Week 6 Learning Summary

Rajeev Shahdadpuri

University Canada West

FNCE 623: Finance Management

Bismark Addai

May 18, 2023

Learning Summary First Video:

Financial Statements: Financial Ratio analysis begins with Financial Statements. Financial

Statements are reports that summarize the financial activities and performance of the

Business. There are three different types of financial statements:

Income Statement, Balance Sheet, and Cash Flow Statements. However, the income

statement and the Balance sheet are widely used for Financial Ratios.

Financial Ratio: Financial ratios are comparing One Line item with another line item and

multiplying it by 100.

Types of Financial Ratios:

1. Profitability Ratio: Measures how efficiently a business generates profit from four

different things. Revenue, Assets, Equity, and Capital employed. It can be further

classified into Margin ratios and Return ratios.

1.1 Margin Ratios: The margin ratio analyses how a business converts revenue into

profit. Profit Margin = Type of Profit/Revenue. Using this formula, we can find
 any margin for, e.g., Gross Profit/ Revenue = Gross Profit Margin. Similarly, we

can find the operating and net profit margins.

1.2 Return Ratios: In return ratios, we measure how much net profit a business can

generate relative to its assets, equity, or capital employed. If we divide a

business’s net profit from its income sheet by total assets, we can determine the

return on assets (ROA).

Point to remember: Use the average balance sheet number because the balance

sheet is a snapshot of a business at a given point, while the income statement covers

a period.

We can find the Return on Equity using a similar structure: net Profit/Total Equity.

However, using Return on Capital employed is much better because the return on

equity can be inflated when the owner’s claim on the net asset decreases.

ROCE = Net Profit/ Capital Employed. (Can also be calculated on Operating profit)

2. Price Ratio: Ratios like Earning per share, price-to-earnings ratio, or Price/Earning to

Growth ratio play a very crucial role from the perspective of an investor and are

therefore essential to understand. Also, other ratios like Dividend per share and

dividend yield ratio can help investors understand the company's financials when

investing. Price Ratios are crucial for a business. The dividend Payout ratio is also a

part of the price ratio. We can calculate that by dividing Total Dividends paid by the

net profit earned over the same period.

3. Leverage Ratio: Leverage is when you take on your risk by taking on debt to

maximize your return or reward. Leverage Ratios can also be classified further into:
 3.1 Balance Sheet Ratios: Dividing total liabilities by total assets will give us the

Debt to assets ratio (DTA). Similarly, dividing the liabilities by equity can

determine the Debt-to-Equity ratio (DTE).

3.2 Income Statement ratios: The interest Coverage ratio compares the business’s

operating profit with its interest expenses. It means whether the business has

earned enough profits to cover the interest on Debt obligations. EBITDA is the

earnings before interest, tax, depreciation, and amortization, which are noncash

expenses.

4. Efficiency Ratio: The efficiency ratio measures how effectively a business sells

inventory to customers and how quickly it can collect cash back from them. It also

measures how reliably it pays off its creditors.

4.1 Turnover Ratio: How quickly the business conducts its operations. For example,

Inventory turnover Ratio: Cost of Goods Sold/ Inventory. Similarly, we find the

Receivables Turnover ratio: Revenue/Accounts receivable. This is the way of

measuring how fast the business collects cash from its customers. Payables and

asset turnover ratios can also be determined using a similar approach.

4.2 Cash Conversion Cycle: The cycle tells us how many days a business needs to

convert its investments in inventory to cash. Cash Conversion cycle = Days Sales

of Inventory+ Days Sales Outstanding+ Days Payable Outstanding

5. Liquidity Ratio: Liquidity ratios measure how well a business can cover its short-

term debt obligations using different assets. Liquidity ratio = Sum of Assets/ Current

Liabilities. The most liquid asset is cash itself, and they are ranked in the balance

sheet based on how fast it can be sold to get cash in return.

 If we divide Cash by Current liability, we can determine the Cash Ratio. The

business can pay all its short-term liabilities if the cash ratio is more significant. This

Is an indicator of good financial health.

Quick Ratio: All liquid assets/ Current Liabilities.

Current Ratio: This is a step further than the quick ratio as it considers the inventory

and prepaid expenses as current assets.

Current Ratio = Current assets/ Current Liabilities.

Learning From the Second Video

Gross Profit Margin: Gross profit/Revenue gives us the gross profit margin. Since it is often

shown in %, we must multiply by 100. Gross Profit margin is a Profitability ratio, and the

revised formula will be as follows:

Revenue – Cost of Goods Sold/ Revenue * 100.

A profit margin is the ratio of profit to revenue * 100. Businesses split out their

expenses into various buckets. Therefore, we get three different kinds of profit in the income

sheet. They are Gross Profit, Operating profit, and Net Profit. Gross Profit margin only

factors the businesses’ direct sales and ignores all indirect expenses, interest, and tax.

Example: MAD earned 1 billion dollars, and the cost of goods sold was 500 million.

This means that their gross profit was 50%.

We cannot know if the gross margin of 50% is good or bad, so we can compare it with

the previous year’s growth margin. The margin of the previous year was 45%. This means

that MAD had a better gross profit margin than the previous year.
 Sometimes, the company can perform better than its previous standards, but

comparing them with other companies or the market average is critical.

An Increase in Gross profit margin can be due to an increase in the selling price or

higher demand for the product. Overall, the context matters, and not just the numbers.

