2. incstat/bs/cf/analtech Flashcards
Describe the components of the income statement and alternative presentation formats of that statement
The income statement shows an entity’s revenues, expenses (costs of goods sold, operating expenses, interest and taxes), gains and losses during a reporting period.
A multi-step income statement provides a subtotal for gross profit and a single step income statement does not. Expenses on the income statement can be grouped by the nature of the expense items or by their function, such as with expenses grouped into cost of goods sold.
Describe the general principles of:
Revenue recognition and accrual accounting
specific revenue recognition applications
- accounting for long-term contracts
- installment sales
- barter transactions
- gross and net reporting of revenue
and the implications of revenue recognition principals for financial analysis
Revenue recognition and accrual accounting
Under the accrual method of accounting, revenue is recognized when earned and expenses are recognized when incurred
Methods for accounting for long-term contracts
- percentage of completion, recognizes revenue in proportion to costs incurred
- completed contract, recognizes revenue only when the contract is complete
Revenue recogniztion methods for installment sales are:
- normal revenue recognition at time of sale if collectability is reasonably assured
- installment sales (profit recognized as cash is collected) method if collectability cannot be reasonably estimated
- cost recovery method (profit recognized only when cash collected exceeds costs incurred) if collectability is highly uncertain
Revenue from barter transactions can oonly be recognized if its fair value can be estimated from historical data on similar non-barter transactions
Gross revenue reporting shows sales and cost of goods sold, while net revenue reporting shows only the difference between sales and cost of goods sold and should be used when the firm is acting essentially as a selling agent and does not stock inventory, take credit risk, or have control over supplier and price
Implications:
Users of financial information must consider two points when analyzing a firms’ revenue:
- how conservative are the firm’s revenue recognition policies (sooner rather than later is more aggresive)
- the extent to which the firm’s policies rely on judgement and estimates
3.
Calculate revenue given information that might influence the choice of revenue recognition method
A firm using a revenue recognition method that is aggressive will inflate current period earnings at a minimum and perhaps inflate overall earnings.
Because of the estimates involved, the percentage of completion method is more aggressive than the completed contract method. Also the installment method is more aggressive than the cost recovery method.
Describe the general principles of:
expense recognition
specific expense recognition applications
- inventory expense recognition
- depreciation expense recognition
and the implications of expense recognition choice for financial analysis
The matching principal requires that firms match revenues recognized in a period with th eexpenses required to generate them. One application of the matching principle is seen in accounting for inventory, with cost of goods sold as the cost of units sold from inventory that are included in the current-period revenue. Other costs, such as staight-line depreciation of fized assets or administrative overhead, are period costs and are taken without regard to revenues generated during the period.
Inventory valuation methods:
- FIFO: inventory reflects cost of most recent purchases, COGS reflects cost of older purchases (IFRS and GAAP)
- LIFO: COGS reflects cost of most recent purchases, inventory (GAAP only)
- Average cost: unit cost equals cost of goods available for sale divided by total units available and is used for both COGS and inventory (IFRS and GAAP)
- Specific identification: each item in inventory is identified and its historical cost is used for calculating COGS when the item is sold
Depreciation methods:
- staight-line: equal amount of depreciation expense in each year of the asset’s useful life
- accelerated depreciation: more expense in early years and v.v
- declining balance: apply a constant rate of depreciation to the declining book value until book value equals residual value
Intangible assets with limited lives should be amortized using a method that reflects the flow over time of their economic benefits. Intangible assets with indefinite lives (e.e. goodwill) are not amortized
Users of financial data should analyze the reasons for any changes in estimates of expenses and compare these estimates with those of peer companies
Littlefield Company recently purchased a machine at a cost of $12,000. The machine is expected to have a residual value of $2,000 at the end of its useful life in five years. Calculate depreciation expense using the straight-line method.
cost- residual value / useful life
12,000-2,000 / 5 = $2,000
Littlefield Company recently purchased a machine at a cost of $12,000. The machine is expected to have a residual value of $2,000 at the end of its useful life in five years. Calculate depreciation expense for all five years using the double-declining balance method.
