Financial Ratio Analysis

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Questions and Answers

If a company's net income is $500,000 and average shareholders' equity is $2,500,000, what is the Return on Equity (ROE)?

  • 5%
  • 25%
  • 20% (correct)
  • 10%

Which of the following is the correct decomposition of Return on Equity (ROE)?

  • ROE = (Net Income / Sales) + (Sales / Assets) + (Assets / Equity)
  • ROE = (Net Income / Sales) * (Sales / Assets) * (Assets / Equity) (correct)
  • ROE = (Net Income / Sales) * (Sales / Assets) + (Assets / Equity)
  • ROE = (Net Income / Sales) / (Sales / Assets) / (Assets / Equity)

What does Asset Turnover measure?

  • Equity relative to sales
  • Net Income generated per dollar of sales
  • Assets relative to equity
  • Sales generated per dollar of assets (correct)

Which of the following formulas accurately calculates Net Capital?

<p>Financial Obligations + Equity (B)</p> Signup and view all the answers

What is the formula for calculating Net Operating Profit After Tax (NOPAT)?

<p>(Operating Revenue - Operating Expenses) * (1 - Tax Rate) (B)</p> Signup and view all the answers

How is Net Investment Profit After Tax (NIPAT) calculated?

<p>(Investment Income + Interest Income) * (1 - Tax Rate) (B)</p> Signup and view all the answers

What is the correct formula for calculating Interest Expense After Tax (IEAT)?

<p>Interest Expense * (1 - Tax Rate) (B)</p> Signup and view all the answers

How is Net Profit related to NOPAT, NIPAT and IEAT?

<p>Net Profit = NOPAT + NIPAT - IEAT (A)</p> Signup and view all the answers

What does Return on Net Operating Assets (RNOA) measure?

<p>Net operating profit after tax / net operating assets (B)</p> Signup and view all the answers

If a company has an Operating Return on Sales (OROS) of 15% and an Operating Asset Turnover (OATO) of 2, what is the Return on Net Operating Assets (RNOA)?

<p>30% (D)</p> Signup and view all the answers

What is Operating Return on Sales (OROS) calculated as?

<p>NOPAT / Sales (C)</p> Signup and view all the answers

How is Operating Asset Turnover (OATO) calculated?

<p>Sales / NOA (B)</p> Signup and view all the answers

What does Return on Investment Assets (ROIIA) measure?

<p>Net investment profit after tax / investment assets (B)</p> Signup and view all the answers

How is Return on Business Assets (ROBA) calculated?

<p>(NOPAT + NIPAT) / Business assets (B)</p> Signup and view all the answers

According to the formulas given, Return on Equity (ROE) can be expressed as:

<p>ROBA + Spread + Financial Leverage (C)</p> Signup and view all the answers

How is Operating Working Capital (OCW) determined?

<p>(Current Assets Cash and Cash Equivalents) (Current Liabilities - Current Portion of Long-Term Debt) (D)</p> Signup and view all the answers

How is Net Non-Current Operating Assets (NNCOA) calculated?

<p>Total long-term operating assets non-interest-bearing long-term liabilities (D)</p> Signup and view all the answers

Which formula represents the Gross Profit Margin?

<p>(Revenue Cost of Sales) / Revenue (A)</p> Signup and view all the answers

What is the formula for the Operating Working Capital to Sales Ratio?

<p>Operating Working Capital / Revenue (B)</p> Signup and view all the answers

How is the Current Ratio calculated?

<p>Current assets / current liabilities (C)</p> Signup and view all the answers

Explain how the decomposition of Return on Equity (ROE) into its components (return on sales, asset turnover, and equity multiplier) can provide deeper insights into a company's performance than simply looking at the overall ROE figure.

<p>Decomposing ROE helps identify the specific drivers of profitability. For example, a high ROE could be due to high-profit margins (return on sales) or efficient use of assets (asset turnover) or high leverage (equity multiplier). Knowing this helps understand the source of the return.</p> Signup and view all the answers

How does reformulating the balance sheet and income statement to focus on operating versus non-operating activities enhance financial analysis?

<p>Reformulating the balance sheet and income statement separates operating performance from financing and investment decisions. This allows for a clearer assessment of how efficiently a company generates profits from its core operations, independent of its financial structure or investment strategies.</p> Signup and view all the answers

A company has a high Return on Net Operating Assets (RNOA) driven by a high Operating Return on Sales (OROS). What strategies might the company employ to sustain this performance, and what risks should it be aware of?

