financial analysis using ratios
DESCRIPTION
Financial Analysis Using Ratios. Agenda. Ratio analysis and EVA Briggs case Cash flow statement analysis Free cash flow. Four Analysis Categories. Evaluate performance relative to a peer group, and period-over-period, to identify strengths and weaknesses in four areas Profitability - PowerPoint PPT PresentationTRANSCRIPT
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Financial Analysis Using Ratios
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Agenda
Ratio analysis and EVA Briggs case Cash flow statement analysis Free cash flow
Four Analysis Categories
Evaluate performance relative to a peer group, and period-over-period, to identify strengths and weaknesses in four areasProfitabilityAsset managementSolvency riskEconomic Value-added
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Key Uses of Ratio Analysis
Consider impact of financial performance on cash flow and stock priceMeasure value-added
Set targets for projected performance to improve valuation
Assist in formulating a cash flow planning forecast
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I. Profitability
Traditional DuPont Model Adjusted DuPont Model Margin analysis
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Unlevered Levered
Assets $10,000 $10,000
Debt $0 $5,000
Equity $10,000 $5,000
# Shares 400 200
Tax Rate 40% 40%
Interest rate 5%
Unlevered Levered
Poor Expected Strong Poor Expect Strong
EBIT $-500 $1,000 $1,500 $-500 $1,000 $1,500
Interest $0 $0 $0 $250 $250 $250
Taxes $-200 $400 $600 $-300 $300 $500
Net Income $-300 $600 $900 $-450 $450 $750
ROA -3.0% 6.0% 9.0% -4.5% 4.5% 7.5%
ROE -3.0% 6.0% 9.0% -9.0% 9.0% 15.0%
EPS $-0.75 $1.50 $2.25 $-2.25 $2.25 $3.75
Which outperformed? Operating performance?
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Traditional DuPont Model
Return onEquity
Return onAssets
MarginsOn Sales
AssetUtilization
FinancialLeverage
x =x
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Profitability summary using the Dupont Model
EquityAvg
AssetsAvg
AssetsAvg
Sales
Sales
NI
EquityAvg
NI
ROE = Return on Equity: rate of return to stockholders
NPM = Net Profit Margin: efficiency in expense control (income statement)
TAT = Total Asset turnover: asset management (balance sheet)
LR = Leverage Ratio (‘financial leverage’; tradeoff is insolvency risk)
ROE NPM TAT LR
Return on Assets
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EquityAvg
AssetsAvg
AssetsAvg
Sales
Sales
NI
EquityAvg
NI
EquityAvg
NI
EquityAvg
AssetsAvg
AssetsAvg
NI
ROAROE
ROA = Return on Assets: summarizes income statement and balance sheet efficiency, before incorporating financial leverage
LR
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DuPont mixes operating and financial decisions
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A problem with this approach is that because net income is biased by financing choice, the equation provides a poor summary of operating performance (e.g. success in product positioning, production efficiency, distribution, overhead control, etc.)
Companies with high debt have low net profit margin, low ROA, but higher ROE, all else equal
Traditional Balance Sheet
Current Assets Current Liabilities
PP&E Long-term Debt
Stockhoders Equity
= Total Assets = Total Liab + Equity
Our objective as financial managers is to enhance the value of the debt and equity capital that we’ve raised in the market, on which the investors require a rate of return.
Let’s show a balance sheet that isolates this investor capital.
Managerial Balance Sheet
+ Current Assets - Oper. Current Liab.
+ PP&E + Debt (L.T. + S.T.)
