1B BUS 503

In-class exercise 1
Due January 9/10, 2017

Analysis of financial information

Return on investment (ROI) is a common operating ratio. Analysts comparing firms in an industry usually
scale by some measure of firm size. Scaling produces a ratio that is comparable across firms, even though
firms differ in size.
ROI = Operating Income / Investment (a)

Investment represents the amount the firm spent on resources to generate the profit. Investment is usually
measured as assets used in operations. ROI measures the profitability of a firm, considering the assets is
has deployed. Higher ROI indicates efficiency (we earn a lot with few assets) or risk (e.g., we transport
dynamite in the same kind of truck that another firm uses to haul dirt, so were paid better).

The DuPont method of calculating ROI splits ROI into two component measures: asset (investment)
turnover and profit margin:

Investment Turnover = Sales / Investment (b) Profit Margin = Operating Income / Sales (c)

so that (Investment Turnover x Profit Margin) = ROI. Notice that Sales cancels out of the two ratios when
they are multiplied, leaving the original equation (a).

Investment turnover represents a firms sales per dollar invested in operating assets. It measures the
firms ability to develop and sell demanded products to customers, given its set of assets.

Profit margin represents a firms profit per dollar of sales. It measures how much value the firms
production and sales activities create, given the products the firm has chosen to offer.

REQUIRED: Examine the graphs shown on pages 2 6, and answer the following questions. (How to
read the graphs: Each blue square represents a firm, plotted according to coordinate pairs (asset turnover,
profit margin). Firms that plot close to the origin are not as profitable as those that plot in the north-east
corner. Firms plotting on the same isobar are equally profitable.)

1) Within industries, is there a relationship between asset turnover and profit margin?

2) How do you think firms that focus on earning profit mainly through generating higher asset turnover
differ from those earning profit mainly through generating higher profit margins (e.g., how do their
strategies, operations, business activities differ)? Does the graph indicate that one focus tends to lead to
higher profitability?

3) Compare the graphs across industries. What are some ways in which the industry graphs are the same
or different? Choose any two industries and discuss potential business and economic reasons why the
industries have different profitability characteristics. Be as specific as you can.

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