Financial Statement Analysis

1. Financial Statement Analysis K R Subramanyam John J Wild

2. Profitability Analysis 8 CHAPTER

3. Net income Net income margin = X 100 (%) Revenue BASIC OF PROFITABILITY ANALYSIS • What are its implications ? • To whom is it important ?

4. Gross Profit Gross margin percent = X 100 (%) Revenue BASIC OF PROFITABILITY ANALYSIS • What are its implications ? • To whom is it important ?

5. Revenue = (times) Average assets BASIC OF PROFITABILITY ANALYSIS • What are its implications ? • To whom is it important ? Asset turnover

6. Net income Return on assets (ROA) = X 100 (%) Average assets BASIC OF PROFITABILITY ANALYSIS • What are its implications ? • To whom is it important ?

7. Net income Revenue ROA = X Revenue Average assets BASIC OF PROFITABILITY ANALYSIS ROA = Net income margin X Asset turnover

8. Example 1 The following information is obtained from the financial statements of two retail companies. One company is a gift shop in a resort area; the other company is a discount household goods store. Neither company has any debt. Indicate which company is more likely to be the gift shop and which is the discount household goods store.

9. Basic of profitability analysis 1 2 Asset turnover 4 3 Net income margin

10. Net income Return on equity (ROE) = X 100 (%) Average equity BASIC OF PROFITABILITY ANALYSIS

11. Net income Revenue Average assets ROE = X X Revenue Average assets Average equity Profitability Efficiency Financial leverage (risk) BASIC OF PROFITABILITY ANALYSIS ROE = Net income margin X Asset turnover X Asset-to-equity ratio

13. Cautions with ROE ROE of company A is 30%, ROE of company B is 20%. • Did Company A perform better than company B ? • Is the price of company A’s share higher than the price of company B’s share ?

14. Example 2

15. Income Invested Capital Return on invested capital (ROI) • Return on invested capital is defined as: • Alternatives of invested capital: • Net operating assets • Stockholders’ equity

16. Return on net operating assets (RNOA) NOPAT (Beginning NOA + Ending NOA) / 2 Where • NOPAT = Operating income x (1- tax rate) • NOA = net operating assets (excluding financial assets/liabilities)

17. Return on net operating assets (RNOA) Operating and nonoperating activities - Distinction

18. Disaggregating RNOA RNOA = Operating Profit margin x Operating Asset turnover Operating Profit margin: measures operating profitability relative to sales Operating Asset turnover (utilization): measures effectiveness in generating sales from operating assets

19. Return on common equity (ROCE) Net income - Preferred dividends (Beginning equity + Ending equity) / 2 Where • Equity is stockholder’s equity less preferred stock

20. Disaggregating ROCE

21. Disaggregating ROCE Alternate View of ROCE Disaggregation

22. Analyzing Return on Common Equity-ROCE Assessing Equity Growth • Assumes earnings retention and a constant dividend payout • Assesses common equity growth rate through earningsretention

23. Analyzing Return on Common Equity-ROCE Assessing Equity Growth Assumes internal growthdepends on both earnings retention and return earnedon the earnings retained