IDR NO:-

CERTIFICATE
This is to certify that RAGINI SINGH of Ranchi Women’s College has
completed the project titled “Profitability Analysis from YOGIK
TECHNOLOGIES Pvt. Ltd.” and has submitted the project file in the
required format. The project was completed under the guidance of Sir
KAMAL SAHU & SHIVAM VERMA.

PROJECT GUIDE
ACKNOWLEDGEMENT
I would like to express my gratitude and appreciation to all those
who gave me the possibility to complete the project.

I sincerely express my gratitude to my mentor KAMAL

SAHU & SHIVAM VERMA, for the invaluable advice and
assistance in completing the project on “YOGIK
TECHNOLOGIES Pvt. Ltd.” I am thankful for providing me
with this wonderful opportunity to work on the project. The
completion of the project would not have been possible
without the help and insights. It was a great learning
experience.

I am grateful to the college administration for providing me

with such a significant opportunity.

My profound thanks to my family and friends for their

invaluable assistance, and appreciation to everyone who
has contributed to the successful completion of this project.
 DECLARATION
This is to certify that I, RAGINI SINGH being the Roll No. 21VCBCBA077,
session: -2021-2024 have completed the project on “Profitability Analysis”
from YOGIK Technologies Pvt. Ltd. under the guidance of “Mr. Kamal
Kumar Sahu & Shivam Verma”.
The project report is submitted to the WOMEN’S COLLEGE RANCHI in
partial fulfilment of the requirement for the award degree of BACHELOR
OF BUSINESS ADMINISTRATION (BBA) under the guidance of Kamal
Kumar Sahu & Shivam Verma of YOGIK Technologies Pvt. Ltd.
Jamshedpur, Jharkhand.
The matter embodied in this project is genuine work done by the student. It
has not been submitted to this University/Institute for the fulfilment of the
requirement of any course of study.

Project Guide

Internal Examiner External Examiner

 TABLE OF CONTENTS
SL CONTENTS PAGE NO.
NO.
1 Introduction to sap
1.1 About ERP Software (enterprise resource
planning)
2 Introduction to sap co module
3 Organisational structure of co module
3.1 Client
3.2 Operating concern
3.3 Controlling area
3.4 Company code
3.5 Profit centre

4 List the component of SAP CO Module

4.1 Cost Center Accounting

4.2 Cost Element Accounting
4.3 Profit Center Accounting
4.4 Internal Order Accounting
4.5 Profitability Analysis
4.6 Product Cost Controlling
4.7 Activity Based Costing

5 Master data of CO module

5.1 Cost Element Accounting

5.2 Cost Center Accounting
5.3 Profit Center Accounting
5.4 Internal Order
5.5 Activity Types
 6 Introduction of Profitability Analysis
6.1 Finance
6.2 Meaning of Finance
6.3 Features of Finance
6.4 Projection of the project budget
6.5 Motivations of profitability analysis
6.6 Reformulated financial statement
6.7 Decomposition of Recurring
Analysis of operating profitability
6.8
.

EXECUTIVE SUMMARY
1. Introduction to SAP (System Application & Product in Data Processing)

SAP is one of the world’s leading producers of software for the management of
business processes. Founded in 1972, the company was initially called System
Analysis Program Development, later abbreviated to SAP. Since then, it has grown
from a small, five-person endeavour to a multinational enterprise headquartered in
Walldorf, Germany, with more than 105,000 employees worldwide.

SAP software helps companies manage their financial logistics, supply chain,
human resources, and other business functions. Yogik technologies provides
enterprise solution services for SAP S4HANA, Rise with SAP and Business By
design Implementation, Support & Upgrade and also customised application
developments from complete ERP and MIS solutions to specific business
applications

1.1 About ERP Software

ERP stands for “enterprise resource planning.” ERP software includes programmes
for all core business areas, such as procurement, production, materials
management, sales, marketing, finance, and human resources (HR). SAP was one
of the first companies to develop standard software for business solutions and
continues to offer industry-leading ERP solutions.
 It is a business process management software that allows an organization to use a
system of integrated applications to manage the business and automate many
back-office functions related to technology service and human resources.

2. Introduction of SAP CO (CONTROLLING) Module

SAP Controlling (CO) is another important SAP module offered to an

organization. It supports coordination, monitoring, and optimization of all the
processes in an organization. SAP CO involves recording both the consumption
of production factors and the services provided by an organization.
SAP CO includes managing and configuring master data that covers cost and
profit center, internal orders, and other cost elements and functional areas.
The main purpose of SAP controlling module is planning. It enables you to
determine variances by comparing actual data with plan data and thus enables
you to control business flows in your organization.

SAP Controlling (CO) helps improve management across the financial spectrum
by Planning and analysing costs to deliver reports that influence decision-
making.

3 Organisational Structure of CO Module

Organizational structures form the basic building blocks of the SAP System. An
organizational structure constitutes a set of key organizational units or objects
which must be implemented in the SAP enterprise structure.

Each of these organizational structure objects may have a defined logical

relationship with one another and must be mapped and assigned to achieve
optimal integration amidst all of the in-scope features of the system. As with all
modules, SAP has devised a methodology which describes how a company is to
be structured and organized for cost accounting purposes.