Learning from Video 3

Operating Profit Margin: Operating Profit Margin = Operating Profit/Revenue

*100 (to mention it in %). It is a similar concept to the Gross profit margin. It measures the

business’s ability to generate operating profit from each unit of revenue earned. Profit means

revenue is more than expenses. Operating profit is subtracting the operating expenses from

the gross profit. Therefore, it is known as EBIT or earnings before income tax. It only

accounts for the direct cost of sales and operating expenses and ignores the interest and tax

expenses.

Example: The same example from video 2 is continued. The company MAD had a

gross profit margin of 50% or 50 cents on the dollar. After deducting the operating expenses

(350 million), we find out the operating profit is 150 million. So, 150 million/ 1 billion *100

will tell us the operating profit margin percentage, i.e., 15%.

The operating profit margin is much more valuable when compared from year to year.

MAD had an operating profit margin of 10% last year. So, a 5 % increase is a good thing.

Similar to the gross profit margin, the operating profit margin must also be compared

to the market standards to determine if our company meets or needs some changes.

An increase in gross profit margin can help increase the operating profit margin or the

expenses associated with operations going down is also a contributor.

 Learning from Video 4

Net Profit Margin: Net profit margin, or net margin, is a profitability ratio that

assesses an organization’s net profit for every dollar of revenue. It is commonly expressed as

a percentage and is calculated by dividing an organization's net profit by revenue.

When a company's revenues exceed its costs, it generates a financial gain known as

net profit. The gross profit is calculated by deducting the direct cost of sales from the

revenue. The operating profit is calculated by subtracting operating costs from gross profit,

which includes selling, general and administrative, and R&D costs, as well as depreciation

and amortization.

For example, if a business earned $1 billion in revenue and had a net profit of $120

million, its net profit margin would be 12% (120 million divided by 1 billion multiplied by

100).

A decline in operating margin, a rise in interest costs, or an increase in tax expenses as

a percentage of revenue are all elements that can reduce the net profit margin. On the other

hand, elements that can boost the net profit margin include a rise in operating margin or a fall

in interest and tax costs as a percentage of sales.

Businesses can assess their profitability and make wise financial decisions by

understanding the net profit margin.

 Learning from Video 5

Return On Assets: The return on assets (ROA) profitability ratio gauges how much

profit a company makes from its assets. It is calculated by dividing a company’s net profit by

its average total assets and is typically expressed as a percentage. One can calculate the

average total assets by adding the total closing assets and opening total assets and then

dividing them by 2.

When determining how effectively a company uses its resources to make a profit,

ROA is a valuable tool. More profitable asset use and a higher ROA are both improved

performance indicators. The performance of companies operating in the same industry is

frequently compared using this method.

While total assets are listed in the balance sheet to calculate ROA, net profit can be

found there. The ROA percentage can be calculated by subtracting the net profit from the

average total assets, then multiplying the result by 100.

Example: SMD contractors' opening and Closing total assets were 930 million, and

last year were 870 million, respectively. The net profit was 45 million. So, to formulate this,

we first add the closing and opening balance by adding 930+870/2 = 900 million. 45/900

*100 will give us the ROA, i.e., 5%.

Increasing net profit from total assets is one way to improve ROA. This can be

accomplished by raising sales prices, concentrating on products with higher profit margins, or

lowering overhead costs, among other strategies. Higher ROA can also result from increasing

the asset turnover ratio, which gauges how effectively assets generate income. ROA offers

essential information about a company's profitability and asset utilization effectiveness.

 Learning From Video 6

Dupont Analysis: The ability to bridge the gap between individual indicators. A rise

in the net profit margin can result from revenue increases or lower expenses. So, by using

Dupont analysis, we can find out the actual reason. The methodology got its name from

Dupont Corporation. The company was one of the leaders in the Chemical industry.

Donaldson Brown came up with a revolutionary and powerful tool for financial analysis.

It is the fundamental core for performance assessment.

Step 1: Breaking down the ROE into its constituent parts

ROE = Net Income/Average Equity

We then multiply both sides by revenue. Doing this still gives us the ROE, but Net

income/Revenue gives us the Net Profit Margin and revenue/average equity indicates the

equity turnover ratio.

Step 2: Multiplying with Average Assets.

After Multiplying with Average assets, we get

1.Net Profit margin = Net Income/Revenue

2. Asset Turnover = Revenue/Average Assets

3. Financial Leverage Ratio = Average assets/Average Equity

This is the 3-way Dupont Analysis and is one of the essential concepts of Finance.

The goal is to understand which component has the highest influence, which can be quickly

done using the model.

 Step 3: In-Depth Net Profit margin

The net profit margin is also reduced to its components and is calculated by

Operating profit margin * Tax burden * Interest Burden.

Even though each of the components seems complex, they are like a timepiece, and

each of the constituents has its function.

The 5-way Dupont model means multiplying these three components to find the Net

profit margin and then multiplying it by Asset Turnover and Financial Leverage Ratio.

A company can use each financial ratio in the model to find the weak link and try to

improve returns. Investors stay away from firms that have a less than zero ROE.

Limitations: The data used to find the ROE (input) will influence the output.

Accounting policies also affect it and estimates.

Comparison can only be made when companies have the same size, industry, and capital

structure. (Apples can only be compared to apples).

The Dupont ratios evolve over an extended period, and any business is susceptible to

seasonal trends. So being aware of that is very important.