Lecture 4

Question 1

What evaluates the Ratio analysis?

Answer 1

Ratio analysis evaluates a firm’s effectiveness in the four areas by relating financial statement line items to each other

Question 2

Why caring about ratio analysis?

Answer 2

Effective ratio analysis must relate underlying business factors to the financial numbers

Question 3

Return on Equity (ROE) (definition and formula)

Answer 3

Return on Equity (ROE) is a comprehensive measure of performance and a good starting point to systematically analyze firm performance.

ROE=Net Profit / Shareholders’ Equity

Question 4

Traditional approach (DuPont decomposition of ROE)

Answer 4

ROE = Return on Sales (ROS) * Asset Turnover * Equity Multiplier

Question 5

What are the formulas of the DuPont traditional approach?

Answer 5

ROS = Net profit/Sales
Asset Turnover = Sales/Total Assets
ROA = Net profit/Total assets | ROS * AT
Equity Multiplier = Total assets/ equity

Question 6

What do these four ratio’s entail?

Answer 6

ROA = How profitably are the assets employed?
ROS = How much profit does the company make per Euro of sales?
Asset Turnover = How many sales does the company generate per Euro of assets?
Equity Multiplier = How big is the asset base relative to equity?

Question 7

What is the alternative approach to decomposing the ROE?

Answer 7

An approach consisting of operating, investing and financing activities.
Return on Invested Capital(Business Assets) + spread * leverage

Question 8

Operating and Investment components = …
Financing component:….

Answer 8

Business Assets
Debt = Current + non-current debt (= all interest bearing liabilities)
(Invested) Capital: Debt + Equity (=Business Assets)

Question 9

Managers can employ four levers to achieve growth and profit targets: (Describe the model)

Answer 9

1.Growth & Profitability
2.Product Market Strategies &Financial Market Policies
3.Operating Management (PMS)
- Investment management (PMS)
- financing decisions (FMP)
- Dividend Policy (FMP)
4. Managing revenue and expenses
- Managing working capital and fixed assets
- Managing Liabilities and equity
- Managing payout

Question 10

What does the operating management?
What are some key questions?
What is the key ratio and the formula?

Answer 10

Operating management assesses the efficiency of a firm’s operations by ‘common-sizing’ income statements.
Common-sized income statements express line items as a percentage of sales to compare these items over time and across different firms

Key questions for operating management analysis include:
How much does the company earn on its sales (vs. spend on operations)?
Are margins consistent with the (claimed) competitive strategy?
Cost control vs. investments in brand, marketing, R&D?
Are margins changing over time? What about the effect of competition, input prices, overhead management?
Are costs well managed (= efficiency)? What are the cost drivers and how ‘sticky’ are these costs (e.g., personnel, depreciation, amortization)?

Key ratio:
Gross profit margin (I/S by function only) indicates:
A firm’s (or product’s) price premium in the market.
The efficiency of a firm’s procurement and/or production process.
GPM = (Sales - Cost of Sales) / Sales

Question 11

What does the investment management and what are some keyquestions?

Answer 11

Investment management assesses how efficient a firm uses its resources
Key focus: Working capital management:
Working capital = Current assets – Current liabilities
Used to assess a firm’s day-to-day business, such as:
Efficiency of operations (and use of resources)
Short-term financial health

Key questions include:
How well does the company manage its inventories?
How well does the company manage its liquidity?
How well does the company manage its credit policies?
Is the company increasing sales artificially?
Is the company relying too much on trade credit?

Question 12

Trade receivables turnover

Answer 12

sales / trade receivables
# of times a firm collects its trade receivables

Question 13

Days’ receivables

Answer 13

(Trade receivables / Sales)*365
Time required to collect trade receivables

Question 14

Inventory Turnover

Answer 14

Cost of sales (or materials) / Inventories
# of times a firm sells its inventory

Question 15

Days’ Inventory

Answer 15

(Inventories/cost of sales (or materials)) * 365
Time required to sell inventory

Question 16

Trade payables turnover

Answer 16

Cost of Sales (or materials) / Trade payables
# of times a firm pays its suppliers

Question 17

Days’ payables

Answer 17

(Trade payables/ Cost of Sales (or materials)) * 365
Time required to pay suppliers

Question 18

Cash Conversion Cycle

Answer 18

Days’ inventories + Days’ receivables - Days’ payables
Period from paying suppliers to collecting customer payment

Question 19

What does the financial management?
What are some key questions?

