Option #1: Profitability Analysis Exercises and Problems
Do the assigned problems using Summer Peebles, Inc.'s condensed 2014 financial data below:
Assets
Current Assets
$250,000.00
Noncurrent Assets
$1,750,000.00
Total Assets
$2,000,000.00
Liabilities and Equity
Current Liabilities
$200,000.00
Noncurrent Liabilities (8% Bonds)
$675,000.00
Common Stockholders' Equity
$1,125,000.00
Total Liabilities and Equity
$2,000,000.00
Additional Information:
•
•
•
•
Net income for 2014 is $157,500.
Income tax rate is 50%.
Amounts for total assets and shareholders' equity are the same for 2013 and 2014.
All assets and current liabilities are considered to be operating.
Required:
1. Determine whether leverage (from long-term debt) benefits Peeble’s shareholders. (Hint: Examine ROCE
with and without leverage.)
2. Compute the NOPAT and RNOA (use ending NOA).
3. Demonstrate the favorable effect of leverage given the disaggregation of ROCE and your answer to part
(B).
Your submission should: Be 1-2 pages for the written portion (can be excel if that is what is needed,
and text boxes for further explanations)
•
•
Include the Excel spreadsheet with computations.
Clearly separate your responses so your instructor knows the problems you are answering.
WATCH THIS VIDEO LINK BELOW FOR FURTHER UNDERSTANDING!!
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https://csuglobal.zoom.us/rec/play/oU-HWf-l1h4GTg8hDUhzMFUDIAv0ENMQjJbLpfut0EjkuaOLdge6zXYfLlC-D3vrPJB-C9teSUgO70c.EXs5vS99ue_0btny
FIN520week five (2) (2).mp4
References:
Benoit, D. (2016). Finance's hot new metric: ROIC. Wall Street Journal.
Gallo A. (2016). A refresher on return on assets and return on equity. Harvard Business Review Digital
Articles. 2-6. (To view this reading, please open the link provided and download the “PDF full text.”)
Subramanyam, K. (2014). Financial statement analysis (11th ed.). New York, NY: McGraw Hill.
ADDITIONAL INFORMATION FOR FURTHER UNDERSTANDING:
Analyzing ROIC: Return on Net Operating Assets (RNOA)
As previously stated, ROIC is an important metric in assessing a company’s profitability. You can use
several ratios to measure ROIC. Return on net operating assets (RNOA) utilizes rate of return of
operating activities in profitability analysis. Operating activities are the core activities of a company
including:
1. on the income statement: sales, cost of goods sold, and operating expenses.
2. on the balance sheet: assets and liabilities that relate the operating activities on the income
statements such as accounts receivable, inventories, property, plant, and equipment, accounts
payable, and accrued expenses (Subramanyam, 2014).
RNOA is calculated as NOPAT divided by Average NOA. Your textbook discusses this calculation in
detail. To make RNOA more meaningful and provide better insight in profitability analysis, it may be
necessary to disaggregate RNOA.
RNOA
=
NOPAT
Average NOA
By disaggregating, you break the RNOA calculation into components like this:
NOPAT
=
NOPAT
X
Sales
Average NOA
Sales
Average NOA
Return on net operating
assets
Net operating profit
margin
Net operating asset
turnover
The net operating profit margin is the ability of an organization to generate earnings at a particular
sales level while the net operating asset turnover is the ability of an organization to manage the level
of investment in assets for a particular sales level. Put another way, net operating profit margin is the
ability to use sales to generate profits and net operating asset turnover is the ability to use assets to
generate sales. These components of RNOA vary across industries depending on the economic
characteristics and even vary across organizations in an industry based on the strategies employed.
Hence, as has been discussed many times, you need to adjust the financial statement numbers when
analyzing RNOA. This will ensure that you use appropriately adjusted financial statement numbers
(Subramanyam, 2014).
