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3. MBA | Finance and Accounting | Financial Analysis - Coggle Diagram
3. MBA | Finance and Accounting | Financial Analysis
Profit analysis
Framework: Profitability Analysis
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
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.
