ASSET

UTILIZATION
ANALYSIS
Chapter 13

CHAPTER 13 OBJECTIVES
Explain

how the definitions of

investment, capital and assets affect
asset utilization analysis.
Indicate the significance of return on
investment measures in the analysis
of asset productivity.
Compute return on assets and equity
measures and their components.

CHAPTER 13 OBJECTIVES
Discuss

the need for technical

adjustments to return on
investment measures.
Present a preliminary asset
utilization analysis for a company
or industry.

OBJECTIVE FOR ANALYZING ASSET

UTILIZATION
An

assessment of an entitys
wealth creating abilities

Measures

the relationship between

inputs (assets) and output
(income)

OBJECTIVE FOR ANALYZING ASSET

UTILIZATION (CONT.)
Asset

utilization provides analysts

with information about
Managerial effectiveness
Shareholders earnings
Future performance

INVESTMENT ACTIVITIES
Return

on investment is the
primary means for measuring
asset utilization
The term investment has multiple
meanings
Its definition is context specific

INVESTMENT ACTIVITIES
(CONT.)
Asset

Valuation
Most assets are measured on the
basis of historical cost
Trend toward more market based
valuations
Revisions only occur when reliable
market data exist
Examples include security investments
and derivative instruments

INVESTMENT ACTIVITIES
(CONT.)
Reporting

valuation

limitations affect asset

Underreported itemsfor example,

research and development costs
Unreported itemsfor example,
human capital

INVESTMENT ACTIVITIES
(CONT.)

Capital is any form of wealth used to

produce additional wealth

Assets are an entities capital as defined in its

broadest sense
Shareholders equity is a narrower definition of
capital
Legal equity is the regulatory view of capital; it is
even more restrictive than shareholders equity
definition
An analyst can modify GAAP-based investment
disclosures to gain additional insights about
asset utilization

INVESTMENT ACTIVITIES
(CONT.)
Asset

utilization is a function of
how capital is defined
Return on assets (ROA) and return on
equity (ROE) measure asset utilization
ROA is based on the total asset
definition of capital
ROE is based on the shareholders
equity definition of capital

RETURN ON ASSETS
Reports

the percentage of income

earned for each dollar invested in
an entitys resources
Computed as: net income /
average total assets
It is a measure of the productivity
of an enterprises total resources

RETURN ON ASSETS
(CONT.)
Managerial

orientation

Analysts use ROA to assess

managerial performance
Measures managers ability to create
wealth with its given store of value
Reports their efficiency in creating
that wealth

RETURN ON ASSETS
(CONT.)

Components of return on assets

Analysts gain greater insight about ROA results

by examining the measures components
Profit margin measures the earnings per
revenue dollar
Computed as net income / revenues
Asset turnover measures the revenues
produced per dollar invested in assets
Computed as: revenues / average total assets

RETURN ON ASSETS
(CONT.)
An

infinite number of profit margins

and asset turnover ratios produce
an equivalent ROA (Exhibit 13-1B)
Increasing one ROA component to
a greater extent than a decrease in
the other one increases overall
ROA (Exhibit 13-1C)

RETURN ON ASSETS
(CONT.)
Technical

adjustments to return on

assets
Financial leverage

Substitution of fixed-charged
financing for common equity financing
Financial leverage can either increase
or decrease ROA, depending on its
cost and the return on assets

RETURN ON ASSETS
(CONT.)
Technical adjustments to return on
assets
Debt Cost

Interest expense affects net income

(Exhibit 13-2)
The actual cost of debt is less than the
effective rate of borrowing because
interest expense is tax deductible

RETURN ON ASSETS
(CONT.)
Computational

procedure for
interest adjustment
Undertaken to eliminate bias in
assessing managerial effectiveness
Adds net interest expense back to net
income in computing overall return on
assets and the profit margin
component to ROA

RETURN ON EQUITY
Reports

the percentage of income

earned for each dollar invested by
the owners of an entity
Common shareholder orientation
Analysts use ROE to determine the
rate of earnings produced by the
owners investment
Measures wealth creation accruing to
risk capital

RETURN ON EQUITY
(CONT.)
Return

on Equity (ROE) Ratio

Computed as: net income /
average common shareholders
equity
Disaggregating the ratio into its
components produces more
information

RETURN ON EQUITY
(CONT.)
Financial

structure leverage ratio

A component of the ROE ratio

Computed as: average total assets /
average common shareholders
equity
It is multiplied by profit margin and
asset turnover (the components of
ROA) to produce ROE

RETURN ON EQUITY
(CONT.)
Components of return on equity
The profit margin and asset turnover
(the components of ROA) are
multiplied by the financial structure
leverage ratio to yield ROE
Computed as: ROE = profit margin *
asset turnover * financial structure
leverage ratio

RETURN ON EQUITY
(CONT.)
The

multiplicative nature of the

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

eSTUFFS ASSET
UTILIZATION RATIOS

Asset Utilization Ratios

Unadjusted profit margin
Unadjusted asset turnover
Unadj. financial structure leverage
Unadjusted return on assets
Unadjusted return on equity
Adjusted profit margin
Adjusted asset turnover
Adj. financial structure leverage
Adjusted return on assets
Adjusted return on equity
Financial structure index

2003
-0.687%
1.523
1.534
-1.05%
-1.61%
0.229%
1.52
1.53
0.35%
-1.61%
-460.30%

2002
1.855%
1.418
1.577
2.63%
4.15%
2.823%
1.42
1.58
4.00%
4.15%
103.64%

2001
1.750%
1.486
1.633
2.60%
4.25%
2.750%
1.49
1.63
4.09%
4.25%
103.92%

ADDITIONAL ASSET UTILIZATION

CONSIDERATIONS

Fixed asset turnover

Subset of asset turnover ratio

Measures the revenue produced per dollar of
fixed investment
Gauges the productivity of an entitys longterm resources
Computed as: revenues / average fixed
assets
The denominator often includes intangible
assets to reflect their contributions to
generating revenues

ADDITIONAL ASSET UTILIZATION

CONSIDERATIONS (CONT.)

