Financial Accounting

Profitability Analysis
Dean Leibovitz

IDC- HCMBA
1
Mini Semester 1
ART- Account Receivable Turnover
Accounts Receivable Turnover
• Represents the number of times per year that
a business manages to collect its average Sales
accounts receivable.
Account Receivable
• A high turnover ratio reflects a business with
conservative credit policy and an aggressive
collection system.

Average collection Period

365
• Represents the time it takes, on average, to
collect the outstanding AR.
ART
• A low average collection period is usually more
favorable since in most cases it indicates that the
business is collecting payment faster.

IDC- AMBA 2
INVT- Inventory Turnover
Inventory Turnover
• Represents the number of times per year that
a company manages to sell and replace its COGS
inventory.
Inventory
• A high turnover ratio can mean either strong sales
and/or large discounts.

Average Inventory Days

365
• Represents the amount of days, on average, it
takes to sell the inventory on hand. Inventory Days

IDC- AMBA 3
APT- Accounts Payable Turnover
Accounts Payable Turnover
• Represents the number of times per year that
a business pays its average payable amount. COGS

• A falling ratio means that it takes the company Account Payable

longer to pay its debt to its suppliers than previous
years.

Payables Days Outstanding (PDO)

• Represents the time it takes the business to
pay out its debt to suppliers. 365

• The longer it takes to pay creditors the more APT

money the company has on hand.

IDC- AMBA 4
Operating Cycle and Financing Period
Operating Cycle:

Calculated as: AR Days + Inventory Days

• Represents the amount of time it takes an entity from the day it

purchases/produces its inventory (spends cash) to the day it collects this
cash from the customer.

Example:

AR Days= 32
Inventory Days= 24

Operating Cycle = (32+24)= 56 days from when cash is first

spent until collected from customer.

IDC- AMBA 5
Operating Cycle and Financing Period
Financing Period:

Calculated as: Operating Cycle - PDO

• Represents the amount of time which the business needs to finance its
operations using other forms of cash generators.
• If financing period is greater then 1 it means that during the year there will
come a time when the cash has not been collected yet from receivables and
the company must pay out to suppliers, therefore will need to finance its
operations using other methods besides its working capital.
Example:
PDO = 40
Operating Cycle= 56 Financing Period Required = (56-40) = 16 days

IDC- AMBA 6
Reformulation of the Financial Statements

IDC- AMBA 7
Reformulating
Why do we reformulate the statements?

The Financial statements include many assets, liabilities, revenues and expenses that
are not part of the main operation of the business.

In order to value the company in its true operating sense- we must first take away any
financial aspects before we asses its performance.

IDC- AMBA 8
Operational/Financial
Asset Liability

Expected to generate economic Probable future sacrifices of

benefit for the company in the future economic benefits for the company

Short-Term = 1 year or less

Long-Term= over 1 year

Operational Financial
An asset/liability used in the primary An asset/ liability that derives value
income generating operation of the because of a contractual claim and is used
business in order to finance the primary operation

IDC- AMBA 9
Operational/Financial
Some Examples of:
Operational Assets: Financial Assets:
Account Receivables Marketable securities
Inventory Passive Investments
PP&E Financial Liabilities:
Operational Liabilities: Bank Loans
Accounts Payable Notes Payable
Deferred Revenue

• Separated into Short and Long term as in the Balance Sheet.

• Is used mainly for various models of valuation

IDC- AMBA 10
Reformulating the Balance Sheet

IDC- AMBA 11
 Reformulating the Balance Sheet
 Stage 1: Classify financial and operational assets/liabilities.
 Stage 2: fill this sub-table
FA XXX FL XXX
P.N OA XXX OL XXX
TA XXX TL XXX
 Stage 3: Create summarized table
OA XXX
OL (XXX)
NOA XXX
FL (XXX)
FA XXX
NFO/NFA (XXX)
BV IDC- AMBA
XXX 12
Reformulating the Income Statement

2 steps:

 Calculate the Net Financial Expense (NFE)

 Compute NOPAT from Net Income

IDC- AMBA 13
Reformulating the Income Statement
Step 1 - NFE Calculation: Example:
(tax=25%)
+Interest income +100
-Interest expense -200
(Gross Financial Expense) -100
+ Tax Benefit (Financial expense X Tax rate) +25
= Net Financial Expense (NFE) -75 NFE

IDC- AMBA 14
Reformulating the Income Statement
Step 2- Compute NOPAT from Summarized Table

Calculate NOPAT through NI & NFE NOPAT = NI - NFE

NOPAT from Comprehensive Income XXX

+ NFE (Since NFE is negative it will be subtracted) (XXX)

= NI (Net Income) XXX

Ex.
NI 1000 NOPAT =?
NFE (200) 1000-(200)= 1200

IDC- AMBA 15
 Profitability Analysis
- We preform the profitability analysis in order to understand
the present operational and financial business of the company
and to be able to forecast future profitability.

IDC- AMBA 16
Profitability Analysis
Levels of Analysis

- Level 1: ROCE breakdown.

- Level 2: PM & ATO.

IDC- AMBA 17
 Level 1
Step 1: Calculating ROCE using the NI formula
𝑁𝐼
𝑅𝑂𝐶𝐸 =
𝐴𝑣𝑔. 𝐵𝑉

Step 2: Calculating ROCE using second formula

ROCE t  RNOA  FLEV  [ RNOA  NFR]

NOPAT Avg.NFO NFE

RNOA  FLEV  NFR 
Avg.NOA Avg.Equity Avg.NFO
Return on Net Operating Assets Financial Leverage Net Borrowing Cost

Step 3: Compare (should match)

IDC- AMBA 18
 Level 2
Step 1: Calculate Return on Net Operating Assets using this formula

RNOA  PM  ATO

NOPAT Sales
PM  ATO 
Sales Avg.NOA

Step 2: compare with the RNOA that you got from Level 1

Explanations:
If PM = 12%, Company profits 12% for every dollar of sales.
If ATO = 2.5, For every dollar the Company invests in Operational Assets it sells ATO $ .

IDC- AMBA 19
IDC- AMBA 20