FSA Quiz #2

what are the two components of ROE, broadly speaking?

operating performance ROA (profit margin & capacity utilization)

& financial strategy (leverage)

what are the 3 determinants of ROE ?

profit margin x

asset turnover x

leverage

what is the formula for ROE (non-dupont) ?

net income / shareholders' equity

what is the formula for profit margin?

net income / revenues

the profit margin % measures a firm's ability to... (2)

1. obtain higher prices for its products or services, relative to competitors &

2. control the level of operating costs, or expenses, relative to sales revenue.

by holding down costs, a firm increases the profits from a given amounts of sales and thereby improves its profit margin %

what is the formula for ROA?

profit margin x asset turnover

(net income / assets)

total asset turnover ratio measures a firm's ability to

generate sales from a particular level of investment in assets, where a higher ratio implies that a firm more efficiently uses its assets

leverage measures the degree to which the a firm uses

common shareholders' funds to finance assets, where a larger ratio implies that a firm uses less equity and more debt to fund its assets

what factors affect ratios? (3)

1. business strategies

2. industry production technology

3. corporate strategies

which items affect business strategy?

differentiation / cost leadership

extent of competition

- entry barrier

- existing competition

- demand elasticity of products (no substitute)

corporate strategies include:

financing

franchise vs. own

business strategy & HIGH profit margin

(nature of product, barriers to entry, extent of competition, price elasticity of demand)

nature of product:

differentiated

barriers to entry: high

extent of competition: more monopolistic

price elasticity of demand: relatively inelastic

business strategy & LOW profit margin (nature of product, barriers to entry, extent of competition, price elasticity of demand)

nature of product: undifferentiated

barriers to entry: low

extent of competition: highly competitive

price elasticity of demand: relative elasticity

IBM has lots of patents & a gross margin of 48% -- this means their barriers to entry are _______ & their profit margin is ______

high & high

microsoft has a gross margin of 72% -- this means they are _________ ________ & have a ________ profit margin

more monopolistic

high

phillips morris (tobacco) has no substitutes & a gross margin of 66%. this means they have a relatively ________ price elasticity of demand & _______ profit margin

relatively inelastic

high

who would have a higher total asset turnover, dell or apple? what is the key business strategy choice that determines this difference?

dell = higher total asset turnover

they employ cost leadership so they turnover assets more efficiently

apple = the differentiator

lower total asset turnover, but likely to have higher margins (ie gross, EBITDA, EBIT, etc)

who would have a higher total asset turnover, comcast or direct TV within industry production technology choice ( ie cable investment vs satellites) ?

direct TV (satellites) has the higher total asset turnover and higher ROE

comcast (cable investment) has more PPE which INCREASES the denominator of total asset turnover, making it lower

how does financing customers purchasing affect asset turnover? net operating margin? leverage likely ?

asset turnover = lower

net operating margin (operating income/sales) = increases

leverage likely = increases

if financing is done well, it can ___________ ROE

increase

why is there a higher profit margin associated with financing for customers?

because you do not have to discount product as much because financing is offered

why is there a lower total asset turnover associated with financing for customers?

when you finance, you are now carrying more accounts receivable, which increases the base (denom)

why is leverage likely to increase when there is financing for customers?

if they have accounts receivable, they need external financing so they have to borrow

who would have a higher total asset turnover, company owned stores or franchising ? (corporate strategy choice)

franchising

a franchise does not actually own the assets, so the denominator is lower & turnover is higher

within asset turnover, what are the three components of working capital turnover?

days inventory

days receivables

days payable

what does the cash to cash cycle measure?

the time it takes from when you pay cash to suppliers to when you receive cash from buyers

what is the formula for the cash to cash cycle?

days receivables + days inventory - days payable

what is the time period for days payable?

from buy inventory to pay for inventory

what is the time period for days inventory?

from buy inventory to sell inventory

what is the time period for days receivable?

from sell inventory to collect receivable

what is the time period for the entire cash to cash cycle?

pay for inventory to collect receivable

what is the advantage of having a short cash to cash cycle?

you want to have cash now because the longer something is uncollected, the higher the risk

T or F: higher ticket items (such as diamonds) have a longer C to C because people take longer to think about purchasing

T

why is amazon's cash to cash shorter than costco's ?

they have a negative cash to cash cycle because they sell & collect cash first, then they will pay suppliers

they are able to push their suppliers around

long term solvency risk

assessing the ability of a firm to generate sufficient cash in the longer term (1-10 years) to pay liabilities coming due

what two things does long term solvency risk measure? what ratios are used for each?

