Part III – Financial Analysis

8. Profitability and Risk Analysis

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Profitability Analysis

 Aim of Profitability Analysis/Economic Analysis:

– To analyze the economic efficiency of a company - its ability to
generate earnings to meet the claims of all the entities with whom
the company interact (customers, suppliers, creditors,
shareholders, employees,...)
– It includes the profitability analysis and productivity analysis

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 Profitability Analysis

 Profitability or Return Analysis consists in assessing the

ability of a company to generate Income (Profit), comparing
it with the invested capital
– Return ratios relate income, or other performance measure,
to a company’s level and source of financing.
:

Income (Profit)/ Invested Capital

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Profitability Analysis

 Return on invested capital allows comparisons with

alternative investment opportunities
 Riskier investments expected to yield a higher return on
invested capital
 Return on invested capital impacts a company’s ability to
succeed, attract financing, repay creditors, and reward
owners

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 Profitability Analysis

 Alternative Measures of Invested Capital:

– Total Assets
– Net Operating Assets (Operating Assets less Operating
Liabilities)
– Shareholders’ Equity

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Profitability Analysis
Return on Assets (ROA)

Return on Assets or ROA (Rendibilidade do

Investimento Total, Rendibilidade do Ativo ou
Rendibilidade Económica)
= EBIT*(1-t)/Total Assets
this ratio gives us the rate of return of all invested capital
independently of the source of financing (Debt or Equity)
It removes the tax effect of debt and therefore gives us the
return on assets that is independent of the capital structure of
the company
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 Profitability Analysis
Return on Assets (ROA)

Other alternative formulas:

ROA = Operating Income/Total Assets
ROA = Net Income/Total Assets

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Profitability Analysis
Decomposing ROA

Net Income Net Income Sales

 
Assets Sales Assets

ROA = Return on Sales × Assets Turnover

ROA is affected both by the Profit Margin (ROS) and

the Assets Turnover 157

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 Profitability Analysis
Return on Equity (or Financial return)

Return on Equity or ROE (Rendibilidade dos capitais

próprios)
= Net Income/Shareholders’ Equity
This ratio measures the efficiency with which the company
uses Shareholders’ capital
As higher the ROE, the more attractive is the company for
potential investors and the greater the likelihood of the
company to develop its future activities with recourse to
self-financing
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Profitability Analysis
Decomposing ROE

Net Income Net Income Total Assets

 
Equity Total Assets Equity

ROE = ROA × Capital Structure

ROE consists of two components: an operating return (ROA) and

a non-operating return (effect of financial leverage)
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 Profitability Analysis
Decomposing ROE

 The relationship between the different return measures

(Dupont analysis):

ROE = ROA × Capital Structure

ROE = ROS × Assets Turnover × Capital Structure

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Profitability Analysis
Decomposing ROE

 Other alternative decompositions

– Additive model:
RL/CP = [RO/AE + CA/CP(RO/AE-J)]*(1-t)
ROE=[Operating ROA+D/E*(Operating ROA-Interest)]*(1-t)
– Multiplicative method:
ROE=(EBIT/Sales*Sales/Assets)*
*(Assets/Equity*EBT/EBIT)*(Net Income/EBT)

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 Profitability Analysis
Financial leverage

 The Financial Leverage Effect: is the positive or negative effect of

financial leverage on the ROE. Considering ROA=EBIT*(1-t)/Assets
and assuming there is no income tax:

ROE > ROA, the financial leverage effect is ______________

ROE < ROA, the financial leverage effect is ______________
ROE = ROA, the financial leverage effect is ______________.

– When the financial leverage effect is positive the ROE increases

by increasing the use of debt.
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Profitability Analysis
Financial leverage

 Ex.: Company A
Total Assets = 20.000 €
Equity = 5.000 €
Debt = 15.000 €
Net Income = 1.200 €
Interest Expense = 1.395 €

Is the financial leverage effect positive or negative?

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 Profitability Analysis
Financial leverage

1) ROA = EBIT*(1-t)/Assets=
(1.200+1.395) / 20.000 = 12,975%

2) Average cost of Debt

= Interest Expense/Debt = 1.395 / 15.000 = 9,3%
 The average cost of debt is 9,3% while the operating ROA is almost 13%.
 As ROA > cost of debt the Financial Leverage Effect is positive.
3) ROE = Net Income/Equity = 1.200 / 5.000 = 24%
Comparing ROE with ROA we reach the same conclusion
ROE > ROA  the Financial Leverage Effect is positive.
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Profitability Analysis
Financial leverage

– If the company had not used Debt the Net Income to

Shareholders would be:
5.000 * 0,12975 = 648,75
– However, the Net Income was much higher (= 1.200).
– Differential between the return and cost of Debt is:
15.000 * (0,12975 - 0,093) = 551,25
– So, the Net Income was:
551,25 + 648,75 = 1.200

