Unit 3 Video Notes Flashcards
benchmarking
means comparing the company’s ratios to something that is meaningful
trend analysis
means looking at how the ratios have changed over time
Profitability Ratios:
Operating Margin Gross Profit Margin Net Profit Margin Return on Total Assets (ROA) Return on Equity (ROE)
Operating Margin
how much of a company’s sales on a % basis are generating operating profit
Gross Profit Margin
how much of the company’s sales on a % basis are generating gross profit (Sales – COGS)
Net Profit Margin
how much of a company’s sales on a % basis are generating Net Income
Return on Total Assets (ROA)
how effective is the company in using its assets to generate profits
Return on Equity (ROE)
how effective is the company in using its equity to generate profits
Liquidity Ratios
Current Ratio: can the company pay its short-term debts (liabilities) using short-term assets?
Quick Ratio: can the company pay its short-term debts (liabilities) using short-term assets excluding inventory?
Debt Ratio
can the company pay its long-term debts (liabilities) using its total assets?
Market Ratios:
Price/Earnings Ratio (P/E): used to determine the relative value of a company – higher P/E means the investor is paying more per dollar of net income so it should have a higher price than a similar firm with a lower P/E. Often quoted as TTM (trailing 12 months)
Price-To-Book Ratio – how much value is management creating from its assets – higher is better
The 4 financial statements
Income Statement
Balance Sheet
Cash Flow Statement
Statement of Owner’s Equity
What is the Income Statement?
The Income Statement contains all of the revenue, expenses, interest and taxes that the company pays and reflects the result of that as Net Income (aka the BOTTOM LINE). This reflects MOST of the firm’s operations.
INCOME STATEMENT
Important to know the following:
Important to know the following:
Revenue (sales of the company’s products or services)
Cost of Goods Sold (aka COGS)
= Gross Profit (aka Gross Margin)
Operating Expense (aka S,G&A expenses) (Salaries, Rent, Office Expenses, etc.)
Depreciation/Amortization Expense (non-cash expenses since we don’t write a check for this)
= Earnings Before Interest and Taxes (EBIT) (aka Operating Profit and Operating Income)
Interest Expense (from Notes Payables and Long-Term Debt)
= Earnings Before Taxes (EBT)
- Taxes
= Net Income
GAAP
GAAP stands for Generally Accepted Accounting Principles and are the guidelines that govern how accountants record transactions.
Matching Principle
expenses are recognized when they occur and are “matched” against recognized revs
Fair Market Value
estimate of the value of an asset based on knowledgeable information on what a buyer might reasonably pay for it
Revenue Recognition
occurs when revenue is considered realizable and earned (not when cash is paid)
Non-Cash Expenses
A non-cash expense is an expense where you are not writing a check to pay for the expense. The 3 most common non-cash expenses are:
Depreciation – records the accounting use of any of the fixed assets (machinery, equipment, etc.) that the company purchased
Amortization – records the accounting use of any intangible asset (goodwill, IP, etc.) that we have on the balance sheet
Obsolescence – when an asset (inventory or fixed asset) is not productive due to spoilage, breakage, etc.
What is the balance sheet and why is it so important?
The balance sheet lists all of the company’s assets (stuff it owns or uses to generate sales and profits) and all of the ways it uses to pay for those assets (liabilities (debt) and Owner’s Equity (stock + the company’s accumulated net profits))
The key to the balance sheet is that it ALWAYS balances (hence, the name)!
Since the balance sheet always has to balance, we have a basic relationship that we use to reflect that balance:
Super Important Equation #1:
Total Assets = Total Liabilities + Owner’s Equity
Important Parts of the Balance Sheet:
Assets:
Current Assets - can be converted to cash in less than one year
Cash
Accounts Receivable - sales that we billed to customers for purchases made on credit
Inventory - stuff we use to make products
Fixed Assets - equipment we’ve purchased that we use to make what we sell
Gross Fixed Assets (aka Fixed Assets/PP&E)
Less Accumulated Depreciation
Net Fixed Assets
Liabilities:
Current Liabilities - debts we owe other people in less than one year
Accounts Payable - debts we owe for operations (rent, utilities, office stuff)
Accruals
Notes Payable - short-term debt
Long Term Debt - debt we owe that we pay for more than 1 year
Owner’s Equity:
Common Stock - ownership
Retained Earnings
Owner’s Equity:
Working Capital
Working capital is a measure of how liquid are a business’ current assets and current liabilities. In other words, if a firm had to sell its current assets to pay its current liabilities, would it be able to cover those liabilities (aka debts)?
