oversight

Government Contracting: Financial Measures for Evaluating Contractor Profitability

Published by the Government Accountability Office on 1990-09-12.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

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                                                                         GOVERNMENT
                                                                         CONTRACTING
                                                                         Financial Measures for
                                                                         Evaluating Contractor
                                                                         Profitability




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                   United States
GAO                General Accounting Office
                   Washington, D.C. 20548

                   National Security and
                   International Affairs Division

                   B-236689

                   September 12,199O

                   The Honorable Barbara Boxer
                   Co-Chairman, Military Reform Caucus
                   House of Representatives

                   Dear Madam Co-Chairman:

                   This report responds to your request that we report on the types of
                   financial measures that could be used to assess the effect that federal
                   government policies may have on the profitability of government
                   contractors.

                   In our report,lwe recommended a framework for a profit reporting pro-
                   gram that would require major government contractors to annually
                   report financial data to the government to provide a basis for evaluating
                   profitability. Such a program has not been implemented and financial
                   data is not publicly available for the specific part(s)-i.e., the segment
                   level-of a company performing government work. Therefore, the
                   framework of data for measuring profitability is not in place. Conse-
                   quently, our analysis reflected in this report is not a government con-
                   tractor profitability study nor was it intended to be.


                   A profit reporting program which requires major government contrac-
Results in Brief   tors to annually report financial results for the part(s) of the company
                   performing government work is a prerequisite to any evaluation of gov-
                   ernment contractor profitability.

                   Return on assets (ROA), which is the ratio of income to assets, should be
                   used as the principal financial measure to use in assessing the profit-
                   ability of government contractors. ROA is the desirable measure of profit-
                   ability because it can (1) provide a basis for measuring the cumulative
                   impact of policies, (2) be computed at the segment level, and (3) be
                   derived from historical financial data which can be audited.

                   The defense industry has objected to using ROA as the preferred financial
                   measure to evaluate contractor profitability. The primary objection cen-
                   ters on the method that we used and a 1976 Department of Defense


                                       A Proposal for a Program to Study the Profitability of Government Con-
                                       175,Sept. 1987).



                   Page 1                                          GAO/NSIAD-SO-200BR      Financial   Measures
                                                                                                 -~
                       B-236089                                                                       I("




                       (DOD) study used to compute RQA. Using this method resulted in a sub-
                       stantially higher profitability for defense contractors than non-defense
                       contractors from 1980 to 1983. As part of the debate, the industry posed
                       the question: If the defense industry’s ROASare so high, why have their
                       price earnings (PE) ratios been historically low? Based on our research of
                       the literature on financial measures, interviews with financial analysts,
                       and analyses of balance sheet and income statement information for
                       companies in Standard and Poors’ (S&P) Industrial Index and for compa-
                       nies that perform defense work, we found that PE is not a good indicator
                       of profitability.

                       If segment-level data were available, a combination of several measures
                       of financing defense contract work could be used, along with ROA, to
                       assess the effect that government policies have on government
                       contractors.


                       PE is the ratio of stock price to earnings per share. The PE ratio is not an
ROA and PE Ratios Do   appropriate indicator of financial performance for the part of the com-
Not Move in Tandem     pany that performs defense work because PE is not computed at the seg-
                       ment level. Furthermore, the PE ratio is better suited to measure stock
                       market expectations than to measure current profitability.

                       Companies that do varying amounts of defense work have generally had
                       lower PE ratios than overall industrial norms. This has generally been
                       true even when the profitability on defense work has increased. In fact,
                       it is not just defense contractors that experience lower PE ratios when
                       profitability increases; this situation usually exists for the S&P Industrial
                       Index.

                       The fact that PE ratios and ROA do not move in tandem is not unexpected,
                       given the nature of these financial measures. ROA is a profitability mea-
                       sure based on actual financial performance over the previous year. PE
                       ratios are based partly on expected future earnings, risk, and growth
                       prospects.


                       Financial measures other than ROA, while not suitable as overall profit-
Other Financial        ability measures, can be used to provide additional insight into the
Measures ”             effect of individual government policies. For example, data to measure
                       such things as capital expenditures ratios and research and develop-
                       ment ratios can be identified in the financial records of a company.



