Session 2

Question 1

Why ratio analysis

Answer 1

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

Question 2

Growth and profitability

Financials market policies

Answer 2

Financing decisions - > managing liabilities and equity

Dividend policy -> managing dividend payout

Question 3

Growth and profitability

Product market strategies

Answer 3

Operating management -> managing rev and expenses

Investment management-> managing working capital&fixed assets

Question 4

Ratio analysis

Profitability

Answer 4

• ROE - need to look at average
• Return on capital employed
• gross/operating/net profit margin

Question 5

Ratio analysis

Investment management

Answer 5

Fixed assets/sales

Debtor days/creditor days/inventory days - want to be lower

Question 6

Ratio analysis

Financial management

Answer 6

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

Question 7

Decomposition of ROE

Answer 7

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

Question 8

Assets

Answer 8

=liabilities + equity

Question 9

What happens if a company has too much debt?

Answer 9

May have borrowed too much and can’t pay back-interest adds up/economy changes
Restrictions on operations = loans

Question 10

Does the company have enough debt?

Answer 10

Cheaper finances - if you do pay interest then it an allowable expense against corporation tax under current UK legislation

Question 11

What does company use debt for?

Answer 11

Investing in fixed assets - using long term loans to pay for long time assets
Paying dividends - paying to shareholders - good for pensions funds

Question 12

Sustainable growth rate

Answer 12

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

Question 13

Mean reverting

Answer 13

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)

Question 14

Seasonality forecasts

Answer 14

Weather-related
Holiday periods
New product intros e.g. cars

Question 15

Forecasting earnings - 3 possible approaches

Answer 15

• Superior forecasting skill to earn excess returns
• PE model to identify incorrectly valued shares
• Forecasts within dividend discount type models to assess ‘intrinsic’ value

Question 16

Forecast sales based on

Answer 16

Expected PEST factor changes
Expected industry effects
Knowledge of company

Question 17

Where to start to forecast sales

Answer 17

Business segments

Geographical markets

Question 18

How to forecast sales

Answer 18

Extrapolating observed trends esp. changes seen in last reported results - interims
Modify in the light of up to date info

Question 19

Forecast operating profit based on

Answer 19

Expected margins in each sector/market
Historical trends valuable
Recognising different cost structures e.g. relationship between fixed/variable costs

Question 20

Forecast other operating income/exceptional items

Answer 20

Interest based on 
-expected borrowing and interest rates 
Tax 
Effective tax rate (tax/profit b4 tax) as appropriate 
Earnings per share

Question 21

Earnings per share

Answer 21

Profit after tax (less pref. Divs) / weighted average number of shares