Business analysis and

valuation
Session 1
Demystifying numbers
Balance Sheet Items
Income Statement
Demystifying ratios
• Ratios are the language of business, and finance people love to create
them, talk about them.
• flip them upside down, break them apart, and so on..
• For example, Coca- Cola’s net profit for 2016 was $7.3 billion. Is that a
lot of money for the company?
• 16 percent of its revenue (net profit divided by revenue) is much
more helpful.
• 71 percent of its assets are financed with liabilities
Ratios answers the following:
• First, how is the company doing in terms of generating profits?
• Second, how efficient or productive is the company?
• Third, how does it finance itself?
• The final question revolves around liquidity, which refers to the ability
of a company to generate cash quickly.
Liquidity ratios
• Liquidity ratios measure this risk by emphasizing the company’s
ability to meet short- term obligations with assets that can quickly
be converted into cash.
• Useful for suppliers????
• Useful for Investors??
• Will its current assets be sufficient to pay off its current liabilities
(including those owed to suppliers)?
• Current Ratio = Current assets / current liabilities
• Quick Ratio
= (Current assets − inventory) / current liabilities
Why make a big deal out of inventories?
To Finance people, inventories represent risk that needs to be Financed.
• Think about BlackBerry, Z10 became obsolete.
• Let’s think about three different companies: Rio Tinto Group, a global
mining and metals corporation; NuCor Corporation, a mini-mill steel
producer; and Burberry, a luxury fashion house. For each, which ratio
would you prefer to see— the quick ratio or the current ratio?
Profitability
• Profitability can be assessed in a number of different ways because the appropriate
measure depends on the specific question being asked.
• For example, you could look at net profit, or the income after all costs and expenses, and
compare it to sales (to represent the margin)
For every dollar of revenue, how much money does a firm get to keep after all relevant
costs
Profit Margin = Net profit / Revenue
A and B have negative profit margins, while companies D and F have profit margins of
approximately 25  percent
• Or to shareholders’ equity (to represent the return to a shareholder)
For every dollar a shareholder puts into a company, how much do they get back every year
Profitability ratios cont….
• Return on Equity (ROE) = Net profit /shareholders’ equity
• Company C has an ROE of 22 percent, while company M has an ROE
of only 6  percent
• Return on Assets = Net profit/ total assets
• How much profit does a company generate for every dollar of assets?
This corresponds to asking how effectively a company’s assets are
generating profits
• EBITDA Margin = EBITDA / revenue
Great finance acronym and a fancy term
• EBIT and DA
• Some companies have different tax burdens and capital structures
• Net profit, which factors in taxes, would provide a distorted view;
EBIT, which excludes tax charges, would not.
• The reason to emphasize DA is because they are expenses that are
not associated with the outlay of cash; it is just an approximation of
the loss of value of an asset.
• Is a measure of the cash generated by operations.
• Amazon, has little profitability but significant EBITDA.
• Among the companies in table , it’s notable that company D generates
a remarkable amount of cash—45 percent, or 45 cents for every
dollar of revenue! Similarly, company L has a reasonable profit margin
of 9 percent, but a whopping EBITDA margin of 28 percent. Why
would that be?
Profitability

Generally, two major types of profitability ratios are calculated:

1. profitability in relation to sales
2. profitability in relation to investment
Profitability
Financing and Leverage
• Leverage is one of the most powerful concepts in finance.
 Leverage
• Leverage in finance allows owners to control assets they couldn’t
control otherwise.
• So managing leverage is critical because it enables you to do things
you couldn’t otherwise do and because it magnifies your returns—in
both directions.
• Debt to Assets = Total debt / total assets
• The ratio of total debt to total assets measures the proportion of all
assets financed by debt. It provides a balance sheet perspective on
leverage.
Leverage
• Debt to Capitalization = Debt/ debt + shareholders’ equity
• As we saw, there are two primary types of financing for a company,
and we think about them differently.
• This ratio tracks what proportion of a company’s financing comes
from debt
• Assets to Shareholders’ Equity= Assets /shareholders’ equity
• This ratio tells us precisely how many more assets an owner can
control relative to their own equity capital
Leverage contd….
• Interest Coverage Ratio = EBIT /interest expense
• critical question is often the degree to which a company can make its
interest payments.
• Over the past two decades, pharmaceutical companies have been
slowly increasing their leverage. For example, in 2001, Merck had a
debt-to-equity ratio of 0.53; Pzer’s was 1.14. In 2016, Merck’s debt-
toequity ratio was 1.28; Pzer’s was 1.58. What was going on in this
industry to cause this shift?
 LBO’s
• Private equity companies sometimes use debt in transactions known
as LBOs—leveraged buyouts—to purchase companies. In these
transactions, the company borrows to buy out many shareholders,
leaving it much more highly levered than previously.
• What sorts of industries would you expect to be the targets of LBOs??
 Productivity or Efficiency
• Productivity or Efficiency : In short, increases in productivity mean you
can squeeze more from less.
• More narrowly, productivity ratios measure how well a company
utilizes its assets to produce output.
• Asset Turnover = Revenue/total assets
• This ratio measures how effectively a company is using its assets to
generate revenue.
• Inventory Turnover =Cost of goods sold / inventory
• Inventory turnover measures how many times a company turns over
or sells all its inventory in a given year.
• The higher the number, the more effectively the company is managing
its inventory as it sells products
• Days Inventory = 365 ÷ inventory turnover
• Average number of days a piece of inventory is kept inside a company
before it is sold
• What kind of companies will have greater inventory turnover ?
• company C – 30 times, B – 4 times
• Receivables Collection Period = sales /receivables
• After a company sells its inventory, it needs to get paid for it. The
lower this figure, the faster a company is getting cash from its sales.
• As you can see, company N looks pretty strange—it collects cash from
its customers after more than twenty years! What could give rise to
such a situation?
• Do you notice anything about the numbers for the other companies?
The remaining companies can be roughly divided into one group that
collects very quickly (fewer than thirty days) and another group that
collects more slowly
Let the games begin
• Service Companies
• Company N: The outlier
• Capital-intensive service providers
• The cash-rich, equity-dependent service company
• Retailers
• Companies with distinctive inventory turnover
• Hint : Bookstores worldwide are disappearing. Bookselling is a very
tough business, given the rise of Amazon, and this shows up as a
negative profit margin. Did any company issue preferred stocks?