Financial Management

Huseynzade Jeyhun

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Apple case (Cash flow statement)

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Interpretation of financials

 Vertical
 Horizontal

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 Stryker corporation (Income Statement)

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Stryker corporation (Balance Sheet)

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 RETURN ON EQUITY

ROE = Net income / Shareholder’s equity

• Careers of CFOs rise and fall with the firm’s ROE

• Measure of efficiency - how company employs the capital
ROE = 1,006/9,047 = 11.1%
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 ROES are similar Competition! ROE
having the great acts as magnet to
variety in profits, attract anxious to
assets and debts. emulate the superior
WHY???? performance.

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 Find the link to ROE

11.2
Net income / Sales = Profit Margin %

ROE (11.1%)
Sales / Assets = Assets Turnover 0.57
(Sales generated by each dollar of asset)

1.74
Assets / Shareholder’s entity = Financial Leverage

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Return on assets

•ROA = PM x AT
•Percentage of money supplied by owners AND CREDITORS
•High profit margin and high assets turn is ideal

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ROE

 The companies’ ROE are quite similar, but combination results widely

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ROE elements: Profit Margin

 Measures fraction of dollar of sales

 Important to op-managers as reflects the pricing strategy
 Differ greatly depending on industry
 Profit margin and asset turnover very inversely ( Why?)

High margin – high value

High value – high spend on assets

FINANCIAL MANAGEMENT Margin is not good or bad – look at combination!

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ROE elements: Return on asset

Net Income/ Assets = Profit Margin x Assets Turnover 6.4%

• How much is earned by each dollar tied up to the business?

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ROE elements: Asset Turnover (0.57)

• More assets – is it good?

• Low asset turnover signifies asset intensive business
• When product technology is similar, the turnover is a margin!!!
• It makes sense to analyze return on each type of assets individually (Why?)

CONTROL RATIOS Just to fix your understanding –

WILL HELP!!! IDEAL COMPANY IS ONE THAT
(next slide) WOULD MAKE PROFIT WITHOUT
THE ASSETS.

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ROE>Assets Turnover>Control Ratios

 Inventory Turnover = COGS/Ending inventory

 WHAT IS FOR STRYKER’S?

1.9 times

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ROE>Assets Turnover>Control Ratios

 Collection period = Account Receivable/Credit sales per day

 WHAT IS FOR STRYKER’S?

 If company sales for 90 days term, 61 is excellent result

61.4 days

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ROE>Assets Turnover>Control Ratios

 Payable periods= Account payable/Credit purchase per day (COGS per day)

 WHAT IS FOR STRYKER’S?

 Assume that purchase is equal to the sales

41.5 days

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ROE elements: Financial Leverage
 Not something that management wants to increase (Why?)
 Important ration as one becomes a tool
 More stable business – more leverage is allowed
 FL and ROA are inversely related (Why?)

• Companies with low ROA generate more debt financing (lets discuss this – why?)

Low income does not allow to finance assets

So you need more money to borrow

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ROE elements: Financial Leverage
LIQUIDITY ROCKS!!!!!
 Not something that management wants to increase (Why?)
 Important ration as one becomes a tool Assets are excessive, but they are
liquid and create borrowing capacity!
 More stable business – more leverage is allowed
 FL and ROA are inversely related (Why?)

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ROE>Financial Leverage>Balance sheet
ratios
 Balance sheet ratios : 42% of money to
pay assets comes
from the debt

Debt to asset ratio = Total liabilities/Total assets 42.5%

Creditors supply
74 cents to
Stryker for every
Debt to equity ratio = Total liabilities/Shareholder’s equity 74% dollar supplied by
Shareholders

FINANCIAL MANAGEMENT WHAT IS WRONG? Hint – cash.2/28/2020 19

ROE>Financial Leverage> Balance Sheet
ratios

Debt to asset ratio = Net (debt) liabilities/Total assets 17.3%

Debt to equity ratio = Net (debt) liabilities/Shareholder’s 30%

equity

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ROE>Financial Leverage> Coverage
ratios
 BS ratios – ability to cover debt upon liquidations
 In other cases – coverage ratios
 Serve to understand cash to serve debt

Times interest earned = EBIT/Interest expense 15.6

Times burden covered = EBIT/ Interest + (Principal 11.4

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repayment/(1-tax rate)) 2/28/2020 21
ROE>Financial Leverage> Coverage
ratios
 BS ratios – ability to cover debt upon liquidations
 In other cases – coverage ratios
 Serve to understand cash to serve debt

Times interest earned = EBIT/Interest expense 15.6

Not necessary
to understand
for now –
Times burden covered = EBIT/ Interest + (Principal 11.4 repayment is
FINANCIAL MANAGEMENT
repayment/(1-tax rate)) 2/28/2020 22 non deductible
ROE>Financial Leverage> Coverage
ratios

WHICH IS BETTER?

