key ratios for financial analysis

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Keys Ratios for Financial Analysis

João Carvalho das Neves

Professor, ISEG School of Economics and Management

Technical University of Lisbon

© João Carvalho das Neves

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Operational performance analysisTurnoverCapitalMargin ×=ROCE

ROCE = Return on Capital Employed = EBIT / Capital EmployedMargin = EBIT / RevenueCapital Turnover = Revenue / Capital EmployedCapital Employed = Financial Debt + Equity

Margin

Capital Turnover

Normal

Low High

High

Low


3

Margin and Return explained• EBIT margin is a measurement of what proportion of a company's revenue

is left over after paying all operating costs such as wages, raw materials, overhead, depreciation and amortization, selling, general, and administrative expenses, advertising, etc.

• A healthy EBIT margin is required for a company to be able to pay for its interest on debt and dividends to shareholders. It is comparable to competitors that use similar technologies and are in the same market segments

• Capital turnover is the amount of sales generated for every euro invested in the company by shareholders and debtholders. It measures the firm's efficiency in using the capital employed to generate revenue. The higher the turnover the better.

• Margin and Turnover is used to understand the pricing strategy and capital intensity: companies with low margins tend to have high turnover, while those with high margins have low turnover.


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Value creation

Value creation

0

+

-

0 +WACC

III

III

ROCEValue destru

ction


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Value creation explained

• The Return on Capital Employed ratio (ROCE) shows how much profit the company earns from the capital invested by shareholders and debtholders

• The cost of the capital employed is the Weighted Average Cost of Capital (WACC)

• WACC = [After-tax cost of debt] x [% debt financing] + [Cost of equity] x [% equity financing]

• You create (shareholder) value when you make decisions that consistently earn a return on capital employed (ROCE) that exceeds the cost of the capital employed. In that case:

– ROCE- WACC >0 or;

– Value Creation Index = ROCE / WACC >1


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Financial liquidity analysis

0

+

-

- 0 +WC/R

WCR/R

NLB/R = 0

I

IIIII

IV

V VI

R

WCR

R

WC

R

NLB −=

NLB – Net Liquid BalanceWC – Working CapitalWCR – Working Capital RequirementR - RevenueWC = Equity + Long Term Debt – Fixed AssetsWCR = Accounts receivables + Inventory + Other operational receivables – Accounts payables – Taxes payables – Other operational payables

Cash Cycle


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Financial liquidity analysisI, V and VI – Balanced Liquidity

II, III and IV – Unbalanced Liquidity

I – WC and WCR > 0 (Balanced liquidity. Most common in healthy companies)

V – WC and WCR < 0 (Balanced liquidity but high risk if market conditions changes)

VI – WC>0 and WCR <0 (Excess of liquidity. Very few industries. Advise: Reduce long term debt or equity or pay dividends.)

II – WC and WCR > 0 (Unbalanced liquidity. Could be a result of aggressive financial policy if the profitability is high. This is the case in healthy companies. It can also be a sign of liquidity risk, specially if profitability is low or even negative).

IV – WC and WCR < 0 (Unbalanced liquidity. Could be a result of aggressive financial policy if the profitability is high. This is the case in healthy companies. It can also be a sign of liquidity risk, specially if profitability is low or even negative. Existence of liquidity risk. High risk if market condition changes. Advise: Increase equity and/or Long term debt).

III – WC and WCR <0 (Excess deficit of liquidity. High financial risk, specially if profitability is low or negative. Advise: Increase equity and/or Long term debt ASAP).


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Definitions

• Working capital requirement (WCR) is the amount of cash required by the operational cycle.

• There is no ideal working capital requirement but the ratio WCR/R can be compared with other companies in the same industry to analyze the efficiency in managing the operational cash cycle.