The depreciation expense using the double declining balance method is:
- year 1: (2/5)($12,000) = 4,800
- year 2: (2/5)($12,000-4,800) = 2,880
- year 3: (2/5)($12,000 - 7,680) = 1,728
In years 1 though 3, the company has recognized cumulative depreciation expense of $9,408. Since the total decpreciation expense is limited to $10,000 ($12,000-2,000 salvage value), the depreciation in year 4 is limited to $592, rather than the (2/5)($12,000 - 9,408) = 1,036.80 using the DDB formula.
- year 5: depreciation expense is $0, since the asset is fully depreciated
Describe the financial reporting treatment and analysis of non-recurring items and changes in accounting standards
- discontinued operations*
- extraordinary items*
- unusual or infrequesnt items*
Non-recurring items
Discontinued operations
- results are reported below income from continuing operations, net of tax from the date the decision to dispose of the operations is made
- results are segregated because they likely are non-recurring and do not affect future net income
Unusual or infrequent items (i.e. gains / losses from the sale of an asset)
- reported before tax and above income from continuing operations
- analysts should determine how “unusual” these items really are for the company when estimated future earning or firm value
Extraordinary items (unusual and infrequent i.e. losses from extpropriation of assets)
- reported below income from continuing operations, net of tax under GAAP, but this treatment is not allowed under IFRS
- extraordinary items are not expected to continue in future periods
Changes in accounting standards
- changes in accounting standards (i.e. GAAP or IFRS), applied methods and corrections require retrospective restatement
- change in accounting estimates are prospective (to subsequent periods), typically don’t affect cash flow
Distinguish between operating and non-operating components of the income statement
- operating and non-operating components usually reported seperately in the income statement
- i.e. for a nonfinancial firm; nonoperating transactions might be investment income and financing expenses
- i.e.for a financial firm; operating activities would include investment income and financing expenses
Describe how earnings per share is calculated for a company’s EPS (both basic and diluted earning per share) for simple and complex capital structures
When a company has potentially dilutive securities, it must report diluted EPS
- a simple capital structure contains no potentially dilutive securities; only common stock, non convertible debt, and nonconvertible preferred stock
- complex captial structure contains potentially dilutive securities (i.e. options, warrants, or convertible securities)
For any convertible preferred stock, convertible debt, warrants, or stock options that are dilutive, the calculation of diluted EPS is the second formula.
Distinguish between dilutive and antidilutive securities and describe the implications of each for the earnings per share calculation
A dilutive security (options, warrants, convertible debt, convertaible preferred stock) is one that, if converted to its common stock equivalent, would decrease EPS.
An **antidilutive security **(options, warrants, convertible debt, convertaible preferred stock) is one that would not reduce EPS if converted to its common stock equivalent.
Johnson Company has net income of $10,000 and paid $1,000 cash dividends to its preferred shareholders and $1,750 cash dividends to its common shareholders. At the beginning of the year, there were 10,000 shares of common stock outstanding. 2,000 new shares were issued on July 1. Assuming a simple capital structure, what is Johnson’s basic EPS?
Weighted average number of shares:
Shares outstanding all year = 10,000(12) = 120,000
Shares outstanding 1/2 year = 2,000(6) = 12,000
Weighted average shares = 132,000/12 = 11,000 shares
Basic EPS = $10,000 - $1,000 / 11,000 = $0.82
During the past year, R & J, Inc. had net income of $100,000, paid dividends of $50,000 to its preferred stockholders, and paid $30,000 in dividends to its common shareholders. R & J’s common stock account showed the following (figure)
Compute the weighted average number of common shares outstanding during the year, and compute EPS.
- adjust the number of pre-stock dividend shares to post-stock dividend units (to reflect the 10% stock dividend) by multiplying all share numbers prior to the stock dividend by 1.1. Shares issued or retired after the stock dividend are not affected
- compute the weighted average number of post-stock dividend shares
- compute EPS
= $100,000 - $50,000 / 13,300 = $3.76
Baxter Company has 5,000 shares outstanding all year. Baxter has 2,000 outstanding warrants all year, convertible into one share each at $20 per share. The year-end price of Baxter stock was $40, and the average stock price was $30. What effect will these warrants have on the weighted average number of shares?
