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 entity’s 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 limitations affect asset
valuation
 Underreported items—for example,
research and development costs
 Unreported items—for 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
entity’s resources
 Computed as: net income / average
total assets
 It is a measure of the productivity of an
enterprise’s total resources
RETURN ON ASSETS (CONT.)
 Managerial orientation
 Analysts use ROA to assess managerial
performance
 Measures manager’s 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 measure’s 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
 eSTUFF’S ASSET
UTILIZATION RATIOS
Asset Utilization Ratios 2003 2002 2001
Unadjusted profit margin -0.687% 1.855% 1.750%
Unadjusted asset turnover 1.523 1.418 1.486
Unadj. financial structure leverage 1.534 1.577 1.633
Unadjusted return on assets -1.05% 2.63% 2.60%
Unadjusted return on equity -1.61% 4.15% 4.25%
Adjusted profit margin 0.229% 2.823% 2.750%
Adjusted asset turnover 1.52 1.42 1.49
Adj. financial structure leverage 1.53 1.58 1.63
Adjusted return on assets 0.35% 4.00% 4.09%
Adjusted return on equity -1.61% 4.15% 4.25%
Financial structure index -460.30% 103.64% 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 entity’s long-term
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 asset’s 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
 Compaq’s 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%
1994 1995 1996 1997 1998
-10%

-20%

-30%

Apple Compaq Dell Gateway

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 13-
8
 PC Industry
Weighted Average Annual Return on Assets
1994-1998

20%

15%

10%
%

5%

0%
Apple Compaq Dell Gateway
-5%
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)
 Apple’s 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 1998
-5%
%

-10%

-15%

-20%

Apple Compaq Dell Gateway

 PC Industry
Annual Asset Turnover

8%

7%

6%
Number of Times

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 13-11A 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 1998

-40%
-60%
-80%

Apple Compaq Dell Gateway

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
 Dell’s 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
 Compaq’s 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 Asia

Apple Dell Gateway