                       Page 2                                    GAO/N&ID-90-200BR   Financial   Measures
A capital expenditures ratio can reflect the amount spent on assets rela-
tive to sales. Some government profit policies are designed to encourage
contractors to invest in new plant facilities and equipment. Computing
the capital expenditures ratio for government contractors could indicate
whether government policies are accomplishing this objective.

A research and development ratio can show the research and develop-
ment expenses that are not reimbursed by the government. This mea-
sure could be used to examine the degree to which government
contractors are required to expend non-recoverable funds for research
and development.


Appendix I provides further details on the financial measures we identi-
fied and the work we did to illustrate the types of analyses that could be
done if segment-level data were available. It was not within the scope of
this report to address the standards for determining whether govern-
ment contractor profitability is at an appropriate level. As part of an
ongoing assignment, we intend to evaluate the criteria that should be
used when comparing government contractor profitability. Appendix II
provides additional information on our scope and methodology.

We have provided briefings on these financial measures to DOD, the
Office of Federal Procurement Policy, Financial Analysis Methodology
Committee, the Procurement Round Table, and interested congressional
committees. As requested, we did not obtain official comments on a
draft of this report from DOD.

Please contact me at (202) 276-8400 if you or your staff have any ques-
tions concerning this briefing report. Major contributors to this briefing
report are listed in appendix III.

Sincerely yours,




Paul F. Math
Director, Research, Development,
Acquisition, and Procurement
Issues



Page 3                                   GAO/NSIAD-QO-200BR   Financial   Measures
                                                                                                       *)
contents



Appendix I                                                                                                   6
What Are the Most       Background
                        Industry Compares Its Relatively High Profitability    With
                                                                                                             6
                                                                                                             8
Appropriate Financial       Its Low PE Ratios
Measures of             Analyses of Selected Financial Measures                                         10
Contractor              Assessment of Profitability Measures                                            16
Profitability?
Appendix II                                                                                             18
Objectives, Scope,and
Methodology
Appendix III                                                                                            20
Major Contributors to
This Report
Table                   Table II. 1: Categories and Formulas for Financial                              19
                            Measures

Figures                 Figure I. 1: PE and ROA for S&P Industrials
                        Figure 1.2: Capital Expenditures to Sales for 110 Firms
                        Figure 1.3:R&D to Sales for 110 Firms
                        Figure 1.4: Times Interest Earned for 110 Firms and S&P
                             Industrials
                        Figure 1.6: Quick Ratio for 110 Firms and S&P Industrials                       15
                        Figure 1.6: Current Ratio for 110 Firms and S&P                                 16
                             Industrials
                        Figure 1.7: ROA and ROE for S&P Industrials                                     17




                        Page 4                                   GAO/NSIAD-BO-200BR   Financial   Measures
    Contents




    Abbreviations

    DFAIR      Defense Financial and Investment Review
    DOD        Department of Defense
    PE         price earnings
    R&D        research and development
Y
    ROA        return on assets
    ROE        return on equity
    ROI        return on investment
    S&P        Standard and Poors


    Page 5                                 GAO/NSIAWO-200BR   Financial   Measures
Appendix I

What Are the Most Appropriate F’inancial
Measuresof Contractor Profitability?

                In the last 14 years, DOD has issued two studies on the defense industry’s
Background      profitability, entitled Profit 76 and the Defense Financial and Invest-
                ment Review (DFAIR). These studies have used ROA as a principal finan-
                cial measure. These studies compared defense profitability with durable
                goods manufacturers. In conducting these studies, DOD contracted with a
                Certified Public Accounting firm to collect and analyze financial data at
                the segment level for firms performing defense work.’

                After the DFAIR results were published, the defense industry objected to
                the methodology that we used in our 1986 study2 and that DOD used in
                its 1976 study to compute RGA. This methodology3 resulted in a substan-
                tially higher profitability for defense contractors than non-defense con-
                tractors from 1980 to 1983.

                In our 1987 report, we recommended that the government develop a sys-
                tematic method for measuring the profitability of government contrac-
                tors. We recommended that financial data be collected, on an ongoing
                basis, at the segment level and that ROA be used as the principal measure
                of profitability.

                In 1987, the Procurement Round Table (a group that reviews govern-
                ment procurement issues) strongly reaffirmed the importance of a pro-
                gram of regular review and research into government profit policies.
                Noting the differences in approach and methodology for evaluating con-
                tractor profitability, it recommended that the most appropriate mea-
                sures of contractor profitability at the segment and firm level be
                determined. It also recommended that the following issues be addressed
                before mandating the creation of our proposed profitability reporting
                program:

              . “What is the most appropriate standard against which to evaluate the
                adequacy of industry profits . . . ?”