If the warrants are exercised, the company will recieve 2,000 * $20 = $40,000 and issue 2,000 new shares.
The treasury stock method assumes the company uses these funds to repurchase shares at the average market price of $30.
The compnay would repurchase $40,000 / $30 = 1,333 shares.
Net shares issued would be 2,000 - 1,333 = 667 shares.
During 2016, ZZZ Corp. reported net income of $115,600 and had 200,000 shares of common stock outstanding for the entire year. ZZZ also had 1,000 shares of 10% $100 par, preferred stock outstanding during 2016. During 2015, ZZZ issued 600, $1,000 par 7% bonds for $600,000 (issued at par). Each of these bonds is convertible to 100 shares of common stock. The tax rate is 40%.
Compute the 2016 basic and diluted EPS
- Compute 2016 basic EPS:
basic EPS = $115,600 - $10,000 / 200,000 = $0.53
2. Calculate diluted EPS: * compute the increase in common stock outstanding if the convertible debt is converted to common stock at the beginning of 2016
shares issuable for debt conversion = (600)(100) = 60,000 shares
- if the convertible debt is considered converted to common stock at the beginning of 2016, then there would be no interest expense related to the convertible debt. Therefore, it is necessary to increase ZZZ’s after-tax net income for the after-tax effect of the decrease in interest expense:
increase in income = (600)($1,000)(0.07) = $25,200
- compute diluted EPS as if the convertible debt were common stock:
diluted EPS = net. inc. - pref. div. + convt. int. (1-t) / wt. avg. shares + convertible debt shares
diluted EPS = $115,600 - $10,000 + $25,200 / 200,000 + 60,000
= $0.50
- check to make sure that diluted EPS is less than basic EPS [$0.5 < $0.53]. If diluted EPS is more than the basic EPS, the convertible bonds are antidilutive and should not be treated as common stock in computing diluted EPS.
During 2016, ZZZ reported net income of $115,600 and had 200,000 shares of common stock and 1,000 shares of preferred stock outstanding for the entire year. ZZZs 10%, $100 par value preferred shares are each convertible into 40 shares of common stock. The tax rate is 40%.
Compute basic and diluted EPS
- Calculate 2016 basic EPS:
basic EPS = $115,600 - $10,000 / 200,000 = $0.53
2. Calculate diluted EPS:
- compute the increase in common stock outstanding if the preferred stock is converted to common stock at the beginning of 2016: (1,000)(40) = 40,000 shares
- if the convertible preferred shares were converted to common stock, there would be no preferred dividends paid. Therefore, you should add back the convertible preferred dividends that had previously been substracted from the net income in the numberator
- compute diluted EPS as if the convertible preferred stock were converted into common stock:
diluted EPS = net. inc. - pref. div. + convt. int. (1-t) / wt. avg. shares + convertible debt shares
diluted EPS = $115,600 - $10,000 + $10,000 / 200,000 + 40,000
- check to see if diluted EPS < basic EPS ($0.48 < $0.53). If yes, the preferred stock is dilutive and must be included in the diluted EPS as computed above. If no, preferred stock is antidilutive and conversion effects are not included
- quick way to check is to divide the preferred dividend by the number of shares that will be created if the preferred stock is converted
$100 * 0.10 / 40 = $25. Since this is less than basic EPS, the convertible preferred is dilutive
During 2016, ZZZ reported net income of $115,600 and had 200,000 shares of common stock outstand for the entire year. ZZZ also had 1,000 shares of 10%, $100 par, preferred stock outstanding during 20126. ZZZ has 10,000 stock options (or warrants) outstanding the entire year. Each option allows its holder to purchase one share of common stock at $15 per share. The average market price of ZZZ’s common stock during 2016 is $20 per share.