Asset impairment
Exists when an assets expected cash
flow is less than its book value
Losses on impaired assets are reported
as part of other gains and losses
Judgment is required in determining if
and when an asset is impaired
Some entities attempt to bury impaired
assets as part of restructuring charges

ADDITIONAL ASSET UTILIZATION

CONSIDERATIONS (CONT.)

Segment returns

Companies report revenues, income, and assets

of their business divisions
Management determines what its segments are
and reports on them accordingly
Analysts use segment disclosures to determine
how well various aspects of the enterprise have
fared
Segment ROA can be computed
Segment ROE cannot be calculated, due to an
inability to divide shareholders equity into
segments

ADDITIONAL ASSET UTILIZATION

CONSIDERATIONS (CONT.)

Knowledge-based assets

Knowledge and information increasingly

produce value and wealth
Such items are more difficult to measure
than traditional resources
They are often underreported or unreported
on the balance sheet
Their existence limits the usefulness of
return on investment measures, especially
for new economy firms

ANALYSIS OF THE PC
INDUSTRY

Intellectual Asset Factors

Property, plant, and equipment compose a
very small proportion of industry resources

Financial reporting requirements reduced asset

disclosures on the balance sheet
Underreported assets, such as research and
development
Aggressive elimination of other intangibles,
such as goodwill and in-process research and
development
Unreported assets, such as human capital

ANALYSIS OF THE PC
INDUSTRY (CONT.)
Component

purchases and out

sourcing reduce fixed asset
requirements
Knowledge-based, relatively small
sized products also decrease
demand for fixed assets
Industry emerged toward product
creation and distribution from
product manufacturing

ANALYSIS OF THE PC
INDUSTRY (CONT.)

Return on assets--data indicated diverse

results

Dell provided the highest rate of return on

assets in the industry (Exhibit 13-6)
Gateway demonstrated steady
improvement, except for 1997
Compaqs poor ROA in 1998 offset an
otherwise steady rate of return
Apple lagged its competition, even in its
profitable years

PC Industry
Annual Return on Assets
40%
30%
20%

10%
0%
-10%

1994

1995

1996

1997

-20%
-30%
Apple

Compaq

Dell

Gateway

1998

ANALYSIS OF THE PC
INDUSTRY (CONT.)
The

cumulative rates of direct

computer sellers (Dell and
Gateway) far surpassed those of
the indirect sellers (Compaq and
Apple), as evidenced by Exhibit 138

PC Industry
Weighted Average Annual Return on Assets
1994-1998
20%
15%

10%
5%
0%
Apple
-5%

Compaq

Dell

Gateway

ANALYSIS OF THE PC
INDUSTRY (CONT.)

ROA components reflected overall ROA

results

Dell increased its profit margin and asset

turnover throughout the period analyzed
(Exhibit 13-7A)
The asset turnovers for Gateway, Compaq, and
Apple decreased over time (Exhibit 13-7B)
Apples profit margin and asset turn lagged
those of the other firms
Lack of debt financing precluded the need to
adjust ROA and profit margin for the effect of
interest expense on net income (Exhibit 13-9)

PC Industry
Annual Net Profit Margin
10%
5%
0%
%

1994

1995

1996

1997

-5%
-10%
-15%
-20%
Apple

Compaq

Dell

Gateway

1998

PC Industry
Annual Asset Turnover
8%
7%

Number of Times

6%
5%
4%
3%
2%
1%
0%
1994

1995

1996

1997

1998

ANALYSIS OF THE PC
INDUSTRY (CONT.)

Return on Equity
None of the four firms were highly
leveraged, due to

Small fixed asset bases

A history of venture equity capital
Substantial retention of earned income
Dell earned substantially higher returns on
common shareholders equity than its
competition

ANALYSIS OF THE PC
INDUSTRY (CONT.)

The PC industry illustrates the dual

nature of financial leverage (Exhibit 1311A and 13-11B)

It can produce returns on equity that are

greater than returns on assets
For example, the equity returns earned by
Dell and Gateway
It can produce ROE that are less than ROA
For example, the negative equity returns
earned by Apple in 1996 and 1997

PC Industry
Annual Returns on Equity
100%
80%
60%

40%
20%
0%
-20%

1994

1995

1996

1997

-40%
-60%
-80%
Apple

Compaq

Dell

Gateway

1998

ANALYSIS OF THE PC
INDUSTRY (CONT.)

Segment returns (Exhibit 13-12A, 13-12B,

and 13-12C)

The American market is the largest market for

PC companies
Dells return on assets in the American market
exceeded those of its competition and
contributed to its improver investment returns
Apple performed poorly in the domestic market
Compaqs segments could not be analyzed
because they did not disclose segment
information

1998 Net Profit by Geographical Segment

16%
14%
12%

10%
8%
6%
4%
2%
0%
-2%

Americas

Europe
Apple

Dell

Asia
Gateway