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
Forecast sales based on
Expected PEST factor changes
Expected industry effects
Knowledge of company
Where to start to forecast sales
Business segments
Geographical markets
How to forecast sales
Extrapolating observed trends esp. changes seen in last reported results - interims
Modify in the light of up to date info
Forecast operating profit based on
Expected margins in each sector/market
Historical trends valuable
Recognising different cost structures e.g. relationship between fixed/variable costs
Forecast other operating income/exceptional items
Interest based on -expected borrowing and interest rates Tax Effective tax rate (tax/profit b4 tax) as appropriate Earnings per share
Earnings per share
Profit after tax (less pref. Divs) / weighted average number of shares
