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Business Finance. BA303 Michael Dimond. Module G: Financial Statement Analysis. Understanding financial statements. Balance Sheet Income Statement Statement of Cash Flows Statement of Shareholders’ Equity. Meaningful Ratio Analysis.

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business finance

Business Finance

BA303

Michael Dimond

understanding financial statements
Understanding financial statements
  • Balance Sheet
  • Income Statement
  • Statement of Cash Flows
  • Statement of Shareholders’ Equity
meaningful ratio analysis
Meaningful Ratio Analysis
  • Analysis means to break something down to understand it.
  • Ratio analysis should be used to answer a specific question or set of questions.
  • If you were examining the financial statements for a company, you might start with this basic question:

“Is this a good use of investors’ money?”

  • What financial ratio would answer this question?

How about Return on Equity?

  • How do you compute Return on Equity (ROE)?
analyzing roe
Analyzing ROE
  • ROE = NI ÷ Equity and answers the question, “is this a good use of investors’ money?”
  • If you were to break this down, there are three basic questions to answer:

How profitable is this business?

How efficiently are assets being used?

How much does financial leverage help the investors?

  • What financial ratios would answer these questions?

Profit Margin (PM)

Total Asset Turnover (TAT)

Equity Multiplier (EM)

drivers of roe
Drivers of ROE
  • Profit Margin (PM) = NI ÷ Sales and answers the question, “How profitable is this business?”
  • Total Asset Turnover (TAT) = Sales ÷ Total Assets and answers the question, “How efficiently are assets being used?”
  • Equity Multiplier (EM) = Total Assets ÷ Equity and answers the question, “How much does financial leverage help the investors?”
the dupont identity
The DuPont Identity
  • ROE is directly driven by profitability, efficiency and leverage.
  • ROE = PM x TAT x EM

How does that work?

  • The numerators and denominators cancel to reduce the equation to NI ÷ Equity
a note about the text s version of roe dupont
A note about the text’s version of ROE & DuPont
  • The author uses Earnings Available to Common Shareholders for ROE computations. While this is not terribly incorrect, it isn’t really correct either.
    • Net Income ÷ Equity = ROE
    • Earnings Available to Common Shareholders ÷ (Equity – Preferred Equity) = Return on Common Equity (ROCE, not ROE)
  • The purpose of analysis is to answer important questions.
    • If the question is how hard the investors’ money is working, compute ROE
    • To find how hard common shareholders’ money is working, compute ROCE
    • Never mix & match. ROCE uses Earnings Available to Common Shareholders and Common Equity. ROE uses Net Income and Total Equity.
    • Notice the author computes ROA as Earnings Available to Common Shareholders ÷ Total Assets. What is wrong with this?
    • ROE & ROA are sometimes very manipulated figures, used by managers to prove a point. Always compute your own figures for analysis.
a word about roa
A word about ROA
  • ROA = Return on Assets
  • What’s the difference between Equity & Assets?
    • Leverage
  • What’s the difference between ROE & ROA?
    • Leverage
  • ROE = PM x TAT x EM
    • EM represents leverage
  • ROA = PM x TAT
    • No leverage
digging deeper with financial ratios
Digging Deeper with Financial Ratios
  • How would you analyze profitability, efficiency and leverage?
    • How do profitability, efficiency and leverage relate?
    • What affects profitability?
    • What drives sales?
    • What is the composition of assets?
    • How were assets paid for?
    • How are liabilities managed?
  • Where shall we begin?
common size financial statements
Common-Size Financial Statements
  • Shows each line item as a percent of an appropriate total.
  • Common-size balance sheet
    • % of Total Assets
    • Shows the composition of assets
    • Liabilities & equity items are also shown as % of total assets
    • Debt Ratio = Total Liabilities ÷ Total Assets
  • Common-size income statement
    • % of Sales
    • PM = Net Income as % of Sales
we don t make a common size cf statement
We don’t make a common-size CF Statement