Compute the diluted EPS.
diluted EPS = $115,600 - $10,000 / 200,000 + 2,500 = $0.52
A quick way to calculate the net increase in common shares from the potential exercise of stock options or warrants when the excercise price is less than average market price is:
[AMP - EP / AMP] * N
average market price over the year, excercise price of the options or warrants, number of common shares that the options and warrants can be converted into
$20-$15 / $20 * 10,000 shares = 2,500
During 2016, ZZZ reported net income of $115,600 and had 200,000 shares of common stock outstanding for the entire year. ZZZ had 1,000 shares of 10%, $100 par convertible preferred stock, convertible into 40 shares each, outstanding for the entire year. ZZZ also had 600, 7%, $1,000 par value convertible bonds, convertible into 100 shares each, outstanding for the entire year. Finally, ZZZ had 10,000 stock options outstanding during the year. Each option is convertible into one share of stock at $15 per share. The average market price of the sotkc for the year was $20.
What are ZZZ’s basic and diluted EPS? (Assume 40% tax rate)
- Calculte basic EPS
basic EPS = $115,600 - $10,000 / 200,000 = $0.53
- Review the number of shares created by converting the convertible securities and options (the denominator)
- Review the adjustments to net income (the numerator)
- Compute ZZZ’s diluted EPS
diluted EPS = (115,600 - 10,000 + 10,000 + 25,200) / (200,000 + 40,000 + 60,000 + 2,500)
= $0.47
Convert income statements to common-size income statements
A vertical common-size income statement expresses each item as a percentage of revenue. The common-size format standardizes the income statement by eliminating th eeffects of size. Commone-size income statements are useful for trend analysis and for comparisons with peer firms.
*note gross profit
Evaluate a company’s financial performance using common-size income statements and financial ratios based on the income statement
Common-size income statements are useful in examining a firm’s business strategies.
Two populat ratios are gross profit margin (gross profit / revenue) and net profit margin (net income / revenue). A firm can often achieve higher profit marings by differentiating its products from the competition.
Describe, calculate, and interpret comprehensive income
Comprehensive income is the sum of net income and other comprehendive income. It measures all changes to equity other than those from transactions with shareholders.
Describe other comprehensive income, and identify the major types of items included in it
Other comprehensive income includes other transactions that affect equity but do not affect net income, including:
- gains and losses from foreign currency translation
- pension obligation adjustments
- unrealized gains and losses from cash flow hedging derivatives
- unrealized gains and losses on available-for-sale securities
Calculate comprehensive income for Triple C Corporation using the selected financial statement data found in the following table.
The dividends recieved for available-for-sale securities and the realized gain on the sale of land are already included in net income. Dividends paid and the reacquisition of common stock are transactions with sharholders, so they are not included in comprehensive income.
Describe the elements of the balance sheet: assets, liabilities, and equity
The balance sheet (statement of financial position or statement of financial condition) reports the firm’s financial position at a point in time.
Assets: Resources controlled as a result of past transactions that are expected to provide future economic benefits
Liabilities: Obligations as a result of past events that are expected to require an outflow of economic resources
Equity: The owners’ residual interest in the assets after deducting the liabilities. Equity is also referred to as stockholders’ equity, shareholders’ equity, or owners equity.
Describe different types of liabilities and the measurement bases of each
Current Liabilities
- Accounts payable* are amounts owed to suppliers for goods or services purchased on credit.
- Accrued liabilities* are expenses that have been recognized in the income statement but are not yet contractually due.
- Unearned revenue* is cash collected in advance of providing goods and services.
Non current liabilities
- Financial liabilites* not issued at face value, like bonds payable, are reported at amortized cost.
- Held-for-trading liabilities* and derivative liabilities are reported at fair value.
Wood Corporation paid $600 million for the outstanding stock of Pine Corporation. At the acquisition date, Pine reported the following condensed balance sheet.
(figure)
The fiar value of the pp&e was $120 million more than its recorded book value. The fair values of all other identifiable assets and liabilities were equal to their recorded book values. Calculate the amount of goodwill Wood should report on its consolidated balance sheet.
