3/3/2020

DRIVERS OF THE FIRM’S PROFITABILITY AND

GROWTH
FINANCIAL STATEMENT
ANALYSIS

Lecturer: Phan Ngoc Anh, MBA

Resources:
Chapter 5- Business Analysis and Valuation by Palepu, Healy, Bernard
and multiple HBS reading materials

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FINANCIAL STATEMENT ANALYSIS:

LEARNING OBJECTIVES TOOLS AND APPROACHES

There are two primary tools in financial analysis: Tools: Approaches used

Common-size Cross-sectional analysis: different

Ratio analysis – to assess how various line items in firms at a single point in time (e.g.,
financial statements relate to each other and to measure statements Wal-Mart and Target in 2008).
relative performance.
Time-series analysis: the same
Trend statements firm over time (e.g., Wal-Mart in
Cash flow analysis – to evaluate liquidity and the 2008 and 2006)
management of operating, investing, and financing
activities as they relate to cash flow.
Financial ratios Benchmark comparison: using
industry norms or
(e.g., ROA and ROE) predetermined standards.

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PRINCIPLES USED IN THIS LECTURE RATIO ANALYSIS

Principle 1: Money Has a Time Value 1/ACTIVITY & ASSET UTILIZATION RATIOS
- We need to recognize that financial statements do not adjust
for time value of money. 2/SHORT-TERM LIQUIDITY RATIOS

3/LONG-TERM SOLVENCY RATIOS

Principle 2: Cash Flows Are the Source of Value
- Financial statements provide an important starting point in 4/PROFITABILITY RATIOS
determining the firm’s cash flow.
- We should be able to distinguish between reported earnings 5/MARKET VALUE RATIOS
and cash flow. It is possible for a firm to report positive
earnings but have no cash!

Principle 3: Market Prices Reflect Information

- Firm’s financial statements provide important information
that is used by investors in forming expectations about firm’s
future prospects and subsequently, the market prices.
FIN3000, Liuren Wu 5

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RECEIVABLES TURNOVER RATIO AND

ACTIVITY AND ASSET UTILIZATION RATIOS COLLECTION PERIOD

Turnover analysis: these are ratios which reflects the Account

Receivables = Net Sales on account
efficiencies of a firm’s investment management Average Accounts Receivable
Turnover
- How efficiently is the firm using its assets?
measures how many times a company
- How efficiently is the firm in managing activities converts its receivables into cash each year.
(collection, payment, inventory control..)

A “good” ratio in one industry is not necessarily “good” in

another industry, as industries differ by nature Average 365
=
Collection Account Receivables Turnover
Period (days
receivable This ratio is an approximation of the number
outstanding) of days it takes a company to collect its A/R
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INVENTORY TURNOVER RATIO AND AVERAGE

DAYS IN INVENTORY FIXED ASSETS TURNOVER

Inventory Cost of Goods Sold Fixed asset Sales

Turnover = Average Inventory Turnover =
Average Fixed assets
measures the number of times merchandise measures the relation between
inventory is sold and replaced during the year Sales and the investment in PPE

Average
Days in = 365
Inventory Inventory Turnover Ratio
(days Indicates the number of days
inventory it normally takes to sell inventory
held) 10

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ACCOUNT PAYABLES TURNOVER SHORT-TERM LIQUIDITY RATIOS

Account Liquidity refers to the company’s short-term ability to

Inventory Purchases
Payable = Average Account Payables generate cash for working capital needs and immediate
Turnover debt repayment needs.
measures how quickly the
firm is paying its suppliers Common used measures include:
- Current ratio
- Quick ratio
Days Payable 365 - CCC – Cash Conversion Cycle
=
outstanding Account Payable Turnover
- CFO to Liabilities ratio
This ratio is an approximation of the number of
days it takes the firm to pay its suppliers/creditors

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CURRENT RATIO QUICK RATIO

Current Quick ratio Cash + Marketable securities + Account Receivable

Current Assets
ratio = (Acid-test) = Current Liabilities
Current Liabilities ratio
Current assets - Inventory
This ratio matches the amount of cash and other current = Current Liabilities
assets that will become cash within one year against the
obligations that come due in the next year
This ratio matches the amount of cash and other current
assets that will become cash within one year against the
obligations that come due in the next year

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OPERATING CASH FLOWS TO CURRENT

LIABILITIES RATIO CASH CONVERSION CYCLE
CCC = Days inventory held + Days sale outstanding – payables deferred period
OCF to Current = CFO
Liabilities ratio Average Current Liabilities

The advantage of the ratio is that it is based on cash

flows after the funding needs for working capital (i.e.
A/R and inventory) has been made.

