BAV Lecture 3

Chapter 5 Financial analysis

The goal of financial analysis is to assess the performance of a firm in the context of its state goals
and strategy. There are 2 principal tools of financial analysis: ratio analysis and cash flow analysis.

 Ratio analysis – involves assessing how various line items in a firm’s financial statement
relate to one another.
 Cash flow analysis - allows the analyst to examine the firm’s liquidity and how the firm is
managing its operating, investment and financing cash flows.

Financial analysis is used to a variety of context. Ratio analysis of a company’s present and past
performance provides the foundation for making forecasts of future performance.
1 . Ratio analysis – the value of a firm is determined by its profitability and growth. As shown in the
figure, the firm’s growth and profitability are influence by its product market and financial market
strategies.

 The product market strategy is implemented through the firm’s competitive strategy,
operating policies and investment decisions.
 Financial market strategies are implemented through financing and dividend policies.

Thus, the four levers that managers can use to achieve their growth and profit targets are:

 Operating management (marketing and pricing decisions, related to supply chain and
logistics)
 Investment management (whether you lease or buys assets, outsourcing, acquisitions, store
location)
 Financing strategy
 Dividend policies

When we try to analyze company would be nice to observe ratios for operations and investments
separately.

The objective of ratio analysis is to evaluate the effectiveness of the firm’s policies in each of these
areas. Effective ratio analysis involves relating the financial numbers to the underlying business
factors in as much detail as possible. While ratio analysis may not give all the answers to an analyst
regarding the firm’s performance, it will help the analyst frame questions for further probing. In ratio
analysis, the analyst can:

 Compare ratios for a firm over several years (time-series comparison) – analyst can hold firm-
specific factors constant and examine the effectiveness of a firm’s strategy over time
 Compare rations for the firm and other firms in the industry (cross-sectional comparison)
facilitates examining the relative performance of a firm within its industry, holding industry-
level factors constant
 Compare ratios to some absolute benchmark – for most ratios there are no benchmark. The
exceptions are measures of rates of return, which can be compared to the costs of capital
associated with the investment. For example, subject to distortions caused by accounting,
the rate of return on equity (ROE) can be compared to the cost of equity capital

2. Measuring overall profitability

The starting point for a systematic analysis of a firm’s performance is its return on equity (ROE),
defined as:
ROE is a comprehensive indicator of a firm’s performance because it provides an indication of how
well managers are employing the funds invested by the firm’s shareholders to generate returns. On
average, over long period, large publicly traded firms in Europe generate ROEs in the range of 8-10%.

In the long run, the value of the firm’s equity is determined by the relationship between its ROE and
its cost of equity capital – the return that the firm’s equity holders require on their equity investment
in the firm. That is, those firms that are expected over the long run to generate ROEs in excess of the
cost of equity capital should have market values in excess of book value and vice versa (5 and 6%
case). A comparison of ROE with the cost of capital is useful not only for contemplating the value of
the firm but also in considering the path of future profitability. The generation of consistent
supernormal profitability will, absent significant barriers to entry, attract competition. For that
reason, ROEs tend over time to be driven by competitive forces towards a "normal" level - the cost of
equity capital. Thus, one can think of the cost of equity capital as establishing a benchmark for the
ROE that would be observed in a long-run competitive equilibrium. Deviations from this level arise
for two general reasons. One is the industry conditions and competitive strategy that cause a firm to
generate supernormal (or subnormal) economic profits, at least over the short run. The second is
distortions due to accounting.

In computing ROE, one can use either the beginning equity or the ending equity or an average of the
two. Conceptually, the average equity is appropriate, particularly for rapidly growing companies that
see their balance sheet change significantly throughout the year. However, for most companies, this
computational choice makes little difference as long as the analyst is consistent. Therefore, in
practice most analysts use ending balances for simplicity.

2.1 Decomposing profitability: Traditional approach

A company’s ROE is affected by two factors:

 How profitably it employs its assets?

 How big the firm’s assets base is relative to shareholders’ investment.

To understand the effect of these two factors, ROE can be decomposed into return on assets (ROA)
and measure of financial leverage (equity multiplier), as follows:

ROA tells how much profit a firm is able to generate for each euro of assets invested. The equity
multiplier indicates how many euros of assets the firm is able to deploy(use?) for each euro invested
by shareholders. The ROA itself can be decomposed as a product of two factors:
The ratio of profit or loss to revenue is called net profit margin or return on revenue (ROR), whereas
the ratio of revenue to total assets is known as asset turnover. The profit margin ratio indicates how
much the company is able to keep as profits for each euro of revenue it makes. Asset turnover
indicated how many euros of revenue the firm is able to generate for each euro of its assets.

