ASSET UTILIZATION ANALYSIS Chapter 13. CHAPTER 13 OBJECTIVES Explain how the definitions of investment, capital and assets affect asset utilization analysis.

ASSET ASSET UTILIZATION UTILIZATION ANALYSISANALYSIS

Chapter 13Chapter 13

CHAPTER 13 OBJECTIVESCHAPTER 13 OBJECTIVES

Explain how the definitions of Explain how the definitions of investment, capital and assets investment, capital and assets affect asset utilization analysis.affect asset utilization analysis.

Indicate the significance of return Indicate the significance of return on investment measures in the on investment measures in the analysis of asset productivity.analysis of asset productivity.

Compute return on assets and Compute return on assets and equity measures and their equity measures and their components.components.

CHAPTER 13 OBJECTIVESCHAPTER 13 OBJECTIVES

Discuss the need for technical Discuss the need for technical adjustments to return on adjustments to return on investment measures.investment measures.

Present a preliminary asset Present a preliminary asset utilization analysis for a company utilization analysis for a company or industry.or industry.

OBJECTIVE FOR ANALYZING ASSET OBJECTIVE FOR ANALYZING ASSET UTILIZATIONUTILIZATION

An assessment of an entity’s An assessment of an entity’s wealth creating abilitieswealth creating abilities

Measures the relationship between Measures the relationship between

inputs (assets) and output inputs (assets) and output (income)(income)

OBJECTIVE FOR ANALYZING ASSET OBJECTIVE FOR ANALYZING ASSET UTILIZATION (CONT.)UTILIZATION (CONT.)

Asset utilization provides analysts Asset utilization provides analysts with information aboutwith information about Managerial effectivenessManagerial effectiveness Shareholders’ earningsShareholders’ earnings Future performanceFuture performance

INVESTMENT ACTIVITIESINVESTMENT ACTIVITIES

Return on investment is the Return on investment is the primary means for measuring primary means for measuring asset utilizationasset utilization

The term investment has multiple The term investment has multiple meaningsmeanings

Its definition is context specificIts definition is context specific

INVESTMENT ACTIVITIES INVESTMENT ACTIVITIES (CONT.)(CONT.)

Asset ValuationAsset Valuation Most assets are measured on the Most assets are measured on the

basis of historical costbasis of historical cost Trend toward more market based Trend toward more market based

valuationsvaluations Revisions only occur when reliable Revisions only occur when reliable

market data existmarket data exist Examples include security investments Examples include security investments

and derivative instrumentsand derivative instruments


Reporting limitations affect asset Reporting limitations affect asset valuationvaluation Underreported items—for example, Underreported items—for example,

research and development costs research and development costs Unreported items—for example, Unreported items—for example,

human capitalhuman capital


Capital is any form of wealth used to Capital is any form of wealth used to produce additional wealthproduce additional wealth Assets are an entities’ capital as defined in its Assets are an entities’ capital as defined in its

broadest sensebroadest sense Shareholders’ equity is a narrower definition Shareholders’ equity is a narrower definition

of capitalof capital Legal equity is the regulatory view of capital; Legal equity is the regulatory view of capital;

it is even more restrictive than shareholders’ it is even more restrictive than shareholders’ equity definitionequity definition

An analyst can modify GAAP-based An analyst can modify GAAP-based investment disclosures to gain additional investment disclosures to gain additional insights about asset utilizationinsights about asset utilization


Asset utilization is a function of Asset utilization is a function of how capital is definedhow capital is defined Return on assets (ROA) and return on Return on assets (ROA) and return on

equity (ROE) measure asset utilizationequity (ROE) measure asset utilization ROA is based on the total asset ROA is based on the total asset

definition of capitaldefinition of capital ROE is based on the shareholders’ ROE is based on the shareholders’

equity definition of capitalequity definition of capital

RETURN ON ASSETSRETURN ON ASSETS

Reports the percentage of income Reports the percentage of income earned for each dollar invested in earned for each dollar invested in an entity’s resourcesan entity’s resources

Computed as: net income / Computed as: net income / average total assetsaverage total assets

It is a measure of the productivity It is a measure of the productivity of an enterprise’s total resourcesof an enterprise’s total resources

RETURN ON ASSETS RETURN ON ASSETS (CONT.)(CONT.)