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LONG-TERM SOLVENCY RATIOS LONG-TERM SOLVENCY RATIOS

Measure the ability of the firm to pay its long term debt
Long-term Long-term Debt
and the interest on that debt  help the business owner
Debt ratio = Long-term Debt + Shareholder’s Equity
determine the chances of the firm's long-term survival

Solvency ratios are of interest to long-term creditors and Debt/Equity Long-term Debt
ratio =
shareholders. These groups are interested in the long-term Shareholder’s Equity
health and survival of business firms

Liabilities/Assets Total Liabilities

ratio =
Total assets

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INTEREST COVERAGE RATIO PROFITABILITY RATIOS

Two ratios that specifically address the ability to pay interest “the bottom line” that shows a company's overall efficiency
on debts are: and performance.
Can be divided into two types: margins and returns
Interest coverage ratio (earnings basis) = - Ratios that show margins: represent the firm's ability to
translate sales dollars into profits at various stages of
Net income + Interest expense + Income Tax expense
Interest expense measurement.
- Ratios that show returns: measure the overall efficiency
Interest coverage ratio (cash flow basis) = of the firm in generating returns for its shareholders.

CFO + Cash payment for Interest expense +Cash payment for income Taxes
Interest expense

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GROSS PROFIT MARGIN NET OPERATING PROFIT MARGIN (NOPM)

NOPM = NOPAT
is the company’s first level of profit – gross profit, and used
to analyze how efficiently a company is in acquiring/using its Sales
raw materials, labor, and manufacturing-related fixed assets In which:
to generate profits NOPAT (Net Operating Profit after Taxes): a measure of Profit
A higher margin percentage is a favorable profit indicator that excludes the costs and tax benefits of Debt Financing
NOPAT = Operating Income x (1 – Tax rate)

Gross Profit Gross Profit Why matters?

=
margin Sales
NOPAT strips away many one-time items from the
Gross margin tends to remain stable over time. When you picture, focusing only on the firm’s core business
are analyzing a company, you do want to pay attention to profitability
changes in gross profit margin levels. It could signal a shift NOPAT strips out interest expense, effectively looking at
in strategies! the firm from a non-levered position
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ANALYSIS OF PROFITABILITY DISAGGREGATING ROE VERSION 1

ROE VS. ROA : VERSION 1 TRADITIONAL DUPONT ANALYSIS

Return on Equity (ROE): measures a firm's profitability by

revealing how much profit a company generates with the
money shareholders have invested
Net Income – Preferred Div.
ROE =
Average Common Shareholder’s Equity

Return on Assets (ROA): measures how efficient

management is at using its assets to generate earnings.

Net Income + Interest expense x(1–tax rate)

ROA =
Average Total Assets
For simplicity, use ROE = NI/Equity and ROA = NI/Assets
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ANALYSIS OF PROFITABILITY
ROE VS. ROA : VERSION 2 HOW TO INCREASE ROA?
Analysts do not always use the reported earnings, sales and asset There are just two ways:
figures. Instead, they often consider adjustments to the reported
numbers:
1.Increase the operating profit margin, or
Remove non-operating and nonrecurring items to isolate 2.Increase the intensity of asset utilization (turnover rate).
sustainable operating profits  use NOPAT
Eliminate after-tax interest expense to avoid financial structure Asset turnover
distortions  use NOPAT

NOPAT
ROA = ROA=
NOPAT____ NOPAT Sales ___ __
Average Total Assets Average assets Sales Average assets

NOPAT
ROE =
Average Shareholder’s Equity Operating profit margin
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ROA, MARGIN, AND TURNOVER EXAMPLE

ROA, MARGIN, AND TURNOVER EXAMPLE KRISPY KREME DOUGHNUTS, INC.

A company earns $9 million of NOPAT on sales of $100

million with an asset base of $50 million.

 Turnover improvement: Suppose assets can be reduced to $45

million without sacrificing sales or profits.
How was Krispy Kreme able to increase it’s ROA from 7.1% to 12.1% over
this period?
1. The expanded store base, along with increased sales, allowed the fixed costs be
 Margin improvement: Suppose expenses can be reduced so that spread over a number of stores- The result was in an improved operating profit margin.
NOPAT becomes $10.
2. However, the asset based was considerably less productive in 2002 ( Asset turnover is
1.48) than it was in 1999 ( Asset turnover is 2.22) – More stores meant more resources
( assets) tied up operating cash, receivables, etc.

