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AFM 212 > Week 2 Lecture 2 > Flashcards

Week 2 Lecture 2 Flashcards

Profit Analysis: 40 Slides

1
Q

What is the return on equity (ROE)?

A

It measures return from the perspective of the company’s stockholders specifically return to common stockholders

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2
Q

Who uses the ROE measure the most

A

Managers
Investors

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3
Q

How to compute ROE?

A

Net income / Average stockholders equity

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4
Q

What do we have to do to adjust our definition of ROE, specifically related to controlling stockholders?

A

ROE focuses on the return to the controlling or parent company’s stockholders, meaning only the financial elements related to the parent company should be used.

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5
Q

What do we have to do in order to adjust our ROE?

A

When calculating ROE (return on equity) for the controlling (parent company) you must exclude the share of income and equity belonging to those noncontrolling interests.

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6
Q

How to recalculate our ROE for the controlling (parent company) stockholders?

A

ROE =

Net income attributable to parent company shareholders / Average equity attributable to parent company shareholders

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7
Q

What is controlling interest?

A

Those who own common stock of the parent company.

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8
Q

What is non-controlling interest?

A

It those who own shares in one or more of the parent company’s subsidiaries

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9
Q

How can we adjust ROE when a company has a preferred stock?

A

What we know is that it measures return from the perspective of the company’s stockholders specifically return to common stockholders so we adjust the ROE to make sure it only accounts for common stockholders

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10
Q

How to adjust ROE and compute the ROE with a preferred stock?

A

ROCE =

Net income - preferred dividends / average stockholder’s equity - average preferred equity

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11
Q

What is a performance analysis?

A

It seeks to uncover the drivers of ROE and how those drivers have trended over time to better predict future performance.

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12
Q

How do we measure ROE drivers?

A

We can measure the ROE drivers using:

First:

The traditional dupont analysis and it breaks down ROE into three components : Profitability, productivity and leverage

Second: We can also measure ROE drivers with an operating focus that distinguishes between operating and non operating activities.

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13
Q

Where does the DuPont name come from (DuPont analysis)?

A
  1. The name comes from the Dupont corporation that started using this formula in the 1920s.
  2. Dupont explosives salesman Donaldson Brown invented this formula of separating ROE as an internal efficiency report in 1912.
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14
Q

What does the dupont analysis break ROE into what three components?

A

Return on assets
Financial Leverage

ROE = return on assets * financial leverage

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15
Q

What does ROE reflect both?

A
  • Company performance (as measured by ROA)
  • How assets are financed (financial leverage)
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16
Q

How do we make ROE higher?

A

When there is more debt and less equity for a given level of assets

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17
Q

What happens when we have greater debt?

A

Greater debt means higher risk for the company.

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18
Q

What is return on assets?

A

It measures return from the perspective of the entire company (at enterprise level)

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19
Q

How to compute ROA?

A

Net income/Average total assets

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20
Q

How to compute a high ROA?

A

The company must be profitable and manage assets (hold the lowest level of assets possible to achieve the highest profit)

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21
Q

What is financial leverage?

A

It measures the relative usage of debt versus equity to finance company’s assets.

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22
Q

Why is financial leverage important?

A

It is important because debt is a contractual obligation and a company’s failure to repay principal or interest can result in legal repercussions or even bankruptcy.

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23
Q

What does higher financial leverage mean?

A

It means higher debt and interest payments

Higher FL increases the probability of default and possible bankruptcy.

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24
Q

How to compute FL?

A

Average total assets/ Average stockholders equity

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25
Q

How can we further dissegregrate ROA?

A

Profit margins
Asset turnover

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26
Q

What is profit margin?

A

What a company earns on each sales dollar

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27
Q

How to compute PM?

A

Net income/Sales

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28
Q

What is asset turnover?

A

Sales generated from each dollar invested in assets.

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29
Q

How to compute asset turnover?

A

Sales/Average total assets

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30
Q

How can we increase ROA?

A

Increase profit margin :
- Increase profitability for a given level of assets

Increase AT:
- Reduce assets while still being to able to generate some profit level

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31
Q

What are two works that can describe how ROA are seprated (disegregated to)?

A

Profitability
Productivity

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32
Q

What are all the equations we might see that fall under profitability?

A

Gross profit margin
Operating expense margin
Profit margin

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33
Q

What are all the equations we might see that fall under productivity?

A

Accounts receivable turnover
Inventory turnover
A/P turnover
Cash conversion cycle
PPE turnover

34
Q

What are all the equations we might see that fall under financial leverage?

A

Total liabilities to equity
Times interest earned

35
Q

How to compute gross profit margin?

A

Gross profit / Sales

36
Q

What is the gross profit margin?

A

The profit remaining after subtracting the cost of goods sold (COGS).

37
Q

What is the gross profit margin influenced by?

A

Its influenced by both the selling price of a company’s products and the cost to make or buy those products.

38
Q

Is a low or high Gross PM better?

A

High or increasing is better

39
Q

What does a low GPM mean?

A

It signals more competition and or less demand for companies products.

40
Q

What are some causes that make the GPM low or decreasing?

A

Competitive intensity has increased

Product line has lost appeal

Product costs have increased

41
Q

What is the operating expense margin?

A

It measures the general operating costs relative to each sales dollar.

42
Q

What do we use this metric for?