Thus, the purpose of SAP CO organizational structure is to facilitate proper

coordination, monitoring and optimization of all processes in an organization.
 These organizational units are associated with each other to
form the foundation of the SAP CO organizational structure.
 Let’s see how each of these units contribute to the optimization
of internal reporting and managerial accounting.

a. Client: -

A client is a self-contained instance which comprises its own set of programs,

tables, master data and transaction records.

b. Operating Concern: -

The operating concern is the highest organizational unit eligible for profitability
analysis (COPA). The prime aim of COPA is to provide profit and loss information
to support decision making, planning and controlling operations within an
organization. The segments are usually made up of a combination of
 characteristics regarding the customer, product or sales channels of the
organization which can be analysed in a multi-dimensional information cube. The
operating concern is required to facilitate additional reporting dimensions
including customer group, product and country.

c. Controlling Area: -

The controlling area refers to the highest level of an organization at which costs
and revenues are recorded. Each controlling area can have one or more
company codes assigned to it.

d. Company Code: -

A company code represents a legal entity in SAP. A company code is set up for
every legal entity which records transactions and maintains its financial books
(i.e. sub-ledgers and GL) in SAP. These financial books enable the generation a
complete set of financial statements, including profit and loss, balance sheet and
cash flow.

e. Profit center: -

A profit center is an organizational unit in accounting that reflects this structure of

the organization for the purpose of internal control. You can analyse operating
results for profit center using either the cost-of-sales or the period accounting
approach.

f. Plant: -

This is one of the indispensable units in the organizational

structure for a company. It represents a facility where goods and
services are produced according to production, maintenance,
procurement and material planning areas of the business. A
company code can possess the assignment of one or more plant.
Generally, plants are defined within the enterprise structure in
the Materials Management module.

4 List the component of SAP CO Modules: -

 1. Cost Center Accounting
2. Cost Element Accounting
3. Profit Center Accounting
4. Internal Order Accounting
5. Profitability Analysis
6. Product Cost Controlling
7. Activity Based Costing

5 Master data of SAP CO Module: -

1. Cost Element Accounting

2. Cost Center Accounting
3. Profit Center Accounting
4. Internal Order
5. Activity Types

a. Cost Element Accounting

In SAP, cost element accounting (CO-OM-CEL) deals with the collection of costs
and summarizes costs within controlling and posts to reconciliation ledger
account. For every profit & loss type G/L account type, corresponding cost
elements are to be created in SAP R/3 system.

Cost element is an item in the chart of accounts, which is used in controlling

area to record the values assigned consumption of production factors like raw
material, utilities, etc.
cost elements are divided in to two types i.e.

 Primary Cost Element

 Secondary Cost Element

1. Primary Cost Element – These area through the consumption of

productions factors that are source externally. Primary cost element is
used for direct posting and must be accompanied in GL A/C in FI.
 2. Secondary Cost element- Cost element arise through the
consumption of production factors that are provided internally by enterprise
itself.Secondary cost element is used strictly for internal controlling posting
like assessment and settlement.

b. Cost Center Accounting

The CO-OM-CCA component tracks where costs occur in your organization. Cost
center can be defined according to several design approaches, such as
functional requirements, allocation criteria, activities, and services provided
geographic location or area of responsibility. The approach should be consistent
throughout the enterprise. As a typical approach, an enterprise can define a cost
center for each low-level organizational level that has responsibility for managing
costs. As costs are incurred, they are assigned or posted to the appropriate cost
center. These costs can include payroll costs, rent and utility costs, or any other
costs relevant to a cost center.

c. Profit Center Accounting

The purpose of creating a profit center is to calculate its profit and losses
separately. By doing this, the corporation can easily determine the revenue and
costs of the specific section of the business and add to management. A profit
center is treated exactly like an independent business conducting its business
separately and making its own accounts. The upper management of a company
segregates the profit center from the main company in order to determine the
effectiveness and profitability of each center separately. Usually, the accounts of
different profit center within a company are also sent separately to the main
company.

d. Internal Order

Internal orders are normally used to plan, collect, and settle the costs of internal
jobs and tasks. The SAP system enables you to monitor your internal orders
throughout their entire life-cycle; from initial creation, through the planning and
posting of all the actual costs, to the final settlement and archiving.

e. Activity Type

Activity types are used to describe the various forms of activity that are
performed at a cost center. Activity types are valuated for each cost center and
 period with a charge rate that consists of a fixed portion and a variable (work-
related) portion.

6 Introduction of profitability Analysis

6.1 Finance

Is the life blood of every business. It is the foundation

of every business activity and itis pivot around which
every business activity relates, Finance has acquired
so muchimportance that modern is described as
money. At present, we cant think of aneconomy
without money, because an economy without money
cannot functioneffectively. Efficiency and smoothly.
Money has overcome the difficulties of the borer
system. It has made possible tremendous saving of
time and troublr in thenarshalling of productive
facilities and in the finance distribution of the output of
theindustry to final consumes.Finance is one of the
major elements which activities the overall growth of
theeconomy. Finance has widely been termed as the
master key providing access to allresources required
for the running business activities. Finance is
regarded for running business activities, Finance is
regarded as the life blood of a business enterprises,
thisis because in the modern money oriented
economy. Finance is one of the basicfoundation of all
kinds of economic activities. Therefore a well-knit
financial systemdirectly contributed to the growth of
 the economy. Finance is the management ofmonitory
affaris of company.

6.2 Meaning Of Finance

The word ‘Finance is derived from an old French word

‘Finer’, meaning thereby to pay, settle or finish. In other
words, the term ‘Finance’ means ‘Money’ or to providemoney
or ‘provision of funds’ as and when needed.Finance is that
administrative functions in an organization which relate with
thearrangement of cash credit, so that the organization may
have the means to carry outits objectives as satisfactorily a
possible

6.3 Features Of Finance

• Finance is essential for business activity in the sense that

business activities are not possible without finance.• All
business concerns weather small or large need finance.•
Business may be short term finance, medium, term finance
depending upon thenature of the activities to be financed.•
Investment opartunities.• Diversify your investment.•
Financial decision making

6.4 Projection of the project budget

The basic characteristic of each project is a triple limit, expressed

through the scope (area) of the project, time (duration) and
budget (costs),
so that each of these items affects significantly the quality.
Figure 1 – Triple project constraint
Рис. 1 – Тройное ограничение проекта
Слика 1 – Троструко ограничење пројекта

