Professional Documents
Culture Documents
Profitability of Firms
Profitability of Firms
Profitability Ratios
Purpose:
Provide insight about ability to generate income
Return on assets
= Net income + interest * (1 - tax rate)
Assets
Return on equity
= Net income / equity
Return on Equity
Simply stated:
ROE = Net income / equity
DuPont ROE
Decompose: ROE = Net income / equity
Into:
ROE = Return on sales
* Asset turnover
* Financial leverage
Tax effect
Unusual items effect
Discuss using handout example.
FIN 551:Fundamental Analysis
Common-Size
Income Statement
Usefulness:
Are the companys margins consistent with its
stated competitive strategy?
Are the companys margins changing? Why?
What are the underlying causes?
Is the company managing its overhead and
administrative costs well? What are the
activities driving these costs? Are the activities
necessary?
FIN 551:Fundamental Analysis
Turnover Ratios
Purpose:
Measure efficiency in managing assets
Definition:
Sales / asset
A slight digression:
Assume total assets
= Cash + receivables + inventory + fixed assets
$1,000 = $100 + $300 + $200 + $400 & sales = $5,000
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11
12
13
Note:
All financing costs are excluded from EBIT
Taxes have been excluded from EBIT
Show a separate tax effect later.
FIN 551:Fundamental Analysis
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Interpretation:
The proportion of $1 of operating earnings (before
interest expense) that is left after paying interest.
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Balance Sheet
Financing Multiplier
Financial leverage = Assets / equity
But, Assets = Debt + Equity
Thus, Assets / equity = (Debt / equity) + 1
Assets / equity
= Current liabilities / equity
+ Long-term debt / equity
+ Other LT liabilities / equity
+ Preferred stock / equity
+ 1.
FIN 551:Fundamental Analysis
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W.T. Grants
Management of Financial Leverage
Assets/Equity
CL/Equity
LTL/Equity
Other/Equity
Preferred/Equity
Equity/Equity
1.761
0.697
0.480
0.024
1.000
1.544
0.389
0.451
0.026
1.000
1.145
0.406
0.403
0.029
1.000
1.246
0.110
0.373
0.033
1.000
1.025
0.127
0.338
0.041
1.000
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W.T. Grants
Interest Rate Environment
9
8
Jan. 74
7
6
5
Jan. 70
Jan. 73
Jan. 69
Jan. 71
4
Jan. 72
3
2
1
0
0
10
Years
12
14
16
18
20
20
10
Interpretation
The proportion of $1 of pretax income left after
paying income tax.
FIN 551:Fundamental Analysis
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22
11
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Background for
Sustainable Growth
Sustainable growth relies on:
Return on equity
Dividend policy.
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Sustainable Growth
Definition:
Growth the firm can sustain
Without issuing new equity
Maintaining current financial policies
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An Example
LY TY
Assets 200 330
Debts
40
80
Equity 160 250
Sales growth = 75%
Asset growth = 65%
Sales
Costs
Profit
Dividends
Retained
LY
400
300
100
40
60
TY
700
550
150
60
90
Growth =
60.0%
56.3%
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13
W.T. Grants
Sustainable Growth
1974
Return on sales
.004
Inverted asset turnover .677
Financial leverage
2.962
Retention rate
-1.542
Sustainable growth
Actual growth (sales)
Formula: Sustainable growth =
1973
.023
.675
2.410
.444
1972
.025
.687
1.983
.402
1971
.031
.644
1.762
.477
1970
.034
.584
1.531
.532
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Inflation-Adjusted Statements
Important considerations:
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14
As Reported
1,849,802
1,163,998
13,579
623,646
48,579
7,033
787
3,778
21,122
-12,693
FIN 551:Fundamental Analysis
Adjusted
1,849,802
1,300,000
17,282
623,646
-91,126
7,033
787
-135,927
21,122
-152,398
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The End
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