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AFM 212 > Module 3 > Flashcards

Module 3 Flashcards

1
Q

what is the most common analysis metric used by managers and investors

A

return on equity (ROE)

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2
Q

what is the basic formula of ROE

A

net income / average stockholders equity

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3
Q

if companies have both common and preferred stock, what adjustments do they need to do to ROE

A
  • remove preferred stock, because you just want to look at common stock
  • subtract preferred dividends form net income
  • subtract preferred stock from stockholders equity
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4
Q

what two things does ROE relate together

A
  • 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
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5
Q

what is the adjusted ROE formula so its in the perspective of controlling stockholders

A

ROE = Net Income Attributable to Company Shareholders / Average Equity Attributable to Company Shareholders

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6
Q

whos perspective is roe measuring return from

A

company’s stockholders

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6
Q

because ROE is based on controlling stockholders, what adjustments are needed to make towards the basic ROE formula

A
  • need to remove the noncontrolling interests
  • use net income attributable to parent company stockholders
  • use equity attributable to parent company stockholders
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6
Q

which stockholders does ROE measures the return to

A
  • controlling (parent company) stockholders
  • common stockholders
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7
Q

what is non controlling interest

A
  • 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
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8
Q

how does the operating focus measure ROE drivers

A
  • 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
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8
Q

what does performance analysis on ROE do

A
  • seeks to uncover the drivers of ROE
  • determine how those drivers trended overtime to better predict future performance
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8
Q

what is the ROE formula after adjusting for preferred stockholders

A

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)

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8
Q

what is the dupont analysis

A
  • 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
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9
Q

what are the 2 methods to measure ROE drivers

A
  1. dupont analysis
  2. operating focus
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10
Q

how does the dupont analysis measure ROE drivers

A

traditional dupont analysis disaggregates ROE into components of profitability, productivity, and leverage

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10
Q

what does the dupont disaggregation of ROE reflect

A

both
- company performance (measured by ROA)
- how assets are financed (measured by financial leverage)

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10
Q

in the dupont analysis, what is the formula for disaggregation of ROA

A

ROA = profit margin x asset turnover

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11
Q

what is the dupont disaggregation of ROE formula

A

ROE = ROA (return on assets) x FL (financial leverage)

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11
Q

what do CFOs ask when managing FL

A
  • how to maintain a stable capital structure
  • how to balance how much equity and debt to have
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12
Q

what is FL

A
  • 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
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12
Q

when is the dupont disaggregation of ROE higher and what is the tradeoff of it

A
  • when there is more debt and less equity for a given level of assets
  • greater debt = higher risk for the company
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12
Q

what does higher FL mean

A
  • means higher debt and interest payments
  • all else equal, it increases the probability of default and possible bankruptcy
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13
Q

what is roa

A
  • 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)
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14
Q

what is the ROA formula

A

net income / average total assets

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15
Q

what is leverage

A

being able to buy more when you have less money

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15
Q

how do you earn high ROA

A
  • 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
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16
Q

what does ROA analysis encourage managers to do

A

focus on both income statement AND balance sheet

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16
Q

what is the formula for FL

A

average total assets / average stockholder’s equity

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16
Q

based on the disaggregation of ROA, how can managers increase ROA

A
  • increase PM, increasing profitability for a given level of assets
  • increase AT, reducing assets while still generating same profit level
  • or both
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16
Q

why isnt leverage always good

A
  • especially when return is volatile
  • high risk
  • can end up loosing money
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16
Q

what is the profit margin formula

A

PM = net income / sales

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16
Q

what is the asset turnover formula

A

AT = sales / average total assets

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17
Q

what is profit margin

A

what the company earns on each sales dollar

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18
Q

what is asset turnover

A

sales generated from each dollar invested in assets

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19
Q

how can gpm fall from increase in competitive intensity

A

Selling prices have dropped to remain competitive

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19
Q

in the dupont analysis, what are the different profitability measures

A
  • gross profit margin (GPM)
  • operating expense margin
  • profit margin (PM)
19
Q

out of the two sources of profitability difference, PM and AT, which one is affected greater by competition?

A
  • PM
  • b/c PM is affected by external factors like the market
  • while AT is affected by management’s decisions
19
Q

in the dupont analysis, what are the different financial leverage measures

A
  • total liabilities to equity
  • times interest earned
20
Q

what is the gross profit margin formula

A

gross profit / sales

20
Q

in the dupont analysis, what are the different productivity measures

A
  • accounts receivable turnover
  • inventory turnover
  • accounts payable turnover
  • cash conversion cycle
  • PP&E turnover
20
Q

what is the gross profit margin

A
  • 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
20
Q

what are examples of what can cause low or decreasing gross profit margin

A
  • 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
21
Q

what is operating expense margin

A
  • 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
21
Q

what is the general formula for turnover formulas

A

turnover = income statement item / average balance sheet item

21
Q

how can gpm fall from change in product mix

A
  • Moved away from high margin products to lower margin products
  • customers are buying more of one product instead of both/the other
22
Q

how can gpm fall from increase in product costs

A

From increases in material or labour and the company can’t pass these extra costs to their customers