Changing each item will have a significant impact on quality, with

simultaneous change and other parameters, in all stages and on
the
complete project. As the scope, time and quality are factors of a
different
character, the budget often appears as a decisive factor in the
planning
and implementation of the project (Barkley & Saylor, p.83).
A particular problem in the realization of each project, but also in
the
budget planning is one of the key characteristics of the project -
that each
project is a unique venture, whose results are always unique
products and

156

VOJNOTEHNIČKI GLASNIK / MILITARY TECHNICAL

COURIER, 2018, Vol. 66, Issue 1
services, and which is realized in a unique way, in unique
conditions, with
unique resources , etc.
For long, costly and complex projects, it is not always easy to
estimate the project budget, especially if the market conditions
are not
stable (Khoury, pp.1-3). Nevertheless, it is certainly a good
parametric
assessment, based on real market data on the price of products
and
services needed for the realization of the activities, every phase
or
project as a whole.
Also, an expert assessment can be very reliable, based on an
expert's
assessment for specific areas.
An experienced assessment also provides great reliability, and is
based on experiential data from the realization of previous, similar
projects.
Quantitative analysis
The cost-effectiveness of the project can be seen from many
angles,
depending on the nature of the project, but also on the indirect
impacts on
the development of a particular area or from the indirect revenues
that
result from the project.
The quantitative analysis is one of the basic elements in deciding
to
start a project, but also to analyze the justification of choosing one
out of
several offered projects. It is based on expected (estimated,
planned)
investments - expenditures, and estimated revenues in a given
period
(DeCarlo, p.332).
The return on investment for certain projects may be after a very
long
period, depending on the nature of the project and the area in
which it is
being implemented.
Regardless of the nature of the project, each investor will be of
great
importance for the return on the investment rate, the return period
of
investments, the net present value of the realized profit, and the
rate at
which returns would be returned.
Different questions and dilemmas can be posed for certain cases:
how long will be the return of the investment return, or when the
net
balance, i.e. the total amount of cash flows, will arise; when profits
will start
to appear; whether the return on investment is greater than the
interest
rate that we could achieve in the banking or investment sector.
A characteristic case is projects that are not directly profitable, but
they represent the entrance to subsequent projects. In this case,
the cost-
effectiveness of the project will not be measurable through
investment
parameters, nor in the case when the completion of the project is
realized

157

Drenovac, A. et al, Project profitability analysis, pp.154-169.

as one-time income, i.e. the entire sales project without the
realization of
cumulative revenues in the following period.
In the case of a single project, planned investments and revenues
would be distributed by periods and items, so that during the
planning and
realization of the project only costs occur, and since the activation
of the
project, revenues are generated, with the necessary further
investments
(Gitman, pp.321- 337).

Table 1 – Project outcomes

Таблица 1 – Расходы проекта
Табела 1 – Расходи пројекта
Investments Initial Year 1 Year 2 Year 3 Year 4 Year 5
Equipment purchase 600 € / / 400 € / /
Renting an object 3000 € 3000 € 3000 € 3000 € 3000 € 3000
€
Certification 1200 € / / 1000 € / /
Procurement of software 4000 € 2000 € / / / /
Salaries 3000 € 3500 € 4000 € 4500 € 5000 € 5500 €
Travelling 1200 € 2000 € 2200 € 2400 € 2400 € 2400 €
Ongoing costs 2000 € 2200 € 2200 € 2200 € 2200 € 2200 €

Table 2 – Project incomes

Таблица 2 – Доходы проекта
Табела 2 – Приходи пројекта
Incomes Initial Year 1 Year 2 Year 3 Year 4 Year 5
Consulting / 4000 € 6000 € 6000 € 6000 € 6000 €
Software implementation / 2000 € 2500 € 3000 € 3500 €
4000 €
Business education / 4000 € 4000 € 5000 € 6000 € 6000 €
Realization of projects / 2800 € 3200 € 3500 € 4000 € 4500 €

Table 3 – Project incomes

Таблица 3 – Доходы проекта
Табела 3 – Приходи пројекта

Project
realization
cost
Year 1 Year 2 Year 3 Year 4 Year 5
Expenses 15000 € 12700 € 11400 € 13500 € 12600 € 13100
€
Arrivals / 12800 € 15700 € 17500 € 19500 € 20500 €
Net cash -15000 100 4300 4000 6900 7400

158
VOJNOTEHNIČKI GLASNIK / MILITARY TECHNICAL
COURIER, 2018, Vol. 66, Issue 1

Project
realization
cost
Year 1 Year 2 Year 3 Year 4 Year 5
(1 + r) n / 1.08 1.17 1.26 1.36 1.47
Discounted
net cash / 92.59 3686.56 3175.33 5071.71 5036.32
Net cash -15000 100 4300 4000 6900 7400
Cumulative
net cash -15000 -14900 -10600 -6600 300 7700
State <0 <0 <0 <0 >0 >0
Investment Indicators
When deciding on one of several investments, i.e. when choosing
one
of several potential projects, it is not enough to consider only one
parameter. If one attempts to analyze one of the essential
parameters, one
of the remaining ones will very soon come to light, which will point
to some
limitation, or to a more favorable variant of the project
implementation.
The quantitative analysis is one of the basic elements in deciding
to
start the project, but also to analyze the justification of the choice
of one of
several offered projects (Gowthorpe, p.492). It is based on
expected
(estimated, planned) investments - expenditures, and estimated
revenues
in a given period.