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DISAGGREGATING ROE VERSION 2

ROA AND COMPETITIVE ADVANTAGE USING NOPAT INSTEAD OF NET INCOME

Competitive Advantage: Net Operating Profit after tax

Competitive
ROA floor NOPAT
Companies that consistently earn
an ROA above the floor. (e.g., Firm C) Sales
Return on
- However, a high ROA attracts more
competition which can lead to an equity (ROE) X
erosion of profitability and advantage. Asset Turnover
Competition works to drive down ROA NOPAT Sales
toward the competitive floor.
Average shareholders’ Average Total Assets
Firm A and B earn the same ROA, but equity
Firm A follows a differentiation
strategy while Firm B is a low cost
leader. X
Leverage
- Differences in business strategies give
rise to economic differences that are Average Total assets
reflected in differences in operating
margin, asset utilization, and Average shareholders’
profitability (ROA). equity
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FINANCIAL LEVERAGE AND RISK FINANCIAL LEVERAGE AND PROFITABILITY

NOPAT

ROE
Leverage shows the extent to which firm relies on Debt
financing in its capital structure
Since cost of Debt is typically less than Cost of Equity, it
is optimal for firms to use some Debt in their capital
structure to take advantage of leverage

Then why not financed with 100% Debt?

Because Debt is risky!!!

Increased risk give rise to the expected return investors
require to provide capital to the firm (both Debt and Equity)
Financial leverage is beneficial only when the company earns (i.e., ROA) more
than the incremental after-tax cost of debt.
If the cost of debt is greater than the earnings, increased leverage will harm
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OTHER MARKET TESTS ASSESSING SUSTAINABLE GROWTH RATE

Sustainable growth rate (SGR): the rate at which a firm

EPS (Earnings per Net Income – Div. on preferred stock can grow while keeping its profitability and financial policies
share) = # Outstanding common shares
unchanged.

Market price per share

P/E ratio = Sustainable Growth Rate  ROE  Retention Ratio
EPS

 ROE  (1 - Payout Ratio)

DPS (Dividend per Total Dividend on common stock
share) = # Outstanding common shares In which:
Return on Equity (ROE) = Net Income / Equity
Payout Ratio = Proportion of earnings paid out as dividends
DPS
Dividend Yield = Market Price per share Retention Ratio = Proportion of earnings retained for investment

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ASSESSING SUSTAINABLE GROWTH RATE

EPS = 10.49 ₡
Payout 76.3% Plow back 23.7% MORE ON THE TECHNIQUES
DPS = 8 ₡ Retained profit = 2.49 ₡

Common-size analysis
Reinvest at ROE = 9.32%
Trend analysis
Growth = 0.23 ₡
(g = 2.21%=23.7%*9.32%)
Growth rate = Return on Equity * Plowback ratio
GlaxoSmithKline (GSK) corporation
EPS 10.49 ₡
DPS 8 ₡
ROE 9.32% (estimated)
Share price $1.15 35

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COMMON-SIZE ANALYSIS COMMON-SIZE ANALYSIS

(VERTICAL ANALYSIS) (VERTICAL ANALYSIS)

Simple way of creating greater comparability across Income

firms and for same firm through time. Statement
Most frequently utilized in: Company appears
- Income statement: by expressing all line items scaled to be a profitable
by Sales. enterprise that is
- Balance sheet: by expressing all line items scaled by becoming even
Total Assets. more successful.

Common scaling enables figures across firms and

across time to be more comparable.

More analysis: Pepsi Co. and Coca Cola

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COMMON-SIZE ANALYSIS COMMON-SIZE ANALYSIS

(VERTICAL ANALYSIS) (VERTICAL ANALYSIS)

Balance Enables a comparison of companies of different sizes.

Sheet
Illustration 14-10
Company is
choosing to finance
its growth through
retention of earnings
rather than through
issuing additional
debt.

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PERCENTAGE CHANGE ANALYSIS PERCENTAGE CHANGE ANALYSIS

(TREND ANALYSIS / HORIZONTAL ANALYSIS) (TREND ANALYSIS / HORIZONTAL ANALYSIS)

Income
Statement
Computes percentage changes in individual line Base year

items. Overall, gross profit

and net income were
Can be compared across firms or across time.
up substantially. Gross
Focus is not on the financial data themselves, profit increased
but on the changes in individual line items 17.1%, and net
through time. income, 26.5%.
Quality’s profit trend
appears favorable.

