Page 106 - FINAL CFA II SLIDES JUNE 2019 DAY 5.2

READING 19: INTEGRATION OF FINANCIAL STATEMENT ANALYSIS TECHNIQUES

MODULE 19.4: CAPITAL ALLOCATION

From Figure 19.10, while the specialty products division has, by far, the lowest EBIT margin, it
has the highest capital expenditures proportion to assets proportion ratio.

Additionally, the specialty products division’s EBIT margin is declining. If Thunderbird continues
to over-allocate capital resources to the specialty products division, the firm’s company-wide
returns may suffer.

Accrual-based measures such as EBIT may not be a good indicator of an entity’s ability to generate cash flow. We would rather evaluate segmental capital allocation
decisions based on cash flows generated by each segment. However, segmental cash flow data is generally not reported. We can, however, approximate cash flow as
EBIT plus depreciation and amortization. Figure 19.11 provides depreciation and amortization expense by segment. Figure 19.12 shows the cash flow estimates using
segmental EBIT from Figure 19.8 and segmental depreciation and amortization information from Figure 19.11.
We then compute cash operating return on average total assets using information from Figure
19.12 and computing average total assets for 2015 and 2016 from information in Figure 19.9.
Figure 19.13 shows the relevant information including EBIT margins from Figure 19.10.

Using data from Figure 19.9, the 2016 average assets for the aircraft division is ($14,777 + $6,861)/2 or
$10,819. Hence, for 2016, the cash flow to average assets for the aircraft division is $2,612 / $10,819 =
24.1%. Figure 19.13 confirms poor capital allocation decision to the specialty products division. In addition,
we can see that the aircraft division—while continuing to produce superior operating margins—has fallen
behind in cash generation in the latest year.