Managerial orientationManagerial orientation Analysts use ROA to assess Analysts use ROA to assess

managerial performancemanagerial performance Measures manager’s ability to create Measures manager’s ability to create

wealth with its given store of valuewealth with its given store of value Reports their efficiency in creating Reports their efficiency in creating

that wealththat wealth


Components of return on assetsComponents of return on assets Analysts gain greater insight about ROA results Analysts gain greater insight about ROA results

by examining the measure’s componentsby examining the measure’s components Profit margin measures the earnings per Profit margin measures the earnings per

revenue dollarrevenue dollar Computed as net income / revenuesComputed as net income / revenues Asset turnover measures the revenues Asset turnover measures the revenues

produced per dollar invested in assetsproduced per dollar invested in assets Computed as: revenues / average total assetsComputed as: revenues / average total assets


An infinite number of profit An infinite number of profit margins and asset turnover ratios margins and asset turnover ratios produce an equivalent ROA produce an equivalent ROA (Exhibit 13-1B)(Exhibit 13-1B)

Increasing one ROA component to Increasing one ROA component to a greater extent than a decrease a greater extent than a decrease in the other one increases overall in the other one increases overall ROA (Exhibit 13-1C)ROA (Exhibit 13-1C)


Technical adjustments to return on Technical adjustments to return on assetsassets

Financial leverage Financial leverage Substitution of fixed-charged financing Substitution of fixed-charged financing

for common equity financingfor common equity financing Financial leverage can either increase Financial leverage can either increase

or decrease ROA, depending on its cost or decrease ROA, depending on its cost and the return on assetsand the return on assets


Technical adjustments to return on Technical adjustments to return on assetsassets

Debt CostDebt Cost Interest expense affects net income Interest expense affects net income

(Exhibit 13-2)(Exhibit 13-2) The actual cost of debt is less than the The actual cost of debt is less than the

effective rate of borrowing because effective rate of borrowing because interest expense is tax deductible interest expense is tax deductible


Computational procedure for Computational procedure for interest adjustment interest adjustment Undertaken to eliminate bias in Undertaken to eliminate bias in

assessing managerial effectivenessassessing managerial effectiveness Adds net interest expense back to net Adds net interest expense back to net

income in computing overall return on income in computing overall return on assets and the profit margin assets and the profit margin component to ROAcomponent to ROA

RETURN ON EQUITYRETURN ON EQUITY

Reports the percentage of income Reports the percentage of income earned for each dollar invested by earned for each dollar invested by the owners of an entity the owners of an entity

Common shareholder orientationCommon shareholder orientation Analysts use ROE to determine the Analysts use ROE to determine the

rate of earnings produced by the rate of earnings produced by the owners’ investmentowners’ investment

Measures wealth creation accruing to Measures wealth creation accruing to risk capitalrisk capital

RETURN ON EQUITY RETURN ON EQUITY (CONT.)(CONT.)

Return on Equity (ROE) RatioReturn on Equity (ROE) Ratio Computed as: net income / Computed as: net income /

average common shareholders’ average common shareholders’ equityequity

Disaggregating the ratio into its Disaggregating the ratio into its components produces more components produces more information information


Financial structure leverage ratioFinancial structure leverage ratio A component of the ROE ratioA component of the ROE ratio Computed as: average total assets / Computed as: average total assets /

average common shareholders’ average common shareholders’ equity equity

It is multiplied by profit margin and It is multiplied by profit margin and asset turnover (the components of asset turnover (the components of ROA) to produce ROEROA) to produce ROE


Components of return on equityComponents of return on equity The profit margin and asset The profit margin and asset

turnover (the components of ROA) turnover (the components of ROA) are multiplied by the financial are multiplied by the financial structure leverage ratio to yield structure leverage ratio to yield ROEROE

Computed as: ROE = profit margin Computed as: ROE = profit margin * asset turnover * financial * asset turnover * financial structure leverage ratiostructure leverage ratio


The multiplicative nature of the The multiplicative nature of the financial structure leverage ratio financial structure leverage ratio increases ROE if the profit margin increases ROE if the profit margin and asset turnover ratios are positiveand asset turnover ratios are positive

