Financial Analysis and Planning

Análise e Planeamento Financeiro

Bachelor in Economics (2nd Year)

Licenciatura em Economia (2º Ano)

Academic Year 2024/2025

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3. Financial Analysis

3.1. Liquidity and Solvency Analysis

(Credit analysis)

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Liquidity
➢ Liquidity - Ability to convert assets into cash or to
obtain cash to meet short-term obligations

Lack of liquidity can limit: Severe illiquidity often precedes:

Advantages of discounts Lower profitability
Profitable opportunities Restricted opportunities
Management actions Loss of owner control
Coverage of current obligations Loss of capital investment
Insolvency and bankruptcy

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Liquidity
• Current Assets - Cash and other assets reasonably expected to be (1)
realized in cash, or (2) sold or consumed, during the longer of one-
year or the operating cycle
• Current Liabilities - Obligations to be satisfied within a relatively short
period, usually a year
• Current Ratio – Current Assets/Current Liabilities
• Relevant measure of current liability coverage, buffer against
losses and reserve of liquid funds
• Limitations – A static measure

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Working Capital
O Indicador Fundo de Maneio (FM)
• Static definition
Investment point of view: the excess of current
assets over current liabilities

Working capital = Current assets – Current liabilities

Financing point of view: the excess of long-term financing

over non-current assets
Working capital = Long-term financing – Non-current assets

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Comment on the following statement/Comente a
seguinte afirmação:

“Currents assets substantially higher than

current liabilities, will be a garantee of liquidity”
“Sendo o ativo corrente de uma empresa
substancialmente superior ao seu passivo
corrente, isso será garantia de equilíbrio
financeiro de curto prazo (liquidez)”

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Working capital requirements
Necessidades de Fundo de Maneio (NFM) ou FM necessário
• Dynamic definition:
Working capital requirements – amount of money tied up
in the operating cycle that has to be funded and can
significantly drain the resources required for investment in
assets
• Receivables + Inventories - Payables
• It is necessary to study the operating cycle of a company
to know its working capital requirements/needs
• depend on the type and volume of business

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Operating cycle

• Operating cycle – lenght of time, usually measured in

days, between a company’s purchase of inventory (raw
materials or goods) and the receipt of cash from
accounts receivable
= Inventory Days + Receivable Days

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 Net Trade Cycle (Ciclo de Caixa)
or Cash Conversion Cycle
Payable Days Net trade cycle

Goods Payment to
purchase suppliers

Inventory Days Receivable Days

Goods Goods sale Collection from

purchase customers
• The net trade cycle corresponds to the number of days during which a
company has to finance its operating activities using external financing
• This happens because the credit of suppliers is not sufficient to finance the
full length of the operating cycle

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Net Trade Cycle (Ciclo de Caixa)
or Cash Conversion Cycle
• Example 1
• Inventory Days = 78
• Receivable Days = 60
• Payable Days = 15

 Net trade cycle = 78 + 60 - 15 = 123

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Net Trade Cycle (Ciclo de Caixa)
or Cash Conversion Cycle
• Example 2
• Inventory Days = 15
• Receivable Days = 0
• Payable Days = 45
Net trade cycle = ?
Conclusion about Working capital requirements:
________________________________________________
________________________________________________

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12

How to compute Working capital

requirements?
I) Indirect method (Using net trade cycle)
1) Compute the operating activity ratios in days of
sales
• Collection period or Receivable Days = Accounts
Receivable/Sales*365
• Days’ sales in Inventories or Inventory Days =
Inventories/Sales*365
• Days’ sales in accounts payable = Accounts
Payable/Sales*365

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13

How to compute Working capital

requirements?
I) Indirect method (Using net trade cycle)
2) Obtain the net trade cycle in days of sales
Collection period or Receivable Days
+
Days’ sales in Inventories
-
Days’ sales in Accounts Payable

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How to compute Working capital
requirements?
I) Indirect method (Using net trade cycle)
3) Compute Working capital requirements
Working capital requirements =
Net trade cycle in days of sales*Sales/365

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 How to compute Working capital
requirements?
II) Direct method
• This method consists in obtaining working capital requirements
from the Functional Balance Sheet (Balanço Funcional)
• The Functional Balance sheet is an adjusted balance sheet
that presents the assets and sources of financing according
to the different financial cycles of the company
• The financial cycles are the financial result of the decisions
made at different levels: strategic decisions, operating
decisions and financial decisions,...