+ Equity
= Invested Capital
Net Working Capital
= Invested Capital
Invested Capital can be calculated both inside and outside the box
Net Working Capital (NWC) NWC = Current Assets minus Operating Current
Liabilities
Operating Current Liabilities grow spontaneously with the firm’s assets not motivated by a return on investment (non-interest) include Accts Payable, Accrued Expenses, Tax Payable exclude short-term interest-bearing debt that is part of
current liabilities on the traditional balance sheet This S.T. debt is now outside the box as a part of the Debt Capital
Invested Capital (IC)
IC is raised to acquire assets inside the box
IC = NWC + PP&E inside the box
IC also = Debt + Equity outside the box
The overall rate of return required by investors on the Invested Capital is known as theWeighted Average Cost of Capital
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Net Operating Profit After Taxes
+ Earnings Before Interest and Taxes
X (1 – cash tax rate)
= NOPAT
This is the after-tax income earned on the Invested Capital
By using earnings before Interest to calculate NOPAT, we exclude the influence of debt funding on earnings
NOPAT is the net income that would be earned if there were no debt
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Return on Invested Capital
ROExED
ETrx
ED
DROIC d
)1(
ROETrxE
D
E
EDROICx d
)1(
Multiply both sides by: E
ED
ROIC is a weighted return on Invested Capital:
ROETrxE
D
E
DxROIC d
)1(1
ROETrROICxE
DROIC d )1(
ROIC = ; rd=interest rate on debtCapital
NOPAT
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Return on Invested Capital (ROIC)
ROIC intersects efficiency on the income statement with the productivity of assets on the balance sheet
ROIC provides a summary measure of operating performance
A financial performance analysis begins with ROIC, and drills down from there
ROIC = NOPAT x Sales
Sales IC
Net Oper. Margin x
Capital Turnover
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Adjusted Dupont Model (isolates operating and financial leverage effects on ROE)
The second term isolates the increase in ROE resulting solely from leverage differences
This term also captures the tax break on interest (1-t) that we ignored when we calculated NOPAT
)1( TrROICxEquity
DebtROICROE d
rd = interest rate on debt
Pure leverage effect
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Unlevered Levered
Assets $10,000 $10,000
Debt $0 $5,000
Equity $10,000 $5,000
# Shares 400 200
Tax Rate 40% 40%
Interest rate 5%
Unlevered Levered
Poor Expected Strong Poor Expect Strong
EBIT $-500 $1,000 $1,500 $-500 $1,000 $1,500
Interest $0 $0 $0 $250 $250 $250
Taxes $-200 $400 $600 $-300 $300 $500
Net Income $-300 $600 $900 $-450 $450 $750
ROA -3.0% 6.0% 9.0% -4.5% 4.5% 7.5%
ROE -3.0% 6.0% 9.0% -9.0% 9.0% 15.0%
EPS $-0.75 $1.50 $2.25 $-2.25 $2.25 $3.75
Which company performed better?
Adjusted Dupont Model
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)1( TrROICxEquity
DebtROICROE d
000,10
600
000,5
000,5
000,10
6005% (1-.40)[ ]+ x -
6% 1.0 6% 3%=9% + x -[ ] From an operating perspective the companies are
identical, earning a 6% ROIC The levered company adds another 3% to its ROE as a
result of its debt usage Ultimately the answer to which is better depends largely
on which debt mix is appropriate given the industry’s operating risk (variability in EBIT)
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Increasing Leverage and ROE
Note that the hurdle rate for increasing ROE (same for EPS) by increasing leverage is very low: ROIC > Int (1-T) Returns to capital > after-tax cost of debt only To increase value need ROIC > weighted average cost of debt and equity
Cost of both debt and equity are rising as debt increases
Goal should not be max ROE
)1( TrROICxEquity
DebtROICROE d
Margin analysis
Gross Margin: ability to mark-up
product and control production
expenses
Net Operating Margin: control of overhead expenses (SG&A) as well
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Sales
profitGross
Sales
NOPAT
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Profits Summary Start with ROIC as a summary measure of
operating performance
Explain ROIC results using Margins on income statement Capital turnovers from balance sheet
Explain ROE result using ROIC and Leverage
Also consider growth’s impact on value
Value Drivers
The three keys to value are 1) ROIC; 2) growth in NOPAT; 3) Risk
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II. Asset Management (turnovers)
Capital Turnover Accts. Receivable Days Inventory Holding Period Working Capital Turnover PP&E Turnover
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365/Sales
receivableAccountsAvg
365/COGS
InventoryAvg
CapitalInvestedAvg
Sales
EPPNetAvg
Sales
&
Measure the efficiency with which the company invests in its assets (e.g. efficiency in collecting receivables, turning inventory, and utilizing PP&E capacity)
NWCAvg
Sales
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III. Solvency risk
Debt-to-EBITDA
Debt-to-Capital
Interest Coverage or Times Interest Earned
EquityDebtLTDebtST
DebtLTDebtST
ExpenseInterest
EBIT
Measure whether the company has an appropriate level of debt in its capital mix, or the risk of becoming insolvent
Tradeoff: There are many considerations that drive this decision, but the primary tradeoff is that while higher debt increases insolvency risk and the cost of capital, it also can boost the return to stockholders (ROE).
