Lecture 1 Flashcards
Balance sheet
Snapshot of the financial state of the firm at the end of the period.
Shows assets, liabilities and shareholder’s equity of the firm as they stand on the last day of period.
Equity = assets - liabilities
Income statement
Shows income and expenditure, profit or loss, taxation suffered, interest and preferred dividends and other unrealized gains and losses that occur during the period.
Net income = revenue - expenses
Statement of cash flows
Describes how a firm generated and used cash during the period. (Only recognizes when cash changes hands)
Is used as contrast to accrual-based accounting -> Accrual recog. transaction rather than payment.
Divided into three types:
-Operating activities:
The money brought in from regular business activities; e.g. selling goods or providing services
Investing activities:
Change in company’s cash position resulting from investing in assets (plants & equipment)
Financing activities:
The change in a company’s cash position due to the firm’s issuing dividends issuing stock or borrowing form a bank
Return on equity ROE (traditional approach)
ROE = Net inc./Shareholder equity
ROE = ROA x Financial Leverage
Return on assets (ROA)
ROA = Net income / Total assets
ROA = Net profit margin x Asset turnover
Financial leverage
Fin. lev = Total assets / Shareholder’s equity
Net profit margin
Net profit margin = Net income / total sales
Asset turnover
Asset turnover = Sales / Total assets
Return net operating assets (RNOA)
Operating income after taxes (OI) / Net operating assets (NOA)
Financial leverage (FLEV)
Net financial obligation (NFO) / Shareholder’s equity (SE)
Net borrowing cost (NBC)
NBC = Net financial expense (NFE) / Net financial obligations (NFO)
Operating PM
Operating PM = Operating income after taxes (OI) / Total sales
Asset turnover (ATO)
ATO - Sales / Net operating assets (NOA)
In the context of ROE, please explain the spread and its impact on FLEV
ROE = RNOA + FLEV(RNOA-NBC)
RNOA-NBC is known as the spread. This is the difference between the firm’s return on its assets and its borrowing costs. As NBC increases the spread diminishes. As this is multiplied by the firm’s FLEV, we see that increasing FLEV only boosts ROE when operating effectiveness (RNOA) exceeds borrowing costs (NBC).
Please calculate ROE
Pls calc. roe
Operating management ratios:
Gross profit
Gross profit margin
Operating profit margin
Asset management ratios
Trade receivables turnover
Inventory holding turnover
Trade payables turnover
Asset management ratios continued
Trade receivables days
Inventory holding days
Trade payables days
Liquidity ratios
Current ratio
Acid test (quick ratio)
Is a ROE of 15% “good” or “bad”?
Difficult to provide a concrete answer to this. It depends on the sector/industry the firm operates within. Typically you would compare against an industry average to determine whether 15% is good
Why can’t managers borrow more to increase leverage & boost ROE?
Because increasing the FLEV level may boost ROE in good times, but will likewise have an further negative impact on ROE should the spread be negative. That is in times where the net borrowing cost exceeds the RNOA
How to separate operating from financing items?
Operating are the incomes and expenses that have to do with the items directly related to the firm’s day to day activities. Sales and costs related to the firm’s goods and services.
Financing pertains to money borrowed and raised in capital markets through issuance of shares and bonds
How do you explain to your 12-year-old niece the key differences between the “traditional” DuPont formula & the reformulated formula?
The traditional DuPont formula breaks ROE into three parts:
ROE=ProfitMargin × AssetTurnover x EquityMultiplier
ROE=ProfitMargin × AssetTurnover × EquityMultiplier
Profit Margin – How much profit you make per cup of lemonade sold.
→ If you sell a cup for $2 and your costs are $1, you keep $1 as profit.
Asset Turnover – How many cups of lemonade you sell using your stand.
→ If you use your stand efficiently, you can sell a lot of lemonade with the same setup.
Equity Multiplier – How much you rely on borrowed money.
→ If you borrowed money to buy a better stand, you might sell more lemonade, but you also owe money.
💡 So, Traditional DuPont shows how well you make money using your sales, assets, and borrowing.
ROE=OperatingReturn+(FinancialLeverage×Spread)
Operating Return (RNOA - Return on Net Operating Assets)
– How good your lemonade stand is at making money from actual business operations, without worrying about loans.
→ This is just about how well you turn lemons into cash!
Financial Leverage (FLEV) – How much borrowed money you used to grow your business.
→ Did you borrow money to buy a bigger stand and sell more lemonade?
Spread (RNOA - Net Borrowing Cost) – How much extra return you get compared to the cost of borrowing.
→ If borrowing helps you make more profit than the interest you pay, it’s good!
💡 The Reformulated DuPont focuses more on how your actual lemonade stand (operations) makes money and how borrowing helps or hurts you.