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Functional Balance Sheet
The financial cycles
• Three type of financial cycles:
• Investment cycle (Ciclo de Investimento)
• Operating cycle (Ciclo de Exploração)
• Financing cycle (Ciclo de Operações Financeiras)
• Long-term financing (Ciclo de Operações de Capital)
• Short-term financing (Ciclo de Operações de Tesouraria)

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Functional Balance Sheet
The Financial cycles
• The functional balance sheet obtained is:
CYCLE INVESTMENTS FINANCING CYCLE

Non-Current Assets Shareholders’ Equity LONG-TERM FINANCING

INVESTMENT
Long-term or stable
liabilities
OPERATING Operating current Operating current OPERATING
assets liabilities
SHORT-TERM Cash & Equivalents Short-term financing SHORT-TERM
FINANCING/Treasury Assets FINANCING/Treasury Liabilities
and other current and other current
assets liabilities

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Functional Balance Sheet
N N+1
1) Shareholders' Equity
2) Long-term or stable liabilities
3) Long-term or stable financing (1+2)
4) Non-current Assets
5) Working Capital (3-4)
6) Inventories
7) Accounts Receivable
8) Other operating receivables
…
9) Operating current assets (6+7+8+…)
10) Accounts Payable
11) Other operating payables
…
12) Operating current liabilities (10+11+…)
13) Working capital requirements (9 -12)
14) NET LIQUIDITY (5-13)

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Functional Balance Sheet
• Net Liquidity = Financial resources – Financing Needs
• Working Capital = Long-term financing – Non-current assets
• Working capital requirements = Operating current assets-
operating current liabilities
• Then
Net Liquidity = Working Capital – Working Capital Requirements
The Fundamental Treasury Relation

• if >0, there is a positive net liquidity

• if <0, there is a negative net liquidity

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Net Liquidity
(+) Working Capital (-)

(-) Working capital (+)

(a) NL < 0
(b) NL < 0

requirements
(c) NL > 0

(e) NL > 0
(d) NL > 0
(f) NL< 0
Source: Adapted from Moreira, 1997, p.150

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 Functional Balance Sheet
Limitations
• Critics to the functional balance sheet:

• It is difficult to reclassify all the items/accounts in the

balance sheet according to the respective financial cycle

• It is difficult to identify stable financing sources: some short-

term loans may be stable due to the fact that they can be
regularly renewed (ex. some bank overdrafts)

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Liquidity ratios
• Ratios that compare current assets with current
liabilities:
• Current ratio (Rácio Liquidez Geral)
• Quick ratio or Acid-test ratio (Rácio Liquidez Reduzida)
• Cash-to-current liabilities ratio (Rácio Liquidez Imediata)

• Operating activity ratios:

• Collection period ratio (Accounts Receivable Turnover)
• Days to sell Inventory ratio (Inventory Turnover)
• Days Accounts Payable Outstanding (Accounts payable
Turnover)
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Operating Activity Analysis of Liquidity

Accounts Receivable Liquidity Measures

• Accounts Receivable Turnover

• Days’ Sales in Receivables

• Receivables collection period

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Operating Activity Analysis of Liquidity

Interpretation of Receivables Liquidity Measures

• Accounts receivable turnover rates and collection periods are usefully
compared with industry averages or with credit terms
• Ratio Calculation: Gross or Net?
• Trend Analysis
• Collection period over time
• Observing the relation between the provision for doubtful accounts and gross
accounts receivable

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Operating Activity Analysis of Liquidity

Inventory Turnover Measures

• Inventory turnover ratio:

• Measures the average rate of speed at which inventories move through and
out of a company.