In the Profit Margin * Asset Turnover * Equity Multiplier we see:

- Ratio about efficiency of operations management

- Ratio about efficiency of investment management
- Ratio about finance decisions that company is making

Main disadvantage of this approach – mixes operations, non-operating investments and financing,

2.2 Decomposing profitability: Alternative approach

Even though the preceding approach is popularly used to decompose a firm’s ROE, it has several
limitations:

 In the computation of ROA, the denominator includes the assets claimed by all providers of
capital to the firm, but the numerator includes only the earning available to equity holders
 (after interest payments have been deducted). The assets themselves include both operating
assets and non-operating investments such as minority equity investments and excess cash.
 Further, profit or loss includes profit from operating and investment activities, as well as
interest income and expense, which are consequence of financing decisions. Often it is useful
to distinguish between these sources of performance for at least 3 reasons
o Valuing operating assets requires different tools from valuing non-operating
investments. Specifically, financial statements include detailed info about the
financial and risk consequences of operating activities, which enables the analyst to
take an informed approach to the analysis and valuation of such activities. In
contrast, what comprises the non-operating investments and drives their profitability
is often not easily identifiable from the financial statement, thus forcing the analyst
to use shortcut methods or rely on a firm’s own fair value disclosures to assess the
value of such assets.
o Operating, investment and financing activities contribute differently to a firm’s
performance and value, and their relative importance may vary significantly across
time and firms. For example, as we will show in this chapter, whereas close to 33
percent of lnditex's invested capital has been allocated to nonoperating investments
that earn an average return of less than 1 percent, Hennes & Mauritz and the
retailers' other industry peers have only 1 and 17 percent of their capital invested in
such low-performing non-operating assets. Mixing operating with non-operating
assets would obfuscate the effect that these investments have on retailers'
performance. Further, an increase in financial leverage may not only have a direct
positive effect on return on equity but also an indirect negative effect through
increasing a firm's financial risk and borrowing costs. The traditional decomposition
of ROE does not make this explicit: whereas the equity multiplier reflects the direct
effect of leverage, the net profit margin reflects the indirect effect.
o Finally, the preceding financial leverage ratio does not recognize the fact that some
of a firm’s liabilities are in essence non-interest-bearing operating liabilities.

These issues are addressed by an alternative approach to decomposing ROE discussed below. First,
some terminology needs to be discussed:
Where:

 Return on invested capital is a measure of how profitably a company is able to deploy its
operating and non-operating assets to generate profits. This would be a company’s ROE if it
were financed with all equity
 Spread is the incremental economic effect from introducing debt into the capital structure.
This economic effect of borrowing is positive as long as the return on invested capital is
greater that the cost of borrowing. Firms that do not earn adequate returns to pay of interest
cost, reduce their ROE by borrowing. Both the positive and negative effect is magnified by
the extent to which a firm borrow relative to its equity base.
  The ratio of debt to equity provides a measure of this financial leverage. A firm’s spread
times its financial leverage therefore provides a measure of the financial leverage gain to the
shareholders

To separate the effect on profitability of a firm’s non-operating investment from its operating
activities, the return on invested capital (ROIC) can be split up into an operating and investment
component:

In other words, the return that a firm earns on its invested capital is a weighted average of its return
on net operating assets (RNOA) and its return on non-operating investment (RNOI). For the average
firm the return on non-operating investments is lower than the return on net operating assets.
Therefore, non-operating investments typically decrease the return on invested capital relative to the
return on net operating assets.

Finally, return on net operating assets can be further decomposed into NOPAT margin and operating
asset turnover, as follows:

 NOPAT margin – the first term in the preceding equation – is a measure of how profitable a
company’s sales are from an operating perspective.
 Operating asset turnover – the second term in the preceding equation – measures the extent
to which a company is able to use its operating assets to generate revenue.
Why financial decisions may matter?

- Leverage can help increase profitability, but these fin decisions should not really affect value.
So why do they matter? How they can still add value? 2 examples when they have value:
o Pension liabilities - companies need to finance them by investing in pension fund,
invests assets to fund these future pension obligations. The assets may have lower
value than the liability, the difference btw the two appears on the balance sheet as
pension liability. What do you use as a discount rate for your pension obligations?
Interest rate are plummeting, and if low discount rate is used you have very large
obligations. Because of that low discount rate a lot of companies have relatively high
pensions liabilities on their balance sheets at the moment. That has some real
economic consequences - regulators are pressuring on those companies to cut down
dividends to secure those pension obligations. They are requiring companies to
better fund those liabilities. So, liability can have very constraining effect, the
company can grow, invest and pay dividends less. That’s why leverage is very
important in financial analysis because it tells us something about the flexibility of
the company, tells whether the company can make investments and grow, whether
it can pay dividends.
o Free cash – Apple cannot bring back cash because it will be taxed (at the past). This
leads to huge piles of excess cash. Investors start complaining about that – free cash
problem. Shareholders want money back because they do not want Apple to invest
in financial instruments, they want the money to be invested in good profitable
investments. Apple solved that by increasing leverage, issued bonds that increased
bonds, used the proceeds from those bonds to pay out additional dividends to
shareholders and satisfy them. So Apple’s balance sheet consisted of a lot cash on
the left side and a lot of debt on the right. These kinds of fin decisions can still have
effect on the value of the company.

3. Ratios