Goodwill is equal to the excess of puchase price over the fair value of identifyable assets and liabilities acquired. Plant and equipment was “written up” by $120 million to reflect fair value. The goodwill reported on Pine’s balance sheet is an unidentifiable assets and is thus ignored in the calculation of Wood’s goodwill.
Analyze balance sheet and statement of changes in equity
The statement of changes in stockholders’ equity summarizes the transactions during a period that increase or decrease equity, including transactions with shareholders
Convert balance sheets to common-size balance sheets and interpret the common-size balance sheets.
A verticle common-size balance sheet expresses each item of the balance sheet as a percentage of total assets. The common-size format standardizes the balance sheet by eliminating the effects of size. This allows for comparison over time (time-series analysis) and across firms (cross-sectional)
In the figure, compare current assets to current liabitlities. East is less liquid and may have more difficulty paying its current obligations when due. How ever West’s superior working capital postion may not be an efficient use of resources. The investment returns on working capital are usually lower than the returns on long-term assets.
East doesn’t have enough cash to pay off current liabilities without selling more inventory. Carrying higher inventories may be an indication of inventory obsolesence.
Compare long-term debt to total assets. East may have trouble satisfying its long-term obligations since its capital structure consists of more debt.
East appears to be growing through acquisitions since it is reporting goodwill. West is growing internally since no goodwill is reported.
Compare cash flows from operating, investing, and financing activites and classify cash flow items as relating to one of those three categories given a description of the items.
3 categoris on a cash flow statement
- Operating activities - inflows and outflows of cash resulting from transactions that affect a firm’s net income
- Investing activities - inflows and outflows of cash resulting from the acquisition or disposal of long-term assets and certain investments
- inflows and outflows of cash resulting from transactions affecting a firm’s capital structure
* don’t confuse dividends received and dividends paid. Under US GAAP, dividends received are operating cash flows and dividends paid are financing cash flows
Distinguish between the direct and indirect methods of presenting cash from operating activities and describe the arguments in favor of each method.
Direct vs. indirect methods (IFRS and US GAAP)
Under the direct method of presenting CFO, each line item of the accrual-based income statement is adjusted to get cash receipts or cash payments.
- The main advantage of the direct method is that it presents clearly the firm’s operating cash receipts and payments.
Under the indirect method of presenting CFO, net income is adjusted for transactions that affect net income but do not affect operating cash flow, such as depreciation and gains or losses on asset sales, and for changes in balance sheet items.
- The main advantage of the indirect method is that it focuses on the differences between net income and operating cash flow.
- This provides a useful link to the income statement when forecasting future operating cash flow.
* in the image, compare the starting and finishing lines
** calculation for CF investing and CF financing is the same under each method
Describe how the cash flow statement is linked to the income statement and the balance sheet
Operating activities relate to the firm’s current assets and current liabilities
Investing activities relate to the firm’s non-current assets
Financing activities relate to the firms noncurrent liabilities and equity
Transactions for which the timingof revenue or expense recognition differs from the receipt or payment of cash are reflected in changes in balance sheet accounts
Use the following balance sheet and income statement to prepare a statement of operating cash flows under the indirect method
Any discrepancies between the changes in accounts reported on the balance sheet and those reported in the statement of cash flows are typically due to business combinations and changes in exchange rates.
Operating cash flow:
Step1: Start with net income of $37,500
Step2: Subtract gain from sale of land $10,000
Step 3: Add back noncash charges of depreciation of $7,500
Step 4: Subtract increases in receivables and inventories and add increases of payables and deferred taxes.