                ‘DOD’s most recent study, called DFAIR, was issued in 1986. This study used segment-level data
                (covering the period 1970-83) to describe the flmancial performance of the defense industry. This type
                of data on the defense industry has not been collected for the last 7 years, despite the rapidly
                changing defense economic environment.

                2Government Contracting: Assessment of the Study of Defense Contractor Profitability (GAO/
                      _87 - 60, Dec. 231986).

                “In calculating ROA, DFAIR increased the asset base by adding progress payments to contractor
                inventories. In an additional computation, DFAIR adjusted income by using a unique method to calcu-
                late “economic profit.” These two actions reduced the apparent ROA for defense business and led, in
                our opinion, to an understatement of defense contractor profitability.



                Page 6                                                  GAO/NSIADgO-200BR        Financial   Measures
  Appendix I
  What Are the Most Appropriate      Fiuaucial
  Measures of contractor Profltnbility?




9 “Is it desirable to adjust or modify data in order to secure comparability
  of results between major government contractors and commercial
  operations?”
. “What are the most appropriate measures of economic risk, and by what
  standards should risk be evaluated?”

  We believe this briefing report identifies several appropriate measures
  for assessing contractor profitability at the segment and firm level. The
  remaining issues, described above, address the standards for evaluating
  whether government contractors’ profitability is at an appropriate level.
  We recognize the importance of assessing economic risk in determining
  the appropriate level of government contractor profitability. As part of
  an ongoing assignment, requested by the Military Reform Caucus, we
  intend to evaluate the criteria that should be used when comparing gov-
  ernment contractor profitability.

  Opponents to our 1987 proposal for establishing a profitability reporting
  program believed that profitability studies should be delayed pending
  resolution of the best measures to use in studying contractor profit-
  ability. As a result, the Congress requested that DOD and the Office of
  Federal Procurement Policy establish the Financial Analysis Method-
  ology Committee to recommend a financial analyses methodology for
  measuring contractor profitability.

  This report is not intended to be a study of the profitability of govern-
  ment contractors. Without segment data, such as that used in DFAIR, we
  have no available data that can allow such a study. Rather, this study is
  intended to emphasize the importance of evaluating government con-
  tractors using a variety of financial measures.

  To illustrate the types of analyses that could be done with the financial
  measure we identified, we used data for two groups of companies to
  hypothetically represent (1) government contractors and (2) U.S.
  industry. These illustrative analyses simply show how information on
  government contractors could be used to provide indications of the
  impact of government policies on government contractors, if segment-
  level data on government contractors were available.

  There is no universally agreed upon definition of what constitutes the
  defense industry. To illustrate measurement methodology, we identified
  110 firms that accounted for about 60 percent of the total dollar value
  of prime contracts awarded by DOD between 1971 and 1988. We used
  firm-level data for the companies we identified. The usefulness of the


  Page 7                                         GAO/NSL4D-9O-2OOBR   Ihancial   Measures
                         Appendix I
                         What Are the Most Appropriate      Financial
                         Measures of Contractor Profitability?




                         data in describing the financial health of government contractors is lim-
                         ited because it is not specific to the defense part of the company.

                         To hypothetically represent U.S. industry, we used the S&P Industrial
                         Index. Appendix II provides additional details on our objectives, scope,
                         and methodology.


                         The defense industry has objected to using ROA as the preferred financial
Industry Compares Its    measure to evaluate contractor profitability. As part of the debate, the
Relatively High          industry posed the question: If the defense industry’s ROAS are so high,
Profitability With Its   why have their PE ratios been historically low?
Low PE Ratios            We found that 110 selected companies that do defense work have gener-
                         ally had lower PE ratios than overall industrial norms over 18 years
                         (1971-88). This has generally been true even when ROAS for many firms
                         performing defense work have increased. In fact, it is not just defense
                         contractors that experience low PE ratios when profitability increases,
                         this situation also exists for companies included in the S&P Industrial
                         Index.

                         Figure I.1 shows the PE ratios for the S&P Industrial Index as being lower
                         when profitability levels are high. In fact, the PE ratio and ROA are
                         strongly negatively correlateds4 In other words, when PE ratios are low,
                         ROA levels are high, and vice versa.