<p>Strategies include maintaining cost controls, pricing power, and efficient operations. Key risks include increased competition eroding pricing, rising input costs affecting margins, and over-investment in operating assets leading to diminishing returns.</p> Signup and view all the answers

Explain the difference between Return on Net Operating Assets (RNOA) and Return on Investment Assets (ROIA), and why both are important in assessing a company's performance.

<p>RNOA focuses on the profitability of core operating activities, while ROIA measures the returns generated from investment assets. RNOA indicates operational efficiency, ROIA reflects the effectiveness of investment strategies, and both together provide a holistic view of value creation.</p> Signup and view all the answers

How does breaking down ROE into ROBA (Return on Business Assets) + Spread + Financial Leverage help in understanding a company's financial health and risk profile?

<p>This breakdown isolates the return generated from business operations (ROBA) from the impact of financial leverage. The 'spread' indicates how effectively the company uses debt to enhance returns (positive spread is good), but also highlights increased financial risk.</p> Signup and view all the answers

Why is it important to analyze Operating Working Capital (OCW) relative to sales? What does a high or low Operating Working Capital to Sales ratio indicate?

<p>Analyzing OCW relative to sales assesses the efficiency of working capital management. A high ratio suggests inefficient use of working capital, tying up more funds in operations. A low ratio indicates efficient management, but potentially tight liquidity depending on sales volume.</p> Signup and view all the answers

Explain the purpose of calculating Net Non-Current Operating Assets (NNCOA). What insights can NNCOA provide about a company's long-term investments and operational strategy?

<p>NNCOA represents the long-term assets used in operations, excluding items like financial investments. NNCOA insights include a company's investment in long-term resources for production, expansion strategy, and capital intensity of operations.</p> Signup and view all the answers

How can the Gross Profit Margin ratio be used to assess a company's competitive advantage and pricing power within its industry?

<p>A higher gross profit margin compared to peers may suggest that a company has a competitive advantage through differentiated products, efficient cost management, or strong pricing power. This can signal a stronger ability to generate profit from each dollar of sales.</p> Signup and view all the answers

A company's PP&E Turnover ratio is decreasing. What are potential reasons for this decline, and how might management address the situation?

<p>Reasons may include over-investment in fixed assets, underutilization of capacity, or obsolete equipment. Management could improve asset utilization, dispose of excess assets, or invest in upgrades to increase productivity.</p> Signup and view all the answers

Explain how the Current Ratio and Quick Ratio provide different perspectives on a company's short-term liquidity. What are the strengths and limitations of each?

<p>The Current Ratio includes all current assets, while the Quick Ratio excludes inventory. Strengths: Current Ratio gives a broad view of short-term assets, Quick Ratio offers a more conservative view of immediately liquid assets. Limitations: Current Ratio can be skewed by illiquid inventory, Quick Ratio may be too conservative for companies with easily convertible inventory.</p> Signup and view all the answers

What does a high Debt-to-Equity ratio signify, and how does it impact a company's financial risk and potential returns?

<p>A high Debt-to-Equity ratio signifies high financial leverage. It increases financial risk due to higher fixed interest costs and potential difficulty in meeting debt obligations, but can also increase potential returns if the company effectively uses debt to finance profitable investments.</p> Signup and view all the answers

Discuss the limitations of using Return on Equity (ROE) as the sole measure of a company's performance, especially in comparing companies across different industries.

<p>ROE does not account for risk, size differences, or the amount of capital employed to generate returns. It's also easily manipulated through financial leverage. Comparing across industries is difficult due to varying capital intensities and business models.</p> Signup and view all the answers

How can the Dividend Payout Ratio be used to infer a company's growth prospects and investment opportunities?

<p>A high payout ratio may suggest limited reinvestment opportunities, indicating a mature firm with slower growth. A low payout ratio typically implies that the company is reinvesting earnings for future growth and has attractive internal investment prospects.</p> Signup and view all the answers

What are the key assumptions underlying the Dividend Discount Model (DDM), and how do these assumptions affect the model's accuracy in valuing a company?

