Module 3 Flashcards
what is the most common analysis metric used by managers and investors
return on equity (ROE)
what is the basic formula of ROE
net income / average stockholders equity
if companies have both common and preferred stock, what adjustments do they need to do to ROE
- remove preferred stock, because you just want to look at common stock
- subtract preferred dividends form net income
- subtract preferred stock from stockholders equity
what two things does ROE relate together
- net income to average total stockholder’s equity
- where average equity is used to reflect about how much equity the company had throughout the year
what is the adjusted ROE formula so its in the perspective of controlling stockholders
ROE = Net Income Attributable to Company Shareholders / Average Equity Attributable to Company Shareholders
whos perspective is roe measuring return from
company’s stockholders
because ROE is based on controlling stockholders, what adjustments are needed to make towards the basic ROE formula
- need to remove the noncontrolling interests
- use net income attributable to parent company stockholders
- use equity attributable to parent company stockholders
which stockholders does ROE measures the return to
- controlling (parent company) stockholders
- common stockholders
what is non controlling interest
- parent company needs to consolidate their subsidiaries into their statements (include all information of all subsidiaries into one statement)
- but some parts of the subsidiaries are not owned by the parent company, they are owned by non controlling interest (like regular other shareholders)
- (parent company holds only majority of the subsidiary shares)
- so you need to remove the amount of the noncontrolling interests
how does the operating focus measure ROE drivers
- it is ROE analysis with an Operating Focus that separates operating and nonoperating activities
- Provides deep insight into the factors (operating activities) that drive value creation
what does performance analysis on ROE do
- seeks to uncover the drivers of ROE
- determine how those drivers trended overtime to better predict future performance
what is the ROE formula after adjusting for preferred stockholders
ROE = (Net Income Attributable to Company Shareholders - Preferred Dividends) / (Average Equity Attributable to Company Shareholders - Average Preferred Equity)
or just
ROCE = (Net Income - Preferred Dividends) / (Average Stockholders’ Equity - Average Preferred Equity)
what is the dupont analysis
- name comes from dupont corporation that started using this formula in the 1920s
- dupont explosives salesman invented the formula of ROE disaggregation in an internal efficiency report in 1912
- its made to aid managers in performance evaluation
what are the 2 methods to measure ROE drivers
- dupont analysis
- operating focus
how does the dupont analysis measure ROE drivers
traditional dupont analysis disaggregates ROE into components of profitability, productivity, and leverage
what does the dupont disaggregation of ROE reflect
both
- company performance (measured by ROA)
- how assets are financed (measured by financial leverage)
in the dupont analysis, what is the formula for disaggregation of ROA
ROA = profit margin x asset turnover
what is the dupont disaggregation of ROE formula
ROE = ROA (return on assets) x FL (financial leverage)
what do CFOs ask when managing FL
- how to maintain a stable capital structure
- how to balance how much equity and debt to have
what is FL
- financial leverage
- measures the relative use of debt vs equity to finance company assets
- its important because debt is a contractual obligation and failure to repay principal or interest can result in legal repercussions or bankruptcy
when is the dupont disaggregation of ROE higher and what is the tradeoff of it
- when there is more debt and less equity for a given level of assets
- greater debt = higher risk for the company
what does higher FL mean
- means higher debt and interest payments
- all else equal, it increases the probability of default and possible bankruptcy
what is roa
- return on assets
- net income generated from average total assets
- measures return from the perspective of the entire company (enterprise level)
- includes profitability (numerator) and total company assets (denominator)
what is the ROA formula
net income / average total assets
what is leverage
being able to buy more when you have less money
how do you earn high ROA
- company must be profitable AND manage assets
- be able to hold the lowest level of assets possible and achieve the desired profit
- so want to minimize assets and increase profits, but don’t was to decrease profit from minimizing assets
what does ROA analysis encourage managers to do
focus on both income statement AND balance sheet
what is the formula for FL
average total assets / average stockholder’s equity
based on the disaggregation of ROA, how can managers increase ROA
- increase PM, increasing profitability for a given level of assets
- increase AT, reducing assets while still generating same profit level
- or both
why isnt leverage always good
- especially when return is volatile
- high risk
- can end up loosing money
what is the profit margin formula
PM = net income / sales
what is the asset turnover formula
AT = sales / average total assets
what is profit margin
what the company earns on each sales dollar
what is asset turnover
sales generated from each dollar invested in assets
how can gpm fall from increase in competitive intensity
Selling prices have dropped to remain competitive
in the dupont analysis, what are the different profitability measures
- gross profit margin (GPM)
- operating expense margin
- profit margin (PM)
out of the two sources of profitability difference, PM and AT, which one is affected greater by competition?
