Chapter 4 Profitability Analysis

Disaggregating ROA

• ROA can be further disaggregated into:

• Chapter: 04

Realized ROA versus Expected ROA

• Realized ROA is derived from financial statement data for a particular period and will not necessarily correlate perfectly with expected returns.
• Reasons for this may be:
• Faulty assumptions were used in deriving expected ROAs.
• Changes in the environment.
• ROA is an incomplete measure of economic rates of return.

• Chapter: 04

Elements of risk - differences in ROAs

• Three elements of risk help in understanding differences across firms and changes over time in ROAs:
• Operating leverage: Refers to proportion of fixed costs relative to variable costs.
• Cyclicality of Sales: Are sales sensitive to economic conditions.
• Product Life Cycle: Relates to the stage and length of firm’s product life.

• Chapter: 04

Trade-Offs between Profit Margin and Assets Turnover

• Important to examine the differences between the relative mix of profit margin and assets turnover.
• Differences in ROA due to relative mix of profit margin and assets turnover can be explained by:
• Microeconomic Theory
• Business Strategy

• Chapter: 04

Microeconomic Theory

• Capacity Constraint
• Heavy fixed capacity costs and lengthy periods required to add new capacity.
• There is an upper limit on the size of assets turnover achievable.
• Only way to increase ROA is to increase profit margin.
• The firms usually achieve the high profit margin through some form of entry barrier.

• Chapter: 04

Microeconomic Theory (Contd.)

• Competitive Constraint
• For firms whose products are commodity- like.
• Few entry barriers and intense competition.
• There is an upper limit on the achievable level of profit margin for ROA.
• Only way to improve ROA is to achieve high asset turnover.
• Firms achieve the high assets turnovers by controlling costs with aggressively low prices to gain market share.

• Chapter: 04