week 2 (mod 2 & 3) - profit & return analysis Flashcards
- what is business analysis?
- business model
- competitive advantage
- business cycle
what is regulation s-k?
- us regulation on providing a description of a business
- requires a description of the general development of the business of the registrant during the past 5 years or such shorter period as the registrant may have been engaged in business
- requires a narrative description of the business done and intended to be done by the registrant and its subsidiaries, focusing on the registrant’s dominant segment or each reportable segment about which financial info is presented in its fs
simpler terms:
- articulate how the company makes money
- identify the type of economic frictions the comp addresses in the econ system
where does a majority of mcdonald’s profit come from?
real estate
where does a majority of airlines’ business come from?
loyalty programs
where does a majority of costco’s profit come from?
membership fees
what is swot analysis
- internal factors
- strengths
- weaknesses- external factors
- opportunities
- threats
- external factors
what questions need to be asked about a company’s competitive advantage?
- does the comp actually have a competitive advantage and if so what factors explain it?
- is the competitive advantage sustainable?
- if the comp has no ca, does its mgmt have a plan to develop a sustainable ca that can be implemented in an acceptable period of time and with a reasonable amnt of investment
what factors are there when it comes to achieving comeptitive advantage?
- barriers to entry
- patents, copyrights, and other legal protections
- regulatory and licensing barriers
- product/service differentiation
- technological innvation and product design
- marketing, distribution, and after-sale customer support
- market segmentation
- cost leader
- access to low cost raw materials/labour
- manufacturing or service efficiency
- manufacturing scale efficiencies
- greater bargaining power with suppliers
- sophisticated it systems
what is the business model
business description:
- industry
- life cycle stage
competition:
-major competition
market share
competitive advantage
product and/or service:
product profile
sales driver
life cycle
customers:
major customers
customer concentration
marketing strategy distribution process
supplier:
key suppliers
credit terms
bargaining power
alternative source of supplier
ownership:
owners
owner structures
owners involvement
governance and mgmt:
board of directors
mgmt and directors’ background/experience
compensation
successor plan
what is financial statement analysis?
- accounting adjustment
- ratio analysis
- common size
what is time series comparison
- horizontal analysis
- comparing ratios with the levels in prior periods
- normal vs abnormal: identifying changes in performance and detecting the underlying cause
- triangulate (use a variety of data sources, including time space and persons) the ratios with structural changes
- basically: comparing a specific line across different periods of the comp or with another comp’s line overall
what is cross sectional comparison?
- comparing a firm’s ratios with competitors
- also called comparative analysis (comps for short)
- triangulate the ratios with corporate strategy
what is ratio analysis
purpose is to forecast future
what does it mean when ratios tend to mean revert?
- if they are unusually high → tend to fall
- if they are unusually low → tend to rise
- caveat: this a general empirical pattern for many ratios in a large sample of firms
- the speed and completeness depend on the ratio and specific firm
what is common size analysis?
- common size (vertical statements)
- all f/s accounts expressed as a % of one amnt
- what should be used as the common denominators for common size income statement and balance statement, respectively?
- revenue, assets
what are advantages of common size (vertical statements)
- allows meaningful comparisons:
- over time while “controlling” for changes in firm size (measured as either sales/total assets)
- for firms using different currencies
- between firms
what is a caution you should take when completing common size analysis?
- changes in expenses may not be directly related to chanegs in sales
- dig deeper to understand reasons underlying changes
what are % change (horizontal) statements?
- amnts are expressed a % of a base year (fixed or rolling)
- focus is on growth in each item over time
what is a caution you should take when completing horizontal statements?
- small (immaterial) accounts (esp on b/s) often can be associated with huge percentage changes
- does not mean that they are important
when calculating ratios what are the 3 types of combinations of accounts that can be used?
- both b/s and i/s accounts (ex. roa (r = ni))
- with only b/s accounts (ex. debt to equity ratio)
- with only i/s accounts (ex. profit margin)
if the purpose is to evaluate the performance in a period of time (ex. year/quarter), how do you use i/s and b/s accounts?
- using i/s accounts WITHIN that period
- using time-weighted b/s - averaging beginning and ending balance
why do we use ending balance?
- with long time-series, it does not matter much if used consistently
- one more year of data
- easier to calculate
- more timely
what are the caveats of ratio analysis?
