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ROE = NI / TE
ROE = (NI/Sales)*(Sales/TA)*(TA/TE) = Net Profit Margin*Asset Turnover*Equity Multiplier
Net Profit margin is a measure of the firms operating efficiency how well it controls costs Total asset turnover is a measure of the firms asset use efficiency how well it manages its assets Equity multiplier is a measure of the firms financial leverage. Lets first look at the ROA identity a firm could have a high volume/low margin strategy, which would be reflected in high asset turnover but low profit margins or the reverse.
P.V. Viswanath
Unattainable
Low Margin
High Margin
Failure
Low Turnover
Two of the four segments might be unattainable or undesirable. But how should a manager improve the firms positioning in the other two segments?
Return on Assets
Net Profit Margin X Asset = Turnover Return on Assets
Provo Bakery
Zales Jewelry
10%
90%
X
X
9 times =
1 time =
90%
90%
Both firms have the same ROA, but different combinations of profit margin and asset turnover. Perhaps the different approaches simply reflects the difference in industries? Lets now look at two firms in the same industry: Tiffany, a jewelry retail firm and Walmart, which is another jewelry retail firm and, according to its website, the worlds largest but quite different. (http://walmartstores.com/sustainability/9137.aspx)
Wal-Mart
Net sales Less: Cost of goods sold $ 139,208 $ 108,725
Tiffany
$ 1,173 $ 515
Gross margin
Less: Operating expense Less: Interest expense Total expense
$ 30,483
$ 22,363 $ 950 $ 23,313
$
$ $ $
658
493 9 502
$
$ $
7,170
2,740 38.21% 4,430
$
$ $
156
66 90
42.31%
* Effective tax rates often differ among corporations due to different tax breaks and advantages.
Cost of
goods sold $108,725 $515 Operating expenses $22,363 $493
Top Number = Wal-Mart Bottom Number = Tiffany Net profit before tax $7,170 $156
+ Interest
expenses $950 $9
Profit Margins
Clearly, Tiffany has the larger profit margin (gross margins 56.1% vs 21.9%; net margins 7.68% vs 3.18%)%. The model in the previous slide also shows exactly where the profit margin comes from. The focus in this approach is on the numerator of the profit margin ratio, viz. on Net Profit After Taxes (NPAT). It behooves the savvy manager to look at the components of NPAT as a fraction of sales. Is it possible to improve cost of goods sold and operating expenses as a fraction of sales but without affecting sales? How are these being used to improve sales?
+
Merchandise inventory $17,076 $481
+
Cash $1,878 $189
+ +
Fixed assets $28,864 $241
Asset Turnover
Clearly, Walmart has the larger asset turnover. The model in the previous slide also shows exactly what is the source of the higher asset turnover. The focus in this approach is on the denominator of the asset turnover ratio, viz. on Total Assets. It behooves the savvy manager to look at the components of total assets in terms of how they contribute to sales. Is it possible to reduce accounts receivable and merchandise turnover and other assets but without affecting sales? How are these assets being used to improve sales?
2000 data
Net Profit Asset Turnover Margin Net Sales/TA Net Income/Net Sales 3.18 7.68 2.78 1.11
ROA
Walmart Tiffanys
8.84 8.525
Although Walmart and Tiffany clearly have different marketing/merchandising strategies, they end up with approximately the same ROA! In principle, this approach could be extended to look at ROE and include leverage choices as part of the mix. The next slide shows how different firms have made different choices in terms of net profit margin, asset turnover and leverage.
Financial Objectives:
The Strategic Profit Model (SPM)
Return on Investment
Net Profit Net Worth
Return on Assets
Leverage Ratio
Return on Assets
Net Profit Total Assets
Asset Turnover
and so ...
SPM Examples
Return on Investment
Big Lots: 24.6% Albertsons: 18.9% The Dress Barn: 32.4% Lands End: 40.2%
Asset Turnover
Leverage Ratio
1998 data
Gross margin
+
Fixed expenses Inventory
Total expenses
Net Sales
x +
Accounts receivable Net sales Total current assets Asset turnover
Return on assets
x
Financial Leverage
Total assets
+
Other current assets Fixed assets
Retail Stratgies
Look at some of these firms and figure out their strategy http://marriottschool.net/teacher/swinyard/Retailing/retail_links.htm
As the previous slide points out, the two arms of the Dupont ROA identity could be thought of as reflecting alternatives focusing on the income statement (profit margin) versus on the balance sheet (volume). However, both approaches really reflect different uses of a companys assets/capabilities. The next slide shows how Walmart has worked on one aspect of its balance sheet, while the remaining slides look at how Tiffanys marketing focus on profit margin is reflected in its asset choices.
Financial Information
Tiffany Net Sales/Cash from Sales Net Sales/Net A/R Net Sales/Inventory Asset Turnover Net Income/Sales ROA ROE Whitehall Net Sales/Cash from Sales Net Sales/Net A/R Net Sales/Inventory Asset Turnover Zales Net Sales/Cash from Sales Net Sales/Net A/R Net Sales/Inventory Asset Turnover 2004 0.993 15.153 2.296 0.836 9.90% 9.01% 11.84% 2004 1.003 99.84 2.14 1.454 2004 1 N/A 2.91 1.338 2003 0.995 15.095 2.331 0.887 11.43% 9.87% 12.25% 2003 1.001 252.54 1.99 1.404 2003 1 N/A 2.88 1.496 2002 1.003 16.306 2.627 0.985 10.81% 10.64% 9.75% 2002 0.999 285.04 1.95 1.343 2002 1 N/A 2.8 1.472 2001 1.006 15.591 2.559 1.064 11.13% 9.87% 15.72% 2001 0.995 210.39 1.73 1.252 2001 1 N/A 2.77 1.709 2000 0.991 12.33 2.915 1.095 10.78% 9.01% 14.68% 2000 1 135.48 1.67 1.201 2000 1 N/A 1.57 1.007
Do you see a difference in the strategies of the three firms? Tiffany, in particular, has a low asset turnover compared to Whitehall and Zales particularly in the later years. Lets see why..
Tiffany focuses on the profit margin. To do this, it needs to spend more on certain assets than Walmart. The TIFFANY & CO. brand is the single most important asset of Tiffany. The strength of the Brand goes beyond trademark rights and is derived from consumer perceptions of the Brand. Management monitors the strength of the Brand through focus groups and survey research. Management believes that consumers associate the Brand with high-quality gemstone jewelry, particularly diamond jewelry; excellent customer service; an elegant store and online environment; upscale store locations; classic product positioning; distinctive and high-quality packaging materials (most significantly, the TIFFANY & CO. blue box); and sophisticated style and romance. Intangible Assets consist primarily of Product Rights and Trademarks (about $10m. in 2010)