                         Although PE ratios and ROA do not move in tandem, this is not unex-
                         pected, given the nature of these financial measures. RQA is a profit-
                         ability measure based on actual financial performance over the past
                         year. PE ratios are based, in part, on expected future earnings.

                         PE  ratios are computed for the overall firm, therefore, their usefulness in
                         describing the part of the company that performs defense work is lim-
                         ited. Since there are very few companies that perform solely defense
                         work and since a PE ratio is only computed at the firm level, using PE
                         ratios to describe the financial health of defense contractors is of limited
                         use.




                         4The correlation coefficient was 0.8661.



                         Page 8                                         GAO/NSIALl-90-200BR   Financial   Measures
                                                                                                                                                                   -
                                                         Appendlx I
                                                         What Are the Most Appropriate      Financial
                                                         Measures of Contractor Profitability?




Figure 1.1: PE and ROA for S&P Industrials




                                  - .._
                                      -        -        .__-._-_--                      .._-            .-_        ..__.
 71          72         73   74           75       78      77        78      79       89        81            82           83    84      88     88          87         88
 Ysars

      -           PE
      --.-        ROA



                                                                                                                                                                   -
Significance of a Low PE                                 A low PE ratio does have significance. It may contribute to a higher cost
Ratio                                                    of capital. The cost of capital is what a corporation must pay for its debt
                                                         and equity financing. Financial theory requires that a company’s return
                                                         on investment (ROI) should be related to its cost of capital.

                                                         Our analyses indicated that companies doing defense work have gener-
                                                         ally had lower PE ratios than the S&P Industrial Index over the last 18
                                                         years. However, the low PE ratios cannot for the entire 110 companies,
                                                         be attributed directly to their defense contracts. If a low PE ratio con-
                                                         tributes to a firm’s higher average cost of capital, that could be an indi-
                                                         cation that the firm may need to earn a higher ROA to cover its cost of
                                                         capital. We intend to explore the relationship between the cost of capital
                                                         and ROI as part of an ongoing assignment.




                                                         Page 9                                                            GAO/NSIAD-90-200BR   Fluaucial    Measures
                          Appendix I                                                                        ,
                          what Are the MO& Approprhte      Finanti
                          Measures of Contractm Rofltabilky?




                          While not suitable as overall profitability measures, financial measures
Analyses of Selected      other than ROA can be used for examining the effect of various govern-
Financial Measures        ment policies on some aspects of firm performance or segment-level per-
                          formance. These other measures include capital expenditures ratios,
                          research and development (R&D) ratios, liquidity ratios, and debt man-
                          agement ratios.

                          Our analyses are not intended to be a study of government contractor
                          profitability. They are merely intended to show the type of analyses
                          that could be made in assessing the financial health of government con-
                          tractors. Since our analyses used firm-level data, the usefulness of the
                          data in describing the financial health of government contractors is lim-
                          ited because it does not isolate the defense part of the companies. Never-
                          theless, the firm-level data used in this report shows the type of
                          analyses that could be done if segment-level data on government con-
                          tractors were made available.


Segment-Level Financial   Financial measures such as capital expenditures ratios and R&D ratios
Measures                  can be identified in the financial records of a company. In some cases,
                          the data is available at the segment level. If not identified at the seg-
                          ment level, methods exist to allocate the data to the segments to com-
                          pute these measures. Our proposal for a profitability reporting program
                          provides for collecting the necessary data at the segment level to com-
                          pute these types of measures.


Capital Expenditures to   Figure I.2 shows the capital expenditures for facilities and equipment to
Sales Ratio               sales ratio for 110 firms that perform varying degrees of defense work.
                          DOD'S policies are designed to encourage investment in plant and equip-
                          ment. Computing this measure for government contractors could over
                          time indicate whether DOD'S policies are accomplishing their intended
                          objective to encourage contractors to invest in new plant and equipment.


