Part 1 Flashcards
Lecture 2:
Outline the three categories of a balance sheet + provide relevant examples:
1: Assets = current and non-current
Current assets = cash, accounts receivable, inventory
Non-current assets = tangible assets, land/buildings, intangible assets, trade marks, goodwill
2: Liabilities = current and non-current
Current = accounts payable
non-current = long term debt
3: Shareholders funds
= equity/capital
Lecture 2:
Outline the various components of an income statement
Sales Other income - COGS - Administration expenses - other expenses - depreciation = Operating income (EBIT) - Interest expense - Taxation = Net income or profit after tax
Lecture 2: Create common size financial statements
How do we create common size financial statements?
Identify the difference between the balance sheet and income statement common size financial statements?
Describe an alternative method for producing CSFS?
Create CSFS:
Balance sheet and income statement = divide all financial figures by the total revenue of the firm
Difference = balance sheet has no limit on the percentage since possible to be greater than 100% revenue, income statement has top line as 100% as the top line is revenue (revenue divided by revenue) everything else will be less.
Alternative = divide balance sheet items by total assets, and the income statement items by the total revenue
Lecture 2: Five steps of financial statement analysis
Outline the five steps of financial statement analysis
- Identify economic characteristics of an industry
- identify strategies that a firm pursues
- Asses quality of financial statements
- Analyse future profitability and risk
- Value the firm
Lecture 2: Porters five forces framework
Outline porters five forces
1: Threat of new entrants = pressure on prices, costs and rate of investment necessary to compete = depends on entry barriers
2: Intensity of rivalry = high when industry growth is slow, competitors are numerous and roughly equal in size and power, exit barriers are high
3: Threat of substitute products = obvious
4: Bargaining power of suppliers = high when costs of switching suppliers are high, supplier group does not depend heavily on the industry for its revenue, is more concentrated then industry it sells to, no substitute exists
5: Bargaining power of buyers = high when few buyers, non-price sensitive, products are standardised or undifferentiated, low switching costs
Lecture 2: Porters five forces framework - Threat of rivalry (Herfindahl-Hirschman index (HHI)) Outline what we mean by concentration? What is the HHI used for? Outline the formula used for HHI? Outline our measures for the HHI
Concentration = In an industry we may have 10 businesses, now if each business has a market share of 10% then the market is spread out across all of the businesses, i.e. it is not particularly concentrated. Now lets say that three of the firms join together and hence have a 30% market share whilst the other 7 still have 10% each. Here the market has become more concentrated. In a sense it has become more concentrated upon the one firm with a 30% share. Think of a glass of water with salt in it, ass you add more salt the water becomes more concentrated upon the salt.
HHI = used to measure the concentration within an industry
HHI formula = the sum of the squared market shares of the firms in the industry
= sum i to n for ((Output of firm i / total sales or output of the market) x 100)^2
= sum i to n for (market share of i x 100)^2
HHI measures =
Post merger HHI: <1000 = not concentrated = any change due to merger calls for no government action
Post merger HHI: 10001800 = concentrated = change of 50 or more calls for government action
Lecture 2: Porters five forces framework - Threat of new entrants (Entry barriers)
How do we determine the level of threat of new entrants?
Outline 5 entry barriers?
Level of threat of new entrants = based upon the barriers to entry, if none exist then high threat of new entrants!
1: Regulatory restrictions = There may be certain regulatory restrictions in place which limit the viability of new entrants
2: Brand names = current entrants with great brand awareness will make it very difficult for new entrants to compete as they will first have to develop their brand name to the same level
3: Patents = patents in place may make it illegal for competitors to replicate products / processes
4: High capital requirements = some industries require enormous capital, it may be difficult for new entrants to accumulate this capital in order to compete
5: Learning curve effect = Existing firms may be able to decrease production costs due to their current knowledge, whilst new competitors would have to learn the ins and outs of the industry before being able to do so to the same degree,
Lecture 2: Porters five forces framework - Threat of substitutes
What is the central question we are concerned with when considering the threat of substitutes?
