Profitability and Ratio Analysis

Question 1

What are the best practices in financial analysis?

Answer 1

1. Gather - Get multiple years of historical financial statement
2. Calculate - Calculate financial ratios that provide a broad range of perspectives on the business. (e.g., liquidity ratios, profitability ratios, and solvency ratios)
3. Analyze - Interpret the calculated ratios and uncover trends and stories.
4. Benchmark - benchmark with an appropriate peer group or industry averages.

Question 2

What are the critical tips for effective analysis?

Answer 2

1. Gather a minimum of five years of historical financial performance to identify trends over time.
2. Make your calculations in excel transparent so that you can trace from financial statements to ratios
3. Need to identify an appropriate peer group of companies.
4. Keep adjustments of ratios to minimum
5. Averages are more academically sound, but in practice closing balances are typically used.

Question 3

What are the two categories of performance ratios?

Answer 3

1. Return and profitability ratios
2. Asset utilization ratios

Question 4

What are the two categories of financial leverage ratios?

Answer 4

1. Liquidity Ratios
2. Solvency ratios

Question 5

What are return ratios essential for?

Answer 5

Evaluating investment returns

Question 6

What are three types of return ratios?

Answer 6

1. Return on Assets - Net Income/Total Assets
2. Return on Equity - Net Income/Total SH Equity
3. Return on Invested Capital - Net Operating Profit after tax/Net Debt + Equity
   (NOPAT = EBIT X (1-tax rate)

Question 7

What does return on equity focus on?

Answer 7

Focuses on returns generated by investors

Question 8

What does Return on invested capital calculate?

Answer 8

Calculates a profit figure that excludes interest expenses, representing the returns to debtholders

Question 9

How is gross profit margin calculated?

Answer 9

Gross Profit/Revenue (higher the better)

Question 10

What are examples of expense ratios

Answer 10

1. Direct Operating Costs/Revenue
2. Indirect Operating Costs/Revenue
   (The lower the better)

Question 11

How is effective tax rate calculated and what does it illustrate?

Answer 11

Total Taxes/Earnings before tax - shows how well a company manages its taxes

Question 12

How do you calculate a companies tax burden and what does it illustrate?

Answer 12

Net Income/Earnings Before Tax - shows how much is leftover for shareholders after taxes

Question 13

How is the effective interest rate ratio calculated?

Answer 13

Total interest expense/Total interest Bearing Liabilities

Question 14

How is a companies interest burden calculated and what does it illustrate?

Answer 14

Earnings Before Tax/Earnings Before Interest and Tax - if you get a number like 65% means 35% of EBIT is eaten up by interest expense.