After completing my ratios and building up to the big scary economic profit ratio, I thought by this stage I would have had some level of comprehension on what this road was leading to…but no. Economic profit, what is it? Renault had both ne positive and negative numbers. Guessing that’s a bad thing? Surely a negative profit cannot be good. That’s when I hit the books and spoke to my peers to understand exactly what was happening.
Economic profit is derived from RNOA, the cost of capital and NOA. A formula which measures not only the financial status of a company but also reflects the effectiveness of the company’s management strategies. It relates to the opportunity cost of the capital investments meaning it compares alternative returns foregone by utilising the selected inputs. Knowing this now, makes me feel slightly more relaxed about Renault’s economic profit because not only do they have a positive revenue, they also produced a positive economic profit for most years.
I was able to identify Renault’s annual weighted average cost of capital (WACC) from their annual reports and they varied from 8.3% to 8.80%. As I was able to find these records, I decided to use them to present a more accurate representation of economic profit rather than using 10% as suggested from Maria if we were unable to identify them.
Utilising the previously calculated ratios, this ratio was easy to calculate however understanding the reasons behind the changes over the years was tricky. Renault when from an economic profit of negative 1480 in 2013 (see figure 5.5) to a positive economic profit of 1160 in 2016. Why was this? I started by compiling a list of each of the numbers that were used in this equation in my notebook for the four years and begun comparing.
I wanted to understand how the WACC effected my numbers. From swapping WACC rates in different years I gained an understanding that the lower the WACC, the greater my economic profit would be if all other figures remained constant. My WACC (see figure 5.6) didn’t change very much over the years however it did reflect my economic profit figures whereby when Renault had a RNOA higher than the WACC, the economic profit was a positive figure explaining why 2016 and 2015 were economic profits and why 2014 and 2013 were economic losses. The 2015 financial year had the lowest WACC (8.3%), and when applied to 2016’s economic profit calculation increased the profit however this alone did not explain the large differences between the different years, so further investigating was required.
I then looked at NOA, these figures had large differences and had been increasing over the last three years. I started by adjusting my 2016 equation by multiplying it by 2015’s NOA. This displayed that the higher the NOA, the higher my economic profit was. I changed 2015’s NOA to 2016’s higher figure and the profit grew substantially. It increased so much that it was now higher than 2016’s economic profit. Noting we are multiplying our RNOA – Cost of capital by our NOA, the large differences in these numbers I believe to be contributing towards the variation of economic profit. From 2015 to 2016, the NOA did deviate substantially due to the fact that Renault had a lot more operation assets than it did liabilities.
The two key accounting drivers for RNOA are Profit Margin (PM) and Asset Turnover (ATO). I broke these down and noticed that the ATO for 2016 was considerably less at just 7.21% compared to 2015’s 10.49%. Noting Renaults continuous growth in OI, I knew this could not be a contributing factor. PM’s in 2013 and 2014 were dramatically less than were recorded in 2015 and 2016 for Renault. When playing around with formulas, it appears that PM has a significant input into economic profit.
From comparing different figures with different years, I was able to determine the main drivers affecting the economic profit. WACC was the main contributor in determining a positive or negative economic profit and NOA and PM appeared to play a crucial role in determining how large the profit or loss was. Through making a previous mistake in restated financial statements in assignment 2 step 3, upon rectification, I was able to see the difference it made to my ratios. I went from a negative to a positive economic profit by simply increasing the NOA by 20 million. For this reason, and through analysing other potential contributors I am confident in my drivers of economic profit.
Through discussing economic profit with other students NOA, WACC, ATO and RNOA appeared to be common themes for reasons behind changes. I have gained a lot of insight into my firm’s financial statements and financial status by doing this step of the assignment but it has definitely been a lengthy stage. I in no way consider myself an expert at any of this however I know for a fact my level of knowledge has dramatically improved through the hours put into calculating my ratios and analysing my firms annual report. I am glad to put the pen down so to speak on this step of assignment two!