Return on assets = Total asset turnover (or Sales/Total assets) x Prof it margin (or Income/Sales) — Companies the same line business usually have similar investments and capital

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) x Prof it 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 business: Empire Company Limited for the year ended May 5, 2012, and Loblaw Companies Limited for the year ended December 31, 2011. 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.

(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

impact the above asset turnover ratios?

(g) Which company has better control over its expenses for each dollar of sales? How do you

🔒

Unlock the complete assignment

You are viewing the free preview. Purchase this assignment once to reveal the complete resource.

$9.99 USD

Secure checkout is completed by Stripe.

explain the asset turnover ratios and the profit ratio comparisons?

SOLUTION

(a) Property plant and equipment (net of accumulated amortization):

Loblaw Companies at December 31, 2011 $8,725.0 million

Empire Company at May 5, 2012 $2,679.2 million

Percent of total assets:

Loblaw Companies 50.1%

Empire Company 38.8%

(b)

1. Fixed asset turnover:

Loblaw	Loblaw		Empire	Empire
$31,250	= 3.65		$16,249.1	= 6.40
$ 8,725 + 8,377	= 3.65		$2,679.2+2,398.1	= 6.40
2			2
	2.	Total asset turnover:

Loblaw	Loblaw	Empire	Empire
$31,250	= 1.82	$16,249.1	= 2.42
$17,428+16,841	= 1.82	$6,913.1+6,518.6	= 2.42
2		2
3.	Profit margin:

Loblaw	Loblaw	Empire	Empire
$769	= 2.46%	$352.1	= 2.17%
$31,250	= 2.46%	$16,249.1	= 2.17%
(c)	Rate of return on total assets:

Loblaw	Loblaw	Empire	Empire
$769	= 4.49%	$352.1	= 5.24%
$17,428+16,841	= 4.49%	$6,913.1+6,518.6	= 5.24%
2		2
	The profit margins for the two companies are similar, with Loblaws having a slightly higher margin. The return on assets is higher for Empire than Loblaws, indicating that Empire makes more profitable use of their assets than Loblaws.
(d)	Empire uses both 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 and terms for depreciation.
(f)	Note 24 from Loblaws’ report indicates that the company has operating leases with future minimum lease payments totaling $1,179 million over the life of the leases. Note 25 of Empire’s report indicates that the company has operating leases with third parties totaling $2,775.7 (add each of the 5 years plus the thereafter to arrive at the total lease payments required) and with related parties totaling $819.3 for a total lease commitment of $3,595. The annual lease payment for Loblaws for 2012 is $194 million and for Empire is $368.3 (309.7 +58.6). This comparison, combined with the fact that Loblaws is more than twice the size of Empire, indicates that Empire leases a lot more of their properties than Loblaws. 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 Loblaws.

Both companies generate the similar returns on each dollar of sales as shown by the similar profit margins. Given that Empire leases more of their assets, these operating leases are reported as expenses. So, even though Empire has a higher asset turnover, which would normally indicate higher profitability, since the leasing costs of the assets would cause the expenses to be higher (in comparison to Loblaws), this results in the profit margins being similar for both companies.