There are other ways to examine relevant information which would be more helpful

vertical horizontal analysis
Vertical & Horizontal Analysis
  • Vertical Analysis compares figures as a percent of a relevant total (“common size” financial statements)
  • Horizontal Analysis compares the same figure over a series of periods (showing % change or % growth)
measuring growth
Measuring growth
  • Financial figures change from year to year
  • To find the % change (“% growth”) over a 1-year period, divide the difference of the two figures by the first year’s value:
    • [ending – beginning] / [beginning]

OR

    • [ending] / [beginning] - 1
  • Measuring growth over more than one period means we need to find the average growth during that time.
cagr compound annual growth rate
CAGR: Compound Annual Growth Rate
  • The CAGR is the result of compounded increase over time at a specific average rate
    • (133.1/100)^(1/3)-1=0.10
  • It can be tested by plugging the result into a compounding formula using the same figures
    • 100*(1+0.10)^3=133.10
  • It can be figured using the TVM functions on your calculator
    • PV = -100 FV = 133.10 n = 3 PMT = 0 solve for I = 10%
  • What if you were given a series of % changes instead of dollar figures?
    • Year 1: 10% increase, Year 2: 12% increase, Year 3: 8% increase
  • You need to find the Geometric Average Growth over the three year period
geometric average vs arithmetic average
Geometric Average vs Arithmetic Average
  • Arithmetic Average only shows the “typical” result
  • Geo Avg = [(1+20%)*(1+-16.67%)* (1+20%)*(1+16.67%)]^(1/4) -1 = 8.78%
  • CAGR also shows the result of compounding
    • (14/10)^(1/4) – 1 = 0.878 = 8.78%
    • The price didn’t increase 8.78% each year, but we end up with the same final value if we compound it by 8.78% every year.
    • 5 years means 4 periods of compounding, so we find the 4th root ( ^1/4 power)
categories of financial ratios
Categories of Financial Ratios
  • Most finance texts group ratios into categories like these:
    • Profitability ratios
    • Efficiency (or Activity) ratios
    • Liquidity ratios
    • Debt ratios
    • Market ratios
  • It is usually more helpful to think of the questions to be answered rather than just crunching a bunch of numbers.
    • Uses critical thinking
    • Easier to read
    • Less time consuming
    • Uses fewer resources
profitability ratios
Profitability Ratios
  • PM = Net Income ÷ Sales (Sometimes called “Net Profit Margin”).
    • This also is the bottom line on a common-size income statement
    • The author makes a distinction for Earnings Available to Common Shareholders.
  • Gross Margin = Gross Profit ÷ Sales
    • Gross Profit = Sales – COGS
    • Also called the “Gross Profit Margin”
  • Operating Margin = Operating Profit ÷ Sales
    • Also called the “Operating Profit Margin”
efficiency ratios
Efficiency Ratios
  • TAT = Sales ÷ Total Assets
  • How hard do specific assets work?
  • Inventory Turnover
    • Inventory Turnover = Sales ÷ Inventory
    • The label “Inventory Turnover” is also used for COGS ÷ Avg. Inventory
    • These two ratios answer different questions:
      • How hard is inventory working? (Sales/Inventory)
      • How many times/year is inventory replaced? (COGS/Average Inventory)
      • How would you convert this into “Days in Inventory?”
  • Average Collection Period or AR Conversion Period
    • Days to Collect AR = Avg. Accts Receivable ÷ Avg. Daily Sales
      • Average Daily Sales = Sales ÷ 365
      • The sales figure should exclude sales paid for in cash, use only sales creating AR
efficiency ratios1
Efficiency Ratios
  • Average Payment Period
    • Days to Pay AP = Avg. AP ÷ Avg Daily Purchases
      • Avg Daily Purchases = Purchases ÷ 365
      • Purchases = COGS + Ending Inventory – Beginning Inventory
  • If you know how long it takes a company to sell inventory, how long it takes to collect accounts receivable and how long to pay its bills, you can compute how long their business takes to function