- no “correct” way to compute many ratios
- how to calculate roe (leverage)
- ratios do not provide answers - just tell you where to look for answers
- rule of thumbs do not always work
- managers know that investors use ratios
- “window-dressing”
what is forecasting and valuation/credit analysis?
- financial modelling
- dcf/multiple
what does forecasting financial numbers mean:
involves formalizing predictions and stating them as financial projections
what 2 factors determine forecast quality?
- quality of our prior analysis
- how well we understand the company’s business
- how thoroughly we examined and adjusted comp’s fs
- realistic and achievable assumptions
- objectively examine what evidence supports, or challenges the forecast assumptions
what is roe that measures return to the common stockholders?
roce = (net income - preferred div) / (av stockholder’s eq - av preferred equity)
- preferred stock necessitates these adjustments
what is return on equity?
- most common analysis metric used by managers and investors alike
- relates net income to average total stockholder’s equity
- measures return form the perspective of the comp’s stockholders
- roe = net income/av stockholder’s equity
- what is the order of forecasting for fs?
why this order?
- what is the order of forecasting for fs?
- income statement
- balance sheet
- statement of cash flows
- why is the forecasting order in this order?
- because each statement uses info from the preceding statement(s)
what is the roe that measures return to the controlling (parent comp) stockholders?
roe = net inc attributable to comp shareholders/ave equity attributable to comp shareholders
what are noncontrolling interests?
- part of subsidiary that is not owned by parent company
- you need to use the correct line items when calculating roe
what does performance analysis seek in relation to roe?
- uncovering drivers of roe and how those drivers have trended over time to better predict future performance
- what are the 2 methods to measure roe drivers?
- trad dupont analysis that disaggregates roe into components of profitability, productivity and leverage
- roe analysis with an operating focus that distinguishes between operating and non operating activities
what is dupont analysis?
- dupont corp started using this in 1920s
- donaldson brown invented the formula of roe disaggregation in an internal efficiency report in 1912
what is dupont’s disaggregation of roe?
roe = (net income/av sh eq) = (roa - net inc/av tot assets) * (FL - av tot assets/av sh e)
- roe reflects comp performance (roa), and how assets are financed (FL)
- roe is higher when there is more debt and less quity for a given level of assets
- tradeoff → greater debt = higher risk
what is return on assets?
roa = net income / av total assets
- measures return from the perspective of the entire company (enterprise level)
- includes both profitability (numerator) and total comp assets (denom)
- encourages managers to focus on btoh the income statement and balance sheet
how do you earn a high roa?
comp must be profitable AND manage assets (hold lowest level assets possible to achieve desired profit)
what is financial leverage?
FL = average total assets / av stocholders’ equity
- measures relative use of debt vs equity to finance the comp’s assets
- significant bc debt is a contractual obligation and failure to repay principal/interest can result in legal repercussions or even bankruptcy
what does higher fl mean?
- higher debt and interest payments
- increases probability of default and possible bankruptcy
what is disaggregation of return on assets?
roa = net inc / av total assets = (PM - net inc/sales) * (AT - sales/av total assets)
- managers can increase roa by:
- increase pm: increase profitability for a given level of assets
- increase at: reduce assets while still generating same profit level
of the two sources of profitability difference (pm and at), which one is affected more by competition?
- profit margin because it is more prone to change:
- firms often reduce prices, increase spending or experience shrinking profits in competitive markets, affecting their margins
- asset turnover is more stable and influenced by long term operational strategies
- what is gross profit margin?
- formula: gross profit / sales
- influenced by both selling price of a comp’s products and the cost to make/buy those products
what is a good or poor gpm?
- good: a high and increasing gross profit margin is better
- poor: low or decreasing signals more competition or less demand for the comp’s products
- competition intensity has increased
- product line has lost appeal
- product costs have increased
- product mix has changed
- volume has declined and fixed costs have not
what is operating expense margin?