More analysis: Pepsi Co. and Coca Cola

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PERCENTAGE CHANGE ANALYSIS

(TREND ANALYSIS / HORIZONTAL ANALYSIS)
CASH FLOW STATEMENT
Balance Sheet ANALYSIS
These changes
Base year
suggest that the
company expanded its
asset base during - Quick review of the Cash Flow Statement
2009 and financed this (since you almost forgot the stuff)
expansion primarily by
retaining income - Cash flow analysis
rather than assuming
additional long-term
debt.

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PRELIMINARIES PRELIMINARIES
THE CASH FLOW STATEMENT CASH FLOW STATEMENT’S BUILDING BLOCKS

Operating activities
The cash flow statement reported how an organization (I/S items)
generated and used cash. Investing activities:
change in Investments
(+) Inflows: and Long-term asset Financing activities:
• From sale of items change in long-term
goods/services Liabilities and Equity
Income statement (+) Inflows:
(+) Inflows:
• From interest/dividend • From sale of PPE
received • From sale of securities of • From sale of common
BS at start Cash flow BS at end (-) Outflows: other companies stock
• To suppliers for Inventory • From collection of principal • From issuance of
on loans to other long-term Debt
• To employees for (bonds/notes)
companies
services (-) Outflows:
(-) Outflows:
A cash flow statement reflects both “profit related” (operating) and • To government for taxes • To purchase PPE • To stockholders as
“non-profit related” activities (investing and financing) with an impact on • To lenders for interest • To purchase securities of Dividends
• To others for expenses other companies • To redeem long-term
available cash over the period covered in the income statement
• To make loans to other Debt
entities • To acquire treasury
2 methods to prepare: Direct and Indirect 45
stock
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PREPARING THE STATEMENT OF CASH FLOWS PREPARING THE STATEMENT OF CASH FLOWS
INDIRECT METHOD FROM ACCRUAL BASIS TO CASH BASIS – INDIRECT METHOD

Net Income
Reconciling adjustments:
+ Depreciation/depletion/amortization (non-cash expenses)
+ Losses on sales of investing assets
- Gains on sales of investing assets
+ or - changes in CA & CL except notes payable and
dividends payable (source/use of cash)
Net cash provided by operating activities

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PRELIMINARIES PRELIMINARIES
SOURCE AND USE OF CASH SOURCE AND USE OF CASH ILLUSTRATION

Sources of cash are those activities that bring in cash.

Uses of cash are those activities that involve spending cash.
The firm’s statement of cash flows summarizes its sources and
uses of cash over a specified period.
A firm uses cash by either buying assets or making
payments
Use of cash:
- Increase in Asset accounts
- Decrease in Liabilities, Equity accounts
Source of cash:
- Increase in Liabilities, Equity accounts
- Decrease in Asset accounts
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PRELIMINARIES PREPARING THE STATEMENT OF CASH FLOWS

SOURCE AND USE OF CASH ILLUSTRATION INDIRECT METHOD – FINAL OUTPUT EXAMPLE

Cash flows from operating activities:

Net income $ 145,000
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation expense 9,000
Loss on sale of equipment 3,000
Decrease in accounts receivable 10,000
Increase in inventory (5,000)
Increase in prepaid expenses (4,000)
Increase in accounts payable 16,000
Decrease in income taxes payable (2,000)
Net cash provided by operating activities 172,000
Cash flows from investing activities:
Purchase of building (120,000)
Purchase of equipment (25,000)
Sale of equipment 4,000
Net cash used by investing activities (141,000)
Cash flows from financing activities:
Issuance of common stock 20,000
Payment of cash dividends (29,000)
Net cash used by financing activities (9,000)
Net increase in cash 22,000
Cash at beginning of period 33,000
Cash at end of period $ 55,000
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ANALYZING CASH FLOW INFORMATION SOME COMMON CASH FLOW PATTERNS

