Using asset turnover and profit margin to forecast changes in profitability: Evidence for Philippine companies

• Main Author: Estrada, Roma Santa Rodriguez
• Format: text
• Language: English
• Published: Animo Repository 2005
• Subjects: Turnover (Business); Profit; Asset allocation; Corporations > Finance
• Online Access: https://animorepository.dlsu.edu.ph/etd_masteral/3302
• Institution: De La Salle University

The disaggregation's of the overall profitability measures of ROA (return on assets) and ROE (Return on equity) are usually used to analyze a firms performance. Most evaluations of profit performance start with the ratio of return on assets (ROA). Research studies suggest that to understand firm value requires forecasts of future return on operating assets, thus the emphasis of Fairfield's and Yohn's paper is on the prediction of return on net operating assets (RNOA) for the analysis. This research paper was patterned after the study of Fairfield and Yohn (2001), which made use of the disaggregation of return on net operating assets (RNOA). Even if they did not specifically mention the Du Ponts ROI, it can be surmised that their research made use of Du Ponts model and then develop their own models to forecast the changes in profitability, defined as the change of return on net operating assets. Fairfield and Yohn hypothesized on the following: 1) that the fundamental decomposition of return on assets presented in textbooks is useful in a forecasting context 2) that the disaggregation of the level of return on assets into asset turnover and profit margin will not improve predictions of the change in profitability, defined as the change in return on assets, one year ahead 3) whether the year-to-year changes in asset turnover and changes in profit margin provide incremental information over the change in total return on assets for forecasts of the change in vii return on assets one year ahead and 4) that the change in asset turnover will be informative about future profitability while the change in profit margin will not be informative about future profitability. To test the hypotheses on the prediction of changes in profitability, Fairfield and Yohn developed models, where the return on net operating assets is the dependent variable and to test the last hypothesis on the prediction of change in operating income, they also made use of the same models except that the operating income is the dependent variable. Following the study made by Fairfield and Yohn, this paper tested these hypotheses: (1) whether the fundamental disaggregation of return on assets or return on investment presented in textbooks is significant in forecasting profitability one year ahead; (2) whether the disaggregation of return on net operating assets into asset turnover and profit margin provide significant improvement in the forecasts of changes in profitability, defined as return on net operating assets, one year ahead; and (3) whether further disaggregation of changes in total return on net operating assets into changes in asset turnover, changes in profit margin and the interaction term between change in asset turnover and change in profit margin will provide incremental information on the forecasts of change in return on net operating assets one year ahead; and 4) whether the change in asset turnover will be informative about future profitability while the change in profit margin will not be informative about future profitability. To test the hypotheses of this study, the financial statements of selected companies listed with the Philippines Stock Exchange covering a period of fourteen years from 1990 to 2003 were used as subject companies. Since the country was beset by a lot of problems, political and economic to name a few during the period covered, the financial statements of the companies, were affected to a certain extent thus affecting the results of the study. This paper tested the aforementioned hypotheses using the models developed by Fairfield and Yohn and the same research methodology. Comparable to Fairfield's and Yohns results, the results of this study indicated that the disaggregation of current level of return on assets into level of assets and level of profit margin is not informative about the change in return on assets one year ahead. Unlike in the study of Fairfield and Yohn, which showed the following results, a) the change in return on assets (prior to disaggregation) provides information for the change in return on assets one year ahead; b) decreases in operating profitability signal additional decreases in the subsequent period; c) that the disaggregation of change in return on net operating assets into change in asset turnover, change in profit margin and their interaction term provides incremental information about future profitability and d) that the change in asset turnover correlates with the change in future profitability, the change in profit margin does not; the results of this research indicated that Model 0: DRNOA = 0, signifying that this naïve model predicts no change in RNOA, is the best among the models used. Model 0 is basically the application of the Random Walk hypothesis, which ix essentially states that the best predictor of the current variable is its last periods value. In other words, the findings showed that the change in return on net operating assets do not provide information for the change in return on net operating assets one year ahead; that decreases in operating profitability do not signal additional decreases in subsequent period; that further disaggregation of change in return on net operating assets into change in asset turnover, change in profit margin and their interaction term do not provide incremental information about future profitability and that neither change in asset turnover and change in profit margin correlate to the change in future profitability. This is how change in return on net operating assets DRNOA and change in operating income DROPINC seem to be best characterized in the Philippines, based on the limited observations used.