• Days to sell Inventory:

• Shows the number of days required to sell ending inventory

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Operating Activity Analysis of Liquidity

Days’ Purchases in Accounts Payable

• Days’ Purchases in Accounts Payable

• Measures the extent accounts payable represent current and not overdue
obligations

• Accounts Payable Turnover

• Indicates the speed at which a company pays for purchases on account.
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Additional Liquidity Measures
• Cash Flow Measures
• Cash Flow Ratio

• Overcomes the static nature of the current ratio since its numerator reflects a flow
variable.
• Financial flexibility - Ability to take steps to counter unexpected
interruptions in the flow of funds
• Ability to borrow from various sources; to raise equity capital; to sell and
redeploy assets; to adjust the level and direction of operations to meet
changing circumstances; levels of prearranged financing and open lines of
credit

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Solvency Analysis

• Solvency - long-run financial viability and its ability to

cover long-term obligations
• Capital structure - financing sources and their
attributes
• Earning power - recurring ability to generate cash
from operations

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Solvency Analysis

• Two necessary conditions:

1st) The structure of capital should lay on Shareholders’
Equity
2nd) To a sustainable solvency a company should generate
operating profits

Solvency = f(Level of Shareholders’ Equity; Operating profitability)

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Capital Structure Analysis
• Shareholders’ Equity vs Debt
• Equity financing
• Risk capital of a company
• Uncertain and unspecified return
• Lack of any repayment pattern
• Contributes to a company’s stability and solvency

• Debt financing
• Must be repaid with interest
• Specified repayment pattern

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 Capital Structure Analysis
• Motivation for Debt:
• From a shareholder’s perspective, debt is a preferred
external financing source:
• Interest on most debt is fixed and if interest cost is
less than the generated return, the excess return
is to the benefit of equity investors
• Interest is a tax-deductible expense
• Financial leverage - the amount of debt financing in a
company’s capital structure

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Solvency Ratios

• Capital structure ratios

• Total debt to total assets or Financial Leverage
(Endividamento)= Total Liabilities/Total Assets
• Debt to Equity Ratio = Total Liabilities/Shareholders’
Equity
• Shareholders’ equity to total liabilities (Solvabilidade
Geral) = Shareholders’ Equity/Total Liabilities
• Shareholders’ equity to non-current liabilities
(Solvabilidade Reduzida)= Shareholders’ Equity/Non
current Liabilities

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Solvency Ratios
• Capital structure ratios
• Shareholders’ equity to total assets ratio (Autonomia
Financeira) = Shareholders’ Equity/Total Assets
• Long-term financing to non-current assets ratio
(Cobertura do Imobilizado) = Long-term
financing/Non-current assets
• Earnings coverage ratios
• Interest coverage ratio (Cobertura dos Encargos
Financeiros) = EBIT/Interest Expense
• ...

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Solvency Ratios

• Earnings coverage ratios

• Fixed charges coverage ratio (Cobertura do Serviço da
Divida) = EBIT/(Interest Expense+Amortization of Debt
Expenses)

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Loss and Recovering of Solvency
• When does a company become insolvent?
• When a company cannot meet its current liabilities (as
they come due), when it does not have liquidity and its
financial structure does not allow its recovering
• How is insolvency detected?
• A gradual and systematic detioration of the solvency
ratios reflecting a situation in which a company is
increasingly dependent on its creditors

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Loss and Recovering of Solvency

• Two distinct situations:

• Insolvency (and technical insolvency): usually a
temporary condition
• Bankruptcy: legal declaration of bankruptcy and
consequent liquidation of company’s assets

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Loss and Recovering of Solvency
• An insolvent company may be recovered if it is possible to
restore its financial equilibrium in the future

• How to know if a company is recoverable?

