Agriculture Reference
In-Depth Information
In the asset utilization area, managers must frequently evaluate their investment in assets;
when should equipment be replaced, what fi xed facilities are needed and what should be
rented, whether inventories can be reduced without reducing sales, how extra cash should be
invested, etc. All of these decisions relate directly to asset effi ciency and indirectly back to
the ROE ratio.
When return on sales (1.47 percent) is multiplied by the asset turnover ratio (2.01),
the result is the return on investment (2.95 percent). Note that the
return on investment
(ROI)
used in this model differs slightly from ROA. ROI has the interest expense subtracted
from net operating income, whereas ROA includes the interest expense as a return to
assets.
The third critical area of the profi tability analysis system relates to solvency via fi nancial
leverage, or use of debt. Should the fi rm expand, given an acceptable solvency ratio? What
implications does expansion have for the fi rm's future earnings? Can a larger fi rm be man-
aged as effi ciently? Obviously these are all tough questions faced by management, stock-
holders, bankers, etc. However, careful evaluation of the solvency relationship helps
managers better understand how use of debt will impact the profi tability of the business. For
BF&G, total liabilities and owner's equity ($6,677,000) is divided by owner's equity
($3,665,000) for a leverage ratio of 1.82.
Improvements in any of the three individual ratios, or paths, will improve profi tability as
measured by ROE. It is important for the manager to understand that these ratios are inter-
related; changes in one may affect performance in the others. Thus, the fi nal impact of a
given change in the fi rm's ROE must be viewed as a dynamic relationship among these three
separate ratios. For example, using more debt will raise the leverage ratio, which would tend
to increase ROE. However, more debt also means more interest expense, which will reduce
ROE. Both the leverage affect and the ROS effect must be considered to determine the fi nal
impact on ROE.
Price is an important consideration
When a price increases, some customers will shift to other fi rms and some will remain. If it
were foreseen that most customers would stay despite the price increase, the earning power
would rise because any reduction in asset turnover would be offset by an increase in the
fi rm's gross margin.
If the fi rm lowered prices, hopefully an increase in the asset turnover would offset the
decline in gross margin. But the question is: how much will sales be increased, or what is the
“elasticity” of demand (see
Chapter 3
)?
Successful use of a low margin and high asset turnover strategy is evident in the rapid
increase in the number and patronage of discount fi rms and warehouse stores. Generally,
businesses with a low turnover will have a high margin, and fi rms with a high turnover will
have a low margin, which is the case with the discount fi rms.
ROE, or the earning power of the business, offers the advantage of bringing together
in a single fi gure the complex relationship of asset turnover and return on sales, and allows
managers additional insights into how decisions and changes made in either area affect
the other. Decision-making in any agribusiness does not occur in a vacuum. An attempt
to control inventory or reduce assets is likely to affect sales. Certain items may be out of
stock, for instance, and some sales will be lost. The use of ROE and the profi tability analysis
model will help the agribusiness manager gauge the effects of such decisions on overall
earning power.