- PM
- b/c PM is affected by external factors like the market
- while AT is affected by management’s decisions
in the dupont analysis, what are the different financial leverage measures
- total liabilities to equity
- times interest earned
what is the gross profit margin formula
gross profit / sales
in the dupont analysis, what are the different productivity measures
- accounts receivable turnover
- inventory turnover
- accounts payable turnover
- cash conversion cycle
- PP&E turnover
what is the gross profit margin
- influenced by both the selling price of a company’s products and the cost to make or buy those products
- generally high and increasing is better
- low or decreasing signals more competition or less demand for company’s products
what are examples of what can cause low or decreasing gross profit margin
- Increase in competitive intensity
- Product line has lost appeal or the technology is not cutting edge
- Product costs to make or buy the products increased
- Product mix changed
- Volume for the product has declined and fixed costs for manufacturing have not
what is operating expense margin
- measures general operating costs for each sales dollar
- analysis focuses on each expense in whatever detail a company discloses in its income statement and its notes
- compare this margin and each of its components overtime and against peers (peers that have similar business models)
- if its decreasing it is a good sign that they are being efficient
what is the general formula for turnover formulas
turnover = income statement item / average balance sheet item
how can gpm fall from change in product mix
- Moved away from high margin products to lower margin products
- customers are buying more of one product instead of both/the other
how can gpm fall from increase in product costs
From increases in material or labour and the company can’t pass these extra costs to their customers
what is the formula for operating expense margin
= SG&A expense / sales
OR
= operating expenses / total revenue
what is a fact about PP&E turnover improvements
PP&E values are big, so slight improvements in PP&E turnover greatly influences ROA and cash flow
what is the formula for A/R turnover
sales / average A/R
what is the formula for PP&E turnover
sales / average PP&E
what is the formula for inventory turnover
COGS / average inventory
what is the formula for A/P turnover
purchase or COGS / average A/P
why is improving PP&E turnover not easy
because the activities to improve it are strategic and financial events
what are ways to improve PP&E turnover
- Divesting of unproductive assets or entire business segments
- Joint ventures to share PP&E assets like distribution of networks, IT, production facilities, warehouses, transportation fleets
- Selling of production facilities with agreements to purchase finished goods from the facilities’ new owners
- Sale and/or leaseback of administrative buildings
what does the analysis of financial leverage usually involve
- The level of borrowed money relative to equity capital
- The level of profitability or cash flow relative to the required debt payments
what is the total liabilities to equity formula
total liabilities / total equity
how can the proper use of financial leverage benefit stockholders
- Its a relatively inexpensive source of capital
- Because debt repayment is mandatory it adds risk
what is the times interest earned formula
EBIT / gross interest expense
what does ROE disaggregation with an operating focus recognize
that companies create value mainly through core operations
what is the ROE formula for operating focus
ROE = Operating Return + Nonoperating Return
what is the difference between Dupont analysis and operating focus
- The balance sheet and income statement have both operating and nonoperating items
- ROA in the Dupont analysis contains the operating assets and nonoperating return
- Analysis can be improved if we separate the operating and nonoperating components and calculate their returns separately
what is nonoperating return
- return from financing and investing activities (non operating activities)
- earned from nonoperating assets and liabilities
what is operating return
- return from operating activities
- earned from operating assets and liabilities
- Ex. sales and expenses from sale of products and services
how are operating returns calculated
by return on net operating assets (RNOA)