• Will the company generate operating profits in the
future?
• It will be necessary to prepare projected financial
statements and to compute the financing needs to
pay debts and interest expenses

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 Loss and Recovering of Solvency
• Financial Restructuring Measures (medidas de saneamento
financeiro ou de consolidação financeira e reestruturação
empresarial)
• Consolidation of liabilities (Consolidação do Passivo):
creditors’ agreement to extend payment deadlines (short-
term debts become long-term debts);
• Transformation of debt into equity (Transformação das
dívidas em capital): creditors’ agreement in which some
creditors become shareholders;

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Loss and Recovering of Solvency

• Debt relief (Perdão das dívidas) (usually below to

50%);
• Entry of new capital (Saneamento com entrada de
novos capitais):
• Long-term bank loan (sooner the long-term loan
becomes a short-term liability)
• Capital increase (new shares issue)

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Loss and Recovering of Solvency
• Portuguese legislation:
• D.L. 132/93
• D.L. 315/98
• D.L. 53/2004 de 18 de Março (CIRE - Código de Insolvência e
Recuperação de Empresas)
• Lei nº 16/2012 de 20 Abril established processo especial de
revitalização
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Bibliography:
- Subramanyam (2014). Financial Statement Analysis,
McGraw-Hill International Edition (chapter 10)
- Neves, J. C. (2012). Análise e Relato Financeiro – um visão
integrada de gestão, Texto Editores (Parte III – Solidez
financeira e equilíbrio financeiro, cap. 9, 10 e 11)

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3. Financial Analysis

3.2. Cash Flow Analysis

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The concept of Cash-Flow
• Cash Flow (fluxo de caixa): difference between cash inflows/cash
receipts and cash outflows/cash disbursements.
• Alternative Cash Flow Measures:
1) Statement of Cash Flows
• reports cash receipts and cash payments by operating, financing, and
investing activities
• Cash flow analysis helps in assessing liquidity, solvency, and financial
flexibility.

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The concept of Cash-Flow
2) Net income plus depreciation and amortization
• Based on the Income Statement:
Earnings before income tax expense
+ Depreciation, Amortization and Impairments
(losses/reversals)
+/- Provisions (Increases/decreases)
+/- Decreases/Increases in Fair Value
= Gross Cash Flow
- Income tax expense
= Net Cash Flow
• EBITDA (Earnings before interest, taxes, depreciation, and
amortization)
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The concept of Cash-Flow
Issues with Net Income plus depreciation & amortization
• The using up of long-term depreciable assets is a real expense
that must not be ignored
• The add-back of depreciation expense does not generate cash.
It merely zeros out the noncash expense from net income.
Cash is provided by operating and financing activities, not by
depreciation
• Net income plus depreciation ignores changes in working
capital accounts that comprise the remainder of net cash
flows from operating activities. Yet changes in working
capital accounts often comprise a large portion of cash
flows from operating activities

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Cash-Flow vs Self-financing
Self-financing (Autofinanciamento): the financing that
is generated by the company and is obtained by
retained earnings
Earnings before Income tax expense
+ Depreciation, Amortization and Impairments
(losses/reversals)
+/- Provisions (Increases/decreases)
+/- Decreases/increases in Fair Value
- Income tax expense
- Dividends payable
= Self-financing
Thus, self-financing is a portion of the Cash Flow

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Self-financing

Self-financing vs Dividends Distribution Policy

• Pay-Out Ratio = Dividends/Net Income
• The higher the pay-out ratio, the lower the self-
financing
• The Retention Rate Ratio or Plowback Ratio:
Retained Earnings/Net Income

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Self-financing

Advantages and disadvantages of self-financing vs

Dividends Distribution Policy
• Advantages:
• Improves the solvency position of the company making
it less dependent on creditors
• Disadvantages:
• Higher self-financing will mean lower payment of
dividends what may lead to unmotivated current and
potential investors
• The company may be losing financial leverage
opportunities

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Statement of Cash Flows
Demonstração de Fluxos de Caixa (DFC)

• Main purpose: to provide information on cash inflows

and outflows for a period
• Cash flows refer to the current period’s cash inflows
less cash outflows
• It also distinguishes among the sources and uses of
cash flows by separating them into operating,
investing and financing activities.