Capital to Labor          The capital-to-labor ratio is a measure of the capital intensity of a spe-
                          cific line of business. This measure could indicate whether the govern-
                          ment’s contract pricing, financing, and profit policies were encouraging
                          contractors to invest in capital. There has been concern expressed that
                          DOD'S contracting processes and profit policy do not provide adequate
                          incentives for contractors to invest in capital equipment. A comparison
                          of the capital intensity measured over time could indicate whether gov-
                          ernment contractors responded to such incentives. Data to compute the


                          Page 10                                    GAO/NSIAD-90-ZOOBR   Financial   lbkasurea
      .                                         Appendix I
                                                What Are the Most Appropriate    Financial
                                                Measures oP Contractor E’roPltabLlity?




                                                capital-to-labor measure are not currently available in financial reports.
                                                The data could be available with segment-level reporting.



Figure 1.2: Capital Expenditures to Sales for 110 Firms
10        Pofcontotwm

 9

 6

 7

 6

 6

4

3

2

 1

0

     7l        72       73   74   75   76         77      76       79       50       81      62   63     64     66      66     87        69
     YOU8




R&D to Sales                                    Financial data on R&D costs from defense segments could indicate to
                                                what degree the defense industry was being required to sponsor its own
                                                K&D. Much of the H&D performed currently by the defense industry is
                                                sponsored by the government. Figure I.3 shows the R&D costs that the
                                                government does not, reimburse to contractors as a percentage of sales.
                                                The ratio of H&D costs to sales could increase, if, for example:

                                            *   DUD  increases the use of fixed-price contracts for R&D efforts. Defense
                                                industry associations have argued that these type of contracts for R&D
                                                are inappropriate because they may cause contractors to expend non-
                                                recoverable funds for R&D. The type of data shown in figure I.3 could be
                                                used to examine the degree to which contractors are required to expend
                                                non-recoverable funds for R&D.
                                            l   Defense contractors are not reimbursed for all of their independent K&D
                                                costs. DOD negotiates ceilings on contractors’ independent R&D expenses.
                                                Defense contractors are reimbursed for much of these independent, R&D


                                                Page11                                             GAO/NSIAD-90-200BRFinancialMeasures
                                        Appendix I
                                        What Are the Most Appropriate      Financial
                                        Measures of Contractor Profitability?




                                        costs through their overhead. By establishing these ceilings, DOD is lim-
                                        iting the amount of reimbursement that contractors will be provided.
                                        The type of data shown in figure I.3 could be used to examine the effect
                                        of causing contractors to expend their own funds for independent H&D in
                                        excess of the ceilings that the government places on these costs.



Figure L3:R&D to Sales for 110 Firms”
6   Percent   ot Sale5




                                        “R&D to sales ratio examines non-reimbursed R&D expenses that relate to the development of new
                                        products and services. It reflects only the firm’s contnbutlon and does not reflect direct or indirect gov
                                        ernment sponsored R&D.




Firm-Level Financial                    Financial measures such as debt and liquidity management measures
Measures                                can be computed using the data in publicly available financial records.
                                        Debt and liquidity measures indicate a firm’s ability to meet short-term
                                        obligations and the relative industry financing structure. These mea-
                                        sures could be done at the segment level but would require an allocation
                                        or attribution of firm-level data to the segment and the establishment of
                                        the proper reporting arrangements as described in our 1987 proposal for
                                        a profitability reporting program.




                                        Page 12                                                     GAO/NSLAD-90-200BR        Financial   Measures
                   Appendix I
                   What Are the Most Appropriate     Financial
                   Measures of Contractor Profltabiuty?




                   Some analysts feel strongly that these measures could not be done at the
                   segment level because they would require an allocation or attribution of
                   firm-level data to the segment. However, since firm-level data, such as
                   “home office” expenses, are currently allocated to the segment level,
                   others believe that it is feasible to expect that other firm-level data
                   could be allocated to the segment level. If a reasonable allocation
                   method were to be proposed, we would consider it a worthwhile exercise
                   to evaluate these allocation methods.


Debt Man.agement   Debt management measures provide data on the amount of borrowed
Measures           funds and the ability to make interest payments. Commonly used debt
                   measures include debt to equity, debt to assets, and times interest
                   earned.” For example, figure I.4 shows that the 110 firms were in a rela-
                   tively better position to make interest payments compared to the S&P
                   Industrial Index. If this ratio is low, then a firm may not be able to pay
                   interest payments.

                   If methods were developed to compute the management measures for
                   the segment level of companies performing defense work, then govern-
                   ment policy analysts would have more insight as to what effect the gov-
                   ernment financing policies are having on government contractors.
                   Again, if such methods were proposed, we believe it would be worth-
                   while to evaluate them.




