Chapter 4 Profitability Analysis



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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

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