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Statement of Cash Flows
• Operating activities: are the earning-related activities of a
company. They include the net inflows and outflows of cash
resulting from related operating activities like extending
credit to customers, investing in inventories, and obtaining
credit from suppliers
• Investing activities: are means of acquiring and disposing of
noncash assets. These activities involve assets expected to
generate income for a company such as purchases and sales
of PPE and investment in securities. They also include other
non-current assets such as lending funds and collecting the
principal on these loans

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Statement of Cash Flows

• Financing activities: are means of contributing,

withdrawing, and servicing funds to support business
activities. They include borrowing and repaying funds
with bond and other loans, contributions and
withdrawals by owners and their return on investment
(dividends)

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Statement of Cash Flows
• Methods for reporting cash flows from operations:
• Direct method: each income item is adjusted for its
related accruals.
• Indirect method: net income is adjusted for noncash
income (expense) items and accruals to yield cash flows
from operations. An advantage is the disclosure of a
reconciliation of differences between net income and
operating cash flows that may aid some users to predict
cash flows
• The format for computing net cash provided by
investing and financing activities is the same for both
methods. Only the presentation of net cash flows from
operations differs.
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Statement of Cash Flows

• Indirect method

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 Statement of Cash Flows

[Link] company purchased a truck during the year at a cost

of $30,000 that was financed in full by the manufacturer.
2. A truck with a cost of $10,000 and a net book value of
$2,000 was sold during the year for $7,000. There were
no other sales of depreciable assets.
3. Dividends paid during Year 2 are $51,000

University of Minho | School of Economics and Management [Link]

 Statement of Cash Flows
Steps in Constructing the Statement

(1) Start with Net Income

(2) Adjust Net Income for non-cash expenses and gains
(3) Recognize cash inflows (outflows) from changes in current assets and liabilities
(4) Sum to yield net cash flows from operations
(5) Changes in long-term assets yield net cash flows from investing activities
(6) Changes in long-term liabilities and equity accounts yield net cash flows from
financing activities
(7) Sum cash flows from operations, investing, and financing activities to yield net
change in cash
(8) Add net change in cash to the beginning cash balance to yield ending cash

University of Minho | School of Economics and Management [Link]

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 Statement of Cash Flows

• The direct (or inflow-outflow) method reports gross

cash receipts and cash disbursements related to
operations - essentially adjusting each income
statement item from accrual to cash basis
• Reports total amounts of cash flowing in and out
of a company from operating activities: cash
receipts from customers, cash paid for
inventories, cash paid for operating expenses,…
• Preferred by analysts and creditors

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Statement of Cash Flows
Implications to financial analysis
Interpreting Cash Flows and Net Income
• An Income Statement records revenues when earned and
expenses Limitations in Cash Flow Reporting
when incurred
– It does not show the timing of cash inflows and outflows, nor the effect
of operations on liquidity and solvency
– This information is available in the Statement of Cash Flows
• Cash flows from operations (CFO) is a broader view of
operating activities than is net income
– It is not a measure of profitability
• Note: A net measure, be it net income or cash flows from
operations, is of limited usefulness. The key is information
about components of these net measures.

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Statement of Cash Flows
Implications to financial analysis
• In evaluating sources and uses of cash, the analyst should
focus on questions like:
✓Are asset replacements financed from internal or external
funds?
✓What are the financing sources of expansion and business
acquisitions?
✓Is the company dependent on external financing?
✓What are the company’s investing demands and opportunities?
✓What are the requirements and types of financing?
✓Are managerial policies (such as dividends) highly sensitive to
cash flows?
✓…
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Statement of Cash Flows
Implications to financial analysis

• The ability to generate cash flows from operations is

vital to financial health. No business survives in the long
run without generating cash from operations.