What is the difference in financial leverage between the operating focus and dupont analysis
- FL in dupont analysis is the ratio of total assets to total stockholders equity
- so when debt > equity, more debt buys more assets
- so as assets increase and equity stays the same, FL increases
- it includes all liabilities
- but liabilities can be split into operating liabilities and borrowed money
- in the operating focus, it separates borrowed money and considers it as nonoperating
what is the formula of RNOA
net operating profit after tax (NOPAT) / Average net operating assets (NOA)
what are things included for borrowed money
- loans/bonds/mortgages
- interest bearing
- severe legal repercussions
what are things included for operating liabilities
- accounts payable, accrued liabilities
- interest free
- self-liquidating
what are the formulas for net operating assets (NOA)
NOA = operating assets - operating liabilities
OR
NOA = NNO + total equity
what are operating items
those that are needed for the business to operate
what are operating assets
- Accounts receivable
- Inventories
- Prepaid expenses/supplies
- PP&E & Right-of-use assets
- Intangible assets and goodwill
- Deferred tax assets
what are operating liabilities
- Accounts payable
- Accrued expenses
- Unearned (deferred) revenue
- Income taxes payable
- Deferred tax liabilities
what are the formulas for NNO
= non operating liabilities - nonoperating assets
OR
= NOA - total equity
what are “other” operating items classified as
operating, unless stated otherwise
what is the formula for net operating profit after tax (NOPAT
= net operating profit before tax (NOPBT) - tax on operating profit
what are examples of operating expenses
- COGS
- SG&A
- research and development
- impairments of operating assets such as goodwill
- other operating expenses or income (unless stated otherwise)
what is the formula for NOPBT
= sales - operating expenses
= EBIT
what are examples of SG&A expenses
- wages
- advertising
- occupancy
- insurance
- depreciation and amortization
- litigation
- restructuring expenses
what is tax on operating profit/what is tax shield
- tax that is related to only operating profit
- the tax shield is taxes a company saves by having tax-deductible nonoperating expenses, mostly interest
- but taxes saved (from the tax shield) is nonoperating, and we want operating
- so we add tax shield back to total tax expense to find the tax on operating profit
what happens when net nonoperating expenses > nonoperating income
pretax net nonoperating is an expense
what is the formula for tax on operating profit
tax expense + (pretax net nonoperating expense x statutory tax rate) <- tax shield
what happens when net nonoperating expenses < nonoperating income
pretax net nonoperating is income
what are examples of nonoperating items on the income statement
- interest expense on debt and lease obligations
- interest and dividend income on marketable securities
- loss or income relating to discontinued operations
- debt issuance and retirement costs
- gains or losses on the sale of nonstrategic investments
- other income or expense if reported separately from operating income
- pension income or losses
what does nonoperating activities usually create for most companies
pretax net nonoperating expense
what is financial leverage relate to (with ROE)
- it relates to the degree the company uses borrowed money
- its an important measure of the risk a company is incurring with its reliance on debt
- increase debt increases risk, but also increases the return to shareholders IF yield on assets > borrowing rate on debt
what is an approximate formula of ROE using the operating focus
= operating return (RNOA) - nonoperating return
why is average NOA usually < average assets
- average NOA is for operating focus
- average assets is for dupont analysis
- since NOA is net of operating liabilities, it is smaller than average assets, which include both operating and nonoperating
why is RNOA usually > ROA
- RNOA is for operating focus
- ROA is for dupont analysis
- because NOA is smaller than average assets, it makes the denominator for RNOA smaller, which results in a larger RNOA
what does it mean when RNOA/ROE for operating focus is higher than ROA/ROE for dupont
operating approach shows that more of ROE is due to operating activities that make up its core business opposed to financial leverage