<p>Key assumptions: dividends are the relevant measure of value, and dividends will grow at a constant rate (or follow a predictable pattern). Accuracy is affected if these assumptions don't hold, as unpredictable dividends or substantial changes in dividend policy undermine the model's reliability.</p> Signup and view all the answers

Explain the concept of "abnormal earnings" in the context of the Discounted Abnormal Earnings model. How does it differ from traditional earnings, and why is it used in valuation?

<p>Abnormal earnings are earnings above and beyond what is required to compensate investors for the company's risk (i.e., earnings exceeding the cost of equity). They are used to determine value creation beyond the minimum required return.</p> Signup and view all the answers

Discuss the benefits and drawbacks of using multiples (e.g., Market-to-Book ratio, Price-to-Earnings ratio) for company valuation, compared to discounted cash flow methods.

<p>Benefits: Simplicity, ease of calculation, and market-based perspective. Drawbacks: Limited comparability across firms due to differences in accounting practices, growth rates, and risk profiles; and potential for misvaluation if the peer group is not truly comparable.</p> Signup and view all the answers

How does the Capital Asset Pricing Model (CAPM) contribute to the enterprise valuation process? What are some limitations of using CAPM to determine the cost of equity?

<p>CAPM provides an estimate of the cost of equity ($R_e$) by relating the risk-free rate, market risk premium, and the company's beta. Limitations include the assumption of market efficieny, stability of Beta over time, and difficulties estimating expected market return ($E(R_m)$).</p> Signup and view all the answers

Explain the role and importance of the Weighted Average Cost of Capital (WACC) in enterprise valuation. How does WACC reflect a company's financing decisions and risk profile?

<p>WACC represents the average cost of a company's financing. It is used to discount future free cash flows in valuation. A higher WACC reflects greater financial risk or a more expensive financing mix, reducing the present value of future cash flows.</p> Signup and view all the answers

What is the significance of Terminal Value (TV) in a discounted cash flow valuation? What are the common methods for estimating TV, and what are their respective strengths and weaknesses?

<p>Terminal Value represents the value of the company beyond the explicit forecast period. Common methods: Gordon Growth Model and exit multiple approach. Gordon Growth assumes constant growth, which may not be realistic. Exit multiples depend on comparable companies and market conditions.</p> Signup and view all the answers

How are abnormal earnings used in valuation when calculating terminal value?

<p>Abnormal earnings can be used in the calculation of terminal value by assuming they will persist into the future at a certain rate, reflecting the company's sustained competitive advantage or its eventual decay. The formula explicitly takes into account book value + the present value of abnormal earnings into the future ($V=BE + PV(AE)$).</p> Signup and view all the answers

Flashcards

Return on Equity (ROE)

Net income divided by average shareholder's equity.

Return on Sales

Net income divided by sales.

Asset Turnover

Sales divided by assets.

Equity Multiplier

Assets divided by equity.

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Net Operating Assets (NOA)

Operating assets minus operating liabilities.

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Net Capital

Financial obligations plus equity.

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Net Operating Profit After Tax (NOPAT)

(Operating revenue – operating expenses) * (1 – tax rate)

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Net Investment Profit After Tax (NIPAT)

(Investment income + interest income) * (1 – tax rate)

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Interest Expense After Tax (IEAT)

Interest expense * (1 – tax rate)

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Net Profit

NOPAT + NIPAT - IEAT

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Return on Net Operating Assets (RNOA)

Net operating profit after tax / net operating assets

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Operating Return on Sales (OROS)

NOPAT / Sales

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Operating Asset Turnover (OATO)

Sales / NOA

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Return on Investment Assets (ROIIA)

Net investment profit after tax / investment assets

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Return on Business Assets (ROBA)

(NOPAT + NIPAT) / Business assets

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Operating Working Capital (OCW)

(current assets – cash and cash equivalents) – (current liabilities - current portion of long-term debt)

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Net Non-Current Operating Assets (NNCOA)

Total long-term operating assets – non-interest-bearing long-term liabilities

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Gross Profit Margin

(Revenue – cost of sales) / Revenue

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Current Ratio

Current assets / current liabilities

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Debt-to-Equity Ratio

Current- and non-current debt / shareholders' equity

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Operating working capital to sales ratio

Operating working capital / Revenue

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Net non-current operating asset turnover