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Statement of Cash Flows
Implications to financial analysis
Limitations in Cash Flow Reporting
• Some limitations of the current reporting of cash flow:
• Practice does not require separate disclosure of cash
flows pertaining to either extraordinary items or
discontinued operations
• Income taxes are classified as operating cash flows
• Removal of pre-tax (rather than after-tax) gains or losses
on sale of plant or investments from operating activities
distorts our analysis of both operating and investing
activities (this is because their related taxes are left in
total tax expense among operating activities)

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Statement of Cash Flows
Demonstração de Fluxos de Caixa
Método Directo Método Indirecto
Actividades Operacionais: Actividades Operacionais:
Alternative model Recebimentos de Clientes Resultados Operacionais
suggested by Neves Outros Recebimentos Operacionais
Pagamentos a Fornecedores
+ Amortizações do exercício
+ Provisões do exercício
(2012, p. 209) Pagamentos ao Pessoal - Acréscimos das NFM
Outros Pagamentos Operacionais - Investimentos de substituição
Investimentos de substituição
Fluxos de caixa operacional (1) Fluxos de caixa operacional (1)
Actividades Compulsivas:
Encargos financeiros
Recebimentos/pagamentos extraordinários
Imposto sobre lucros
Fluxos de caixa compulsivos e extraordinários (2)
Meios disponíveis para decisões estratégicas
(3=1+2)
Investimentos de expansão (4)
Meios libertos pelo negócio (5=3-4)
Investimentos de diversificação (6)
Meios disponíveis para accionistas e credores
(7=5-6)
Fluxos de financiamento estável (8)
Meios libertos líquidos (9=7-8)
Fluxos de financiamento curto prazo (10)
Variação dos depósitos bancários e caixa
(11= 9-10)

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Bibliography:
- Subramanyam (2014). Financial Statement Analysis,
McGraw-Hill International Edition (Chapter 7)
- Neves, J. C. (2012). Análise e Relato Financeiro – uma visão
integrada de gestão, Texto Editores (Parte III – Solidez
financeira e equilíbrio financeiro, cap. 7 e 12)

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3. Financial Analysis

3.3. Profitability and Risk Analysis

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Profitability Analysis
• Aim of Profitability Analysis/Economic Analysis:
• To analyze the economic efficiency of a company - its
ability to generate earnings to meet the claims of all the
entities with whom the company interact (customers,
suppliers, creditors, shareholders, employees,...)
• It includes the profitability analysis and productivity
analysis

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Profitability Analysis

• Profitability or Return Analysis consists in assessing the

ability of a company to generate Income (Profit),
comparing it with the invested capital
• Return ratios relate income, or other performance measure,
to a company’s level and source of financing.

Income (Profit)/ Invested Capital

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Profitability Analysis

• Alternative Measures of Invested Capital:

• Total Assets
• Net Operating Assets (Operating Assets less Operating
Liabilities)
• Shareholders’ Equity

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Profitability Analysis
Return on Assets (ROA)

Return on Assets or ROA (Rendibilidade do

Investimento Total, Rendibilidade do Ativo ou
Rendibilidade Económica)
= NI+[Interest Expense*(1-t)]/Total Assets
• this ratio gives us the rate of return of all invested
capital independently of the source of financing (Debt
or Equity)
• It removes the tax effect of debt and therefore gives us
the return on assets that is independent of the capital
structure of the company

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Profitability Analysis
Return on Assets (ROA)

Other alternative formulas:

ROA = Operating Income/Total Assets
ROA = (Net Income+Interest Expense)/Total Assets
ROA = Net Income/Total Assets

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Profitability Analysis
Decomposing ROA

Net Income Net Income Sales

= 
Assets Sales Assets

ROA = Return on Sales × Assets Turnover

ROA is affected both by the Profit Margin (ROS) and the Assets
Turnover

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Question: In the table below you have the Assets
Turnover and the Return on Sales ratios of two
companies: one is a food retailing company and the
other is an oil and gas exploration company. Identify
each of the companies and justify your choice.