Too liberal (
Times interest earned = EBIT/Interest expense assumes
constant debt
replacement)

Times burden covered = EBIT/ Interest + (Principal More

repayment/1-tax rate) conservative
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ROE>Financial Leverage> Liquidity ratios

CURRENT RATIO = CURRENT ASSETS / CURRENT LIABILITIES

(compares she asset that will turn into cash within the
year)

ACID TEST = CURRENT ASSET – INVENTORY/CURRENT

LIABILITIES

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SUMMARY OF ROE

So far, we:
 Assumed that management wants to increase ROE
 Careful management of levers can positively affect ROE
 Maintaining of levers is challenging managerial task that requires an
understanding of business

BUT

IS ROE RELIABLE METHOD?

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 If C increase
IS A better than B is ROE, is that an
its ROE is higher? evidence of
improvement?

IS IT RELIABLE???

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ROE deficiencies

 TIMING
 RISK
 VALUE

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ROE deficiencies: TIMING

 Cliché – managers must be forward-looking and have long-term perspective

(Agree?)
 What ROE does?

Backward looking and focused on one single year!

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ROE deficiencies: TIMING

IMAGINE START UP INTRODUCING NEW HOT PRODUCT(DISCUSS)

• SIMPLE FALL BECAUSE OF MYOPIC , ONE-YEAR PERIOD YARDSTICK

• BECAUSE IT INCLUDES ONLY ONE YEAR EARNING – FAULURE TO CAPTURE A FULL
IMPACT

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ROE deficiencies: RISK

EAT WELL – SLEEP WELL (Explain)

 You take high in search for high return

 You take safety and forego high returns
 Seldom you realize high return and safety

…and when you do – give

me a call!!!!

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ROE deficiencies: RISK

Quick quiz:

Company A : ROA = 6%, FL= 5 Personally, I am for B: IT has modest risk. High risk
Company B: ROA = 10%, FL = 2 and extreme leverage of A make one uncertain
enterprise for the risk averse people like ME.

What is ROE?
Who performs better? ( Discuss)

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ROE deficiencies: RISK

 But my preference may still be distorted by ROA and ROE

USE RETURN ON INVESTED CAPITAL (ROIC) TO CURCUMVENT!

Not an easy
thing to catch
though…Get
RIOC = EBIT (1-Tax rate)/Interest-bearing sense, but do
debt + Equity nor dive too
deep…YET

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ROE deficiencies: RISK

A B
Debt @ 10% interest 900
Equity 100 1000
ROIC = EBIT (1-Tax rate)/Interest- Total assets 1000 1000
bearing debt + Equity
EBIT 120 120
Less Interest expense 90 0
Earning before tax 30 120
Less tax @ 40% 12 48
Earning after tax 18 72
ONLY ROIC IS INDEPENDENT OF
FINANCING SCHEMES THAT COMPANY
ROE 18% 7.2%
EMPLOYS ROA 1.8% 7.2%
FINANCE FOR NON FINANCE MANAGERS RIOC 2/28/20207.2% 33 7.2%
ROE deficiencies: VALUE

 Stryker’s ROE is 11.1%

 Stryker’s equity – book value of USD 9,047
 Stryker’s market value – I will take best estimates

USD 28,403

3.5% vs 11.1%
WHAT IS ROE THEN?

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ROE deficiencies: VALUE
If market value, what represents market value?

EARNING YIELD = NET INCOME/MARKET VALUE OF EQUITY

= EARNINGS PER SHARE / PRICE PER SHARE

 Is EY useful? (discuss)
 NO! Stock price is exposed to volatility – very sensitive to expectations. Clearly, high EY is not an
indicator of superior performance – just reverse!

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 SUMMARY ON RATIOS

• So if not correct value – what to do?

Compare ratios to industry Compare ratios over the periods

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ROE deficiencies: VALUE

 NO! Stock price is exposed to volatility – very sensitive to expectations. Clearly, high EY is not an
indicator of superior performance – just reverse!

Price per share/Earnings per share = PE ratio

Stryker’s PE = 75.14/2.66 = 28 times (shareholders pay over 28 per dollar of Stryker earnings). Reflects
expectations of investors.

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SUMMARY ON RATIOS

 Used with care and imagination, the technique can reveal much about the firm, but few things to
remember:
✓ Ratio is simple numbers divided by another (so we cant expect that in isolation it will reveal the
clear picture)
✓ Ratio has no single correct value:

Current ratio = Current assets / Current liabilities

High ratio is a sign

High ratio is Conclusion: for owner that
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attractive for ration has no assets are not
creditor effectively
correct value
deployed