Revenue / Net non-current operating assets

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PP&E turnover

Revenue / Net PP&E

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Quick ratio

(Cash and cash equivalents + net trade receivables) / current liabilities

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Cash ratio

Cash and cash equivalents / current liabilities

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Dividend payout ratio

Cash dividends paid / profit or loss (net income)

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ROE decomposition

ROBA + spread + Financial leverage

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Study Notes

Ratio Analysis

(All Balance Sheet values are averages)

  • Return on Equity (ROE) is calculated as Net Income divided by Average Shareholder's Equity.
  • ROE can be decomposed into (Net Income / Sales) * (Sales / Assets) * (Assets / Equity).
  • Return on Sales is Net Income divided by Sales.
  • Asset Turnover is Sales divided by Assets.
  • Equity Multiplier is Assets divided by Equity.

Reformulation of Balance Sheet (BS) and Income Statement (IS)

  • Net Operating Assets are Operating Assets minus Operating Liabilities.
  • Net Capital is Financial Obligations plus Equity.
  • Business Assets is equal to Net Operating Assets plus Investment Assets.
  • Net Operating Profit After Tax (NOPAT) is (Operating Revenue – Operating Expenses) * (1 – Tax Rate).
  • Net Investment Profit After Tax (NIPAT) is (Investment Income + Interest Income) * (1 – Tax Rate).
  • Interest Expense After Tax (IEAT) is Interest Expense * (1 – Tax Rate).
  • Net Profit is NOPAT + NIPAT - IEAT.

Advanced Ratio Analysis

  • Return on Net Operating Assets (RNOA) is Net Operating Profit After Tax divided by Net Operating Assets.
  • RNOA is also equal to Operating Return on Sales (OROS) * Operating Asset Turnover (OATO).
  • Operating Return on Sales (OROS) is NOPAT divided by Sales.
  • Operating Asset Turnover (OATO) is Sales divided by NOA.
  • Return on Investment Assets (ROIIA) is Net Investment Profit After Tax divided by Investment Assets.
  • Return on Business Assets (ROBA) is (NOPAT + NIPAT) divided by Business Assets.
  • ROE is ROBA + spread + Financial Leverage.
  • Spread = ROBA – (Interest Expense After Tax / Debt).
  • Financial Leverage = Debt / Equity.
  • Operating Working Capital (OCW) is (Current Assets – Cash and Cash Equivalents) – (Current Liabilities - Current Portion of Long-Term Debt).
  • Net Non-Current Operating Assets (NNCOA) is Total Long-Term Operating Assets – Non-Interest-Bearing Long-Term Liabilities.

Additional Ratios

  • Gross Profit Margin is (Revenue – Cost of Sales) divided by Revenue.
  • Operating Working Capital to Sales Ratio is Operating Working Capital divided by Revenue.
  • Net Non-Current Operating Asset Turnover is Revenue divided by Net Non-Current Operating Assets.
  • PP&E Turnover is Revenue divided by Net PP&E.
  • Current Ratio is Current Assets divided by Current Liabilities.
  • Quick Ratio is (Cash and Cash Equivalents + Net Trade Receivables) divided by Current Liabilities.
  • Cash Ratio is Cash and Cash Equivalents divided by Current Liabilities.
  • Debt-to-Equity Ratio (Leverage) is Current- and Non-Current Debt divided by Shareholders’ Equity.
  • Dividend Payout Ratio is Cash Dividends Paid divided by Profit or Loss (Net Income).

Valuation

  • Dividend Discount Model: V = (Dividends1 / (1 + Re)) + ... or V = Dividends / (Re - g).
  • Discount Abnormal Earnings: V = BVE0 + (Earningst – RE * BVE(t − 1)) / (1 + RE)^t.
  • Market-to-Book Ratio is Market Value divided by Book Value.
  • Enterprise Valuation: V = BVA0 + ((NOPAT1 + NIPAT1 – Rwacc * BVE1) / (1 + Rwacc)) +....
  • Rwacc = (FO / Net Capital) * (1 – Tax %) * Rd + (Equity / Net Capital) * Re.
  • Price-Earnings Ratio is Market Share Price divided by Earnings per Share.
  • CAPM: Re = rf + Beta * (E(Rm) – Rf).

Terminal Value

  • TV = ((Abnormal Earnings(t) * (1 – g)) / (Re – g) * (1 + Re)^t.
  • V = BE + PV(AE) + TV.

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