Company Company
Ratios A B

Assets Turnover=Sales/Total Assets 2,15 0,4

Return on Sales=Net Income/Sales 4% 47%

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Profitability Analysis
Return on Equity (or Financial return)
Return on Equity or ROE (Rendibilidade dos capitais
próprios)
= Net Income/Shareholders’ Equity
• This ratio measures the efficiency with which the
company uses Shareholders’ capital
• As higher the ROE, the more attractive is the
company for potential investors and the greater the
likelihood of the company to develop its future
activities with recourse to self-financing

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Profitability Analysis
Decomposing ROE

Net Income Net Income Total Assets

= 
Equity Total Assets Equity

ROE = ROA × Capital Structure

ROE consists of two components: an operating return (ROA) and

a non-operating return (effect of financial leverage)

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 Profitability Analysis
Decomposing ROE
• The relationship between the different return measures (Dupont analysis):

ROE = ROA × Capital Structure

ROE = ROS × Assets Turnover × Capital Structure

𝑵𝑰 𝑵𝑰 𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔 𝑵𝑰 𝑺𝒂𝒍𝒆𝒔 𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔

𝑹𝑶𝑬 = = × = × ×
𝑬𝒒𝒖𝒊𝒕𝒚 𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔 𝑬𝒒𝒖𝒊𝒕𝒚 𝑺𝒂𝒍𝒆𝒔 𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔 𝑬𝒒𝒖𝒊𝒕𝒚

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 Profitability Analysis
Decomposing ROE
• Other alternative decompositions

Additive model:
𝐷
𝑅𝑂𝐸 = 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑅𝑂𝐴 + × 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑅𝑂𝐴 − 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 × 1−𝑡
𝐸

Multiplicative method:
𝐸𝐵𝐼𝑇 𝑆𝑎𝑙𝑒𝑠 𝐴𝑠𝑠𝑒𝑡𝑠 𝐸𝐵𝑇 𝑁𝐼
ROE = × × × ×
𝑆𝑎𝑙𝑒𝑠 𝐴𝑠𝑠𝑒𝑡𝑠 𝐸𝑞𝑢𝑖𝑡𝑦 𝐸𝐵𝐼𝑇 𝐸𝐵𝑇

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Profitability Analysis
Financial leverage
• The Financial Leverage Effect: is the positive or negative
effect of financial leverage on the ROE. Considering
ROA=NI+[Interest Expenses*(1-t)]/Assets and assuming there
is no income tax:
• ROE > ROA, the financial leverage effect is ______________
• ROE < ROA, the financial leverage effect is ______________
• ROE = ROA, the financial leverage effect is ______________.

• When the financial leverage effect is positive the ROE

increases by increasing the use of debt.

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Profitability Analysis
Financial leverage

• Ex.: Company A

Total Assets = 20000 €

Equity = 5000 €
Debt = 15000 €
Net Income = 1200 €
Interest Expense = 1395 €

Is the financial leverage effect positive or negative?

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Profitability Analysis
Financial leverage
1) ROA = NI+[Interest Expenses*(1-t)]/Assets=
(1200+1395)/20000 = 12.975%
2) Average cost of Debt
= Interest Expense/Debt = 1395/15000 = 9.3%
• The average cost of debt is 9.3% while the operating ROA is
almost 13%.
• As ROA > cost of debt the Financial Leverage Effect is positive.
3) ROE = Net Income/Equity = 1200/5000 = 24%
•Comparing ROE with ROA we reach the same conclusion
•ROE > ROA  the Financial Leverage Effect is positive.

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81

Profitability Analysis
Financial leverage

• If the company had not used Debt the Net Income to

Shareholders would be:
5000 * 0.12975 = 648.75
• However, the Net Income was much higher (=1200).
• Differential between the return and cost of Debt is:
15000 * (0.12975 – 0.093) = 551.25
• So, the Net Income was:
551.25 + 648.75 = 1200

Financial Leverage Effect

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82

Profitability Analysis
Financial leverage
• Ex.: Company B
Total Assets = 15000 €
Equity = 5000 €
Debt = 10000 €
Net Income= 600 €
Interest Expense 1500 €
1) ROA = NI+[Interest Expenses*(1-t)]/Total Assets
= (600 + 1500)/15000 = 14%

2) Average cost of Debt = Interest Expense/Debt

= 1500/10000 = 15%
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Profitability Analysis
Financial leverage

3) ROE = Net Income/Equity= 600/5000 = 12%

ROA < Average Cost of Debt; ROA>ROE, therefore the Financial

Leverage Effect is negative.
Income to shareholders would be = 5000 * 0.14 = 700
Differential between the return and cost of debt
= (0.14 – 0.15) * 10000 = - 100
In this case, the use of debt negatively affected the ROE.