Use the following balance sheet and income statement to prepare a statement of investing cash flows under the indirect method
Investing cash flow:
In this example there are two components of investing cash flow: the sale of land and the change in gross plant and equipment
cash from sale of land = decrease in asset + gain on sale = $5,000 + $10,000 = $15,000 (source)
beginning land + land purchased - gross cost of land sold = $40,000 + $0 - $5,000 = $35,000
Note: if land has been purchased at a loss, we would have subtracted the loss amount from the decrease in land
P&E purhcased = ending gross P&E + gross cost of P&E sold - beginning gross P&E = $85,000 + $0 - $60,000 = $25,000 (use)
beginning gross P&E + P&E purchased - gross cost of P&E sold = ending P&E = $60,000 + $25,000 - $0 = $85,000
Use the following balance sheet and income statement to prepare a statement of financing cash flows under the indirect method
Calculate total cash flow (need CFO and CFI from previous 2 examples)
Financing cash flows
cash from bond issue = ending bonds payable + bonds repaid - beginning bonds payble = $15,000 + $0 - $10,000 = $5,000 = $35,000
beginning bonds payble + bonds issued - bonds repaid = ending bonds payable = $10,000 + $5,000 - $0 = $15,000
cash to reacquire stock = beginning common stock + stock issued - ending common stock = $50,000 + $0 - $40,000 = $10,000 (use, or a net share repurchase of $10,000)
beginning common stock + stock issued - stock reacquired = ending common stock = $50,000 + $0 - $10,000 = $40,000
cash dividends = -dividend declared + increase in dividends payable = -$8,500* + $5,000 = -$3,500 (use)
beginning dividends payble + dividends declared - dividends paid = ending dividends payable = $1,000 + $8,500 - $3,500 = $6,000
*note: if the dividend declared amount is not provided, you can calculate the amount as folows: dividends declared = beginning retained earnings + net income - ending retained earnings. Here, $30,000 + $37,500 - $59,000 = $8,500
Triple Y Corporation’s common-size cash flow statement is shown in the table below. Explain the decrease in Tripple Y’s total cash flow as a percentage of revenues.
- Operating cash flow* has decreased as a percentage of revenues. This appears to be due largely to accumulating inventories.
- Investing activities,* specifically purchases of plant and equipment, have also required an in an increasing percentage of the firm’s cash flow.
Using the company information provided, calculate the current year ratios. Discuss how these ratios compare with the company’s performance last year and wit the industry’s performance.
Current ratio = current assets / current liabilities
= 620/ 325 = 1.9
- indicates lower liquidity levels when compared to last year and more liquidity than the industry average
Quick ratio = cash + marketable securities / current liabilities
= (105 + 205) / 325 = 0.95
- ratio is lower than last year and is in line with the industry average
DSO = 365 / (revenue/average receivables)
= 365 / (4,000/(205+195/2)) = 18.25
- DSO is a bit lower relative to the company’s past performance but slightly higher than the industry average
Inventory turnover = COGS / average inventories
= 3,000 / (310+290 /2) = 10
- inventory turnover is much lower than last year and the industry average. This suggests that the company is not managing inventory efficiently and may have obsolete stock
Total asset turnover = revenue / average assets
= 4,000 / (2,060+1,940 / 2) = 2.0
- Total asset turnover is slightly lower than last year and the industry average
Working capital turnover = revenue / average working capital
beginning w.c. = 580-275=305
ending w.c. = 620-325=295
working capital turnover = 4,000 / (305+295 / 2) = 13.3
- Working capital turnover is ower than last year, but still above the industry average
Gross profit margin = gross profit / revenue
= 1,000 / 4,000 = 25%
- The gross profit margin is lower than last year and much lower than the industry average
Net profit margin = net income / revenue
= 200 / 4,000 = 5.0%
- The net profit margin is lower than last year and much lower than the industry average
Return on total capital = EBIT / short- and long-term debt and equity
beginning t.c. = 140+45+690+880 = 1,755
ending t.c. = 160+55+610+1,020 = 1,845
Return on total capital = 350 (1,755 + 1,845 / 2) = 19.4%
- The return on total capital is below last year and below the industry average. This suggests a problem stemming from the low asset turnover and low profit margin
Return on common equity = (net income - preferred dividends) / average common equity
= 200 / (1,020 + 880 / 2) = 21.1%
- The return on equity is lower than last year but better than the industry average. The reason it is higher than the industry average is probably because of greater use of leverage
Debt-to-equity = total debt / total equity
= (610+160+55) / 1,020 = 80.9%
- Note that preferred equity would be included in the denominator if there were any, and that we have included short-term debt and the current portion of long-term debt in calculating total (interest bearing) debt.