- measures general operating costs for each sales dollar
- consider each expense in whatever detail the comp provides in its income statement
- compare margins over time and against peers (making sure that peers have similar business models)
what is analysis of productivity
asset turnover = sales/av tot assets
turnover = inc statement item/av balance sheet item
working capital turnover ratios:
a/r turnover = sales/average a/r
inven turnover = cogs / av inven
a/p turnover = purchase OR cogs / av a/p
what is analysis of ppe?
ppe turnover = sales/av ppe
- improving it is difficult, usually entails:
- divesting of unproductive assets or entire business lines
- joint ventures to share assets such as distribution networks, info tech, prod facilities, transportation fleets and warehouses
- selling prof facilities with agreements to purchase finished goods from facilities new owners
- sale and leaseback of admin buildings
what is analysis of financial leverage?
- proper use of FL benefits stockholders
- relatively inexpensive source of capital
- but adds risk because debt repayment is mandatory
- analysis of FL typically involves:
- level of borrowed money relative to equity capital
- level of profit/cash flow relative to required debt payments
total liabilities to equity = tot liab / tot equity
times interest earned = ebit / interest exp gross
what does roa in dupont method reflect?
roa in dupont method reflects a blend of the return on a comp’s operating assets and its nonoperating return
what is operating focus to roe analysis?
- roe disagg. with an operating focus recognizes that comps create value mainly thru core operations
- b/s and i/s include both operating and nonoperating items
how can analysis be improved?
if we separately identify the operating and nonoperating components of the business and their separate returns
what are the 2 returns that roe consists of?
roe = operating return + nonoperating rteurn
operating return:
- return from op act
- earned from op assets and liab
nonoperating return:
- return from fin and invest act
- earned from nonop a&l
what is return on net operating assets (rnoa)?
rnoa = net operating profit after tac (nopat) / av net operating assets (noa)
av noa = (noa start of year + noa end of year)/2
measures operating returns
what is FL in dupont?
- ratio of total assets to stockholders’ equity
- liabilities used in this computation include ALL liabilities
liab = borrowed money + op liabilities
borrowed money
- loans,bonds, mortgagaes
- int banking
- seveere legal repercussions
op liab
- a/p / acruals
- interest free
- self liquidating
- operating focus roe treats these 2 types of liabilities differently for roe analysis
what is noa
net operating assets = operating assets - operatiing liabilities
OPERATING ASSETS
A/R
inventories
prepaid expenses/supplies
pp&e and right of use assets
intangible assets and goodwill
deferred tax assets
NO EQUITY METHOD INVESTMENTS
OPERATING LIABILITIES
A/P
accrued expenses
unearned (deferred0 revenue
income taxes payable
deferred tax liabilities
NO PENSION OBLIGATIONS
OTHER POST-EMPLOYMENT BENEFITS
what is net operating profit after tax (nopat)
nopat = net operating profit before tax - tax on operating profit
nopbt = sales - oper expenses = ebit
- operating expenses
- costs of goods sold (cogs)
- sg&a: wages, advertising, occupancy, insurance, depreciation and amortization, litigation, and restructuring expenses
- research and development
- impairments of operating assets (ex. goodwill)
- ~~NO INCOME FROM JOINT VENTURES, PARTNERSHIPS AND ASSOCIATED COMPS~~
- ~~NO GAINS AND LOSSES ON ASSET DISPOSALS~~
- other operating expenses or income
what is tax on operating profit
apart of nopat
tax on operating profit = tax expense + (pretax net nonop expense * statutory tax rate)
tax shield = (pretax net nonop expense * statutory tax rate)
- tax shield: taxes a comp saves by having tax-deductible nonoperating expenses, mostly interest
- taxes saved (by tax shield) do not relate to operating profits
- add back tax shield to total tax expense to compute the tax on operating profit
- how are roe and financial leverage related?
- FL relates to degree to which comp uses borrowed money
- FL is an important measure of the risk a comp is incurring with its reliance on debt
- FL increases risk and also increases return to shareholders if yield on assets > borrowing rate on debt
- operating approach shows that much more of pfizer’s roe is due to operating activities that make up its core business as opposed to FL
what are nonoperating items on the income statement?
- items:
- interest expense on debt and lease obligations
- interest and dividend income on marketable securities
- loss/income relating to discont. operations
- debt issuance and retirement costs
- gains/loss on the sale of nonstrategic investments
- “other” income/expense if reported separately from operating income
- pension income or losses
- for most comps, nonop activities create a pretax net nonoperating expense
- when the reverse is true, the net nonop item is “income”
