Chapter 4 Flashcards
How to measure corporate performance
What is the definition of profit margin?
Profit margin represents the % of revenue remaining after deducting the costs of goods sold (COGS) and other expenses.
There are 3 types of profit margins:
What are the different types of profit margins, and how do they differ from one another?
- Gross Profit Margin : focuses only on production costs (COGS) & its purpose is to assess production efficiency.
- Operating profit margin : includes operating expenses in addition to COGS & its goal is to evaluate operational efficiency.
- Net profit margin : accounts for all expenses, including interest and taxes & its purpose is to provide a complete picture of overall profitability.
What does a declining profit margin over time suggest about a company?
A declining profit margin over time can signal challenges in a company’s pricing strategy or cost management. It may indicate that the company is struggling to maintain profitability in a competitive environment, facing rising costs, or experiencing operational inefficiencies.
How can a high profit margin be misleading when comparing companies in different industries?
While a high profit margin can indicate strong profitability, it can be misleading when comparing companies across different industries due to variations in cost structures, revenue recognition practices, business models, and risk profiles.
Therefore, it is essential to consider industry context and other financial metrics when making comparisons to gain a more accurate understanding of a company’s performance.
How might external economic factors impact a company’s profit margins?
External economic factors such as inflation and changes in consumer demand can have profound effects on a company’s profit margins.
Inflation can increase costs and limit pricing power, while shifts in consumer demand can alter market dynamics and competitive pressures.
Name and explain all profitability ratios.
- Return on Assets (ROA) = measures how effectively a company uses its assts to generate profit.
- Return on Equity (ROE) = assesses a company’s ability to generate profit from its shareholders’ equity.
- Return on Capital (ROC) or Return on Invested Capital (ROIC) = at how well a company is using its capital to generate profits.
Economic Value Added (EVA)
EVA measures a company’s ability to generate value beyond the cost of capital it employs. It’s often referred to as residual income and is used to assess how effectively a company is utilizing its capital to create wealth for its shareholders.
How does economic value added (EVA) relate to liquidity and overall corporate performance?
Positive EVA indicates strong financial health and value creation, which can enhance liquidity by improving cash flow.
Additionally, EVA serves as a comprehensive measure of corporate performance, guiding strategic decision-making and aligning management incentives with shareholder interests.
Explain what the Dupont model is.
It is a financial performance framework that breaks down a company’s return on equity (ROE) into component parts.
This helps to understand the underlying factors that drive a company’s profitability and efficiency.
What is Solvency/Leverage and name all ratios related.
It refers to how well a company can meet its long-term financial obligations.
- LT debt ratio
- LT debt to equity ratio
- Total debt ratio
- Times interest earned
- Cash coverage ratio
What is liquidity, and why is it important for a business?
Liquidity enables a company to meet its short-term obligations, maintain operational flexibility, attract financing, and enhance overall efficiency.
A strong liquidity position not only supports day-to-day operations but also contributes to long-term sustainability and growth.
How can a company measure its liquidity?
- Cash ratio
- Quick ratio
- Current ratio
- Net Working Capital ratio (NWC)
The invested capital (CI) is composed of…
Long-term assets and the Operating Working Capital.
OWC = ST asstes - (ST liab - ST debt)
IC also stands for Net assets or Capital employed.
Who uses all these ratios and why?
1) Managers : compare across firms and over time to monitor the business and see where they can improve.
2) Equity-investors : to monitor the managers via the board by setting up bonus schemes based on profitability & potential shareholders use ratios to decide whether to buy shares or not -> market-ratios).
3) Debt-investor : mostly look at liquidity and solvency ratios
4) Suppliers, clients, employees and other stakeholders : mostly look at liquidity and solvency ratios