measures the level of debt in the capital structure

- debt to equity ratio

- long term debt ratio

measures the ability of the firm to generate sufficient cash to service the debt (= make interest & principle payments)

- interest coverage ratio

- operating cash flows to total liabilities

what was the issue with bed bath & beyond's interest coverage ratio?

they did not have enough money to keep up with their interest payments, & since there was too much debt, they had to file for bankruptcy

do we want the leverage to be as high as possible?

no, its not costless

higher leverage = higher solvency risk (going bankrupt)

unexpected shocks can still happen & you will have no cushion for them

in some instances leverage causes the _________ to be higher than the ________ ; however in other instances it has just the opposite effect, why ?

ROE than the ROA

financial leverage increases the return to equity holders, if ROA exceeds the cost of debt capital

if a company is not doing well, a company will do _______ with high leverage

worse

what is the formula for ROA (simple)

net income / total assets

minority interest (non-controlling interest) & consolidation

if own greater than 50%, say 60% of subsidiary

consolidation means that 100% of income & assets are included, yet 40% belongs to minority interests

which income should be used then to find ROA? (3)

net income from continuing operations +

(1 - tax rate) x (interest expense) +

minority interest in earnings

net income from continuing operations

NO debt & NO minority interest

(1- tax rate) x (interest expense)

with debt but NO minority interest

minority interest in earnings

with debt & minority interest

typically comes from acquisitions

what is the conceptual thinking behind the net income formula in ROA ?

if the denominator is total assets, the income should reflect "net income to all stakeholders, including equity, debt & minority shareholders"

ROE can be achieved through (2)

operating performance (profit margins or asset utilization)

OR

financial risk

which business strategies affect ratios?

differentiation, entry barrier, competition

industry structure affects ratios:

compare within industry

many ratios are ________ __________ & does not capture future growth

backwards looking

LECTURE 11: DUNKIN V STARBUCKS

what industry are dunkin & starbucks in? who is the differentiator? cost leader?

quick service industry

differentiator: starbucks

premium beans & in store experience

cost leader: dunkin

what are the macroeconomic factors of their industry?

somewhat cyclical

profits sensitive to price of coffee beans

labor costs: probably matters more to SBUX than DNKN because the baristas are well-trained, harder to replace

porters' 5 forces & the coffee industry: barriers to entry?

mom & pop shops but available prime sites might be taken

is the industry competitive - rivalry among existing competitors?

fairly competitive

threat of substitutes?

brew coffee at home, K cups ; energy drinks

power with customers?

low switching costs for consumers ; points too

supplier power?

of sufficient size to demand some concessions from suppliers

supplier of coffee beans

can argue either way for labor of baristas

given the operating strategies of the firms (own vs franchise), which would you expect to have a higher profit margin?

starbucks (own)

they are the differentiator

the higher asset turnover?

dunkin (franchise)

fewer assets actually owned

the higher leverage?

starbucks (own)

you need the PPE

on the income statement, company-operated stores > licensed stores, indicates?

ownership model (starbucks)

on the income statement, franchise fees & royalty income > sale at company-owned restaurants, indicates?

franchise (dunkin)

on a common size income statement, who has the higher profit margin between starbucks & dunkin? why?

dunkin

even though starbucks offers differentiated products, they have many more expenses to run company-owned stores

operating expenses: 87% for SBUX, 67% for DNKN

on the common size income statement, how does dunkin erode their 20% lead on starbucks from operating expenses?

their high interest expense (11%) and higher taxes (8.3%)

who has the higher asset turnover between starbucks & dunkin?

starbucks has the higher asset turnover

you would expect dunkin to have a higher asset turnover because they are a franchise (vs. owned) but it is lower

why does starbucks have a higher asset turnover than dunkin?

starbucks has a high PPE (32%) & working capital because they are company owned

& dunkin has low PPE (6%) & no inventories & small cash because they are a franchise HOWEVER

dunkin has very high goodwill (28%) & other intangible assets (46%)

how did dunkin accumulate almost 75% of its assets to be intangibles?

because dunkin was ACQUIRED after the development of its brand name

its balance sheet includes intangible asset "Trade Names" in the line item "Other intagible assets, net"

because starbucks' brand name was __________ __________ and not acquired, SBUX is not permitted to list its brand name on its balance sheet

internally developed

T or F: dunkin's intangible assets appear to be significantly less productive then SBUX's stores and inventory investments

T

how would you make the balance sheets of starbucks and dunkin comparable given this information?

recast dunkins balance sheet without "trade names" by writing it off

in what circumstances can dunkin's "trade names" be re-evaluated from its current 1.2 billion?

