Lecture 4 Flashcards
What evaluates the Ratio analysis?
Ratio analysis evaluates a firm’s effectiveness in the four areas by relating financial statement line items to each other
Why caring about ratio analysis?
Effective ratio analysis must relate underlying business factors to the financial numbers
Return on Equity (ROE) (definition and formula)
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
Traditional approach (DuPont decomposition of ROE)
ROE = Return on Sales (ROS) * Asset Turnover * Equity Multiplier
What are the formulas of the DuPont traditional approach?
ROS = Net profit/Sales
Asset Turnover = Sales/Total Assets
ROA = Net profit/Total assets | ROS * AT
Equity Multiplier = Total assets/ equity
What do these four ratio’s entail?
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?
What is the alternative approach to decomposing the ROE?
An approach consisting of operating, investing and financing activities.
Return on Invested Capital(Business Assets) + spread * leverage
Operating and Investment components = …
Financing component:….
Business Assets
Debt = Current + non-current debt (= all interest bearing liabilities)
(Invested) Capital: Debt + Equity (=Business Assets)
Managers can employ four levers to achieve growth and profit targets: (Describe the model)
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
What does the operating management?
What are some key questions?
What is the key ratio and the formula?
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
What does the investment management and what are some keyquestions?
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?
Trade receivables turnover
sales / trade receivables
# of times a firm collects its trade receivables
Days’ receivables
(Trade receivables / Sales)*365
Time required to collect trade receivables
Inventory Turnover
Cost of sales (or materials) / Inventories
# of times a firm sells its inventory
Days’ Inventory
(Inventories/cost of sales (or materials)) * 365
Time required to sell inventory
Trade payables turnover
Cost of Sales (or materials) / Trade payables
# of times a firm pays its suppliers
Days’ payables
(Trade payables/ Cost of Sales (or materials)) * 365
Time required to pay suppliers
Cash Conversion Cycle
Days’ inventories + Days’ receivables - Days’ payables
Period from paying suppliers to collecting customer payment
What does the financial management?
What are some key questions?
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)
What are two types of analysis relating to a firm’s obligations and where does it focus on:
Liquidity analysis focuses on current assets vs current liabilities.
Solvency analysis focuses on longer-term liabilities.
current ratio
(Cash and equivalents+Trade receivables+inventories)
/ Current Liabilities
Current Assets/ Current Liabilities
The firms ability to pay its current obligations
Cash ratio
Cash and cash equivalents / current liabilities
The firms ability to pay its current obligations
Quick ratio
(Cash and cash equivalents + Trade receibles) / current liabilities
The firms ability to pay its current obligations
What do Liquidity and Solvency assess?
Liquidity assesses a firm’s ability to pay its current obligations.
Solvency measures a firm’s ability to meet long-term obligations
Interest coverage (Earnings based)
Earnings before interest and Taxation(EBIT) / Interest Expense
Interest coverage assesses a firm’s ability to pay interest on its debt.
Sustainable growth rate
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
Two primary tools in financial analysis:
- 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.
Cash flow analysis of Operating Investing Financing for Startup, growth, mature and decline
Start- up Growth Mature Decline
Operating - -/+ ++ +
Investing - – - +
Financing + ++ - –
Free cash flow (definition, where can it be used for?, Formulas)
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
Start-up firms often have a negative FCFDE, what do other such firms need to do?
What are key questions of cash flow analysis?
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!
Free cash flow is also a key measure for firm valuation:
- To calculate enterprise value: FCFDE
- To determine equity value: FCFE
FCFe
= FCFde + Net Borrowing
What tells an high or low FCFe us?
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.
