TOPICS FOR THE SESSION

 Quiz

 Integrated ratio analysis (cont.)

• Assessment of financial management
• Assessment of dividend policy

 Brainstorming between groups - financial analysis

FINANCIAL ANALYSIS & FORECASTING| Joana Cardoso Fontes

 Quick review

One difference between the traditional and the alternative approach to

decomposing ROE is that:

A. The traditional approach defines leverage as debt-to-equity, whereas the

alternative approach defines leverage as assets-to-equity.

B. Only the traditional approach explicitly shows the impact of financial spread
on return on equity.

C. The approaches use different definitions of profit margins and asset turnover.

D. One approach uses beginning-of-year balance sheet items to calculate ratios,

whereas the other approach uses end-of-year balance sheet items.

Choose the correct answer and explain why the others are wrong.

FINANCIAL ANALYSIS & FORECASTING| Joana Cardoso Fontes

 Company A discloses the following information:
• ROE = 15 %
• NOPAT + NIPAT = €500,000
• Invested capital = €4,000,000
• Effective interest rate after tax = 8 percent

Company A’s financial leverage (debt-to-equity ratio) is

A) Between 40 and 49.9 percent
B) Between 50 and 59.9 percent
C) Between 60 and 69.9 percent
D) Between 70 and 79.9 percent

FINANCIAL ANALYSIS & FORECASTING| Joana Cardoso Fontes

 Which of the following types of firms do you expect to have high or low sales
margins? Why?

A) A supermarket.

B) A pharmaceutical company.

C) A jewelry retailer.

D) A software company.

FINANCIAL ANALYSIS & FORECASTING| Joana Cardoso Fontes

 ROE

ROA:
Assets profitability

Operating efficiency: Gross Asset use efficiency:

profit margin, EBITDA Operating WC and LT asset
margin, … management
FINANCIAL ANALYSIS & FORECASTING| Joana Cardoso Fontes
 Assessing financial management

 Financial leverage: asset base greater than equity vs risk increase

 impact on ROE: cost of leverage vs ROIC

ROE = Return on invested capital +

Return on invested capital − Effective interest rate after tax × Financial leverage

 Analysis of financial management can be performed on both current and non-current

level:
 Liquidity analysis relates to short term liabilities
 Solvency analysis relates to long term liabilities

 Debt policy and optimal capital structure is left to firm valuation’s course.

FINANCIAL ANALYSIS & FORECASTING| Joana Cardoso Fontes

 Assessing financial management

 The ratio analysis aims to answer general questions related to solvency:

- Does the company have enough debt? That is, is it exploiting the potential benefits of debt

– interest tax shields, management discipline, and easier communication?

- Does the company have too much debt given its business risk? What type of debt

covenant restrictions does the firm face? Is it bearing the costs of too much debt, risking

potential financial distress and reduced business flexibility?

- What is the company doing with the borrowed funds? Investing in working capital?

Investing in fixed assets? Are these investments profitable?

- Is the company borrowing money to pay dividends? If so, what is the justification?

FINANCIAL ANALYSIS & FORECASTING| Joana Cardoso Fontes

 Liquidity analysis

 Shall a firm have high or low liquidity?

 Useful ratios to evaluate a firm’s liquidity include:

Current ratio = Current assets

Current liabilities

Quick ratio = Cash and marketable securities + Trade receivables (net)

Current liabilities

Cash ratio = Cash and marketable securities

Current liabilities

Current ratio
• Most widely used
• Rule of thumb: current ratio > 1 (but…)

Quick ratio
• Similar to current ratio but excludes inventories
• Large inventories are usually (depending on business) a sign of trouble

FINANCIAL ANALYSIS & FORECASTING| Joana Cardoso Fontes

 Liquidity analysis

FINANCIAL ANALYSIS & FORECASTING| Joana Cardoso Fontes

 Solvency analysis

 Beyond short-term survival, solvency measures the ability of a firm to meet long-term
obligations.

 Key ratios used to analyze solvency, include:

 Using shareholders’ equity as a denominator:
Total liabilities
Liabilities - to - equity ratio =
Shareholde rs' equity

Current debt + Non - current debt

Debt - to - equity ratio =
Shareholde rs' equity

Current debt + Non - current debt

Debt - to - capital ratio =
Current debt + Non - current debt + Shareholde rs' equity

Debt to equity ratio benchmark: optimal capital structure depends on the industry’s risks: in industries
with greater risk, debtholders require equityholders to have more of their “skin in the game”

Damodaran website provides info by industry: Useful Data Sets (nyu.edu)

FINANCIAL ANALYSIS & FORECASTING| Joana Cardoso Fontes

 Solvency analysis

 Addressing the ability to pay interest on debt:

Profit or loss + Interest expense + Tax expense

Interest coverage (earnings - based) =
Interest expense

Interest coverage (cash flow - based)

Cash flow from operations + Interest expense + Taxes paid
=
Interest expense

Interest coverage: number of times EBIT (or CF) covers the interest requirements

FINANCIAL ANALYSIS & FORECASTING| Joana Cardoso Fontes

 ROE

ROA:
Financial leverage
Assets profitability

Operating efficiency: Gross Asset use efficiency: Liquidity and Solvency

profit margin, EBITDA Operating WC and LT asset
margin, … management

FINANCIAL ANALYSIS & FORECASTING| Joana Cardoso Fontes

 Sustainable growth

 Sustainable growth rate is the rate at which the firm can grow while keeping its
profitability and financial policies unchanged.

 ROE and dividend payout determine the funds available for growth

 Benchmark for firm’s growth plans

Sustainable growth rate = ROE x (1 - Dividend payout ratio)

where

Cash dividends paid

Dividend payout ratio =
Profit or loss

 Dividends constraints:
• Legal reserves
• Contractual constraints included in covenants
• Signaling of managers expectations about future prospects

FINANCIAL ANALYSIS & FORECASTING| Joana Cardoso Fontes

 Sustainable growth

 If the firm intends to grow at a higher rate than its sustainable growth rate, the analyst
could assess which ratios are likely to change in the process.

 This analysis can lead to asking business questions such as:

- Where is the change going to take place?

- Is management expecting profitability to increase? Or asset productivity to improve? Are

these expectations realistic?

- Is the firm planning for these changes?

- If the profitability is not likely to go up, will the firm increase its financial leverage or cut
dividends? What is the likely impact of these financial policy changes?

FINANCIAL ANALYSIS & FORECASTING| Joana Cardoso Fontes

 Cash flow analysis

 Free cash flow: is a measure of company’s cash-generating ability

 Non-GAAP (generally accepted accounting principles) measure

 Given by the cash provided by operating activities adjusted for

 capital expenditures necessary to keep current level of operations
 dividend policy
 FCF >0: the company
 Has met all of its planned cash commitments and
 Has cash available to reduce debt or expand

 FCF<0: to continue at its planned level of operations the company

 Has to sell investments or/and
 Has to borrow money or/and
 Has to issue stocks

FINANCIAL ANALYSIS & FORECASTING| Joana Cardoso Fontes

Brainstorming:

• What are the key ratios that you will select/ have selected for your company?
• How do you link this to the business analysis?

FINANCIAL ANALYSIS & FORECASTING| Joana Cardoso Fontes