23
Q

what is the formula for operating expense margin

A

= SG&A expense / sales
OR
= operating expenses / total revenue

23
Q

what is a fact about PP&E turnover improvements

A

PP&E values are big, so slight improvements in PP&E turnover greatly influences ROA and cash flow

23
Q

what is the formula for A/R turnover

A

sales / average A/R

24
Q

what is the formula for PP&E turnover

A

sales / average PP&E

24
Q

what is the formula for inventory turnover

A

COGS / average inventory

24
Q

what is the formula for A/P turnover

A

purchase or COGS / average A/P

24
Q

why is improving PP&E turnover not easy

A

because the activities to improve it are strategic and financial events

24
Q

what are ways to improve PP&E turnover

A
  • 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
25
Q

what does the analysis of financial leverage usually involve

A
  • The level of borrowed money relative to equity capital
  • The level of profitability or cash flow relative to the required debt payments
25
Q

what is the total liabilities to equity formula

A

total liabilities / total equity

26
Q

how can the proper use of financial leverage benefit stockholders

A
  • Its a relatively inexpensive source of capital
  • Because debt repayment is mandatory it adds risk
26
Q

what is the times interest earned formula

A

EBIT / gross interest expense

26
Q

what does ROE disaggregation with an operating focus recognize

A

that companies create value mainly through core operations

27
Q

what is the ROE formula for operating focus

A

ROE = Operating Return + Nonoperating Return

27
Q

what is the difference between Dupont analysis and operating focus

A
  • 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
28
Q

what is nonoperating return

A
  • return from financing and investing activities (non operating activities)
  • earned from nonoperating assets and liabilities
28
Q

what is operating return

A
  • return from operating activities
  • earned from operating assets and liabilities
  • Ex. sales and expenses from sale of products and services
28
Q

how are operating returns calculated

A

by return on net operating assets (RNOA)

29
Q

What is the difference in financial leverage between the operating focus and dupont analysis

A
  • 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
30
Q

what is the formula of RNOA

A

net operating profit after tax (NOPAT) / Average net operating assets (NOA)

30
Q

what are things included for borrowed money

A
  • loans/bonds/mortgages
  • interest bearing
  • severe legal repercussions
31
Q

what are things included for operating liabilities

A
  • accounts payable, accrued liabilities
  • interest free
  • self-liquidating
31
Q

what are the formulas for net operating assets (NOA)

A

NOA = operating assets - operating liabilities
OR
NOA = NNO + total equity

31
Q

what are operating items

A

those that are needed for the business to operate

32
Q

what are operating assets

A
  • Accounts receivable
  • Inventories
  • Prepaid expenses/supplies
  • PP&E & Right-of-use assets
  • Intangible assets and goodwill
  • Deferred tax assets
33
Q

what are operating liabilities

A
  • Accounts payable
  • Accrued expenses
  • Unearned (deferred) revenue
  • Income taxes payable
  • Deferred tax liabilities
33
Q

what are the formulas for NNO

A

= non operating liabilities - nonoperating assets
OR
= NOA - total equity

33
Q

what are “other” operating items classified as

A

operating, unless stated otherwise

34
Q

what is the formula for net operating profit after tax (NOPAT

A

= net operating profit before tax (NOPBT) - tax on operating profit

35
Q

what are examples of operating expenses

A
  • COGS
  • SG&A
  • research and development
  • impairments of operating assets such as goodwill
  • other operating expenses or income (unless stated otherwise)
35
Q

what is the formula for NOPBT

A

= sales - operating expenses
= EBIT

36
Q

what are examples of SG&A expenses

A
  • wages
  • advertising
  • occupancy
  • insurance
  • depreciation and amortization
  • litigation
  • restructuring expenses
37
Q

what is tax on operating profit/what is tax shield

A
  • 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
37
Q

what happens when net nonoperating expenses > nonoperating income

A

pretax net nonoperating is an expense

37
Q

what is the formula for tax on operating profit

A

tax expense + (pretax net nonoperating expense x statutory tax rate) <- tax shield

37
Q

what happens when net nonoperating expenses < nonoperating income

A

pretax net nonoperating is income

38
Q

what are examples of nonoperating items on the income statement

A
  • 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
38
Q

what does nonoperating activities usually create for most companies

A

pretax net nonoperating expense

38
Q

what is financial leverage relate to (with ROE)

A
  • 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
38
Q

what is an approximate formula of ROE using the operating focus

A

= operating return (RNOA) - nonoperating return

38
Q

why is average NOA usually < average assets

A
  • 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
38
Q

why is RNOA usually > ROA

A
  • 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
39
Q

what does it mean when RNOA/ROE for operating focus is higher than ROA/ROE for dupont

A

operating approach shows that more of ROE is due to operating activities that make up its core business opposed to financial leverage

AFM 212 (7 decks)

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