• Working capital is the excess of long term capital (equity + long term debt) after fixed assets has been financed that is available to finance the operational cash cycle;

• Working capital should be enough to finance Working capital requirements


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Value destruction

Risk-Return Analysis

ROE

D/E

Normal

Low High

High

Low

ROE

Debt-Pay-YearsLow High

High

Low

ROE

TIEHigh Low

High

Low

Normal

Normal

ROE=Return on Equity = Net Profit / EquityD/E = Debt to Equity = Financial Debt / EquityDebt-Pay-Years = Financial Debt / Cash FlowTIE = Times Interest Earnings = = EBITDA / Financial Expenses

Value creation

Value destruction

Value creation

Value creation

Value destruction

Value destruction


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Risk-Return from NN

ROE

RiskLow High

High

Low

High

Normal

O indicador de risco a usar poderia ser o que resulta do nosso modelo: - ou o indice - ou os ratings AAA, AA, A, BBB, BB, B, etc. em sequência do modelo da Ning

Value destruction

Value creation


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Risk-Return trade-off explained• The principle is that return tends to rise with an increase in risk. This

means that lower levels of uncertainty (low risk) are associated with lower expected returns and higher levels of uncertainty (high risk) are associated with higher expected returns.

• Consequently, the investor must be aware of his personal tolerance to risk when choosing his investment portfolio. If he wants to make money, he can't cut out all risks, but he can find the appropriate balance for his profile.

• The proxies for risk used in the previous graphs are:

– Debt to Equity – A higher proportion of Debt in comparison to Equity has higher financial risk

– Debt-Pay-Years – The higher the debt in comparison to cash-flow generated by the business evidences an higher level of risk

– TIE – A lower TIE evidences more difficulty to pay interests than an higher TIE. The lower the TIE the higher is the financial risk

– The index that results from the NN model

• The proxy for return is the Return on Equity (ROE)


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Sustainable Growth Analysis

( )1

* 1

−

−⋅=

i

ii

E

dNPg

Growth Rate (g)

Sustainable Growth Rate

(g*)

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−=−i

i

R

Rg

Low

High

HighLow

NPi – Net Profit of the yeard – pay-out ratio = Dividends/NPEi-1 – Equity in the beginning of the yearRi = Revenue of the yearRi-1 = Revenue of the previous year

Excess of cash

Lack of cash to grow

Excess of cash: Search for growth opportunities, or pay debt, or pay dividends, or reduce equityLack of cash to grow: Slow down or search for equity or long term loans


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Sustainable Growth Rate explained

• Sustainable growth rate (g*) is the maximum growth rate of revenues a company can afford without issuing new equity or increase the debt ratio. Although it can grow at extremely high rates for some time, it is not sustainable in the long term.

• If revenues are projected to grow by more than the Sustainable Growth Rate, then the company must obtain the additional cash required to finance the growth: It can issue new debt or equity, increase the profit margin, pay less dividends or sell assets such as subsidiaries, divisions and/or other assets.

• The cumulated gap between the company’s historic growth rate and the sustainable growth rate evidences a need for additional financial resources to continue fuel the growth. Otherwise the company needs to slow down.


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Size Effect

ROCE

SizeLow High

High

Low

WCR/R

High

Low

Size = Revenue or Capital Employed or Number of EmployeesROCE = Return on Capital Employed (see page 2)WCR/R = Cash Cycle (See page 3)

Economies of scale

No economies of scale

Diseconomies of scale

SizeLow High

Economies of scale

No economies of scale

Diseconomies of scaleCash Cycle


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Is Bigger really Better? Size effect explained

• There is a worldwide debate about the effects of expanding a business to seek economies of scale. Economies of scale is a long run concept. It refers to reductions in costs per unit as the size of a company increases.

• Some of the factors that may cause economies of scale are: labor costs, marketing expenses, purchasing costs, managerial costs, interest expenses and amount of investments compared to sales. The size may also improve in the revenue side.

• However, in some cases it is also possible to find diseconomies of scale. In this case the production is less in proportion to the inputs, which means that there are inefficiencies within the firm that is resulting in the rising of average costs.

• Proxies for efficiency in the previous graphs are: – ROCE and Cash Cycle

• Proxies for size are as follows:– Total Assets

– Revenues

– Number of employees

key ratios for financial analysis

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