The cost-benefit analysis of the project must take into account

consideration of the following parameters:
- DR (Discount Rate)
- ROI (Return on Investment)
- IRR (Internal Rate of Return)
- NPV (Net Present Value)
- PbP (Payback Period)
NPV- Net Present Value
The net present value of money represents the discounted value
of
cash flows in each income period. Practically, the individual
values of
discounted cash flows would represent an amount that would,
with an
interest rate equal to the discount rate, give rise to the value of
the cash
flow. It would certainly be positive that the net present value
(NPV) is
higher than the value of the initial investment, which would show
that we

159
Drenovac, A. et al, Project profitability analysis, pp.154-169.
made profit, i.e. that the sum of the value of cash flows (PV-
Present Value)
reduced to today's value has a value higher than the initial
investment.
This would mean that on this day we would have more money
than what
we have invested in the development of a project.
n
n
r
PV
r
PV
r
PV
r
PV
NPV
)1(
...
)1()1(1 3
3
2
21







 (1)
Each cash flow in a certain period is reduced by the n-th factor of
the
discount factor (1 + r), where r is the discounted rate.

Table 4 – Discounted cash flow

Таблица 4 – Дисконтированное движение денежных средств
Табела 4 – Дисконтовани новчани токови
Net cash -15000 100 4300 4000 6900 7400
(1+r)n / 1.08 1.17 1.26 1.36 1.47
Discounted

Net cash / 92.59 3686.56 3175.33 5071.71 5036.32

Sum of discounted cash flows, combined with an initial

investment,
will give an indication of the net present value of the project. Since
the sum
of the discounted monetary values is 17062.5, and the initial
investment is
15000, the net present value will be 2062.5.
The positive value of the net present value indicates that the
project is
cost-effective, i.e. that its interpretation would be the same as
having
additional € 2062.5 at the start of the project launch.
ROI- Return of Investment
For a large number of projects, investors are in the first place
interested in returning the investment, or in that sense, at the rate
at which
the capital invested will be returned. In other words, ROI is the
rate at
which the sum of the discounted values will be equal to the initial
investment, i.e. when the total cash flow is equal to zero. Viewed
through
the planned costs and revenues, it represents the share of profit
in the
overall investment, i.e. the return of funds for one invested
monetary unit.

160

VOJNOTEHNIČKI GLASNIK / MILITARY TECHNICAL

COURIER, 2018, Vol. 66, Issue 1
%100
exp_
exp__ 


ensesPlaned
ensesPlanedincomesPlaned
ROI

Table 5 – Calculation of ROI

Таблица 5 – Расчет ROI
Табела 5 – Прорачун ROI
Project
realization
cost Year 1 Year 2 Year 3 Year 4 Year 5
Expenses 15000 € 12700 € 11400 € 13500 € 12600 € 13100
€
Incomes / 12800 € 15700 € 17500 € 19500 € 20500 €
Cumulative
expense 15000 27700 39100 52600 65200 78300
Cumulative
income / 12800 28500 46000 65500 86000
Cumulative
net cash -15000 -14900 -10600 -6600 300 7700
ROI -100% -53.79% -27.11% -12.55% 0.46% 9.83%
DR- Discount Rate
In real business, the discount rate will represent the highest rate
at
which we can place certain funds. It can be practically determined
as the
highest interest rate that can be achieved on the market. In the
analysis of
the cost-effectiveness of the project, there is no direct significance
for
analyzing the financial effects of a particular project, but in
decision making
for the launch of the project, it plays a major role. If it is a unique
project,
which is not followed by another project, a very important
information can
be information on the amount of returns, i.e. about the rate at
which
resources are returned. The discount rate of 8% was taken as a
case.

IRR- Internal Rate of Return

The internal rate of return on investment gives a realistic picture
of the
return on investment. It shows the rate at which the invested
investment
would bring profit during the observed period. It represents one of
the
important parameters when deciding and selecting an investment
project.
A definite prerequisite for accepting a project is that the IRR is
higher than
the discount rate, which would mean that the realization of the
project will

161
Drenovac, A. et al, Project profitability analysis, pp.154-169.
bring more profit over a certain period of time than simply
investing in a
bank or investment fund.
PbP- PayBack Period
A very important factor in deciding on one of several offered
projects
or investment programs is the time of return of the investment.
The
moment of return of the investment is the cutoff point of
cumulative
expenditures and cumulative revenues, i.e. the moment when the
cumulative cash flow becomes positive, since at that moment
cumulative
revenues start exceeding cumulative expenditures.

Net cash -15000 100 4300 4000 6900 7400

Cumulative
Net cash -15000 -14900 -10600 -6600 300 7700
State <0 <0 <0 <0 >0 >0

From the table, it is obvious that the return of the investment

comes in
the fourth year, so that a large part of the funds remains unsettled
at the
beginning of the fourth year, but still less than the planned
income, and
according to the projection of net cash should be compensated for
a longer
interval from the beginning of the fourth year.
Minus in the cumulative state should be compensated from the
net
cash that arises next year, so the very number of days will be
obtained
from the absolute ratio of the current negative state and the
projected net
cash next year. In the concrete case, that would be 6600/6900, or
0.956.
By conversion to time units, the data is 349 days, i.e. a total of 3
years and
349 days.
Computer analysis
Modern management requires the application of positive global
practice, which shows the justification of decision-making based
on
realistic indicators and facts.
A program created in Microsoft Excel can be processed and
analyzed
for all data, which enables automatic data processing in real time,
thus
providing analyzes for the shortest time, solving and obtaining the
results
needed for decision making.

162
VOJNOTEHNIČKI GLASNIK / MILITARY TECHNICAL
COURIER, 2018, Vol. 66, Issue 1
The program gives the possibility to quickly, easily and efficiently
obtain the results, i.e. data on parameters ROI, IRR, NPV and
PbP.