Central question = How easily can customers switch to substitutes and how likely are they to!
Lecture 2: Porters five forces framework - Buyer power and supplier power
What do we mean by buyer power?
What do we mean by supplier power?
When is supplier power high vs low?
Buyer power = relates to the relative number of buyers and sellers in the industry and the leverage buyers have with respect to price = relates to buyers price sensitivity and the elasticity of demand
Supplier power = relates to leverage in negotiating input prices from suppliers
Supplier power = high when low amount of suppliers and large amount of buyers (vice versa for low)
Lecture 2: Other influences on industry growth, profitability, and risk
Outline four other influences?
1: Technological changes = new technologies limit viability of existing products
2: Demographic changes = Ageing populations result in changing wants and needs
3: Regulatory changes = tax policies and government spending
4: Social changes = change in views result in changing wants and needs
Lecture 2:
What are the three tools used to study economic characteristics of an industry?
List the 4 macroeconomic influences
3 tools
1: Interest rates
2: Availability of credit
3: Economic growth
4: Inflation
Lecture 2: Porters competitive advantage framework
According to Michael porter what are three strategies for developing competitive advantage?
1: Cost leadership: Low-cost advantage
2: Product differentiation: Develop product configurations that achieve customer preference
3: Focus: concentrate on particular niche markets
Lecture 2: porters five forces - New entrants - Barriers
There are seven barriers to entry which exist and effect the Threat of new entrants category, outline each.
Supply-side economies of scale: Firms producing at large volumes enjoy lower costs = new entrants must produce at same volume or larger to compete or they must accept a cost disadvantage
Demand-side benefits of scale: Buyers willingness to buy a product increases with the number of other buyers who buy from the business = limits customer willingness to buy from new entrants + limits the price tag new entrants can place on products.
Customer switching costs: Fixed costs that buyers face when they change suppliers
Capital requirements: large capital requirements limit the threat of new entrants, however if an industry is likely to stay profitable for the foreseeable future then financing can be found.
Incumbency advantages independent of size: Some businesses just have certain advantages due to skills acquired, geographical location, etc.
unequal access to distribution channels: The more limited the wholesale or retail channels are and the more that existing competitors have tied them up, the tougher entry into an industry will be.
Restrictive government policy: licensing requirements and restriction on foreign investment, pansive patenting rules, environmental or safety regulations (raise scale economies for newcomers)
Lecture 3: Who are the users of Financial statements?
Outline 4 users of financial statements
1: Customers
2: Suppliers
3: Financiers
4: Employees
Lecture 3: Profitability ratios Outline the following: Return on sales or net profit margin Gross margin Operating profit over sales EBIT over sales
ROS = Net income / Net sales = amount available from each dollar of sales for the owners = how much excess per sale GM = Gross profit / Net sales = amount used to cover costs of production = how much of excess we need to keep OP/S = Operating profit / net sales = amount used to cover costs of production net of taxes EBIT/S = EBIT / Net sales = profitability before financing and taxes EBITDA/S = EBITDA / Net sales = proxy for cash earnings = eliminates outside influence on profitability
Lecture 3: Profitability using Growth rates
How do we manage when a change in numbers is due to expansion or acquisition?
What is the difference between Real and Nominal rates?
Changes due to alternate circumstances = instead of looking at the company as a whole, utilise the statements of individual stores.
Real = growth rates which subtract inflation Nominal = growth rates which include inflation
Lecture 3: Various content
What reason do managers have to maximise/minimise reported earnings?
During a time of inflation, would a manager prefer to use LIFO or FIFO?
What problems would be associated with using a cash return on assets ratio instead of a return on assets ratio?
What benefits and issues are associated with using a cash return on assets ratio instead of a return on assets ratio?
Maximise = To get bonuses, increase stock price so that bonus stock options are more valuable, to not breach debt covenants, in order to borrow more money.
Minimise = make next years goals easier to meet, if under criticism (i.e. oil companies) lowering can help lower pressure on unethical exploitation, reduce payments to contracts that are based on earnings.
