Topic 3.2 Ratios and Financial Leverage Analysis

What is the debt ratio

d= D/ E

debt ratio constant = Debt/ Equity

What is the asset turnover equation

Asset turnover = S/TA

Sales volume = S

Total Assets = TA

What is the cost of debt constant

K_L=K_D=K_i

What is the Profit before taxes equation

PBT = EBIT - (Ki x D)

Ki = debt constant

D = Debt

EBIT = Earnings before tax

Financial ratios: profitability

It measures the operational capacity of the company. We will use data related to income generated by the company and means used to obtain them.

Financial ratios: Liquidity

It measures the financial capacity of the company to meet short-term financial obligations

Financial ratios: Solvency

It measures the financial capacity of the company to meet all its obligations (short and long term)

Ratios of structure of liabilities and indebtness

They are used to analyze the level of indebtness of a company

Asset structure ratios

They are used to analyze the relationship between non current A and current A

Explain economic profitability

It measures profitability from the point of view of the ASSET

Profitability is defined by taking the interest free profit to make comparisons between companies having different financial strategies

What is the ROA equation and explain it

ROA = EBIT / TA

Return on assets = earnings before income tax / total assets

With ROA we are able to know how much profit the company generates for its professional activity, for each euro invested in the assets of the company

ROA is the economic profitability indicator

Who can impact a companies ROA and how?

Operating managers can impact ROA by improving profit margin or asset turnover

How can operating managers improve the profit margin?

Through cost control or revenue increases

What are two ways to calculate profit margin?

EBIT/Sales (Gross Profit Margin)

Net Profits / Sales (Net Profit Margin)

How can managers improve asset turnover

By better capacity utilization, increasing sales relative to assets

Margin on Sales ratio

Margin on sales = Earnings before interests and taxes / sales

What is the Asset Turnover / what does it mean

ATO means the sales generated by each euro of assets. The importance is the trend.

ATO ratio

ATO = Sales/ Assets

An improvement in the ATO…

• Means a great deal of efficiency and creativity in managing and controlling the company assets

• But it may also reveal some assets (especially fixed assets) are not renewed, which may create some long term efficiency problems

A deterioration in ATO

• is a signal of poor asset management or

• is the result of an ambitious program of asset renewal or

• an aggressive policy of acquisitions

How can ROA be improved?

Improving margin (EBIT/Sales) y controlling costs or increasing revenues or improving the efficiency of the company, ie its asset turnover (Sales/Total Assets) through better utilization of company capacity

ROE ratio

ROE= Net Profit/ Equity

What does ROE measure

It measures the percentage of net profits that shareholders make for every euro of net worth that the company has.

• Owner focuses on this

Why improve the ROE?

One of the main objectives of the shareholder —> to increase the dividend

How can assets be financed?

Using equity (owners money) or through debt (loans, bonds, etc)

Two companies can have the same assets and same profits but different financing structures

How does debt vs equity affect profitability (ROE)

It takes into account how the company finances its assets, specifically how much debt vs equity the company uses

Explain financial leverage

Using debt to finance assets

More debt = higher leverage

less debt = lower leverage

Debt can:

Increase returns to shareholders (if assets earn more than the cost of debt)

Increase risk (interest MUST be paid even if profits fall)

Example:

• Company A: Financed only with equity

• Company B: Financed with equity + debt

If both earn the same operating profit

Company B may have a higher ROE because profits are spread over LESS equity

This is the effect of its financial leverage

The difference between ROA and ROE

ROA measures economic profitability and u calculate it with operating profit (EBIT)/ TA whereas ROE measures financial profitability (looks at return for shareholders) and you measure it with Net income/Equity. ROE changes when debt changes

Simple ROE equation

Net Profit / Equity

• use for quick measure of shareholder return

• Use when NOT asked to explain why ROE is high or low

• Calculating ROE from financial statements

DuPont Decomposition of ROE

ROE = (Net profits / sales) x (sales/assets) x (assets/equity)

ROE = Profit Margin x Asset Turnover x Financial Leverage

Used when asked to explain or compare ROE, comparing two firms with the same ROE, when the question mentions strategy, efficiency, leverage, or risk

Example of ROE decomposition
Explain:

Firm A = 6% profit margin x 0.5 asset turnover x 4 financial leverage = 12%

Firm B = 2% profit margin x 1.5 asset turnover x 4 financial leverage = 12%

Firm A has a high profit margin, meaning it earns a lot per unit sold, and a low asset turnover, meaning assets are used less efficiently (capital intensive), and high financial leverage (uses significant debt). Firm A competes on high margins, not on volumes (eg luxury brand, specialized manufacturing)

Firm B has a low profit margin at 2%, a high asset turnover (assets generate a lot of sales), same financial leverage (same level of debt as firm A). Firm B competes on high volume and efficiency (eg retail, airlines, supermarkets)

Both deliver 12% ROE but Firm A relies on pricing power, Firm B relies on operational efficiency.

Financial rate of return equation

ROE = ROA + (ROA -K_i) x (D/ E)

This measures the rate of return from equity or the owners or shareholders POV

Financial rate of return relies on ROA (economic performance), level of debt (D/E), financial leverage (ROA-K_i)

Why is maximizing ROE a fundamental objective of the firm?