Questions to be addressed in analyzing Cash Flow Statement: Cash Flows Cash Flows Cash Flow
From which sources did the company raise cash last year? How was this from from from General Explanations
Operating Investing Financing
cash used?
Were the normal operating activities capable of satisfying its need for Building up pile of cash.
cash during the year? If not, is the shortage of cash compensated by new 1 + + + Possibly looking for
borrowings, issuing new share capital or by selling fixed assets? acquisitions
Is a surplus of cash used for repayment of debt, for investments or for _ _ Operating cash flow enough
distribution of dividends? 2 + to buy fixed assets and pay
back Debt/Dividend…
How much cash did the company invest in growth? Are these investment
_ Operating cash flow and
consistent with its business strategy? Did the company use internal CF to 3 + + sale of fixed assets being
finance growth, or external? used to pay Debt/Dividend..
What type of external financing the company relies on? Is the financing Operating cash flow and
_
consistent with company’s overall business risk? What is the use of cash 4 + + borrowed money being used
received from new financing? to expand
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CASH FLOW ANALYSIS

SOME COMMON CASH FLOW PATTERNS OPERATING ACTIVITIES

Cash Flows Cash Flows Cash Flow

from from from General Explanations Ask yourself:
Operating Investing Financing
Are there significant discrepancy between Net Income
Operating cash flow problems and CFO? Does this gap change over time?
covered by sale of fixed
5 _ + + assets, borrowing, stock
issuance Is it possible to identify the source of this difference?
_ _ Rapid growth and short falls in ex: persistent negative OCF b/c of net loss? Or substantial
6 + operating cash flow covered
increases in working capital?
by new Debt/stock issuance
Sale of fixed assets to fund ex: sudden increase in OCF b/c of increased depreciation
_ from intensive newly acquired PPE?
7 + _ operations and pay off Debt

_ _ _ Company is using cash

8 reserves to finance cash flow
short falls and pay creditors
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CASH FLOW ANALYSIS CASH FLOW ANALYSIS

INVESTING ACTIVITIES FINANCING ACTIVITIES

Ask yourself:
Is the rate of expansion (investment in PPE) compatible Ask yourself:
with the expected sales growth? Is the financing decisions related to the current operating
- If not compatible  lower PPE turnover rate  reduced performance of the firm?
ROA and ROE
- Should be linked with growth
Reductions in capital expenditure over time?
Take into account the nature of the business
- Signal expected decline in future sales, earnings, and
OCF - Each industry has its own “norm” for optimal capital
Take into account the nature of the business structure (ex: technology firm often financed by Equity
while airlines/automobiles often financed by Debt)
- Capital intensive (airlines, automobiles … vs. Retailers)
Where does the primary investing cash outflows come Reduction/elimination of Dividends/share repurchase?
from? Does it provide information about “operational”
investments?
- Purchase of PPE or purchase of marketable securities?
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A FINAL WORD ON CASH FLOWS ANALYSIS RECASTING THE CASH FLOW STATEMENTS
FOR ANALYSIS PURPOSE
One year of cash flows analysis is not enough in determining a Traditional SCF Format Recast SCF Format
company’s financial health  Cash flow pattern should be checked for
Net Income Net Income
consistency/trend over time + Depreciation and Amortization + Interest Expense (Net of Tax)
± Deferred Taxes + Depreciation and Amortization
± Gains/Losses ± Deferred Taxes
Cash flow analysis has to take into account: ± Changes in Working Capital ± Gains/Losses
= Cash Flow from Operating Activities = OCF before Working Capital Investments
o Stage in firm (product) life cycle: young, growing vs. mature firm ± Changes in Working Capital
- Purchases of Long Term Assets = OCF before Investment in Long Term Assets
o Strategy of the firm + Sales of Long Term Assets - Purchases of Long Term Assets
- A rapidly growing capital intensive firm? = Cash Flow from Investing Activities + Sales of Long Term Assets
= FCF Available to Debt and Equity-holders
- A firm opting for organic growth? + Issuance of Stock - Interest Expense (Net of Tax)
- A firm pursue growth by acquiring other firms? + New Borrowing - Debt Payments
- Debt Payments + New Borrowing
- A diversified firm that is refocusing and divesting itself of non-core business? - Dividends = FCF Available to Equity-holders
o Industry norms - Stock Repurchases + Sale of Stock
= Cash Flow from Financing Activities - Dividends
- Stock Repurchases
Note: Although none of the indicators by themselves represents conclusive evidence of Cash Flow from Operating Activities = Net Change in Cash
+ Cash Flow from Investing Activities
cash flow problems, they do signal the need to obtain explanations from management to + Cash Flow from Financing Activities OCF = Operating Cash Flow
see whether an emerging cash flow problem does exist. 59
= Net Change in Cash FCF = Free Cash Flow

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