The multiplicative nature of the The multiplicative nature of the financial structure leverage ratio financial structure leverage ratio decreases ROE if the profit margin is decreases ROE if the profit margin is negativenegative

eSTUFF’S ASSET eSTUFF’S ASSET UTILIZATION RATIOSUTILIZATION RATIOS

Asset Utilization Ratios 2003 2002 2001Unadjusted profit margin -0.687% 1.855% 1.750%Unadjusted asset turnover 1.523 1.418 1.486 Unadj. financial structure leverage 1.534 1.577 1.633 Unadjusted return on assets -1.05% 2.63% 2.60%Unadjusted return on equity -1.61% 4.15% 4.25%Adjusted profit margin 0.229% 2.823% 2.750%Adjusted asset turnover 1.52 1.42 1.49 Adj. financial structure leverage 1.53 1.58 1.63 Adjusted return on assets 0.35% 4.00% 4.09%Adjusted return on equity -1.61% 4.15% 4.25%Financial structure index -460.30% 103.64% 103.92%

ADDITIONAL ASSET UTILIZATION ADDITIONAL ASSET UTILIZATION CONSIDERATIONSCONSIDERATIONS

Fixed asset turnoverFixed asset turnover Subset of asset turnover ratioSubset of asset turnover ratio Measures the revenue produced per dollar Measures the revenue produced per dollar

of fixed investmentof fixed investment Gauges the productivity of an entity’s long-Gauges the productivity of an entity’s long-

term resourcesterm resources Computed as: revenues / average fixed Computed as: revenues / average fixed

assetsassets The denominator often includes intangible The denominator often includes intangible

assets to reflect their contributions to assets to reflect their contributions to generating revenuesgenerating revenues

ADDITIONAL ASSET UTILIZATION ADDITIONAL ASSET UTILIZATION CONSIDERATIONS (CONT.)CONSIDERATIONS (CONT.)

Asset impairmentAsset impairment Exists when an asset’s expected cash Exists when an asset’s expected cash

flow is less than its book valueflow is less than its book value Losses on impaired assets are reported Losses on impaired assets are reported

as part of other gains and lossesas part of other gains and losses Judgment is required in determining if Judgment is required in determining if

and when an asset is impairedand when an asset is impaired Some entities attempt to Some entities attempt to burybury impaired impaired

assets as part of restructuring chargesassets as part of restructuring charges


Segment returnsSegment returns Companies report revenues, income, and Companies report revenues, income, and

assets of their business divisionsassets of their business divisions Management determines what its segments Management determines what its segments

are and reports on them accordinglyare and reports on them accordingly Analysts use segment disclosures to determine Analysts use segment disclosures to determine

how well various aspects of the enterprise have how well various aspects of the enterprise have faredfared

Segment ROA can be computedSegment ROA can be computed Segment ROE cannot be calculated, due to an Segment ROE cannot be calculated, due to an

inability to divide shareholders’ equity into inability to divide shareholders’ equity into segmentssegments


Knowledge-based assetsKnowledge-based assets Knowledge and information increasingly Knowledge and information increasingly

produce value and wealthproduce value and wealth Such items are more difficult to measure Such items are more difficult to measure

than traditional resourcesthan traditional resources They are often underreported or unreported They are often underreported or unreported

on the balance sheeton the balance sheet Their existence limits the usefulness of Their existence limits the usefulness of

return on investment measures, especially return on investment measures, especially for new economy firms for new economy firms

ANALYSIS OF THE PC ANALYSIS OF THE PC INDUSTRYINDUSTRY

Intellectual Asset FactorsIntellectual Asset Factors Property, plant, and equipment compose a Property, plant, and equipment compose a

very small proportion of industry resourcesvery small proportion of industry resources Financial reporting requirements reduced asset Financial reporting requirements reduced asset

disclosures on the balance sheetdisclosures on the balance sheet Underreported assets, such as research and Underreported assets, such as research and

developmentdevelopment Aggressive elimination of other intangibles, Aggressive elimination of other intangibles,

such as goodwill and in-process research and such as goodwill and in-process research and developmentdevelopment

Unreported assets, such as human capitalUnreported assets, such as human capital

ANALYSIS OF THE PC ANALYSIS OF THE PC INDUSTRY (CONT.)INDUSTRY (CONT.)

