Session 2 Flashcards
Why ratio analysis
Compare ratios for a firm
- Time series analysis
- cross-sectional analysis - over years/firms
- to some absolute benchmark - ROE vs cost of capital
Use historical data to forecast
Growth and profitability
Financials market policies
Financing decisions - > managing liabilities and equity
Dividend policy -> managing dividend payout
Growth and profitability
Product market strategies
Operating management -> managing rev and expenses
Investment management-> managing working capital&fixed assets
Ratio analysis
Profitability
- ROE - need to look at average
- Return on capital employed
- gross/operating/net profit margin
Ratio analysis
Investment management
Fixed assets/sales
Debtor days/creditor days/inventory days - want to be lower
Ratio analysis
Financial management
Current ratio/quick ratio
- high=pay off liabilities
- low=don’t want money tied up in trade receivables
Debt to equity / debt to capital employed
Cover ratios: tax, interest
Decomposition of ROE
Return on equity = return on assets x measure of financial leverage =net income/assets x assets/equity Return on assets =net income/sales x sales/assets
Assets
=liabilities + equity
What happens if a company has too much debt?
May have borrowed too much and can’t pay back-interest adds up/economy changes
Restrictions on operations = loans
Does the company have enough debt?
Cheaper finances - if you do pay interest then it an allowable expense against corporation tax under current UK legislation
What does company use debt for?
Investing in fixed assets - using long term loans to pay for long time assets
Paying dividends - paying to shareholders - good for pensions funds
Sustainable growth rate
Rate at which firm can grow while keeping its probability and financial policies unchanged ROE x retained profit ROE x (1-dividend payout ratio) Dividend payout ratio = cash dividends/net income
Mean reverting
Firms with above average sales growth ten to revert over time (3-10yrs) to normal level
Implications:
Assess whether firms currently has above average sales growth
Apply mean reversion logic to adjust forecast down (up)
Seasonality forecasts
Weather-related
Holiday periods
New product intros e.g. cars
Forecasting earnings - 3 possible approaches
- Superior forecasting skill to earn excess returns
- PE model to identify incorrectly valued shares
- Forecasts within dividend discount type models to assess ‘intrinsic’ value
