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Module 4

Module 4. Analyzing and Interpreting Financial Statements. Analysis Questions. Are earnings sufficient? Can they pay their current bills? (Liquidity) Can they pay debts over the long term? (Solvency). Are Earnings Sufficient? Return on Equity. Return on equity (ROE) is computed as:

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Module 4

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  1. Module 4 Analyzing and Interpreting Financial Statements

  2. Analysis Questions Are earnings sufficient? Can they pay their current bills? (Liquidity) Can they pay debts over the long term? (Solvency)

  3. Are Earnings Sufficient? Return on Equity • Return on equity (ROE) is computed as: • Analysis often expands ROE: ROE= RNOA + Impact of debt

  4. Operating Return (RNOA) • Operating income = revenues - costs of goods sold (COGS) - operating expenses (SG&A) • Operating assets typically include receivables, inventories, prepaid expenses, property, plant and equipment (PPE), and capitalized lease assets • Operating obligations typically include accounts payable, accrued liabilities, employee obligations (pensions), and tax obligations. • Operating assets and obligations are netted out.

  5. Target’s Operating Items

  6. Tax on Operating Profit For Target: Tax rate on operating income = $1,855 / $5,252 = 35.32%

  7. Net Operating Assets (NOA)

  8. Net Operating Assets (NOA) NOA = Operating Assets - Operating Liabilities

  9. Net Operating Profit Margin (NOPM) • Net operating profit margin (NOPM)reveals how much operating profit the company earns from each sales dollar. • NOPM is affected by • the level of gross profit • the level of operating expenses (efficiency) • competition and control of costs affect NOPM

  10. Net Operating Asset Turnover (NOAT) • Net operating asset turnover (NOAT) = Sales / Average net operating assets • measures the productivity of the company’s net operating assets. • level of sales the company realizes from each dollar invested in net operating assets. • All things equal, a higher NOAT is preferable.

  11. Nonoperating Return Component of ROE • Assume that a company has $1,000 in average assets for the current year in which it earns a 20% RNOA. It finances those assets entirely with equity investment (no debt). • Its ROE is computed as follows:

  12. Effect of Financial Leverage • Next, assume that this company borrows $500 at 7% interest and uses those funds to acquire additional assets yielding the same operating return. • Its net operating assets for the year now total $1,500 and its profit is $265.

  13. Effect of Financial Leverage on ROE • We see that this company has increased its profit to $265 (up from $200) with the addition of debt, and its ROE is now 26.5% ($265/$1,000). • The reason for the increased ROE is that the company borrowed $500 at 7% and invested those funds in assets earning 20%. $500 * (20%-7%)= $65 • The difference of 13% accrues to shareholders.

  14. Nonoperating Returns to Equity (APP A) ROE is the return on net operating assets plus a leverage ratio times the spread between return on assets and the net cost of borrowing on an after-tax basis. In the formula: NNO: Nonoperating obligations net of nonoperating assets NNEP: Net nonoperating expenses / Average NNO

  15. Nonoperating Return with Debt Financing $500/$1,000 20%-7%

  16. Liquidity and Solvency (App B) • Liquidity refers to cash: how much we have, how much is expected, and how much can be raised on short noticeto pay current bills. • Solvency refers to the ability to meet obligations; primarily obligations to creditors, including lessors.

  17. Liquidity Measures

  18. Solvency Ratios

  19. Vertical and Horizontal Analysis • Analysis down a statement and across time • Looking for consistency and efficiency • Often use common dollar statements: • Income statement: divide by the total revenues • Balance sheet: divide by total assets

  20. Common Dollar Income Statement

  21. DuPont Analysis (App C)Older, different form of analysis • Profit margin is the amount of net income that the company earns from each dollar of sales. • Asset turnover is a productivity measure that reflects the volume of sales that a company generates from each dollar invested in assets. • Financial leverage measures the degree to which the company finances its assets with debt rather than equity.

  22. Return on Assets

  23. Adjusted Return on Assets • Some adjust the numerator to reflect the company’s operating profit after taxes • Like NOPAT

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