We want shareholders happy

Why do shareholders care about ROE

Because they accept risk when investing and expect a return consistent with that risk.

How is ROE related to raising additional equity capital?

If a firm does not provide adequate ROE, shareholders will be unwilling to provide additional funds.

What happens if a firm fails to satisfy shareholders?

They may leave, or another firm may take over to make them happy by using assets more efficiently.

What is Self Sustainable Growth (SSG)?

The maximum growth rate a firm can maintain internally without changing its debt to equity (D/E) ratio, without issuing new equity

Why do firms want to maximize SSG

To grow using internally generated funds while keeping the same financial structure

What is the relationship between ROE and SSG?

Higher ROE increases internally generated funds and therefore increases self sustainable growth

What is the key managerial question behind SSG

Higher ROE increases internally generated funds and therefore increases Self Sustainable Growth

What is the key managerial question behind SSG

Given the firms characteristics, how fast can it grow without changing its D/E ratio or raising outside equity

SSG formula

SSG= ROE x Retention Ratio

Explain ROA> i

Borrowed money earns more than it costs
( ROA - i ) > 0
Leverage factor > 0

Effect: Debt increases ROE, shareholders benefit from borrowing, leverage is value-creating for shareholders

ROA = i

Borrowed money neither creates or destroys value
ROA - i = 0

Leverage factor = 0

Effect: ROE = ROA, debt has no impact on shareholder return, leverage is neutral

ROA < i

Borrowed money costs more than it generates

ROA - i < 0

Leverage factor < 0

Effect: ROE < ROA, shareholder return is reduced by borrowing

Leverage is value-destroying

Current ratio and explain what it measures

CA = Current assets / current liabilities

Measures a companies ability to pay off current liabilities using all current assets, including inventory

Includes cash receivables, inventory, and other short term assets

General measure of short term liquidity

Acid test ratio and explain what it measures

A- T = Current assets - Inventory / current liabilities

Measures the companies ability to pay current liabilities without relying on inventory

Excludes inventory bc inventory may not be easily or quickly converted to cash, a more conservative measure of short term liquidy - uses only most liquid assets

What does working capital do

It allows us to see if the company is able to assume with its asset at short term debt or obligations at short term

Working capital and at >0

= current assets - current liabilities

>0 the most liquid assets are able to assume the debt to short term

General liquidity ratio

Liquidity = working capital = current assets / current liabilities

Cash Ratio and what does it measure

Cash ratio = cash / current liabilities

Measures the companies ability to take on its current debt without including the effect of inventory

what are the two liquidity ratios

ACP and ACM

Average collection period

Average payment period

ACP Average collection period

Gives us the information about how long it takes for customers to pay, OR how long it takes to collect the purchases made by customers

ACP = Clients / Sales * 365

APP Average payment period (in days)

Gives us information about what it takes to pay our suppliers

APP = suppliers / cost of goods * 365

Average period of stock rotation (ASRP)

Relates to stock purchases

Period of stock rotation = stock/ cost of goods sold *365

Solvency ratio

Gives us information about how close or how far the company is from bankruptcy

Solvency ratio = Total Asset / Debt = TA / NCL + CL

NCL = non current liabilities

Solvency Ratio

Total Assets / Total Liabilities = how far the firm is from bankrupt, measures if the assets are or not enough to face debts
Equity / Total Assets = it measures the level of debt over equity

Solvency ratio > 1

The company has more assets than liabilities and is considered solvent (able to meet long term obligations)

Solvency ratio < 1

The company’s liabilities exceed its assets, indicating negative equity. This means the company may be insolvent or bankrupt, as its liabilities are greater than its available assets to cover them

Equity ratio > 1

The company has more long term debt than short term debt

Equity (partners investment) is relatively strong, supporting long term financing

Equity ratio < 1

The company has more short-term debt than long-term debt

The company relies more on short term liabilities which can be riskier due to liquidity pressures

Debt ratio relative to EBITDA

Net financial debt / EBITDA

Financial autonomy ratio when its = 1 or <1

Equity / Total assets

= 1 implies the company is financed only with its own resources and has no debt in short or long term

<1 implies the company is financed with its own resrouces, the closer to zero it is implies the company is heavily in debt

Financial dependency ratio = 1 and < 1

Current liabilities + non-current liabilities / total assets

= 1 implies that the company is financed solely by debt and has no net worth or is very close to zero (implies that the company is on the verge of bankruptcy)

< 1 implies that the company is financed with its own resources and with others (debt). The closer to zero it implies the company is very little in debt

Interest coverage ratio

= EBITDA/ Financial expenses

Helps to know to what extent the company is able to meet the financial expenses of its debt

Immobilization ratio

= Non current assets/ total assets

Allows to know to what extent the assets of the company are fixed assets. The closer to 1 the less liquidity the company has

Profitability includes

ROA

ROE

Sales margin

Solvency includes

Debt ratio

Assets to liabilities

Liquidity measures

Current ratio

Acid test

Efficiency measures

ATO