- The debt-to-equity ratio is lower than last year but still much higher than the industry average. This suggests the company is trying to get its debt level more in line with the industry
Interest coverage = EBIT / interest payments
= 350 / 50 = 7.0
- The interest coverage is better than last year but still worse than the industry average. This, along with the slip in profit margin and return on assets, might cause some concern.
Demonstrate the application of (original) DuPont analysis of return on equity, and calculate and interpret the effect of changes in its components.
- use to see the impact of leverage, profit margins, and turnover on shareholder returns
- there are 2 approaches, original 3part and extended 5 part
- remember that (net income / sales)(sales / assets) = ROA
Original
- take ROE (net income/equity)
- multiply by sales/sales
- multiply by assets/assets
- ROE = (net income/sales)(sales/assets)(assets/equity)
If ROE is low, one of the following must be true
- the company has a poor profit margin
- the company has poor asset turnover
- or the firm has too little leverage
Staret, Inc. has maintained a stable and relatively high ROE of approximately 18% over the last three years. Use traditional DuPont analysis to decompose this ROE into its three components and comment on trends in company performance.
ROE 2013: 21.5 / 119 = 18.1%
2014: 22.3 / 124 = 18.0%
2015: 21.9 / 126 = 17.4%
DuPont 2013: 7.0% * 1.33 * 1.93
2014: 6.4% * 1.21 * 2.34
2015: 5.3% * 1.17 * 2.78
(some rounding)
- While ROE has dropped only slightly, both the total asset turnover and the net profit margin has declined
- The effects of declining net margins and turnover on ROE have been offset by a significant increase in leverage
- The analyst should be concerned about the net margin and find out what combination of pricing pressure and/or increasing expenses have cused this
- Also, the analyst must note that the company has become more risky due to increased debt financing
Demonstrate the application of (extended) DuPont analysis of return on equity, and calculate and interpret the effect of changes in its components.
Extended (5-way) Dupont takes the net profit margin and breaks it down further
First term in 3-way is broken down
- net income / EBT is the tax burden (1-tax rate)
- EBT/EBIT is the interest burden
- EBIT/revenue is the EBIT margin
Increases in tax burden or interest burden (decrease in ratios) will decrease ROE
5-way shows that more leverage does not always lead to higher ROE, as leverage rises so does interest burden
Higher taxes will always lead to lower ROE
An analyst has gathered data from two companies in the same industry. Calculate the ROE for both companies and use the extended DuPont analysis to expalin the critical factors that account for the differences in the two companies ROEs
EBIT margin = EBIT/revenue
- A: =35/500 = 7.0%
- B: = 100/900 = 11.1%
Asset turnover = revenue / assets
- A: = 500/250 = 2.0
- B: 900/300 = 3.0
Interest burden
- A: = 30/35 = 87.5%
- B: = 100/100 = 1
Financial leverage = assets / equity
- A: = 350/150 = 1.67
- B: = 300/250 = 1.2
Tax burden = net income / EBT
- A: 20/30= 66.7%
- B: 60/100 = 60%
A ROE = 0.667*0.857*0.07*2.0*1.67 = 13.4%
B ROE = 0.608*1.0*0.111*3.0*1.2 = 24%
Company B has a higher tax buren but a lower interest burden (a lower ratio indicates a higher burden).
Company B has better EBIT margins and better asset utilization (perhaps inventory, receivables, or payables, or a lower cost basis in its fixed assets due to their age), and less leverage.
Its higher EBIT margins and asset turnover are the main factors leading to its significantly higher ROE, which it achieves with less leverage than Company A.
The following figure provides data for three companies
Calculate the sustainable growth rate for each company
RR = 1- (dividends / earnings)
A: RR = 1 - (1.5/3.00) = 0.500
B: RR = 1 - (1.00/4.00) = 0.750
C: RR = 1 - (2.00/5.00) = 0.600
g = RR * ROE
A: g = 0.500 * 14% = 7.0%
B: g = 0.750 * 12% = 9.0%
C: g = 0.600 * 10% = 6.0%