ADDITIONAL INFORMATION FOR FURTHER UNDERSTANDING:
Analyzing ROIC: Return on Common Equity (ROCE)
The main difference between RNOA and return on common equity (ROCE) or simply return on equity
(ROE) is how you analyze the company’s performance. As you just explored, RNOA is a profitability
measure from an operating activities standpoint. In other words, RNOA measures a firm’s operational
profitability before considering financing effects. Conversely, ROCE is a profitability measure from an
equity point of view. It measures common shareholders’ return after subtracting from revenues
operating expenses and cost of financing debt and preferred stock. Hence, ROCE comprises RNOA
and non-operating return components. RNOA is a profitability measure of operating activities while
the non-operating component reflects the favorable or unfavorable effects of financial leverage
(Subramanyam, 2014). As expected, ROCE is important to common shareholders.
ROCE is calculated as:
Net income – Preferred stock dividends
Average common shareholders’ equity
In analyzing ROCE, you can disaggregate it for better analysis.
Net income –
Preferred stock
dividends
Net income –
=
Preferred stock
dividends
Average
X
Sales
X
assets
Average common
shareholders’ equity
Sales
Average assets
Average
common
shareholders’
equity
Return on common
shareholders’ equity
Adjusted profit
margin
Asset turnover
Leverage
The adjusted profit margin indicates the earnings allocable to common shareholders after subtracting
from revenues all operating expenses and financing costs of capital with higher ranking than common
shareholders. Asset turnover is the ability of an organization to manage the level of investment in
assets for a particular sales level. The leverage ratio measures the degree to which a company
utilizes financial leverage to finance assets. As in the case of RNOA and other financial analysis
discussed in earlier modules, you need to adjust the financial statement numbers when analyzing
RNOA. This will ensure that you use appropriately adjusted financial statement numbers.
1
Profitability Analysis Exercises and Problems
Cori White
Colorado State University Global
FIN 520: Financial Reporting and Analysis
Dr Williams
March 14, 2021
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2
Profitability Analysis Exercise and Problems +
1. Determine if leverage (from log-term debt) benefits Rose’s shareholders.
a. Financial leverage represents the magnitude of which a company uses its
income debt securities to obtain more assets. “Financial leverage is the use of
debts to finance the purchase of assets with the expectation that the income or
capital gain from the new asset will exceed the cost of borrowing” (CFI, n.d.).
Looking at the computations, notated in the spreadsheet, the ROCE is 14%,
with leverage. However, to calculate the ROCE without leverage, a provision
is made for the interest expense of half of the total interest charged, which is
$27,000; to get this we take 4% * 675,000. Net income without leverage is
calculated by adding net income and saved interest together, in this situation,
the net earnings are $184,500. Without leverage, the return on investment is
10.25%. Leveraging is helpful for shareholders as they will have a higher
return than they would get without leveraging.
2. Compute the NOPAT and RNOA (use ending NOA)
a. NOPAT is Net Operating Profit After Tax and is essentially an organization’s
operating income if they did not have debt (CFI, n.d.). To calculate RNOA or
return on net operating assets, you divide profits after taxes by the net
operating assets (NOA) (Accounting Hub, 2020). (See the excel sheet to for
computations.)
3. Demonstrate the favorable effect of leverage given in the disaggregation of ROCE
and your answer to part B.
a. Because the ROCE with leverage is higher than the return on ROCE without
leverage, the favorable effect of leverage can be seen. Leverage is the total
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3
company debt divided by the shareholder’s equity (O’Connell, 2018). In this
situation it would be 675,000 / 1,125,000 = 60%. The leverage is 14% and the
favorable effect is 3.75%, as you can see in the attached spreadsheet. The
favorable effect percentage shows the amount of earnings a stockholder will
give up if the organization does not leverage. With that being said, it would be
beneficial to an organization to have long-term debts because of their positive
effects on earnings.
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References
Accounting Hub. (2020). Return on Net Operating Assets (RNOA): Definition, formula, and how
to calculate it. Retrieved from: https://www.accountinghub-online.com/return-on-netoperating-assets-rnoa/
CFI. (n.d.). NOPAT. Retrieved from:
https://corporatefinanceinstitute.com/resources/knowledge/valuation/what-is-nopat/
CFI. (n.d.). What is financial leverage. Retrieved from:
https://corporatefinanceinstitute.com/resources/knowledge/finance/financial-leverage/
O’Connell., B. (2018). What Is Leverage in Finance and What Is the Formula? Retrieved from:
https://www.thestreet.com/personal-finance/education/what-is-leverage-finance14700895
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