Figure 2 – Input data

Рис. 2 – Входные данные
Слика 2 – Улазни подаци

The program created by the authors is designed to include only

the
values of the planned investments and revenues for each period,
as well
as the value of the discount rate. On the basis of data entered,
the output
gives the results obtained on the parameters necessary for
decision
making, as well as data on revenues, expenditures and
cumulative cash
flows by periods.

163

Drenovac, A. et al, Project profitability analysis, pp.154-169.

Instead of making decisions based on intuitive analyses, or long,
extensive and complicated calculations, using a computer quickly
and
easily results in the necessary results.

Figure 3 – Analysis of incomes and outcomes

Рис. 3 – Анализ доходов и расходов
Слика 3 – Анализа прихода и расхода

Figure 4 – Analysis of the investment identifiers

Рис. 4 – Анализ инвестиционных показателей
Слика 4 – Анализа инвестиционих показатеља

164
VOJNOTEHNIČKI GLASNIK / MILITARY TECHNICAL
COURIER, 2018, Vol. 66, Issue 1

Figure 5 – Analysis of the investment identifiers

Рис. 5 – Анализ инвестиционных показателей
Слика 5 – Анализа инвестиционих показатеља

At the same time, the output provides consolidated data on

significant
parameters, as well as a graphic representation of the movement
of
revenues, expenditures and net cash, which contributes to a
visual
perception and presentation.
Investment Decision Making

The above mentioned indicators represent an important basis and

relevant data that would help to make the optimal decision to
enter the
project, as well as the effects of the given project.
In particular, the data analysis also provides adequate data on
cash
flows, by periods and in total. Through this data, the current
position can
be determined, and at the portfolio level and effectively plan the
allocation
of resources - material, human and financial.
One piece of the initial information that is crucial for deciding on
the
choice of the project or the decision to initiate the project is the
way the
organization operates, i.e. the state of the organization in which
the project
team operates.

165

Drenovac, A. et al, Project profitability analysis, pp.154-169.

The financial situation, in other words, the medium and long-term
positions of the organization, directly and very significantly
influence the
nature of the project that will be accepted. Namely, organizations
that have
a very large budget, and stable long-term positions, can be
defined for
projects that do not have a quick return on investment, their key
item is the
amount of profit realized in the later stages of the exploitation of
project
results. For organizations with weaker positions, or developing
organizations, an important element in deciding is the faster
return of funds

in order to provide liquidity and resources for regular functioning,

commitments and investment in new projects. It is exactly the
Payback
Period that provides an image of the time needed to return the
investment,
or equalization of invested funds with realized income, viewed at
a
cumulative level (Keat & Young, pp.324-330). In deciding on the
choice of
the project, the financial capacity of the organization that launches
the
project plays an important role, as well as the goals of the
organization.
For a given case, a period of 3 years and 349 days requires the
provision
of funds that would function until the full return of the investment
and the
transition to the net profit zone.
The next significant figure may be the rate at which the funds are
invested. If it is a project whose results are exploited only by
delivering the
results of the project, or if the result of the project itself is a
product that is
delivered and which does not have any subsequent benefits, then
in
certain cases it is necessary to compare the discount rate with the
internal
rate of return on investments. For the value of the discount rate,
the
highest interest rate can be obtained in commercial banks, or the
official
discount rate determined by the official competent banking
bodies.
When deciding on starting a project or choosing one of several
projects, an internal rate of return (IRR) with a discount rate is
often made,
so the project is initiated if the internal rate of return is higher than
the
discount rate. This will mean that the investment brings more
revenue
through the project, than it would be achieved through pure
investment
through the banking sector, i.e. the investment is more cost-
effective in this
way. In the given case, the internal rate of return of 11.89% is
higher than

the discount rate of 8%, which shows that a higher return would
be
achieved than the investment in the financial sector could make it.
One of the parameters in the investment analysis is the return on
investment (ROI). A higher ROI means a higher return on
investment, so it
is logical to always choose a project that has a higher ROI, if the
other
parameters are the same. In the given case, the ROI of 9.83%
shows that
for every 100 money units invested, a profit of 9.83 cash units is
realized.

166
VOJNOTEHNIČKI GLASNIK / MILITARY TECHNICAL
COURIER, 2018, Vol. 66, Issue 1

Conclusion
An important item in modern management is fact-based decision-
making. Such an approach has full validation in the analysis of the
cost-
effectiveness of the project, because of the exceptional
significance of
such analysis and results.
The starting point in each project is the cost-effectiveness of the
project, which is perceived through the parameters NPV, ROI,
IRR and
PbP. In order to get a realistic view of the project, it is necessary
to look at
each of the parameters and make conclusions based on the
analysis.
There is no unique model of decision-making based on given
parameters, because each project is unique, so it is realized in a
different
way and depends on different conditions and parameters.
When analyzing, the nature and purpose of the project, the
market
conditions, the available resources and the liquidity of the
organization, as
well as the importance of returning investments in a given period,
should
be taken into account. Each of the items will have a different
impact on the
execution of the project, and therefore the importance in the
analysis and
decision-making.

By looking at the above parameters, one can definitely conclude

that
a project is more valuable when it has a higher net present value
(NPV), a
return on investment (ROI) and an internal rate of return (IRR), or
a shorter
investment return time (PbP).
However, as in real terms it is difficult to achieve optimal results
for all
parameters, if there is a choice between two or more projects,
certain
compromise on one of the parameters will definitely have to be
made.
When choosing one of possible, offered or available projects, all
options should be considered at the portfolio manager level,
including
more complex analyses of operational and financial risks, without
relying
on only one analysis. Portfolio managers in the given situation
must count
on adequate diversification, so as not to jeopardize company's /
organization's positions, as well as on the likelihood of achieving
the
results of the project, or on a possible impact of project failure on
total
business.

Each project is also a unique, special business venture that gives

certain economic parameters in given conditions and with given
market
conditions; therefore, at the portfolio level, each project has to be
approached individually in detail, on the basis of real and relevant
parameters in order to make an optimal decision.