Component purchases and out Component purchases and out sourcing reduce fixed asset sourcing reduce fixed asset requirementsrequirements

Knowledge-based, relatively small Knowledge-based, relatively small sized products also decrease sized products also decrease demand for fixed assetsdemand for fixed assets

Industry emerged toward product Industry emerged toward product creation and distribution from creation and distribution from product manufacturingproduct manufacturing


Return on assets--data indicated diverse Return on assets--data indicated diverse resultsresults Dell provided the highest rate of return on Dell provided the highest rate of return on

assets in the industry (Exhibit 13-6)assets in the industry (Exhibit 13-6) Gateway demonstrated steady Gateway demonstrated steady

improvement, except for 1997improvement, except for 1997 Compaq’s poor ROA in 1998 offset an Compaq’s poor ROA in 1998 offset an

otherwise steady rate of returnotherwise steady rate of return Apple lagged its competition, even in its Apple lagged its competition, even in its

profitable yearsprofitable years

PC IndustryAnnual Return on Assets

-30%

-20%

-10%

0%

10%

20%

30%

40%

1994 1995 1996 1997 1998

%

Apple Compaq Dell Gateway


The cumulative rates of direct The cumulative rates of direct computer sellers (Dell and computer sellers (Dell and Gateway) far surpassed those of Gateway) far surpassed those of the indirect sellers (Compaq and the indirect sellers (Compaq and Apple), as evidenced by Exhibit 13-Apple), as evidenced by Exhibit 13-88

PC IndustryWeighted Average Annual Return on Assets

1994-1998

-5%

0%

5%

10%

15%

20%


%


ROA components reflected overall ROA ROA components reflected overall ROA resultsresults Dell increased its profit margin and asset Dell increased its profit margin and asset

turnover throughout the period analyzed turnover throughout the period analyzed (Exhibit 13-7A)(Exhibit 13-7A)

The asset turnovers for Gateway, Compaq, and The asset turnovers for Gateway, Compaq, and Apple decreased over time (Exhibit 13-7B)Apple decreased over time (Exhibit 13-7B)

Apple’s profit margin and asset turn lagged Apple’s profit margin and asset turn lagged those of the other firmsthose of the other firms

Lack of debt financing precluded the need to Lack of debt financing precluded the need to adjust ROA and profit margin for the effect of adjust ROA and profit margin for the effect of interest expense on net income (Exhibit 13-9)interest expense on net income (Exhibit 13-9)

PC IndustryAnnual Net Profit Margin

-20%

-15%

-10%

-5%

0%

5%

10%

1994 1995 1996 1997 1998

%


PC IndustryAnnual Asset Turnover

0%

1%

2%

3%

4%

5%

6%

7%

8%

1994 1995 1996 1997 1998

Num

ber

of T

imes



Return on EquityReturn on Equity None of the four firms were highly None of the four firms were highly

leveraged, due toleveraged, due to Small fixed asset basesSmall fixed asset bases A history of venture equity capitalA history of venture equity capital Substantial retention of earned incomeSubstantial retention of earned income Dell earned substantially higher returns on Dell earned substantially higher returns on

common shareholders’ equity than its common shareholders’ equity than its competitioncompetition


The PC industry illustrates the dual The PC industry illustrates the dual nature of financial leverage (Exhibit 13-nature of financial leverage (Exhibit 13-11A and 13-11B)11A and 13-11B) It can produce returns on equity that are It can produce returns on equity that are

greater than returns on assetsgreater than returns on assets For example, the equity returns earned by For example, the equity returns earned by

Dell and GatewayDell and Gateway It can produce ROE that are less than ROAIt can produce ROE that are less than ROA For example, the negative equity returns For example, the negative equity returns

earned by Apple in 1996 and 1997earned by Apple in 1996 and 1997

PC IndustryAnnual Returns on Equity

-80%

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%

1994 1995 1996 1997 1998

%



Segment returns (Exhibit 13-12A, 13-12B, Segment returns (Exhibit 13-12A, 13-12B, and 13-12C)and 13-12C) The American market is the largest market for The American market is the largest market for

PC companiesPC companies Dell’s return on assets in the American market Dell’s return on assets in the American market

exceeded those of its competition and exceeded those of its competition and contributed to its improver investment returnscontributed to its improver investment returns

Apple performed poorly in the domestic Apple performed poorly in the domestic marketmarket

Compaq’s segments could not be analyzed Compaq’s segments could not be analyzed because they did not disclose segment because they did not disclose segment informationinformation

1998 Net Profit by Geographical Segment

-2%

0%

2%

4%

6%

8%

10%

12%

14%

16%

Americas Europe Asia

%

Apple Dell Gateway

ASSET UTILIZATION ANALYSIS Chapter 13. CHAPTER 13 OBJECTIVES Explain how the definitions of investment, capital and assets affect asset utilization analysis.

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