction)

❍ There is a balance of backward-looking measures

(e.g., financial measures like growth in sales)

and forward-looking measures (e.g., number of new

patents as an innovation measure)

Note: The balanced scorecard measures vary with

a company’s strategy and industry Exhibit 18.5 listsexamples of performance indicators for each balancedscorecard dimension across a wide rage of industries.There are numerous Web resources that you can log

on to to learn more about the balanced scorecard andperformance evaluations For example, managers fre-quently look to industry ‘‘best practices’’ or examples of