Tutorial 3 Flashcards
Why does the return on assets differ between Company A and Company B?
ROA= Net income/total assets
Companies that hold less than 20% of another company (or subsidiary) only record income when dividends are paid (BUSN company accounting).
Therefore, profits will be under reported. This causes return on assets to be distorted downwards.
Since Company B has $50 million in equity investments, but no corresponding income, its ROA is lower than Company A.
ROA is readily used to
compare firms in the same industry and can show the efficiency of a firm in using its assets to generate earnings.
An analyst or investor would prefer this number to be higher because that would indicate that the
company is earning more with less.
Return on Equity (ROE) is calculated as
net income divided by shareholder’s equity.
Used in comparing firms with the same capital structure, ROE reveals the level of profitability which a firm realizes by the money which was given to them by equity investors.
Return on Invested Capital (ROIC) tells an analyst
net operating profits after taxes (NOPAT) divided by invested capital.
• ROIC tells an analyst how efficient the firm was in investing capital in profitable investments. This invested capital can go into anywhere from buildings to other companies. The upside to this ratio is that it can be used to compare firms with different capital structures.
NOPLAT =
profits generated from the company’s core operations after subtracting the income taxes related to the core operations.
When we calculate NOPLAT, interest is not subtracted from operating profit, because interest is considered a payment to the company’s financial investors, not an operating expense.
Net investment is
the increase in invested capital from one year to the next:
• Net Investment = Invested Capitalt+1 − Invested Capital
Free cash flow (FCF)
cash flow generated by the core operations of the business after deducting investments in new capital
FCF = NOPLAT + Noncash Operating Expenses − Investment in Invested Capital
invested capital can be calculated using the operating method
financing method
operating assets minus operating liabilities
debt plus equity
From an investing perspective, total funds invested equals
invested capital plus nonoperating assets eg such as marketable securities, prepaid pension assets, nonconsolidated subsidiaries, and other long-term investments.
From the financing perspective, total funds invested equals
debt and its equivalents, plus equity and its equivalents.
Why does the return on equity differ between Company A and Company C?
ROE= Net incoem/ equity
Company C’s return on equity outpaces both Company A and Company B because the company uses leverage.
OA− OL= Invested Capital = Debt + Equity
Leverage will magnify operating results. Leverage makes good results look great, but can bankrupt companies with poor performance.
invested capital
= working capital + PPE
Operating current asset
Operating current liabilities
Invested capital = working capital + PPE
Operating working capital = operating current assets - operating current liabilities.
Operating current assets comprise all current assets necessary for the operation of the business, including working cash balances, trade accounts receivable, inventory, and prepaid expenses.
Operating current liabilities include those liabilities that are related to the ongoing operations of the firm. The most common operating liabilities are those related to suppliers (accounts payable), employees (accrued salaries), customers (deferred revenue), and the government (income taxes payable).
Does including excess cash as part of invested capital distort the ROIC upward or downward? Why?
is unnecessary for core operations. Rather than mix excess cash with core operations, analyze and value excess cash separately. Given its liquidity and low risk, excess cash will earn very small returns. Failing to separate excess cash from core operations will incorrectly depress the company’s apparent ROIC
Invested capital represents
In addition to invested capital,
Invested capital represents the capital necessary to operate a company’s core business.
In addition to invested capital, companies can also own nonoperating assets. Nonoperating assets include excess cash and marketable securities, certain financing receivables (e.g., credit card receivables), nonconsolidated subsidiaries, and excess pension assets. Summing invested capital and nonop- erating assets leads to total funds invested.
why should we focus on ROIC and value drivers