Net working capital is Current Assets – Current Liabilities
What about the Cash Flow Statement?
The Cash Flow Statement has only ONE use in life: to explain the change in Cash from one period to the next.
There are 3 sections on the Cash Flow Statement:
Cash Flow From Operations (CFO)
Cash Flow From Investing (CFI)
Cash Flow From Financing (CFF)
Cash Flow From Operations (CFO)
Cash Flow From Operations (CFO) represents the actual cash that is generated from the operations of the company. The Income Statement is where much of the operations of the company is listed, but there are balance sheet accounts that are also part of operations. These include accounts receivables, inventory, accounts payables and accruals.
Cash Flow From Investing (CFI)
Cash Flow From Investing (CFI) represents the equipment, machinery, etc. that the company has purchased in the current period. It also includes any investments of cash in things like bonds, stock, etc. that the company has made in the current period.
Cash Flow From Financing (CFF)
Cash Flow From Financing (CFF) represents the amount of short-term debt (Notes Payables), long-term debt, preferred stock and common stock a company has either sold to the public, borrowed from a bank, or repaid over the current period. It also subtracts any dividends that have been paid to equity holders.
Statement of Owner’s Equity
The Statement of Owner’s Equity also has only ONE use in life: to explain the change in the Owner’s Equity section of the Balance Sheet.
Items you normally see on this statement include:
Net Income (from the Income Statement)
Dividends paid
Stock Issuance or Redemption
Other items affecting the firm’s Equity
What are the five main ratio categories for this course?
Profitability Ratios – measure the company’s use of assets and expenses to generate a return that’s acceptable to its shareholders
Liquidity Ratios – measure how much cash is available for the company to pay its debt
Debt Ratios – measure the firm’s ability to pay its long-term debt
Market Ratios – measure the return and the value of the company’s stock and the cost of issuing that stock
Efficiency Ratios – measure how effective is the company in using its assets to generate sales/income
Profitability Ratios:
Operating Margin: how much of a company’s sales on a % basis are generating operating profit
Gross Profit Margin: how much of the company’s sales on a % basis are generating gross profit (Sales – COGS)
Net Profit Margin: how much of a company’s sales on a % basis are generating Net Income
Return on Total Assets (ROA): how effective is the company in using its assets to generate profits
Return on Equity(ROE): how effective is the company in using its equity to generate profits
Liquidity Ratios:
Current Ratio: can the company pay its short-term debts (liabilities) using short-term assets?
Quick Ratio: can the company pay its short-term debts (liabilities) using short-term assets excluding inventory?
Debt Ratios
Debt Ratio: can the company pay its long-term debts (liabilities) using its total assets?
Market Ratios:
Price/Earnings Ratio (P/E): used to determine the relative value of a company – higher P/E means the investor is paying more per dollar of net income so it should have a higher price than a similar firm with a lower P/E. Often quoted as TTM (trailing 12 months)
Price-To-Book Ratio – how much value is management creating from its assets – higher is better
DUPONT EQUATION
The DuPont equation was developed to help managers make effective decisions to increase Return on Equity. The key to using the DuPont equation on the OA is to learn the NAMES of the 3 components that make up the equation.