                   ‘Times interest earned provides an indication of a firm’s ability to make its interest payments.



                   Page 13                                                  GAO/NSIAD90-200BR        Financial   Measures
                                                       Appendix I
                                                       What Are the Most Appropriate      Flmncial
                                                       Measures of Contractor Profltabtity?




Figure 1.4:Times Interest Earned for 110 Firms and S&P Industrials
20        Tlmr    Intmel   Eamd

18




2
0                                                                                                    --.         .._-        .._--

     71          72        72          74   75   711     77       78       78       80       gl            112          83           64   65   86          87     88
     YONS

          -           IlOFlrms
          1.1.        S6P lnduseials




Liquidity Measures                                     Liquidity measures provide information on working capital or short-
                                                       term financing requirements. These measures show the relationship of a
                                                       firm’s cash and other liquid assets to its current financial obligations.
                                                       Two of the most commonly used liquidity measures are the quick ratio
                                                       and current ratio, which are shown in figures I.6 and 1.6. (See app. II for
                                                       the definition of these measures.) Both figures show that the 110 firms
                                                       in our sample are in a relatively better position to meet their short-term
                                                       financial obligations. If this information were available for defense seg-
                                                       ments, then government policy analysts would be better able to assess
                                                       more accurately the effect of the government’s progress payment policy
                                                       on government contractors.

                                                       To use these measures at the segment level, procedures would be needed
                                                       to allocate or attribute cash to the defense segments. Cash is generally
                                                       managed at the corporate level and is not allocated to the company’s
                                                       segments. Again, if such methods were proposed, we believe it would be
                                                       worthwhile to evaluate them.




                                                       Page 14                                                           GAO/NSIAD-90-200BR    Financial    Measures
                                                       Appendix I
                                                       What Are the Moot Approprhte    Financial
                                                       M-urea   of Cmtmctor   ProfltabWty?




FigUrO        1.5:%~iCk Ratio for 110 Firma and S&P Indu@trlalr
2.1        R&b
2.0
1.0
1.6
1.7
1.6
1.8
1.4
1.3
11
1.1
1.0
0.S
0.8

      7l          72        72          74   75   76     n       70       76      60       01      82   82     84     65      86          67     I)B
      Yam

           -           1loFkms
           -1-1        SIP lndurwials




                                                       Page 16                                           GAO/NSIAD-SO-200BR   Financial    Measures
                                                                 Appendix I
                                                                 What Are the Most Appropriate      Financial
                                                                 Measures of Contractor Profitability?




Figure 1.6:Current Ratio for 110 Firms and S&P industrials
3.0 RJIO

24

2.0

2.4

2.2

2.0

1.6

1.6
                                                                                                   . . . . . . . . . . . . ..---~..~~
                                                                                                                                                  ---0.        . . . . ..----c.~
1.1                             -         ._   ..   .                              ,, ,,   ,_,.-   .-   ..,,--    .,.---   -    ---                                                      -0


     7l        R         R           74        76       78         n        78        79           80            81        82         83     a4           85          88           a7     88
     Yam
          -        110 Firma
          I 0I -   S&P Industrials



                       Traditional profitability measures include ROI and return on sales. ROA
Assessmentof           and return on equity (ROE) are two measures of ROI. ROE is widely used in
Profitability Measures f.mancial markets because it measures the return to stockholders but it
                                                                 is not computed at the segment level because of the lack of procedures
                                                                 for allocating or attributing equity to the segments. As indicated in our
                                                                  1987 report, we believe that ROA is the more desirable measure of profit-
                                                                 ability for the reasons listed below:

                                                             l Provides a basis for measuring the cumulative impact of policies.
                                                             . Computed at the segment level of a firm.
                                                             . Derived from historical, financial, and audited data.

                                                                 Return on sales, which can be computed at the segment level, is a less
                                                                 desirable measure because it does not measure how effectively a firm
                                                                 invests its capital and is based on the value of output instead of the
                                                                 input. On the other hand, comparing return on sales among firms in the
                                                                 same industry, in limited cases, may be useful in providing an additional
                                                                 measure of the relative profitability among those firms.




                                                                 Page 16                                                               GAO/NSIAD-90-200BR             Financial     Measures
          t
     .
                                               Appendix I
                                               What Are the Moat Appropriate    Finaucial
                                               Meamms of Contractor   ProfItabiUty?