6.5 Motivations for profitability analysis

Profitability decompositions provide relevant information in

several ways.5 First, the component ratios that interact to
generate ROCE inform on different aspects of profitability and
related

used to analyze the effects of borrowing. In addition, some

components of operating profitability inform on the link between
investment and revenue, while others focus on the relationship
between revenue and operating profit. Analyzing component
ratios of operating profitability is important because they evolve
differently over time, and they drive free cash flow.

Thus, profitability analysis helps in forecasting free cash flow,

estimating value, and predicting stock returns (e.g., Nissim and
Penman 2001, Binz et al. 2022).6 Similarly, understanding the
leverage effect on profitability is critical to understanding financial
risks and other borrowing effects (e.g., Nissim and Penman
2003). Second, because business activities are reflected in
different ways in ROCE components, ROCE decompositions help
in understanding and evaluating the underlying activities.

For example, outsourcing of manufacturing increases asset

turnover (by reducing the investment in fixed assets) but reduces
profit margin (cost of goods sold includes the manufacturer’s
profit); outsourcing of services may increase profit margin but
heighten operating risks and potentially reduce sales growth;7
“just-in-time inventory” improves asset turnover but may reduce
sales growth (e.g., Baños-Caballero et al. 2014); operating credit
increases net asset turnover but lowers profit margin (the cost of
operating credit is embedded in costs and operating expenses);
business combinations increase revenue but reduce asset
turnover (acquired intangibles are recognized and tangible assets
are marked up); and organic growth increases revenue but
reduces profit margin, 6 In his letter to Berkshire Hathaway
Shareholders, included in the 2020 10-K, Warren Buffett explains
the importance of evaluating components of operating profitability:
“Our leadership in fixed-asset ownership,

I should add, does not, in itself, signal an investment triumph. The

best results occur at companies that require minimal assets to
conduct high-margin businesses – and offer goods or services
that will expand their sales volume with only minor needs for
additional capital. We, in fact, own a few of these exceptional
businesses, but they are relatively small and, at best, grow slowly.

” 7 Outsourcing of services may also have offsetting effects within

components of the profit margin. For example, it may reduce
SG&A expenses but also reduce the gross margin due to a
reduction in overall customer experience and pricing power. 7 at
least in the short-term (e.g., Fairfield et al. 2002).

Therefore, examining the levels of and changes in profitability

ratios is useful for understanding management’s decisions and
the company’s success in implementing the decisions. Moreover,
comparing the ratios to those of other firms in the industry (e.g.,
Schröder and Yim 2018, Jackson et al. 2018), and evaluating the
ratios in the context of the company’s business environment (e.g.,
Selling and Stickney 1989), helps in assessing the likelihood of
success of alternative strategies.

For example, the extent to which a firm is subject to competition

or capacity constraints affects its ability to improve profitability by
increasing profit margin via product differentiation strategies, or by
increasing asset turnover via cost leadership strategies. Third, the
decomposition of operating profitability informs on operating risks.
Each of the three main components of operating profitability
analyzed in this study capture an important risk dimension.

Operating profit margin is an important determinant of the degree

of operating leverage (i.e., the sensitivity of the percentage
change in operating profit to a given percentage change in sales),
and asset turnover is correlated with operating leverage (the
proportion of fixed cost), the other determinant of the degree of
operating leverage (Li et al. 2014).

In addition, the operations funding ratio (i.e., the proportion of

operating assets funded by capital) is negatively related to the
firm’s power over its operating counterparts, which is an important
determinant of operating flexibility (e.g., Nissim and Penman
2003). Fourth, the firm’s profile—as reflected in the levels of and
trends in its financial ratios— helps in evaluating the average life-
cycle stage of the company’s products as well as its growth
prospects(e.g., Klepper 1996, Dickinson 2011).

For example, as firms progress through the growth stage, their

operating margin, asset turnover and financial leverage all tend to
increase. Relatedly, profitability analysis applied at the aggregate
level provides insight relevant for forecasting real 8 economic
activity (Konchitchki and Patatoukas 2014), essentially by
informing on the economy’s stage in the business cycle. Similarly,
aggregating profitability ratios at the industry level helps in
understanding the stage of the industry’s life cycle and the
industry’s characteristics.

For example, industries with significant operating leverage and

high entry barriers tend to have low asset turnover and high profit
margin, while industries with low capital intensity and
commoditylike products tend to have high asset turnover and low
profit margin (e.g., Selling and Stickney 1989). Fifth, ROCE
decomposition helps in predicting profitability and evaluating its
sustainability (e.g., Fairfield and Yohn 2001, Esplin et al. 2014).

This follows because the different ROCE components vary in their

persistence and cross-correlations. For example, “special items”
are less persistent than other income statement items (e.g.,
Dechow and Ge 2006); operating profitability is more persistent
than the financial leverage effect (e.g., Nissim and Penman
2001); asset turnover is more persistent than profit margin (e.g.,
Soliman 2008, Amir at al. 2011); negative special items predict
earnings increases (e.g., Burgstahler et al. 2002, Cready et al.
2012) but lower profit margin for high profitability firms (e.g.,
Fairfield at el. 2009);

and increases in operating liabilities (debt) are often associated

with subsequent increases (decreases) in operating profitability
(e.g., Nissim and Penman 2003, Chen at al. 2019). Evaluating the
persistence or sustainability of earnings is at the core of earnings
quality analysis, and it is relevant for both relative and
fundamental valuation as well as for various risk-related analyses
(e.g., when evaluating debt capacity). In addition, some patterns
of and relationships among component ratios are indicative of
earnings management (e.g., Jansen et al., 2012).

