FSA Chapter 9


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FSA Chapter 9

  1. 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. 2. Index <ul><li>Introduction </li></ul><ul><li>Return on assets </li></ul><ul><li>Return on equity </li></ul><ul><li>Financial leverage </li></ul>
  3. 3. Index <ul><li>Introduction </li></ul><ul><li>Return on assets </li></ul><ul><li>Return on equity </li></ul><ul><li>Financial leverage </li></ul>
  4. 4. Introduction <ul><li>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 </li></ul><ul><li>Profitability can be measured by this quotient : </li></ul><ul><li>Profit </li></ul><ul><li>Investment </li></ul>
  5. 5. Introduction <ul><li>Profitability can be measured from a double perspective, relative to the total investment or to the invested resources themselves. </li></ul><ul><li>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. </li></ul><ul><li>  </li></ul><ul><li>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. </li></ul>
  6. 6. Index <ul><li>Introduction </li></ul><ul><li>Return on assets </li></ul><ul><li>Return on equity </li></ul><ul><li>Financial leverage </li></ul>
  7. 7. Return on assets <ul><li>So, to measure the ROA the following ratio is used: </li></ul><ul><li>  </li></ul><ul><li>ROA = EBIT </li></ul><ul><li> Assets </li></ul><ul><li>  </li></ul><ul><li>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 . </li></ul><ul><li>This analysis requires detailed Income Statement by Nature, Cash Flow Statement by Indirect Method, or detailed notes. </li></ul>
  8. 8. Return on assets, components <ul><li>ROA = EBIT x Revenue Revenue Assets </li></ul><ul><li>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. </li></ul><ul><li>This differentiation reveals which strategy among those described by Michael Porter in 1980 the company has adopted.   </li></ul><ul><ul><li>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. </li></ul></ul><ul><ul><li>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. </li></ul></ul>
  9. 9. Added value <ul><li>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 </li></ul><ul><li>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 </li></ul><ul><li>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. </li></ul>
  10. 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. 11. Added value Employee benefits expense Finance costs Income tax expense, continuing operations Dividends Self-financing (reserves, depreciation and impairment) Added value, distribution
  12. 12. Added value
  13. 13. Return on assets, components <ul><li>A second breakdown can be obtained by multiplying and dividing the first of the factors in the previous expression by the added value: </li></ul><ul><li>ROA = EBIT = EBIT x Added value </li></ul><ul><li>Revenue Added value Revenue </li></ul><ul><li>  </li></ul><ul><li>This breakdown reveals what portion of the added value is profit, and the company’s value generation capacity expressed as a percentage of sales. </li></ul>
  14. 14. Index <ul><li>Introduction </li></ul><ul><li>Return on assets </li></ul><ul><li>Return on equity </li></ul><ul><li>Financial leverage </li></ul>
  15. 15. Return on equity <ul><li>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: </li></ul><ul><li>  </li></ul><ul><li>ROE = EBT </li></ul><ul><li> Equity </li></ul>
  16. 16. Cost of debt <ul><li>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: </li></ul><ul><li>  </li></ul><ul><li>Average cost of debt = i = Financial costs </li></ul><ul><li> Liabilities </li></ul>
  17. 17. Index <ul><li>Introduction </li></ul><ul><li>Return on assets </li></ul><ul><li>Return on equity </li></ul><ul><li>Financial leverage </li></ul>
  18. 18. Financial leverage <ul><li>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 </li></ul>
  19. 19. Financial leverage <ul><li>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. </li></ul><ul><li>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 . </li></ul>
  20. 20. Financial leverage <ul><li>In algebraic terms </li></ul><ul><li>ROE = Return on equity </li></ul><ul><li>E = Equity </li></ul><ul><li>L = Liabilities </li></ul><ul><li>i = Average cost of debt </li></ul><ul><li>D = Debt to equity ratio </li></ul><ul><li>then: </li></ul><ul><li>  </li></ul><ul><li>ROE = EBT = (EBITDA – financial costs) </li></ul><ul><li>E E  </li></ul><ul><li>ROE = (ROA * Total assets – i*L) = (ROA *(E+L) - i*L </li></ul><ul><li>E E </li></ul><ul><li>ROE = (ROA * E ) + (ROA * L ) - (i * L ) </li></ul><ul><li>E E E  </li></ul><ul><li>ROE = (ROA * E ) + (ROA - (i * L ) </li></ul><ul><li>E E </li></ul><ul><li>ROE = ROA + (ROA –i) * D </li></ul>