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Chapter 3
Profitability
and
Risk Analysis
Which is more profitable?
Wal-MartHome Depot
May Company
Profitability Analysis
• Project future profitability based on an analysis of past performance
• Time series analysis • changes in financial ratios over time
• Cross-sectional analysis• examines company’s financial ratios in comparison
to - its competitors - industry averages
Profitability Analysis - Nuts & Bolts
• Rate of return on assets (ROA)• firm’s success in using assets to generate earnings• independent of financing considerations
N.I. + Interest Expense net of taxes + Minority Interest in Earnings
Average Total Assets
• Net Income - from continuing operations• Interest Expense net of taxes
(1 - marginal tax rate) (Interest Expense)
• Minority Interest - added back to obtain consistency between numerator and denominator
Nuts & Bolts, cont’d
• Dissaggregating ROA
ROA = Profit Margin X Assets Turnover
__Adj. NI_____ = Adj. NI X ____Sales________
Avg.Tot.Assets Sales Average Total Assets
Profit Margin Analysis
• Look at the components of net income as a percentage of sales• Other revenues• Cost of goods sold• Selling and administrative expenses• Income taxes
• Gives insight into how the company earned its income• “quality of earnings”
Analyzing Asset Turnover
• Looks at the relationship between operating revenues, expenses, and assets• Accounts receivable turnover
Net Sales on Account / Average Accounts Receivable
• Inventory turnover
Cost of Goods Sold / Average Inventories
• Fixed assets turnover
Sales / Average Fixed Assets
Chapter 3, cont’d
Risk Analysis
Case Assignment (due Monday, 3/1)
Case 3.1: Wal-Mart Profitability and Risk AnalysisGeneral guidelines for analysis are provided with the case. Simply answering the questions in a reasonably complete manner should garner a score of 80%. Additional points will be awarded based on thoroughness of analysis, presentation, and creativity.
In addition to the stated analysis requirements, you should also prepare a strategic analysis. This analysis should evaluate the market in which Wal-Mart operates (is it growing or shrinking, how intense is the competition, etc.) as well as evaluate Wal-Mart’s position relative to its competitors.
Financial Analysis Software
• Program and documentation available on the class web page• documentation is in a self-extracting file
Profitability Analysis Summary
ROA = Profit Margin x Asset Turnover
ProfitMargin
Asset Turnover
A
B
C
D
ROAA=12%B=12%C=18%D=6%
Return on Common Equity
• Measures return not allocated to debt or preferred equity
ROCE = Net Income - Preferred Dividends*Avg. Common Equity
* also known as NI to Common
• Using lower-cost debt and preferred stock financing can increase the return to common shareholders• financial leverage
Disaggregating ROCE
• Allows us to interpret causes for differences between ROA and ROCE
ROCE = ROA x CEL x CSL
NI to common = __NI+I.E. X NI to common X Avg. Total Assets Avg. Common Avg. Total NI+I.E. Avg. Common Equity Assets Equity
Significance of ROA, CEL, and CSL• ROA tells us the return on all assets employed• CEL tells us about the relative cost of debt and preferred
stock• indicates the proportion of net income that is available to
common shareholders• the higher the cost of debt and preferred stock, the smaller the
ratio, the less income will remain for common shareholders
• CSL tells us about the degree to which a firm uses debt to increase its asset base• the more debt and preferred stock is used to finance assets, the
greater the multiplier effect on earnings • when the cost of debt and preferred is less than ROA, common
shareholders earnings are enhanced
• when the cost of debt and preferred is greater than ROA, common shareholders earnings are depressed
Putting numbers with the concepts
• Hi-debt Company has: Total Assets 2M Common Equity1MInterest Expense 100KTax rate 40%Year 1 N.I. 180K Year 2 N.I.
-0-
ROCE = ROA x CEL x CSLYR1 18% = 12% x 75 x 2
YR2 0% = 3% x 0 x 2
Putting numbers with the concepts
• No-debt Company has: Total Assets 2MCommon Equity 2MInterest Expense -0-Tax rate 40%Year 1 N.I. 240K Year 2 N.I.
60K
ROCE = ROA x CEL x CSL YR1 12% = 12% x 1 x 1
YR2 3% = 3% x 1 x 1
Financial Leverage and ROCE
3 -
9 -
15 -
18 -
12 -
6 -
Hi-Debt Co.
No-Debt Co.
Poor Neutral Good
Type of earnings year
ROCE
(%)
Leverage hurts
Leverage helps
0 -
Sources of Risk
Political Unrest
RecessionRecession
Technology
CompetitionDemographicsDemographics
Regulation
Short-term liquidity
• A firm’s ability to meet short-term commitments and the relative level of those commitments
• Ability to meet short-term commitments• Current ratio• Quick ratio• Operating cash flow to current liabilities ratio
• Amount of working capital required to support sales• A/R turnover & Days Receivables Outstanding• Inventory turnover & Days Inventory Held• A/P turnover & Days Payables Outstanding
Long-term solvency
• Measure the firm’s ability to meet interest and principal repayment on long-term debt
• Debt ratios - higher proportions indicate greater risk• Long-term Debt Ratio• Debt/Equity Ratio• Liabilities/Assets Ratio
• Coverage Ratios - lower ratios indicate greater risk• Interest Coverage Ratio• Operating Cash Flow to Total Liabilities Ratio• Operating Cash Flow to Total Capital Expenditures Ratio
Earnings per Common Share
• Simple capital structure (no convertible bonds, convertible preferred stock, or stock options)
Basic EPS = Net Income to Common Weighted Avg. Common Shares Outstanding
• Complex capital structure - EPS must reflect the ability of convertible securities to dilute common
Diluted EPS = NI to Common + Adj. For Dilutive Securities Weighted Avg.+ Wgtd. Avg. Shares from Common Outstanding Dilutive Securities
Problems with EPS measures
• Doesn’t reflect level of investment
• Therefore difficult to use in cross-sectional
analysis
• Mixes profitability measures (net income) with
capital structure decisions (# shares
outstanding)• can be manipulated by managing capital structure
TheEnd