Module 4Module 4

Analyzing and Analyzing and Interpreting Interpreting

Financial Financial StatementsStatements

Analysis Analysis QuestionsQuestions

• Are earnings sufficient?Are earnings sufficient?• Can they pay their current bills? Can they pay their current bills?

(Liquidity)(Liquidity)• Can they pay debts over the long Can they pay debts over the long

term? (Solvency)term? (Solvency)

Are Earnings Sufficient? Are Earnings Sufficient? Return on EquityReturn on Equity

Return on equity (ROE) is computed as:Return on equity (ROE) is computed as:

Analysis often expands ROE:Analysis often expands ROE:

ROE= RNOA + Impact of debtROE= RNOA + Impact of debt

Operating Return (RNOA)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.

Target’s Operating ItemsTarget’s Operating Items

Tax on Operating ProfitTax on Operating Profit

For Target:

Tax rate on operating income = $1,855 / $5,252 = 35.32%

Net Operating Assets Net Operating Assets (NOA)(NOA)

Net Operating Assets Net Operating Assets (NOA)(NOA)

NOA = Operating Assets - Operating Liabilities

Net Operating Profit Net Operating Profit Margin (NOPM)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

Net Operating Asset Net Operating Asset Turnover (NOAT)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.

Nonoperating Return Nonoperating Return Component of ROEComponent 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:

Effect of Financial Effect of Financial LeverageLeverage

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.

Effect of Financial Leverage Effect of Financial Leverage on ROEon 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.

Nonoperating Returns to Nonoperating Returns to Equity (APP A)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

Nonoperating Return Nonoperating Return with with

Debt FinancingDebt Financing

$500/$1,000 20%-7%

Liquidity and Solvency Liquidity and Solvency (App B)(App B)

LiquidityLiquidity refers to cash: how refers to cash: how much we have, how much is much we have, how much is expected, and how much can be expected, and how much can be raised on short notice to pay raised on short notice to pay current bills.current bills.

SolvencySolvency refers to the ability to refers to the ability to meet obligations; primarily meet obligations; primarily obligations to creditors, obligations to creditors, including lessors. including lessors.

Liquidity MeasuresLiquidity Measures

Solvency RatiosSolvency Ratios

Vertical and Horizontal Vertical and Horizontal AnalysisAnalysis

• 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

Common Dollar Income Common Dollar Income StatementStatement

DuPont Analysis (App C)DuPont Analysis (App C)Older, different form of Older, different form of

analysisanalysis

• Profit margin Profit margin is the amount of net income that the company earns from each dollar of sales.

• Asset turnover Asset turnover is a productivity measure that reflects the volume of sales that a company generates from each dollar invested in assets.

• Financial leverage Financial leverage measures the degree to which the company finances its assets with debt rather than equity.

Return on AssetsReturn on Assets

Adjusted Return on Adjusted Return on AssetsAssets

• Some adjust the numerator to reflect the company’s operating profit after taxes

• Like NOPAT