    • Operating Cycle: Days in Inventory + Days in Receivables
    • Cash Cycle: Days in Inventory + Days in Receivables – Days in Payables
efficiency ratios2
Efficiency Ratios
  • There is an easy and consistent way to compute and understand the components of the cash cycle.
    • Each of the “Days in…” figures represents a year divided by the appropriate turnover rate:
      • Days in Inventory = 365 ÷ Inventory Turnover Rate
      • Days in Receivables = 365 ÷ Receivables Turnover Rate
      • Days in Payables = 365 ÷ Payables Turnover Rate
    • This means the turnover rates can be simplified to these:
      • Inventory Turnover Rate = COGS ÷ Avg. Inventory
      • Receivables Turnover Rate = Sales ÷ Avg. Receivables
      • Payables Turnover Rate = Purchases ÷ Avg. Payables
    • …and the days in each can be computed as:
      • Days in Inventory = 365 ÷ (COGS ÷ Avg. Inventory)
      • Days in Receivables = 365 ÷ (Sales ÷ Avg. Receivables)
      • Days in Payables = 365 ÷ (Purchases ÷ Avg. Payables)
liquidity ratios
Liquidity Ratios
  • The Current Ratio
    • Pretty much useless in my opinion, but memorize it anyway.
    • Current Assets ÷ Current Liabilities
  • Liquidity means something can be converted into cash immediately without significant loss of value. Current Assets includes inventory. Is inventory really liquid?
  • Quick Ratio (also called the “Acid Test”)
    • Answers the question, “how well can this firm meet its short-term obligations?”
    • [Current Assets – Inventory] ÷ Current Liabilities
debt management ratios
Debt Management Ratios
  • Debt ratio = Total Liabilities ÷ Total Assets
    • Also called “Debt to Total Capital” ratio
  • Debt-to-Equity ratio = Total Liabilities ÷ Total Equity
  • EM (from DuPont) = 1 + D/E
  • Times Interest Earned ratio = EBIT ÷ Interest
    • NOTE: The book has a typo on page 78. It claims TIE = EBIT ÷ Tax, which is not correct.
  • TIE can be altered to cover any financial obligations.
    • TIE = EBIT ÷ Interest
    • :. TIE = (EBT + Interest) ÷ Interest
    • (EBT + Interest + Lease Pmts) ÷ (Interest + Lease Pmts) = Fixed Payment Coverage
  • (EBT + Interest + Lease Pmts) ÷ (Interest + Lease Pmts + Principal Repayments/(1-t)) = Fixed Payment Coverage
market value ratios
Market Value Ratios
  • Price-to-Earnings ratio = Share Price ÷ Earnings per Share
    • Earnings per Share (EPS) = Earnings Available to Common Shareholders ÷ Number of Shares of Common Stock
    • If there is no preferred equity (or an insignificant amount), EPS can be NI ÷ Number of Shares
    • Because the Numerator and Denominator are both “per share,” the PE ratio can be computed as Market Capitalization ÷ Total Earnings Available
  • Market-to-Book ratio = Price per Share ÷ Book Value per Share
    • Book Value per Share = Common Equity on Balance Sheet ÷ Number of Shares
    • Common Equity = All equity except preferred equity
    • Again, because the Numerator and Denominator are both “per share,” the MB ratio can be computed as Market Capitalization ÷ Total Common Equity
other useful analysis
Other useful analysis
  • Dividends & Retained Earnings
    • d: Dividend Payout Ratio = Dividends ÷ Net Income
    • b: Retention Ratio = 1 – d

Also called the “plowback ratio.” Why do you think that name is used?

  • Growth Limitations
    • SGR: Sustainable Growth Rate = b x ROE = b x PM x TAT x EM
    • IGR: Internal Growth Rate = b x ROA = b x PM x TAT
  • Breakeven
    • BE = Total Fixed Costs ÷ Contribution Margin
      • Contribution Margin = Price per unit – Variable Costs per unit
      • Operating, Accounting, and Financial breakevens all exist. The definition of “Fixed Costs” changes.
  • Degree of Operating Leverage
    • Looks a lot like an elasticity formula: %Δ Op. Income ÷ %ΔSales
    • As firm approaches breakeven, DOL gets larger
    • A point estimate of DOL can be computed as Gross Profit ÷ Operating Income