EBITDA
DebtLTDebtST
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III. Solvency risk: Liquidity focus
Current ratio
Quick ratio
sLiabilitieCurrent
AssetsCurrent
sLiabilitieCurrent
InventoryAssetsCurrent
Measure ability to meet near-term financial obligations by holding sufficient assets that are expected to convert to cash within the year
Inventory is the least liquid current asset, so exclude it in the quick ratio
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Liquidity interactions
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Tradeoff: By shrinking the current ratio companies can reduce Invested Capital requirements and thereby boost ROIC
But a lower current ratio indicates greater liquidity risk
Liquidity can also be located off the balance sheet in committed unused lines of credit
Companies that have less total debt and/or have stronger cash flow can afford to have lower liquidity
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IV. Economic Value Added EVA is a measure of periodic economic profit,
or single period $value-added to shareholders
Unlike Net Income, EVA measures residual income after deducting a charge for all of the Invested Capital used in the business (i.e. it charges for Equity capital) Net income fails to effectively capture the cost of an
inefficient balance sheet
EVA’s relation to value
Market value added, the difference between a company’s market value and its book value, is the present value of the company’s future expected EVAs EVA links profit measurement to valuation
Net Present Value (NPV) for a new capital investment is equal to the present value of the investment’s future expected EVAs EVA links profit measurement to capital budgeting
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Value-based management using EVA Focus managers on controlling capital investment
and beating the cost of capital “Incredibly, most corporate groups, divisions, and
departments have no idea how much capital they tie up or what it costs”— Fortune
Provide appropriate incentives for value-added growth investments, while divesting value-destroying business lines
Push accountability for capital charges down into profit centers at all levels of organization
Optimize the use of debt to minimize WACC
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Calculating EVA
EVA deducts a Capital (financing) Charge for the Investment Capital used to generate NOPAT
WACC = Weighted Average Cost of Capital WACC is an estimate of the % return
required by investors on the firm’s Invested Capital
$Capital Charge
CapitalWACCNOPATEVA $%$$
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ROIC > WACC = +EVA
Investments must generate an ROIC that exceeds the cost of financing $Capital captures the firm’s ability to find profitable growth
opportunities Recall that MVA is present value of future EVA
WACC captures risk The EVA spread can be compared across firms, but do not target max
CapitalWACCNOPATEVA $%$$
CapitalWACCCapital
NOPATEVA
CapitalWACCROICEVA
EVA spread %
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Overinvestment problem of net income focus
Only need to earn ROIC > Interest (1-T) x 50%, which here is 3.5%, to increase Net Income; need 12% for breakeven EVA; result is overinvestment
Assumptions: Net Income: EVA:Investment $100 EBIT $12.0 NOPAT $8.40EBIT $12 Interest Exp $5.0 Capital Charge 12.0Interest rate 10% EBT $7.0 EVA -3.6Tax rate 30% Taxes 2.1 ROIC 8.4%Equity Cost 17% Net Income 4.9WACC 12%
Assume capital structure is 50%/50% D/E:
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Should the investment be made?
Before Investment: New Investment: After Investment:Capital $1,000 $300 $1,300EBIT $340 $60 $400Tax rate 40% 40% 40%NOPAT 204 36 240ROIC 20.4% 12.0% 18.5%WACC 10% 10% 10%EVA $104 $6 $110
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EVA captures Equity cost risk effects not included in any measure of profitability, and encourages optimal capital structure
Captures differences in risk and associated financing cost side of the risk/return tradeoff via WACCseek optimal use of debt to minimize WACC include risk shifts in profit measurement
If use excessive debt to increase ROE, cost of Equity and Debt increase, resulting in higher WACC and capital charge in EVA calculation
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Accounting adjustments
Adjusts capital for accounting distortions that understate capital (e.g. leases, reserves on balance sheet) or discourage investment (e.g. R&D, advertising, and training expenses)
Key terms
NOPAT Invested Capital ROIC EVA WACC
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