DuPont Equation:
Return on Equity = Net Income Margin x Total Asset Turnover x Leverage Multiplier
Return on Equity = Net Income/Sales x Sales/Total Assets x Total Assets/Total Equity
Practice Problem #1: NSG Corp. has Sales of $35 million, Net Income of $2.5 million, Total Assets of $44 million and Leverage Multiplier of .95. What is their Return on Equity?
x
Practice Problem #1: NSG Corp. has Sales of $35 million, Net Income of $2.5 million, Total Assets of $44 million and Leverage Multiplier of .95. What is their Return on Equity?
x
Practice Problem #2: NSG Corp. has a Return on Equity of 15.2%, Net Income Margin of 7.2% and Total Asset Turnover of 1.5. What is the Leverage Multiplier?
x
Practice Problem #2: NSG Corp. has a Return on Equity of 15.2%, Net Income Margin of 7.2% and Total Asset Turnover of 1.5. What is the Leverage Multiplier?
x
Dividend
Dividends are defined as payments made by the company to its shareholders to give them a portion of the firm’s Net Income. Dividends are normally paid on a per share basis (a set amount for each share of stock that a shareholder owns).
Remember that there are only 2 things a firm can do with their Net Income: 1. Pay them to shareholders as dividends; and 2. Retain them in the company (Retained Earnings)
The Dividend Payout Ratio is defined as the % of Net Income that the company pays to its shareholders as a dividend.
Dividend Payout Ratio (b) = Dividends / Net Income
The Retention Ratio, defined as the % of Net Income that a firm retains in the company is calculated as:
Retention Ratio (RR) = 1 – b (Payout Ratio)
The Dividend Payout Ratio is defined as the % of Net Income that the company pays to its shareholders as a dividend.
Dividend Payout Ratio (b) = Dividends / Net Income
The Retention Ratio, defined as the % of Net Income that a firm retains in the company is calculated as:
Retention Ratio (RR) = 1 – b (Payout Ratio)
Return on Assets measures how effective the company has been in using its assets to generate Net Income.
Return on Equity measures how effective the company has been in using its equity to generate Net Income.
ROE is what the company’s sustainable growth rate (SGR) is based on.
Percentage of Sales
The Percentage of Sales method of forecasting is used by many companies to develop forecasted Income Statements and Balance Sheets (called Pro-Forma Financials) by using the % of growth forecasted in Sales and apply that growth rate to any forecast any account that changes as sales changes (called a spontaneous account).
Using this forecasting methodology, a firm can determine how much additional funding will be necessary to support the forecasted change in Sales.
PERCENTAGE OF SALES FORECASTING
How to Calculate the Growth in Sales
The Sales Growth Rate is what is used to forecast the Income Statement and Balance Sheet using the Percent of Sales method of forecasting. ALL of the spontaneous accounts are changed by the Sales Growth Rate. The change in Spontaneous accounts also drives the forecast of the discretionary accounts.
What is the formula for calculating the Sales Growth Rate?
Sales Growth Rate = Forecasted Sales/Last Year’s Sales – 1
How to Calculate the Growth in Sales
Sales Growth Rate = Forecasted Sales / Last Year’s Sales – 1
Example: 2017 Sales were $50 million and we are forecasting 2018 Sales to be $60 million. What is the Sales Growth Rate?
Solution: Forecasted Sales = $60 million; 2017 Sales = $50 million.
Sales Growth Rate = 60 / 50 – 1 = 0.20 = 20%
Problem: NSG is projecting sales to be $125 million next year. This year’s sales is $85 million. What is the sales growth rate?
Sales Growth Rate = Forecasted Sales / Last Year’s Sales – 1
So, Sales Growth Rate = 125 million / 85 million – 1
Sales Growth Rate = 1.4706 – 1
Sales Growth Rate = .4706 = 47.06%
What are Spontaneous Accounts?
A spontaneous account is any Income Statement or Balance Sheet account that changes as SALES changes.
Which accounts are SPONTANEOUS accounts???
Income Statement accounts - Revenues, COGS, all Operating Expenses, Depreciation, Taxes
Balance Sheet accounts - Accounts Receivables (billings will increase as sales increases), Inventory (we sell more stuff means we have to buy more inventory to make more stuff), Accounts Payables (we buy more stuff means we have more invoices to pay for that stuff), Accruals (we sell more stuff means we have to hire more people to make and sell the stuff).