1. unless the company is acquired again

2. it can be impaired (ie a negative event) that triggers a re-evalulation of the brand name

which accounts will you recast to reconcile dunkin's balance sheet? (3)

DECREASE "Other Intangible Assets"

the value of the brand name (1.2B). =

DECREASE Deferred Tax Liability (DTL). +

DECREASE Retained Earnings

asset turnover will increase or decrease given the recasting?

increase

why is the DTL account affected in the recasting of Dunkin?

imagine the acquirer purchased an asset, brand name for 1.2B

for GAAP, this is CAPITALIZED & not expensed

for IRS, this is DEDUCTED from TAXABLE INCOME

therefore IRS < GAAP income, leading to DTL

is the franchise rights & other intangibles DTL associated with the recasting of the brand name accurate?

its not accurate though because some intangible assets NEED to be amortized & this lumps them all together

who has a higher leverage, dunkin or starbucks? why?

dunkin has a higher leverage (5.88)

its higher because it was acquired by PE in 2005, which is typical of this kind of transaction

measuring performance is _________. the economic activities & competitive environments are ________

complex

comparative analysis is _________. firms, even though in the same industry, have different ________ ________ & _________ _________

complex

operating strategies & asset structures

T or F: to be competent, analysts must be informed by an understanding of the company's industry, strategy & accounting choices

T

financial statement analysis should take into account the ________

context

LECTURE 12: STATEMENT OF CASH FLOWS

the statement of cash flows is the ________ in _______ for the fiscal period BUT.....

change in cash

but it is not the change in cash that is most important, but rather the SOURCE of that chance

what is included in operating activities?

current assets & current liabilities

what is included in investing activities?

long lived assets (PPE)

what is included in financing activities?

long term liabilities & owner's equity (loans, etc)

the indirect method follows the formula of ? with 2 types of adjustments being?

net income + adjustments

2 types of adjustments:

- non working capital accounts

- changes in working capital accounts

information about past cash flows, particularly cash flows from operations, helps in assessing ______________ ______________

financial flexibility

financial flexibility

a firms ability to generate sufficient amounts of cash to respond to unanticipated needs & opportunities

why do companies typically fail to achieve financial flexibility?

they lack the cash flow necessary to conduct their business

how can cash flows be useful for assessing earnings quality? (2)

gauge whether reported net income reflects the underlying economics of the business

highlights accounting accruals, which can provide insight into the sustainability & quality of a firm's reported earnings

if net income grows faster than operating CF, we need to understand whether cash flows will .....

increase in the future OR whether income has been improperly recognized only to reverse in the future (think prepaid legal)

if tesla thought they would lose a lawsuit in 2013, where would it appear on the CF statement & how would it be reconciled in 2014?

2013 depreciation & amortization: positive

loss but have not paid: their earnings is low because they paid for it

2014 accrued litigation charge: negative ( )

you have to take it out, so earnings is not affected by that

you paid for the loss, but it doesn't hurt earnings

a growing company is likely to have what kind of CFO ? CFI ? CFF ?

CFO = NEGATIVE because they are small & just starting out

CFI = NEGATIVE

buying PPE, spending

CFF = POSITIVE

taking on debt

issuing equity (IPO)

what are the 4 phases a company could be in?

introduction

growth

mature

declining

what is the difference between growth & mature phases?

growing =

operations are increasing,

investing is still negative so they are buying PPE

& still raising money

mature =

relatively stable CFO (but slightly declining)

investing is decreasing CFI still investing (negative)

& CFF becomes negative because they are paying off some debt

a declining company is likely to have what kind of CFO ? CFI ? CFF ?

CFO = positive but STEEP decline

CFI = investing is decreasing & could be positive because they are selling off their PPE

CFF = paying off debt (negative)

what is another name for share-based compensation expense? why don't you add back this expense in CFO ?

stock option

US GAAP require that stock options be expense

the recognition of an expense does not use cash

but the expense is deducted from net income

any increase in a DTA is added or subtracted? why ?

increase in DTA -->

IRS taxes > GAAP taxes (in net income)

cash paid to IRS > tax expenses in net income (you paid too much to the IRS)

thus SUBTRACTED to get cash effect