                                               Since a profitability reporting program would require a measure that
                                               would track the pattern of profitability over time to indicate the cumu-
                                               lative effect of government policies, we tracked the relationship of two
                                               measures, RQAand ROE. Figure I.7 shows that generally ROA and ROE for
                                               the S&P Industrials have moved in tandem to each other over the past 18
                                               years. RQAcan be calculated at the segment level and is therefore, the
                                               primary measure of defense segments’ profitability. We believe, for the
                                               purposes of a profitability reporting program, ROA represents an accept-
                                               able surrogate for ROE.



Figure 1.7: ROA and ROE for S&P Indurtrialr
20       Poroml

18




 71             72         73   74   75   75     77       78      79       80       el      52   83     84      ee    86          87     ee
 YOM8

         -           ROE
         1-m.        ROA




                                               Page 17                                            GA0/NSIAD904!00BR   Fluaucial    Measures
Appendix II

Objectives,Scope,and Methodology


              The House Co-Chairman of the Military Reform Caucus requested that
              we examine the types of financial measures that could be used to assess
              the effect that federal government policies may have on the profitability
              of government contractors.

              To accomplish these objectives, we researched the literature on financial
              measures, interviewed experts on financial theory, analyzed balance
              sheet and income statement information for the companies in the w
              Industrial Index, as well as financial information for companies that
              perform defense work. Our analysis assesses government contractors
              using publicly available firm-level data. The usefulness of the firm-level
              data in describing the financial health of government contractors is lim-
              ited because it does not isolate the profitability of the defense part of
              the companies. Nevertheless, our analysis of firm-level data shows the
              type of analyses that could be done if segment-level data were made
              available. The lack of available data, identified discreetly to government
              contractor segments reconfirms our previous position that a profit-
              ability reporting program is needed.

              In performing our review, we analyzed financial measures at the firm
              level during the 18-year period 1971433. We computed the measures
              using S&P’s Compustat II data base. Table 11.1shows the formulas used
              to compute the financial measures.

              The companies included in our sample performing defense work were
              identified as such based on the annual dollar value of prime defense con-
              tracts received during each year of the B-year period so that the com-
              panies selected would account for 60 percent of the dollar value of
              prime contracts awarded by DOD each year. Our reviews included 110
              firms.

              The method used to compute the financial measures was similar to the
              method that S&P uses, while the profitability measures are those used in
              our 1986 study.

              Our review was performed in accordance with generally accepted gov-
              ernment auditing standards from March 1989 to March 1990.




              Page 18                                  GAO/NSIA.DBO-BOOBRNnanciaJ Measurea
                                         Appe*      n
                                         ObjectIves, Scope, and Methodology




Table 11.1:Categories and Formulas for
Flnanclal Measurea                       Mearurea           Formula
                                         Prlco
                                         PE                 Year-end stock price divided by 1Fmonth earnings per share.
                                         Proflt
                                         ROE                After tax income divided by stockholder’s equity.
                                         ROA                After tax income plus deferred taxes plus interest costs divided by total
                                                            assets.
                                         Debt
                                         Management
                                         ;;y;:nBgSerest     Interest expense plus income taxes plus net income divided by interest
                                                            expense.
                                         Llquldlty
                                         Current            Total current assets divided by total current liabilities.
                                         Quick              Total current assets minus inventories divided by total current liabilities.
                                         Other
                                         R&D/ sales         R&D costs divided by sales (excludes R&D costs reimbursed by the
                                                            government).
                                         Capital            Amounts spent for construction of facilities and equipment, including
                                         expenditures       acquisitions accounted for as purchases.




                                         Page 19                                             GAO/NSIAD-90.2OOBR F’inancial Measures
Appendix III

Major Contributors to This Report


                         Clark G. Adams, Assistant Director
National Security and    Ralph C. Dawn, Assignment Manager
International Affairs    James L. Field, Evaluator
Division, Washington,
D.C

                         James A. Przedzial, Evaluator-in-Charge
Phi1ade1phia   Re@onal   J&, Marie Henry Evaluator
Office                   Stephen L. Ballard, Evaluator
                         Amy Ganulin, Evaluator
                         Wayne J. Turowski, Computer Analyst




(898144)                 Page 20                                   GAO/NSIAD-90.200BR Finamid   Measures
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