Sustainable Growth Rate (SGR)
We define the Sustainable Growth Rate (SGR) as the company’s maximum growth rate where they don’t have to use additional debt or equity to finance future growth.
We calculate the SGR using Return on Equity (ROE) (either using the basic equation of Net Income / Total Equity or using the DuPont Equation of Net Income Margin x Asset Turnover x Leverage Multiplier)
SUSTAINABLE GROWTH RATE
The SGR formula is:
SGR = ROE x (1 – b)
Where ROE is the Return on Equity and b is the Payout Ratio (defined as Dividends / Net Income)
However, we will rewrite the SGR formula to make it a bit more understandable:
SGR = Net Income/Sales x Sales/Assets x Assets/Equity x (1 – Dividends/Net Income)
This is another way of saying:
SGR = Net Income Margin x Asset Turnover x Leverage Multiplier x (1 – b)
Problem: NGS Corp. has Net Income of $2.66 million, pays dividends of $1.0 million, has Sales of $66.0 million, Total Assets of $165.9 million and Total Equity of $95 million. What is its SGR?
Step 1:
Calculate ROE = Net Income / Total Equity
ROE = $2.66 million / $95 million = 2.80%
Step 2:
Calculate b = Dividends / Net Income
b = $1.0 million / $2.66 million = 37.59%
Step 3:
Plug and chug to get the SGR
SGR = ROE x (1 – b) SGR = 2.80% x (1 – 37.59%) SGR = 1.75%
Problem: A firm has net income of $75.0 million and pays out $12.4 million in dividends. If the firm has total assets of $ $832 million and total liabilities of $488 million, what is the firm’s sustainable growth rate?
Step 1: Calculate ROE
We are given Net Income but not Equity. However, given Total Assets and Total Liabilities we can calculate ROE using our formula: Net Income/Equity
Step 1: Calculate ROE
Let’s first calculate Total Equity:
Total Assets = Total Liabilities + Equity
Total Assets – Total Liabilities = Equity
$832 million - $488 million = Equity
$344 million = Equity
Step 2: Calculate ROE
Now, we can calculate ROE:
ROE = Net Income / Equity ROE = $75 million / $344 million ROE = 21.8%
Step 3: Calculate Payout Ratio (b)
We know that b = Dividends / Net Income
b = $12.4 million / $75.0 million b = 16.53%
Step 4: Calculate SGR
SGR = ROE x (1 – b)
SGR = 21.8% x (1 – 16.53%) SGR = 18.2%
DISCRETIONARY FINANCING NEEDED (DFN)
DFN tells us an estimate of how much additional financing (debt and/or equity) the company needs for next year based on the forecast of the balance sheet and income statement. This is an estimate and is based solely on what we believe our forecast is for next year.
To calculate DFN, we can use the following formula:
DFN = Assets – Liabilities – Equity
Problem: Our forecasted Current Assets are $120 million, Current Liabilities are $80 million, Fixed Assets are $450 million, Long-Term Debt is $200 million and Equity is $140 million. What is our DFN?
DFN = Assets – Liabilities – Equity
Assets = Current Assets + Fixed Assets = $120 + $450 = $570
Liabilities = Current Liabilities + Long-Term Debt = $80 + $200 = $280 DFN = $570 - $280 - $140 = $150 million
If the company believes that the DFN is too high, they will have to take appropriate action(s) to reduce their DFN. There are several strategies they can use:
Reduce Sales Growth – if the company increases prices, it gets 2 benefits: a) increased net income margin; and b) decreased need for assets and a lower DFN. What is an obvious negative to doing this?
Review Capacity Constraints – does this company really need to buy additional fixed assets to increase capacity? Are there other ways to increase capacity without buying new machinery or equipment?
Lower Dividend Payout – if the firm retains more of its Net Income, it will have more cash to purchase new assets
Increase Net Income Margin – higher Net Margin means more cash that the firm can use to purchase assets rather than additional financing.