8 8 Profitability analysis may inform on earnings management or

earnings quality for additional reasons (see Section 2.8 in Nissim
2021a). For example, executives of firms with deteriorating
operating profitability may have stronger than average incentives
to overstate earnings (e.g., Donelson et al. 2021). Profitability
decomposition may also 9 Finally, in many cases ratios higher in
the hierarchy are problematic or even meaningless, while
component ratios still provide useful information. For example, if
common equity is negative, ROCE cannot be interpreted but profit
margin and asset turnover are still informative. This is an
important benefit of profitability decompositions, as negative book
values are quite common and are due to different reasons,
including substantial share repurchases by successful companies.

As another example, some companies obtain more operating

credit than they invest in operating assets, resulting in negative
net operating assets and thus inability to measure the rate of
return earned in operations. In such cases, component ratios of
operating profitability (e.g., profit margin) are still meaningful

6.6 Reformulated financial statements

Conducting informative profitability and valuation analyses

requires reformulating the financial statements to separate
operating activities—the core of value creation—from financing
and other nonoperating activities. It also requires distinguishing
between recurring and transitory items in the income statement.

Nissim (2022b) provides a step-by-step explanation of the

reformulation process, and it describes how the reformulated
financial statements can be measured using Compustat data
items. The analysis in this paper uses the reformulated financial
statements constructed in Nissim (2022b).

The following is a short description. Reformulating the balance

sheet involves classifying assets and liabilities as either operating,
financing, or other nonoperating, as shown in Exhibit A. Appendix
A lists the items comprising the different categories.
 inform on the source of earnings sustainability—persistent
profitability versus additional investments—which is another
aspect of earnings quality (e.g., Estridge et al. 2009). 10 Exhibit A.
Reformulated Balance Sheet Operating assets Operating
liabilities + Financial assets + Debt + Other nonoperating assets +
Other nonoperating liabilities Total liabilities + Equity Total assets
Total liabilities and equity The reformulated balance sheet can
also be presented in a net format, derived by subtracting financial
assets, operating liabilities, and other nonoperating liabilities from
both sides of the balance sheet: Exhibit B.

Reformulated Balance Sheet (net presentation) Operating assets

Debt - Operating liabilities - Financial assets Net operating assets
Net debt + Net other nonoperating assets + Equity Net assets
funded by net capital Net capital Net operating assets—that is,
the difference between operating assets and operating liabilities—
measures the amount of net capital invested in operations.

Net capital is also used to fund investments in net other

nonoperating assets (i.e., other nonoperating assets, such as
equity method investments, minus other nonoperating liabilities,
such as reserves for unusual litigation). Net capital is also referred
to as invested capital or capital employed.

Like the reformulated balance sheet, the reformulated income

statement distinguishes between operating, financing, and other
nonoperating items. However, unlike the balance sheet, another
layer of analysis is required. Because recurring earnings have
greater impact on value than transitory items, and they help
predict future profits, it is important to identify and separate out
transitory components before classifying items by the nature of
activity.
Once transitory items are 11 separated out, the classification is
(mostly) straightforward. Revenue generated in operations is
classified as operating, while income earned on financial assets
(e.g., interest income on long-term marketable securities) is
classified as financing, and income earned from other
nonoperating activities (e.g., equity method income) is classified
as other nonoperating. Similarly, expenses representing
consumption of operating assets (e.g., depreciation of fixed
assets or cost of inventory sold) or incurrence of operating
liabilities (e.g., accrued expenses) are classified as operating,
while interest on debt is classified as financing.

Income taxes are allocated to transitory, operating, financing, and

other nonoperating activities based on the related income and tax
rates. Exhibit C presents the reformulated income statement and
Appendix B lists the items comprising each category.

6.7 Decomposition of Recurring

ROE The next step in the profitability analysis is to decompose

Recurring ROE into the effects of operating, financing, and other
nonoperating activities: 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑅𝑅𝑅𝑅𝑅𝑅 =
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 + 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 + 𝑂𝑂𝑂𝑂ℎ𝑒𝑒𝑒𝑒
𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 Where
RNOA measures the rate of return earned in operations;

Financial Leverage Effect measures the impact of financing

activities on shareholders’ profitability (i.e., the additional return to
shareholders from earning a spread on borrowed funds); and
Other Nonoperating Effect measures the impact on shareholders’
profitability of investments other than operating or financing (e.g.,
equity method investments, real estate not used in operations).
I next define the last two components, and then discuss RNOA in
a separate section. 4.4 Financial Leverage Effect The Financial
Leverage Effect is calculated as follows:

𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 =

𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 ×
𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 Where
𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 =
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑛𝑛𝑛𝑛𝑛𝑛 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝑐𝑐𝑖𝑖𝑖𝑖𝑖𝑖 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 = 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 −
𝑁𝑁𝑁𝑁𝑁𝑁 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 16 𝑁𝑁𝑁𝑁𝑁𝑁
𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 = 𝑁𝑁𝑁𝑁𝑁𝑁
𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
𝑛𝑛𝑛𝑛𝑛𝑛 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 Financial Leverage measures the amount of
net borrowing per dollar of equity;

Net Borrowing Cost measures the after-tax cost of each dollar

borrowed (net of amounts invested in financial assets); and
Financial Spread measures the additional return that accrues to
shareholders per dollar of borrowing. The decomposition of the
financial leverage effect informs on the trade-off between risk and
return that financial leverage entails. Shareholders earn the
difference between RNOA and Net Borrowing Cost (i.e., Financial
Spread) on each dollar of debt, but they also absorb the volatility
of the excess return, as lenders generally receive a constant
return independent of the profitability of operations.

