Reading 19 Integration of Financial Analysis Flashcards
Earning Sources and Performance
Use Extended Du Pont Equation
ROE = Tax Burden x interest Burden x EBIT Margin x Asset Trunover x Financial Leverage
ROE = NI/EBT x EBT/ EBIT x EBIT/Revenue x Rev/Av Assets x Av Assets/ Av Equity
- Tax Burden and Interest Burden are Misnomer because the higher the ratio the lower the burden.
- Objective is to ascertain whether the firms earnings are generated internally (i.e from operations) of from acquisition or investments from associates.
ADJUSTMENT: Remove Equity Method and the investment Income from the extended Du Pont Equation.
Capital Allocation Decisions
• Consolidation can hide the individual characteristics of dissimilar subsidiaries • Firms must dis-aggregate financial information into segments to assist users • Segmental disclosures are valuable in identifying ○ Revenue and Profit by Segment ○ The relationship between capital expenditure and returns Segments that should be de-emphasized
Segmental Analysis
• Reportable business or geographic segment • 50% of its revenue from sales external to the firm and atleast 10% of a firms revenue, earning or assets ○ For each segment, firm reports limited financial statement information For primary segments, must report revenues (internal and external), operating revenue, assets, liabilities (IFRS only), capex, depreciation and amortization
Divisional Analysis
• Compute the following ○ % of revenue from each division ○ % of assets used by each division ○ % of operating profit (%EBIT) contributed by each division ○ % of Capex attributed to each division ○ Divisional Margins (Segment EBIT / Segment Sales) ○ Resource Allocation (% Capex / % Assets) § If > 1 then “Firm is growing the segment by allocating more resources to the segment” If it remains less than 1 continusiously then the segment will become insignificant.
Earnings Quality
• High Quality Earnings = Persistent and Sustainable Earnings • Earnings can be dis-aggregated into Cash Flows and Accruals using a ○ Balance Sheet Approach ○ Cash Flow Statement Approach • Measure earning quality using the ratio of accruals to average net operating assets ○ Interpretation: Lower Ratio = Higher Quality • Aggregate Accruals = Accrual Based Earnings - Cash Earnings Inverse relationship between accruals and earning quality
Balance Sheet Based Accruals
○ Net Operating Assets (NOA) = (Total Assets - Cash and Equivalents) - (Total Liab - Total Debt) ○ Aggregate Accruals ruals = NOAt - NOA(t-1) Accrual Ratio = (Aggregate Accruals) / ((NOAt + NOT(t-1))/2
Cash Flow Based Accruals
○ Aggregate Accruals = Net Income - (CFOt + CFIt) Accrual Ratio = Aggregate Accruals / ((NOAt+Not(t-1))/2)
Cash Flow Analysis
• Purpose is to determine whether earnings are confirmed with cash flow. • Cash Generated from Operations (CGO) = OCF + Cash Interest + Cash Taxes • Compare CGO to operating Income CGO is cash equivalent to EBIT. Hence it is equal to operating cash flow + Cash Interest + Cash Taxes (IF INCLUDED- under USGAAP it is always included . However under IFRS it may or may not be included as it can be part of CFI as well)
Cash Basis Ratios
○ Operating Earning Quality: CGO/EBIT ○ Cash Flow Return on Assets: CGO / Average Total Assets ○ Cash Flow to Reinvestment: CGO/ CAPEX (including intangibles) ○ Cash Flow Interest Coverage: CGO/Cash Interest Cash Flow to Total Debt: CGO/ Total Debt
Decomposition of Market Value
• Purpose is to determine the implied value of the parent excluding the value of its associates. • Implied Value of Parent = Mkt Cap of Parent - Parents share of associate Mkt Cap. • It may be necessary to convert Associates Mkt cap the parents reporting currency at the Current exchange rate • Next determine the implied P/E of the parent by eliminating the associate’s income from the parent = (Implied Value of parent excluding associates)/(Net Income - Parent’s share of associates earning.) It may be necessary to convert Associates Earnings to the parents reporting currency using the average exchange rate.
Off-Balance Sheet Financing
• This is only for the purpose of an Lessee (one who is leasing the asset for use) • For Analytical purposes treat an operating lease as a finance (Capital) Lease. § Increase assets and liabilities by the present value of the remaining lease payments § Remove rent expenses (payments) from the income statement and § Replace with depreciation expenses and Interest Expense RESULT: Higher leverage and lower Interest coverage.
Other Off-Balance Sheet Financing Options
Other OBS techniques: receivable sale with recourse, debt gtee, and take or pay agreement.
Problem 4
Problem 3
Problem 2
Problem 1