FIFO/LIFO inflation = depending on whether or not the manager wants to report higher or lower earnings. FIFO gives a higher profit figure, and LIFO gives a lower profit figure.
CROA = Benefits) reflects actual cash flows that are generated from the assets instead of attempting to allocate across time and matching. Problem) may not accurately reflect the total investment and expenses.
Lecture 3: Asset Utilisation Ratios
Overall what do these ratios tell us?
Outline the following ratios:
Asset turnover (TATO) Inventory turnover Days inventory Accounts receivable to sales Account receivables period Account payable to purchases Payables payment period
What these ratios tell us = How effectively or efficiently a firm uses its assets
Assets turnover = Net sales / Assets
- For Assets and Inventory, use the year end figure, or if changes occur in the year then use an average.
Inventory turnover = Cost of sales / Inventory
- How many times does the inventory turn over
Days Inventory = (Inventory / cost of sales) x 365
- Indicates how many days it takes to turnover the inventory
Accounts receivable to sales (turnover ratio) = Net credit sales / Accounts receivable
- Measures how many times a company is able to turn over the AR account (higher is better) (low indicates that income is often receivable for a long time and not being used in other investments)
Account receivable period = (Accounts receivable / net sales) x 365
- Measures how many days it takes to turnover the AR account
Accounts payable to purchases = Cost of sales / Accounts payable
= A liquidity ratio which measures how many times the company pays the AR account over the period
Payables payment period = (Accounts payable / cost of sales) x 365
= How many days it takes to pay the AR account
Lecture 3: Financial leverage ratios
Explain the concept of financial leverage
When is leverage good and when is leverage bad?
Financial leverage = This is actually a very simple concept to understand. The core idea is that it is possible to generate a higher Return on equity by using debt. How does this work?? One may think that the less debt we have, then the more money we can give our shareholders right? That is not the case. This is because if we have $1m in assets and generate $100,000 a year we have a ROA of 10%. Now if our company is fully financed through equity with 10 shareholders then we have a ROE of 10% and each shareholder receives $10,000. This means that our shareholders receive a 10% return. Now if we accept a 50/50 debt equity financed structure then our yearly income will go down. lets say our interest payment is $20,000 and so our income goes down to $80,000 a year. However, since we have dropped our shareholders down to 50%, because we substituted 50% debt as well, then those shareholders will be splitting the $80,000 amongst only 5 people. That means that each shareholder receives $16,000 which is 16% ROE.
By using Financial leverage, by using debt, we have been able to increase the amount of money our shareholders receive.
Leverage is good when = ROA is higher than the cost of debt. In our example above, the ROA was 8% after we used debt and the cost of debt was only 4%
Leverage is bad when = ROA is lower than the cost of debt. In our example above, if our debt payment was 60,000 then our cost of debt would have been 12%. Profit would be 40,000 which is a ROA of 4% and so our leverage would have been bad.
Lecture 3: Financial leverage ratios
Outline the following ratios
Financial leverage ratio
Long term debt ratios
EBIT coverage
Debt-service coverage
Financial leverage ratio = Assets / shareholders equity
- measures how much of our assets are funded by shareholders equity = 100% then all equity financed = higher ratio indicates a higher leverage
Long term debt ratios = (three)
1) Long term debt / Equity
2) Long term debt / Assets
3) Long term debt / long term debt + Equity
EBIT coverage = EBIT / Interest expense
- measures firms capacity to repay its debt expense = used by banks to ensure viability of lending money to a company
Cash flow coverage = EBIT + Depreciation / Interest expense
- Refactors in depreciation so as to consider a companies ability to repay debt obligations in regards to actual operating cash flows
Debt-service coverage = EBIT / (Interest + (Principal payments/(1-tax rate)))
- measures a companies ability to repay current obligations
Lecture 3: Liquidity ratios What are these used for? Outline the following Current ratio Acid-test ratio or quick ratio
Liquidity ratios = used to determine if a company can pay their most immediate obligations
Current ratio = current assets / current liabilities
- measures ability to pay off current liabilities using current assets
Acid test ratio or quick ratio = (Current assets - inventories) / Current liabilities OR (cash and marketable securities + Accounts receivable) / current liabilities
- Measures ability to pay off current liabilities using highly liquid assets (essentially using cash and cash equivalents)
Lecture 3: Capital Market Ratios
What are capital market ratios used for?