In other words, holding net operating assets constant, leverage

reduces the amount of equity but does not reduce the variability of
net income (because debtholders’ claims are fixed), thereby by
increasing the volatility of ROE. Moreover, when RNOA is lower
than Net Borrowing Cost, leverage has a negative effect on
shareholders’ profitability. RNOA is typically higher than Net
Borrowing Cost, leading to a positive leverage effect on
shareholders’ profitability. However, this does not necessarily
imply that leverage adds value because of its impact on volatility
and the related negative effects.10 Evaluating the components of
the financial leverage effect—including the amount of leverage,
the cost of borrowing, and the spread—shed light on the benefits
and costs of leverage, as explained next. 10 In his letter to
Berkshire Hathaway Shareholders, included in the 2018 10-K,
Warren Buffett notes: “We use debt sparingly.

Many managers, it should be noted, will disagree with this policy,

arguing that significant debt juices the returns for equity owners.
And these more venturesome CEOs will be right most of the time.
At rare and unpredictable intervals, however, credit vanishes and
debt becomes financially fatal. A Russian-roulette equation –
usually win, occasionally die – may make financial sense for
someone who gets a piece of a company’s upside but does not
share in its downside. But that strategy would be madness for
Berkshire. Rational people don’t risk what they have and need for
what they don’t have and don’t need.”

17 The costs of leverage • Increased volatility of shareholders

profitability by a factor equal to the Financial Leverage. For
example, if Financial Leverage is equal to 2 (i.e., two dollars of
net debt per dollar of equity), shareholders’ profitability is 200%
more volatile than RNOA. Importantly, this effect applies to both
systematic and idiosyncratic volatility.

11 • Increased probability of bankruptcy and related costs.

Financial Leverage measures the relative magnitude of claims
that the firm is required to repay (debt). Therefore, high financial
leverage indicates that a relatively small equity cushion is
available to absorb losses, which in turn implies high solvency
risk. Bankruptcy results in significant costs (e.g., lawyer fees) as
well as losses from distressed asset sales and low exit values of
intangible assets (e.g., assembled work force). • Refinancing risk.
High-debt firms are dependent on capital markets for continued
refinancing and so are more sensitive to changes in interest rates,
credit spreads, or funds availability.

• Lower growth. Because debt capacity is constrained, high-debt

firms have limited ability to borrow additional funds when growth
opportunities arise. Moreover, lack of financial flexibility may lead
to contraction when the firm is faced with negative operating
shocks. In addition, “debt overhang” may cause managers to
forgo profitable projects that require new capital if that capital
inflow primarily benefits existing debtholders by making their
claims less

6.8 Analysis of operating profitability

Measuring operating profitability (RNOA) for a given period

involves comparing net operating profit after tax (NOPAT) to the
net investment in operations that generated it: 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝑁𝑁𝑁𝑁𝑁𝑁 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎
𝑡𝑡𝑡𝑡𝑡𝑡 (𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁) 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑛𝑛𝑛𝑛𝑛𝑛
𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 Where NOPAT is calculated
by removing transitory, financing, and other nonoperating items
from net income (including the related income taxes), as
described in Nissim (2022b).

Accordingly, RNOA is a summary measure of recurring

profitability from operating activities. RNOA is measured relative
to net operating assets (i.e., operating assets minus operating
liabilities), rather than relative to operating assets, because
NOPAT is the dollar return from operations after deducting the
cost of operating credit, which is included in operating expenses
(see Section 1).

For example, suppliers and other vendors often charge higher

prices (or do not offer discounts) when they extend credit,
resulting in higher cost of sales and SG&A expenses. Moreover,
some operating liabilities are reported discounted, with the
interest cost included in operating expenses (e.g., the accretion
expense on asset retirement obligations).

In other words, 21 operating creditors have no claim on NOPAT;

NOPAT measures the dollar return on net operating assets, which
in turn flows or accrues to shareholders and debtholders. RNOA
is generally less volatile than Recurring ROE. Unlike Recurring
ROE, RNOA is not directly affected by financial leverage as it
excludes the impact of financial activities.

As explained in Section 4.4 above, financial leverage magnifies

the impact of operating shocks on shareholders’ profitability by
reducing the amount of equity (the denominator of Recurring
ROE) without reducing the variability of recurring income (the
numerator of Recurring ROE).

That is, compared to RNOA, Recurring ROE has the same

variability of the numerator (recurring income versus NOPAT),
spread over a smaller denominator (equity versus net operating
assets). Financial leverage does not affect the variability of
recurring income since debt holders’ claims on NOPAT are fixed
(after-tax interest expense).

5.1 The standard decomposition of operating profitability To

obtain insights into the drivers of operating profitability, RNOA can
be decomposed into margin and turnover, which are defined as
follows:12 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 = 𝑁𝑁𝑁𝑁𝑁𝑁 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜
𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑡𝑡𝑎𝑎𝑎𝑎 (𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁)
𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑁𝑁𝑁𝑁𝑁𝑁
𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 = 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂
𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑛𝑛𝑛𝑛𝑛𝑛
𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 Multiplying the two drivers
together yields RNOA: 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 = 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 × 𝑁𝑁𝑁𝑁𝑁𝑁
𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 This disaggregation of RNOA is useful
because, as discussed below, business strategies and activities
are reflected in different ways in profit margin and net asset
turnover.

Net Operating Asset Turnover should generally be less volatile and

more persistent over time than the profit margin.

This follows because, percentagewise, changes in income are more

volatile than changes in sales due to (1) fixed costs, which reduce
earnings without offsetting the variability in revenue (i.e., the impact
of operating leverage), and (2) the inclusion of volatile expenses,
gains, and losses in earnings. Excluding transitory items from NOPAT
increases the persistence of profit margin and so reduces the
difference in persistence between profit margin and asset turnover.

In addition, as discussed below, when net operating assets is

relatively small, Net Operating Asset Turnover is quite volatile. Still,
in most cases, net asset turnover is more persistent than profit
margin (e.g., Nissim and Penman 2001)
Thank You