Lecture 5 - Ratio Analysis Flashcards
How to calculate ROCE?
ROCE=(Net Income-Preference Dividends )/(Average shareholder^’ s equity-preference shares)
What is the average ROE over the long run?
10-12%
Which profits do we use?
We use profits of the group as a whole as the parent has control over all the assets.
What is adjusted ROCE?
Adjusted ROCE can be adjusted for non-recurring (after tax).
What is the benchmark for ROA? Why is this the case?
Weighted Average Cost of Capital.
2 claims to the firms assets
RNOA
Return on Net Operating Assets:
RNOA = NOPAT/NOA
NOPAT
Net profit + NFE after tax
- Look out for contra in asset.
NOA
Average net operating assets
NBC
NFE/NFO
NFO
Net financing obligation (net average debt)
NFE
Net financing expense after tax
Net financing expense*(1-effective tax rate)
How to decompose RNOA?
RNOA=Net profit margin*asset turnover
Net profit margin
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.
Asset Turnover
Indicates how many dollars of sales the firm can generate for each dollar of assets.
Dependent on:
- Sales
- Reduce NOA
What factors can dictate RNOA?
Industry Structure
Firm Strategy
How can industry structure impact RNOA’s ratios?
- 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)
How can firm strategy impact RNOA’s ratios?
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
3 Economic factors impacting RNOA
Operating Leverage
Product Life Cycles
Cyclical of Sales
Leverage and financing
Operating Leverage
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)
Product Life Cycles:
Introduction = negative RNOA
Growth = Positive RNOA
Maturity = Growing RNOA
Decline = Positive or declining RNOA
Cyclicality of Sales:
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.
Leverage and Financing:
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
Breaking down profit margins
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
Breaking down Asset Turnover.
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.