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 Profitability Analysis
Financial leverage

The two companies present the following solvency ratios:

Ratios Company A Company B

Equity/Total Assets 25% 33%
Equity/Debt 33% 50%

Can Company A continue to increase the use of Debt?

Should Company B not use debt?

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Productivity Analysis

• Productivity: production per unit of factor used

• Gross Value Added (Valor Acrescentado Bruto ou VAB)

• Gross Value Added - is the wealth created by the

company; the value added by the company to the
goods and services purchased; the difference between
the production and the intermediate consumption.

• The Gross Value Added represents the contribution of

the company to the GDP of an economy.

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Productivity Analysis
• Two alternative methods of computation:
• Production approach (subtractive method)

Gross Value Added = Gross Production - intermediate consumption

+ Sales + Cost of Goods Sold

+ Services + External Services and Supplies
± Change in inventories (production) + Indirect taxes
(consumption taxes)
+ Operating subsidies
+ Own Work for the company

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Productivity Analysis
• Income approach (additive method)

Gross Value Added=  Income earned by the production of goods and services
+ Direct taxes (except Income tax)
+ Personnel Costs
+ Impairment losses
+ Provisions
• The Gross Value Added is used to pay
+ Deprectation and Amortization
employees, creditors, the State and to
+ other operating costs
ensure the company’s maintenance and
+ Interest Expense
growth..
- Other operating revenues
- Interest Income
+ Income Tax
+ Net Income
+…
= Gross value added

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 Productivity Analysis
• Productivity ratios
• Labor Productivity (Produtividade do trabalho)
= Gross Value Added/Nº of employees
= Gross Value Added/Personnel Costs

• Fixed Assets Productivity (Produtividade do Ativo Fixo)

= Gross Value Added/Tangible Fixed Assets (Gross value)

• Aging degree of Tanglible Fixed Assets (Grau de Envelhecimento

do Ativo Fixo)
=Accumulated depreciation/Tangible Fixed Assets (Gross value)

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 Risk Analysis
Business Risk or Operational Risk (Risco de negócio ou
risco operacional)

• Break-even sales point: is the level of Sales where the

total fixed and variable costs equal total revenues
(where the company neither has profit nor loss).
• Total costs = Fixed costs + variable costs: the higher the
fixed costs, the higher the business risk of the company.
• The Margin of Safety: is the difference between the actual
(or projected) sales and the level of break-even sales (the
higher this margin, the lower the business risk).

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Business Risk
Break-even sales point
• Break-even point (sales unit):
Q0 * SP1 - Q0 * VC1 - FC = 0  Q0 (SP1 –VC1) = FC
 Q0 = FC / (SP1– VC1)

• Break-even point (sales dollars):

Q0 * SP1 = FC / [ (SP1 – VC1)/SP1 ]

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Business Risk
• Margin of Safety (MoS)

(Q * SP1 )
MS = −1
(Q 0 * SP1 )

• Degree of Operating Leverage:

DOL= Contribution Margin/Operating Income
DOL = [Q*(SP-VC)]/[Q*(SP-VC)-FC]

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“The break-even sales point should be a
company’s profitability and risk target”

Comment on this statement.

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Risk Analysis
Financial risk

• Financial risk is the likelihood of the company not

being able to pay interest, repay loans, and to
compensate shareholders. The financial risk depends
on:
• The level of Debt
• The Financial Leverage Effect
• Degree of Financial Leverage:
DFL= EBIT/EBT

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Bibliography:
- Subramanyam (2014). Financial Statement Analysis,
McGraw-Hill International Edition (Chapter 8).
- Neves, J. C. Análise e Relato Financeiro – um visão
integrada de gestão, Texto Editores (Parte IV – Eficiência e
rendibilidade, cap. 13, 14, 15 e 16 e Parte V – Risco, cap.
18)

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