3. MBA | Finance and Accounting | Financial Analysis

Profit analysis

Framework: Profitability Analysis

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As you learnt in this video, the main stakeholders of a business are the shareholders. They are interested in comparing the net income with the owner's equity to ascertain their return on investment. This measure is called return on equity (RoE)

  • If you borrow more, the net income will decrease, and if you borrow less, the owner's equity will increase. Hence, there is a need to find an optimum point between the percentage of debt that you want to borrow and the interest rate on this debt. You need to operate near the optimum point.

Another important aspect that needs to be determined is the resources employed by the company in generating the operating profit. Therefore, the operating profit of a company needs to be compared with the resources employed by the company in order to determine the efficiency of the company. This measure is called return on capital employed (RoCE).

Operating working capital = Inventory + Accounts receivable - Accounts payable

Economical Balance Sheet

Capital employed:

  • Total asset - current liability, or
  • PPE + WC

Invested capital:

  • The total of financing items, or
  • Owner’s equity + Net debt

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Operating Margin

Operating margin = Operating income (EBIT) / Sales revenue

Return on Capital Employed (RoCE)

RoCE = Operating income (EBIT)/ CE
= Operating margin ratio x CE turnover ratio

Return on Average Capital Employed (RoACE)

RoACE = Adjusted net operating income/ Average CE

  • Adjusted net operating income indicates the operating income after paying taxes and excluding non-recurring items (abnormal).

With the help of the example of the TOTAL group, you learnt that analysing the RoACE of a company reveals the actual operating performance of the company

  • The drivers of return on average capital employed are the operating margin and capital employed turnover ratio

Value Creation and WACC

WACC = Cost of debt x Proportion of debt + Cost of equity x Proportion of equity


If the after-tax RoCE is higher than or equal to the return expected by shareholders and banks

Return on Equity and Financial Leverage

Equity shareholders are the owners of a company. They enjoy the residual profit, after all the other stakeholders are rewarded for their investment


ROE = Net income (EAT)/ Owner's equity - included RE


  • Increase net income: By minimising interest expense; By minimising taxes
  • Decreasing owner’s equity: By borrowing more

If you borrow more, the net income will decrease, and if you borrow less, the owner's equity will increase. Hence, there is a need to find an optimum point between the percentage of debt that you want to borrow and the interest rate on this debt. You need to operate near the optimum point

Financial leverage

  • EBT/EBIT: Cost of debt, higher is better
  • CE/Owner's equity: proportion of debt, higher is better

Tax implications

  • EAT/EBT: tax expenses

Operating Working Capital

Activity Ratios

Operating working capital = Inventory + account receivable - account payable

Working capital ratio = (WC/Sales revenue) * 100


A measure to benchmark the performance of a company against that of other companies of different sizes

  • Day sales outstanding (DSO) = (Receivable/sales) *360
  • Days payable outstanding (DPO) = (Payables/COGS) *360
  • Days inventory outstanding (DIO) = (Inventory/COGS) *360

Drivers of Operating Working Capital

  • Technology: A faster production process results in lower inventory-holding cost
  • Effectiveness: Timely payment reminders to customers result in lower accounts receivables
  • Payment Habits: Long payment terms granted to customers may result in a higher operating working capital requirement
  • Sales Revenue: Increase in sales revenue results in a higher working capital requirement

Inventory Management

It is important to determine the optimum batch size and number of units to be produced in each batch. This prevents an organisation from paying additional set-up costs and inventory-holding costs.

  • Total cost = Inventory-holding cost + Set up cost
  • Inventory-holding costs = (Inventory-holding costs per unit) * (Average number of units held in inventory)
  • Average quantity held in inventory = Batch size/2
  • Size of a batch = Total quantity sold during the year/ number of batches
  • Optimum number of batch = Square root [(holding cost per unit x Annual quantity produced) / (2 X setup cost per batch)]
  • Economic order quantity = Annual quantity produced/ optimum number of batches

Cash Flow Statement

Basic Structure

  • Cash Flow from Operating Activities (CFO): Day-to-day core business of the company
  • Cash Flow from Investing Activities (CFI): Purchase or sale of assets that the company plans to use or dispose of in the long run, or acquisition of other companies
  • Cash Flow from Financing Activities (CFF): Activities linked to shareholders and bankers that are used to finance other activities

You also saw the graphical presentation of the cash flow statement of a healthy company that generated enough cash from operations to fund its investment and growth. The excess cash generated from operations remaining after investment in the company’s growth is called the free cash flow, which belongs to the bankers and shareholders of the company as a reward for their investment in the company.

Cash Flow Profile

The cash flow profile is represented using a waterfall graph

Detailed Structure

Financing Activities:

  • Issue of new loans or repayment of existing loans
  • Issue of new shares or buyback of old ones
  • Dividend distribution / Interest payment

Investing Activities:

  • Purchase of property, plant and equipment
  • Sale of fixed assets

The cash flow from operating activities starts with EBIT, as it is closely linked to cash. The depreciation expense is an accounting non-cash expense and, hence, must be added back to the EBIT to determine the true cash flow of the company.