Financial Leverage Effect

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 Profitability Analysis
Financial leverage

 Ex.: Company B
Total Assets = 15.000 €
Equity = 5.000 €
Debt = 10.000 €
Net Income= 600 €
Interest Expense 1.500 €

1) ROA = EBIT*(1-t)/Total Assets

= (600 + 1.500)/15.000 = 14%

2) Average cost of Debt = Interest Expense/Debt

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= 1.500/10.000 = 15%

Profitability Analysis
Financial leverage

3) ROE = Net Income/Equity= 600/5.000 = 12%

ROA < Average Cost of Debt; ROA>ROE, therefore the Financial

Leverage Effect is negative.
Income to shareholders would be = 5.000 * 0,14 = 700
Differential between the return and cost of debt
= (0,14 - 0,15) * 10.000 = - 100
In this case, the use of debt negatively affected the ROE.

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 Profitability Analysis
Financial leverage

In terms of solvency, the two companies present the following ratios:

Ratios Company A Company B

Equity/Total Assets 25% 33%
Equity/Debt 33% 50%

Can Company A continue to increase the use of Debt?

Should company B not use debt?

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Productivity Analysis

 Productivity: production per unit of factor used

– Gross Value Added (Valor Acrescentado Bruto ou VAB)

Gross Value Added - is the wealth created by the company;

the value added by the company to the goods and services
purchased; the difference between the production and the
intermediate consumption.

The Gross Value Added represents the contribution of the

company to the GDP of an economy.
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 Productivity Analysis

 Two alternative methods of computation:

– Production approach (subtractive method)
Gross Value Added = Gross Production - intermediate consumption

+ Sales + Cost of Goods Sold

+ Services + External Services and Supplies
± Change in inventories (production) + Indirect taxes
+ Operating subsidies (consumption taxes)
+ Own Work for the company

170

Productivity Analysis

– Income approach (additive method)

Gross Value Added=  Income earned by the production of goods and services
+ Direct taxes (except Income tax) • The Gross Value Added is used to pay
+ Personnel Costs employees, creditors, the State and to
+ Impairment losses ensure the company’s maintenance and
+ Provisions growth..
+ Deprectation and Amortization
+ other operating costs
+ Interest Expense
- Other operating revenues
- Interest Income
+ Income Tax
+ Net Income
+…
= Gross value added 171

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 Productivity Analysis

 Productivity ratios
– Labor Productivity (Produtividade do trabalho)
= Gross Value Added/Nº of employees
= Gross Value Added/Personnel Costs
– Fixed Assets Productivity (Produtividade do Ativo Fixo)
= Gross Value Added/Tangible Fixed Assets (Gross Value)
– Ageing degree of Tanglible Fixed Assets (Grau de
Envelhecimento do Ativo Fixo)
=Accumulated depreciation/Tangible Fixed Assets (Gross Valueç)
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Risk Analysis
Business Risk or Operational Risk (Risco de
negócio ou risco operacional)
 Break-even sales point: is the level of Sales where the total
fixed and variable costs equal total revenues (where the
company neither has profit nor loss).
– Total costs = Fixed costs + variable costs: the higher the fixed
costs, the higher the business risk of the company.
– The Margin of Safety: is the difference between the actual (or
projected) sales and the level of break-even sales (the higher
this margin, the lower the business risk).

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 Business Risk
Break-even sales point
 Break-even point (sales unit):
Q0 * SP1 - Q0 * VC1 - FC = 0  Q0 (SP1 –VC1) = FC
 Q0 = FC / (SP1– VC1)
 Break-even point (sales dollars) :
Q0 * SP1 = FC / [ (SP1 – VC1)/SP1 ]
where (SP1 – VC1)/SP1 is the contribution margin ratio.

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Business Risk
Margin of Safety

 Margin of Safety (MoS)

(Q * SP1 ) (Q * SP1 )
MS   1 or MS  1  0
(Q 0 * SP1 ) (Q * SP1 )

 Degree of Operating Leverage:

DOL= Contribution Margin/Operating Income

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 Risk Analysis
Financial risk

 Financial risk is the likelihood of the company not being

able to pay interest, repay loans, and to compensate
shareholders. The financial risk depends on:
– The level of Debt
– The Financial Leverage Effect
 Degree of Financial Leverage:
DFL= EBIT/EBT

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 Bibliography:
– Subramanyam (2014). Financial Statement Analysis,
McGraw-Hill International Edition (Chapter 8).
– Neves, J. C. Análise e Relato Financeiro – um visão integrada de
gestão, Texto Editores (Parte IV – Eficiência e rendibilidade, cap.
13, 14, 15 e 16 e Parte V – Risco, cap. 18)

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