Answer 19

Financial management assesses a company’s capital structure:
Does the firm sufficiently exploit the benefits of debt?
To have an asset base larger than equity;
To access capital that is cheaper than equity;
To increase its return on equity.
Does the firm have too much debt given its business risk?
Debt covenants; risk of financial distress (and bankruptcy)
Does it employ the borrowed funds appropriately?
Type of investment and profitability (e.g., Apple has raised funds to pay dividends)

Question 20

What are two types of analysis relating to a firm’s obligations and where does it focus on:

Answer 20

Liquidity analysis focuses on current assets vs current liabilities.
Solvency analysis focuses on longer-term liabilities.

Question 21

current ratio

Answer 21

(Cash and equivalents+Trade receivables+inventories)
/ Current Liabilities
Current Assets/ Current Liabilities
The firms ability to pay its current obligations

Question 22

Cash ratio

Answer 22

Cash and cash equivalents / current liabilities
The firms ability to pay its current obligations

Question 23

Quick ratio

Answer 23

(Cash and cash equivalents + Trade receibles) / current liabilities
The firms ability to pay its current obligations

Question 24

What do Liquidity and Solvency assess?

Answer 24

Liquidity assesses a firm’s ability to pay its current obligations.
Solvency measures a firm’s ability to meet long-term obligations

Question 25

Interest coverage (Earnings based)

Answer 25

Earnings before interest and Taxation(EBIT) / Interest Expense
Interest coverage assesses a firm’s ability to pay interest on its debt.

Question 26

Sustainable growth rate

Answer 26

ROE * (1- Dividend payout ratio)
Dividend payout ratio = Cash dividends paid/Netprofit
a comprehensive measure of a firm’s ability to maintain its profitability and financial policies

Question 27

Two primary tools in financial analysis:

Answer 27

• Ratio analysis assesses how various line items in financial statements relate to each other and measures relative performance.
• Cash flow analysis evaluates liquidity and the management of operating, investing, and financing activities as they relate to cash flow.

Question 28

Cash flow analysis of Operating Investing Financing for Startup, growth, mature and decline

Answer 28

Start- up Growth Mature Decline
Operating - -/+ ++ +
Investing - – - +
Financing + ++ - –

Question 29

Free cash flow (definition, where can it be used for?, Formulas)

Answer 29

Free cash flow is the cash a company generates after having maintained or expanded its asset base (= capital expenditures).
- It can be used for further growth – or to return money to debt / equity holders.
- That is, it is a firm’s discretionary cash flow.

FCFde = Net Income + Depreciation&Amortization – Investment in Working Capital – Capital Expenditures
→ Or more simply: FCFDE = CFO – Capital Expenditures

Question 30

Start-up firms often have a negative FCFDE, what do other such firms need to do?
What are key questions of cash flow analysis?

Answer 30

Other such firms need to borrow funds to meet interest/debt repayments, cut their investments, or raise equity.
Key questions:
Is the company ‘wasting’ money? Is this a one-time issue or a recurring problem? Is the firm’s business model still viable? How can the free cash flows turned around?
More generally: Are free cash flows increasing/decreasing? What is driving firm growth (higher revenues vs. fewer expenses)? How much is the firm investing in its working capital?
Implications for forecasting!

Question 31

Free cash flow is also a key measure for firm valuation:

Answer 31

• To calculate enterprise value: FCFDE
• To determine equity value: FCFE

Question 32

FCFe

Answer 32

= FCFde + Net Borrowing

Question 33

What tells an high or low FCFe us?

Answer 33

Firms with a negative FCFE would need to borrow money to pay dividends. Vice versa, firms that have a high FCFE may risk making unproductive investments.