Outline the following EPS P/E ratio Market price / EBIT Market price / sales Market to book value Market price / EBITDA Market price / cash flow Dividend yield
Capital market ratios = used to assess aspects of shares usually on a per share basis
EPS = Net income / number of shares outstanding
P/E ratio = Price per share / EPS
Market price / EBIT = market price per share / EBIT per share
Market price / sales = market price per share / sales per share
Market to book value = market value per share / book value per share
Market price / EBITDA = market price per share / EBITDA per share
Market price / cash flow = Market price per share / Cash flow per share
Dividend yield = Dividends per share / market price per share
Lecture 3: Ratio analysis frameworks
What is it we need to understand when using ratio analysis?
understand = Company strategy is important. What is the company in questions competitive advantage? + the industry it operates in is important. How do the ratios compare to other companies in different industries
Lecture 3: DuPont Analysis
What is DuPont Analysis?
Outline the three components of ROE
DuPont Analysis = Combines profitability, asset utilisation and leverage to have a comprehensive view of a firm’s performance. This allows us to understand why ROE is different between two firms or why ROE is different in consecutive years.
Net profit margin = Net income / Revenue
- Tells us what percentage of revenue is converted to profit
Asset Turnover = Revenue / Total assets
- Tells us how effectively management uses assets to generate revenue
Financial Leverage = Total assets / Equity
- Tells us how leveraged the company is
Lecture 3: Sustainable Growth Rate
What is the SGR used for?
Outline the steps in calculating SGR
Outline how Profitability, asset efficiency, and retention rate effect SGR
SGR = measures the maximum rate a company can grow using internally generated funds (without changing their equity structure)
1 - Calculate Dividend payout and hence Retention rate
- Dividend payout = Dividends / net income
- Retention rate = Retained earnings / net income ( OR 1-DPO)
2 - Multiply DuPont ROE by the calculated retention rate
Effect on SGR = If any or all of the three go up then SGR will go up too (All have positive relation)
Lecture 3: Return On Invested Capital
What is ROIC??
How is ROIC calculated
ROIC = measures the percentage return a company makes over its invested capital = measures the percentage return a company generates above the WACC or Cost of capital = for example a ROIC of 13% vs a WACC of 11% indicates that the company generates 2% more profit than is required to keep operations going = analyses actual operating profitability
ROIC = (EBITA / Revenue) x (1 - operating tax rate) x (Revenue / Invested capital)
- invested capital = Debt + Equity
Lecture 3: Return versus Risk Performance Ratios
Outline the formula for spread
What adjustments are made for spread?
As Spread goes up what happens in market to book ratio?
What is EVA?
Spread = Return on equity - required return on equity
Adjustments = ROE is adjusted for non-cash accruals like depreciation
Spread up = Market to book ratio up
EVA = Economic value added = a variation of profit (because profit does not factor in the Cost of capital) = real value added when additional return are generated for shareholders above their required rate of return = a profit of $1000 is meaningless if investors require a return on their investment of $1100
EVA = Invested capital x (ROIC - WACC)
- where ROIC = NOPLAT / invested capital… and NOPLAt = earnings before interest charges and before non cash charges
lecture 4: Forecasting performance
What do we mean by achieving a steady state?
What are the implications for free cash flow of a company in a steady state?
how long should the explicit forecast period be?
Steady state = the explicit forecast period must be long enough for the company to reach a steady state. This means that the company grows at a constant rate by reinvesting a constant proportion of its operating profits into the business each year + the company earns a constant rate of return on both existing capital and new capital invested
Free cash flow steady state = free cash flow will grow at a constant rate and can be valued using a growth perpetuity
Explicit forecast period length = long enough that the company growth rate is less than or equal to that of the economy
