Companies in the same line of business usually have similar investments and capital structures, and an opportunity for similar rates of return. One of the key performance indicators that is used to assess the profitability of companies is the return on assets ratio. This ratio results from two key relationships—the profit margin and the total asset turnover— and in general terms can be written as follows:
Return on assets = Total asset turnover (or Sales/ Total assets) × Profit margin (or Income/Sales)
This says that profitability depends directly on how many sales dollars are generated for each dollar invested in assets (total asset turnover) and on how costs are controlled for each dollar of sales (profit margin). An increase in either ratio results in an increase in the return on assets. As property, plant, and equipment is often the largest single asset on the balance sheet, companies need to have strategies to manage their investment in such assets.
Instructions
Access the financial statements of two companies that are in the food distribution and retail business: Empire Company Limited for the year ended May 2, 2015, and Loblaw Companies Limited for the year ended January 3, 2015. These are available at www.sedar.com or each company’s website. Review the financial statements and answer the following questions.
(a) At each company’s year end, determine the percentage of property, plant, and equipment to total assets.
(b) Calculate each company’s fixed asset turnover, total asset turnover, and profit margin (using net income) for the most recent year.
(c) Determine the return on assets for each company. Which company is more profitable?
(d) Which company appears to use its total assets more effectively in generating sales? Its fixed assets?
(e) Are there any differences in accounting policies that might explain the differences in the fixed asset turnover ratios?
(f) Examine the leasing note for each company. How might the amount of assets that are leased affect the above asset turnover ratios?
(g) Which company has better control over its expenses for each dollar of sales? How do you explain the asset turn- over ratios and the profit ratio comparisons?
SOLUTION
(a) Property plant, and equipment (net of accumulated amortization):
Loblaw Companies at January 3, 2015 $10,794.0 million
Empire Company at May 2, 2015 $ 3,500.4 million
Percent of total assets:
Loblaw Companies 32.0%
Empire Company 30.5%
(b)
1. Fixed asset turnover:
| Loblaw | Loblaw | | Empire | Empire |
|---|
| $42,611 | = 4.28 | | $23,928.8 | = 6.66 |
| $ 10,794 + $9,105 | = 4.28 | | $3,500.4 + $3,685.6 | = 6.66 |
| 2 | | | 2 | |
| 2. | Total asset turnover: | | |
| Loblaw | Loblaw | | Empire | Empire |
|---|
| $42,611 | = 1.57 | | $23,928.8 | = 2.02 |
| $33,684 +$20,741 | = 1.57 | | $11,473.4 + $12,243.7 | = 2.02 |
| 2 | | | 2 | |
| 3. | Profit margin: | | | |
| Loblaw | Loblaw | | Empire | Empire | Empire |
|---|
| $53 | = 0.12% | | | $436.9 | = 1.83% |
| $42,611 | = 0.12% | | | $23,928.8 | = 1.83% |
| (c) | | Rate of return on total assets: | | | |
| Loblaw | Loblaw | | Empire | Empire |
|---|
| $53 | = 0.20% | | $436.9 | = 5.24% |
| $33,684 + $20,741 | = 0.20% | | $11,473.4 + $12,243.7 | = 5.24% |
| 2 | | | 2 | |
| The profit margin for Empire is considerably higher than the margin for Loblaw, and Empire’s return on total assets is also higher than Loblaw’s. This indicates that Empire makes more profitable use of its assets than Loblaw. | | | |
However, Note 5 to Loblaw’s financial statements that deals with its acquisition of Shoppers Drug Mart Corporation on March 28, 2014 indicates a loss of $12 million and expenses of $75 million related to the acquisition of Shoppers Drug Mart in 2014; and Note 12 on Inventories indicates a $798 million adjustment to the Shoppers Drug Mart inventory acquired equal to the difference between the date of acquisition fair value of the inventory and its cost. If these acquisition adjustments had not been recognized in net income, the profit margin ratio for Loblaw would have been 2.20% -- a higher, and more comparable, profit margin ratio than the one that includes these one-time non-operating adjustments.
In addition, it should be noted that while all the assets from the Shoppers Drug Mart acquisition are included in the “total assets’ denominator, the income from the Shoppers’ acquisition in the numerator reported in Loblaw’s net earnings is included only for 9 months – since the date of acquisition. Any adjustment to annualize the earnings would have a positive effect on Loblaw’s return on total assets.
Without the Shoppers Drug Mart acquisition adjustments, the ratios would have been much closer.
(d) Based on the results in part (b) above, Empire appears to use its total assets and its fixed assets more effectively in generating sales as indicated by its total asset turnover and fixed asset turnover ratios, both of which are higher than Loblaw’s.
(e) No, there are no apparent differences in accounting policies which might explain the differences in fixed asset turnover. Both companies capitalize interest and they use similar methods (straight line) and terms for depreciation. However, the Shoppers’ acquisition probably affects the Loblaw results somewhat because the sales number used includes revenue from Shoppers for 9 months only, but the ratio compares it to the full assets acquired.
(f) Note 29 from Loblaw’s report indicates that the company has operating leases with future minimum lease payments totaling $5,573 million (net of sub-lease income) million over the life of the leases. Note 25 of Empire’s report indicates that the company has operating leases with third parties and related parties totaling $4,020.5 million (net). The annual lease payment for Loblaw for 2015 is $614 million and for Empire is $466.1 ($338.0 + $128.1). This comparison, combined with the fact that Loblaw is more than twice the size of Empire, indicates that Empire leases a lot more of their properties externally than Loblaw does. Since assets under these operating leases are not reflected on the balance sheet, this would cause Empire’s asset turnover ratios to be better than Loblaw’s.
(g) Using the adjusted profit margin for Loblaw calculated in part (c), it appears that Loblaw does as well as Empire and perhaps slightly better in controlling its costs as a percentage of sales. Given that proportionately Empire leases more of its assets, these operating leases affect Empire’s income reported because they are deducted as expenses. However, Loblaw must then own proportionately more of its fixed assets, causing depreciation expenses to be higher, so this evens out the effect on net income.
An important thing to remember is that profitability can be generated through two separate strategies:
Careful utilization of the total investment in assets (and particularly capital assets as they tend to be among the most significant of the assets). This is measured by the asset turnover ratio. The more sales that can be generated from a fixed investment in capacity, the more likely the company is to be profitable.
Careful control over costs -- that is, the more of each sales dollar a company is able to keep as profit instead of spending on expenses, the more likely the company is to be profitable.
Improved return on assets can be generated from improvements in either, or both of these strategies.