Lecture 5 - Ratio Analysis

Question 1

How to calculate ROCE?

Answer 1

ROCE=(Net Income-Preference Dividends )/(Average shareholder^’ s equity-preference shares)

Question 2

What is the average ROE over the long run?

Answer 2

10-12%

Question 3

Which profits do we use?

Answer 3

We use profits of the group as a whole as the parent has control over all the assets.

Question 4

What is adjusted ROCE?

Answer 4

Adjusted ROCE can be adjusted for non-recurring (after tax).

Question 5

What is the benchmark for ROA? Why is this the case?

Answer 5

Weighted Average Cost of Capital.

2 claims to the firms assets

Question 6

RNOA

Answer 6

Return on Net Operating Assets:

RNOA = NOPAT/NOA

Question 7

NOPAT

Answer 7

Net profit + NFE after tax

• Look out for contra in asset.

Question 8

NOA

Answer 8

Average net operating assets

Question 9

NBC

Answer 9

NFE/NFO

Question 10

NFO

Answer 10

Net financing obligation (net average debt)

Question 11

NFE

Answer 11

Net financing expense after tax

Net financing expense*(1-effective tax rate)

Question 12

How to decompose RNOA?

Answer 12

RNOA=Net profit margin*asset turnover

Question 13

Net profit margin

Answer 13

Tells us how much the company is able to keep as profits for each dollar of sales.

Dependent on:

• Price  competition
• Cost  efficiency at which management is dealing with costs.

Question 14

Asset Turnover

Answer 14

Indicates how many dollars of sales the firm can generate for each dollar of assets.

Dependent on:

1. Sales
2. Reduce NOA

Question 15

What factors can dictate RNOA?

Answer 15

Industry Structure

Firm Strategy

Question 16

How can industry structure impact RNOA’s ratios?

Answer 16

• Capital-intensive industries:
  High degree of operating leverage (high fixed costs)
• E.g. construction and heavy equipment manufacturing
• Have low asset turnover  charge higher profit margins to compensate.
• Commodity-like industries:
  Low degree of operating leverage (more variable costs)
• E.g. discount retailers and fast food chains.
• Low margins  high-asset turnover to compensate (high volume)

Question 17

How can firm strategy impact RNOA’s ratios?

Answer 17

Firm Strategy:
- Strategy to produce at the lowest cost = low price  low margins, but high turnover.
o E.g. Coles “down down”
- Strategy to rely on product differentiation = price premium  higher margins, and low turnover.
o E.g. Apple stand

Question 18

3 Economic factors impacting RNOA

Answer 18

Operating Leverage

Product Life Cycles

Cyclical of Sales

Leverage and financing

Question 19

Operating Leverage

Answer 19

Firms with high FC will be more risky  due to greater cost per sale during periods of low production.

• Economies of scale
• High operating leverage  more significant increases (decreases) in operating income as sales increases (decreases)

Question 20

Product Life Cycles:

Answer 20

Introduction = negative RNOA

Growth = Positive RNOA

Maturity = Growing RNOA

Decline = Positive or declining RNOA

Question 21

Cyclicality of Sales:

Answer 21

Sensitivity of sales to economic conditions

Highly sensitive:
- E.g. luxury goods, cars, digital equipment

Less sensitive:
- E.g. food, electric utilities

Firms with higher sensitivity incur more risk, and will have a more variable RNOA.

Question 22

Leverage and Financing:

Answer 22

Higher leverage increases (decreases) ROCE when spread is positive (negative)

ROCE can be made larger than RNOA by leveraging assets

Why do firms not ROCE by increasing leverage?
- Higher risk
- Lower spread
o As debt increases, interest will increase (higher risk) and this will lower NPM

Question 23

Breaking down profit margins

Answer 23

Gross margins:
Explanations for increase (decrease) in gross profit margins:
- Price: Increase in price due to increase in demand
- Fixed cost allocation: increase in sales resulting in lower unit costs as fixed costs allocated over a greater number of units
- Change in product mix
- Lower price to gain market share an increase volume sold gives rise to lower unit costs

Question 24

Breaking down Asset Turnover.

Answer 24

Accounts Receivable Turnover:
- Increase (decreases) in credit worthiness of customers
- Changes in a firm’s credit extension policies to stimulate sales
o Could be a positive or negative signal.

Inventory turnover
An increase in I/T can be good as it involves lower cost for financing and carrying inventory and lower risk of obsolescence

Firm could be carrying too little inventory and misses sales.

Question 25

When should a firm leverage?

Answer 25

When Spread is positive (i.e. the benefit outweighs the cost of borrowing)
RNOA > NFE

Question 26

Du pont - 3 drawbacks

Answer 26

1. rubbish in rubbish out
2. No cost of capital considerations
3. Accounting numbers are subject to earnings management