A

Its used to compare company margins over time against peers making sure that peers have similar business models

43
Q

What is the turnover ratio?

A

It is a general formula used to compute different types of turnover ratios.

44
Q

How to compute the turnover ratio?

A

Income statement item/ Average balance sheet item

45
Q

What are the ratios that fall under working capital turnover ratios?

A

A/R turnover
Inventory turnover
A/P turnover

46
Q

How to compute A/R turnover?

A

Sales/Average A/R

47
Q

How to compute inventory turnover?

A

COGS/Average inventory

48
Q

How to compute A/P turnover?

A

Purchase or COGS / Average A/P

49
Q

What is PP&E Turnover?

A

It tells you how many dollars of sales you company receives for each dollar invested in PP&E

50
Q

How to compute PPE?

A

Sales/Average PP&E

51
Q

How can we improve PPE turnover?

A

Sell or get rid of assets or parts of the business that aren’t performing well.

Partner with other companies to share resources like distribution networks, technology, or factories.

Sell factories but make deals to buy the products back from the new owners.

52
Q

What does financial leverage tell us?

A

How debt impacts a company’s profitability and risk

53
Q

What are some benefits of the proper use of financial leverage?

A
  • It benefits stockholders
  • Its a relatively inexpensive source of capital
54
Q

What are some cons of financial leverage?

A

There is some added level of risk because debt repayment is mandatory.

55
Q

What does the analysis of financial leverage typically involve?

A
  • The level of borrowed money relative to equity capital
  • The level of profit or cash flow relative to required debt payments
56
Q

What are the two key ratios used for financial leverage?

A

Total liabilities to equity ratio

TIE ratio

57
Q

how to compute the total liabilities to equity ratio?

A

= Total liabilities / Total equity

58
Q

How to compute the times interest earned ratio?

A

Ebit / Gross interest expense

59
Q

What is the operating focus for the ROE analysis?

A
  • Its when we separate (disaggregate) ROE with an operating focus
  • It helps recognize that companies create their value mainly through core operations
60
Q

What does the balance sheet and income statement include?

A

It includes both operating and nonoperating items

61
Q

When we disaggregate (separate) operating focus what does ROE consist of?

A

ROE = Operating return + Non operating return

62
Q

What is operating return?

A
  • Its return from operating activities
  • Its return earned from operating both assets and liabilities
63
Q

What is nonoperating return?

A
  • Its return from financing and investing activities
  • Its return earned from non operating assets and liabilities

Examples
Investment income, interest income

64
Q

How do we measure operating return?

A

Return on net operating assets (RNOA)

65
Q

How to compute RNOA?

A

= Net operating profit after tax (NOPAT) / Average net operating assets (NOA)

Average NOA = NOA start of year + NOA end of year / 2

66
Q

How are liabilities treated differently in the Dupont analysis than the operating focus?

A

In the financial leverage in the Dupont analysis is the ratio of total assets to stockholders equity

  • In this it helps us measure the extent on a company relies on debt financing (using financial leverage)

Liabilities used in this computation includes all liabilities

Liabilities = Borrowed money + operating liabilities

67
Q

What are examples of borrowed money?

A
  • Loans
  • Bonds
  • Mortgages
  • Interest bearing
  • Severe legal repercussions
68
Q

What are examples of operating liabilities?

A

Accounts payable
Accurals
Interest-free
Self-liquidating

69
Q

Does the ROE operating focus treat liabilities differently?

A

Yes : It treats borrowed money as a non-operating item

70
Q

How to compute Net operating assets (NOA)?

A

Net operating assets = Operating assets - Operating liabilities

71
Q

What is some examples operating assets (NOA)?

A
  • Accounts receivable
  • Inventories
  • Prepaid expenses/supplies
  • PP&E and right-of-use assets
  • Intangible assets and Goodwill
  • Deferred tax assets
71
Q

What is the operating liabilities (NOA)?

A
  • Accounts payable
  • Accrued expenses
  • Unearned (deferred) revenue
  • Income tax payable
  • Deferred tax liabilities
72
Q

How to compute the net operating profit after tax (NOPAT)

A

NOPAT = Net operating profit before tax - Tax on operating profit

73
Q

How to compute net operating profit before tax?

A

Sales - operating expenses = EBIT

74
Q

What are the operating expenses?

A

COGS
SG&A
Research and development
Impairments of operating assets such as good will
Other operating expenses or income

75
Q

How to compute the tax on operating profit?

A

Tax expense + (Pretax net non operating expense * statutory tax rate)

76
Q

What is the (Pretax net non operating expense * statutory tax rate) ?

A

Its a tax shield

77
Q

What is a tax shield?

A
  • Its the taxes a company saves by having tax deductible non-operating expenses (mostly interest)
  • The taxes saved by the tax shield does not relate to operating profits.
78
Q

Why do we add back the tax shield?

A

To help compute the tax on operating profit.

79
Q

What are non-operating items on the income statement?

A

Interest expenses on debt and lease obligations

Interest and dividend income on marketable securities

Loss or income relating to discontinued operations

Debt issuance and retirement costs

Gains or losses on the sale of non strategic investments

Other income or expense if reported separately from operating income

Pension income or losses

80
Q

How to compute the net nonoperating expense before tax?

A

Non Operating expenses - non operating income

AFM 212 (6 decks)

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