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  • 1. Financial Statement Analysis Chapter 9 Profitability Bonsón, E., Cortijo, V., Flores, F.   Content on this file is licensed under a Creative Commons Attribution Non-Commercial No Derivatives Works 3.0
  • 2. Index
    • Introduction
    • Return on assets
    • Return on equity
    • Financial leverage
  • 3. Index
    • Introduction
    • Return on assets
    • Return on equity
    • Financial leverage
  • 4. Introduction
    • Profitability analysis turn to measuring how a company, after performing its basic activity of sales and services rendered, and paying all the production factors concerned, is able to generate a profit to be distributed among shareholders that can be compared to the total of resources invested
    • Profitability can be measured by this quotient :
    • Profit
    • Investment
  • 5. Introduction
    • Profitability can be measured from a double perspective, relative to the total investment or to the invested resources themselves.
    • Return on total investment or return on assets (ROA) calculates the relationship between EBIT ( earnings before interests and taxes ) and total assets , as a measure of the investment necessary to obtain this profit.
    •  
    • Return on equity (ROE): determines the relationship between EBT ( earnings before taxes ), and equity , as a measure of the resources the shareholders have invested in the company.
  • 6. Index
    • Introduction
    • Return on assets
    • Return on equity
    • Financial leverage
  • 7. Return on assets
    • So, to measure the ROA the following ratio is used:
    •  
    • ROA = EBIT
    • Assets
    •  
    • The study of the return of assets can be completed by analysing its components and the relationships between them. These include profit margin, assets turnover and added value .
    • This analysis requires detailed Income Statement by Nature, Cash Flow Statement by Indirect Method, or detailed notes.
  • 8. Return on assets, components
    • ROA = EBIT x Revenue Revenue Assets
    • We can thus differentiate two factors: profit margin and assets turnover , or the number of times that the sales assume the quantity of the share.
    • This differentiation reveals which strategy among those described by Michael Porter in 1980 the company has adopted.  
      • Cost leadership strategy: this aims to sell a lot of units or render a lot of services at low cost. In this instance, the margin is low and turnover is high.
      • Differentiation strategy: based on quality – it seeks to sell exclusive products at a high price even though the number of units sold is low. Thus the margin is high but turnover is low.
  • 9. Added value
    • Added value is the wealth generated by the activity of a company during a specific period, and is calculated by the difference between the value of the production of goods and services and the purchase value of external acquisitions
    • This difference, which measures the company’s contribution to the economy, is distributed as income: to employees via staff costs, to investors and financial entities via dividends , to interests , to self-finance via provisions, depreciation and amortization, and to governments and public entities via taxes
    • It therefore assumes the demarcation between the company and its environment, measuring the value that it generates and observing how it is later distributed added to which, even when a company makes a loss it can still generate positive value for society.
  • 10. Added value + Revenue + Other income + Work performed by entity and capitalised - Raw materials and consumables used - Other expense, by nature Added value, generation
  • 11. Added value Employee benefits expense Finance costs Income tax expense, continuing operations Dividends Self-financing (reserves, depreciation and impairment) Added value, distribution
  • 12. Added value
  • 13. Return on assets, components
    • A second breakdown can be obtained by multiplying and dividing the first of the factors in the previous expression by the added value:
    • ROA = EBIT = EBIT x Added value
    • Revenue Added value Revenue
    •  
    • This breakdown reveals what portion of the added value is profit, and the company’s value generation capacity expressed as a percentage of sales.
  • 14. Index
    • Introduction
    • Return on assets
    • Return on equity
    • Financial leverage
  • 15. Return on equity
    • The ROE calibrates the relationship between EBT ( earnings before taxes ) and equity, as a measure of the resources that shareholders have invested in the company. The following ratio is used to calculate ROE:
    •  
    • ROE = EBT
    • Equity
  • 16. Cost of debt
    • It is also possible to calculate the ROE on the basis of the ROA and the average cost of debt. To obtain the latter, not all debt is considered to carry a cost, for example, the company’s commercial creditors do not usually charge interest when payment for supplies and services is delayed. The average cost of debt is calculated thus:
    •  
    • Average cost of debt = i = Financial costs
    • Liabilities
  • 17. Index
    • Introduction
    • Return on assets
    • Return on equity
    • Financial leverage
  • 18. Financial leverage
    • The effect of financial leverage is felt when a more than proportional variation in the return on equity occurs, caused by the variation in the return on assets
  • 19. Financial leverage
    • One company taking on the same additional amount of debt at the same cost is more leveraged than another when its ROE enjoys higher growth.
    • Or rather, it is more leveraged when, with the same share quantity and ROA, it has a greater ROE due to a superior debt level – in these circumstances, the shareholders have invested fewer funds, thanks to the debt, to finance the same share whose profitability, being a variable relative, is obviously greater .
  • 20. Financial leverage
    • In algebraic terms
    • ROE = Return on equity
    • E = Equity
    • L = Liabilities
    • i = Average cost of debt
    • D = Debt to equity ratio
    • then:
    •  
    • ROE = EBT = (EBITDA – financial costs)
    • E E 
    • ROE = (ROA * Total assets – i*L) = (ROA *(E+L) - i*L
    • E E
    • ROE = (ROA * E ) + (ROA * L ) - (i * L )
    • E E E 
    • ROE = (ROA * E ) + (ROA - (i * L )
    • E E
    • ROE = ROA + (ROA –i) * D