Part III – Financial Analysis
8. 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
Return on invested capital allows comparisons with
alternative investment opportunities
Riskier investments expected to yield a higher return on
invested capital
Return on invested capital impacts a company’s ability to
succeed, attract financing, repay creditors, and reward
owners
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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)
= EBIT*(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 8
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%
Profitability Analysis
Return on Equity (or Financial return)
Return on Equity or ROE (Rendibilidade dos capitais
próprios ou Rendibilidade Financeira)
= 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
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Profitability Analysis
Decomposing ROE
Other alternative decompositions
– Additive model:
ROE=[Operating ROA+D/E*(Operating ROA-Interest)]*(1-t)
– Multiplicative method:
ROE=(EBIT/Sales*Sales/Assets)*
*(Assets/Equity*EBT/EBIT)*(Net Income/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=EBIT*(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 = EBIT*(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. 16
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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Profitability Analysis
Financial leverage
Ex.: Company B
Total Assets = 15000 €
Equity = 5000 €
Debt = 10000 €
Net Income= 600 €
Interest Expense 1500 €
1) ROA = EBIT*(1-t)/Total Assets
= (600 + 1500)/15000 = 14%
2) Average cost of Debt = Interest Expense/Debt
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= 1500/10000 = 15%
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
+ Services + Cost of Goods Sold
+ External Services and
± Change in inventories
(production) Supplies
+ Operating subsidies + Indirect taxes
(consumption taxes)
+ 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) • The Gross Value Added is used to pay
+ Personnel Costs employees, creditors, the State and to
+ Impairment losses ensure the company’s maintenance and
+ Provisions growth..
+ Deprectation and Amortization
+ other operating costs
+ Interest Expense
- Other operating revenues
- Interest Income
+ Income Tax
+ Net Income
+…
= Gross value added 23
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 Operating 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 ]
where (SP1 – VC1)/SP1 is the contribution margin ratio.
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Business Risk
Margin of Safety (MoS)
(Q * SP1 ) (Q 0 * SP1 )
MS 1 or MS 1
(Q 0 * SP1 ) (Q * SP1 )
Degree of Operating Leverage:
DOL= Contribution Margin/Operating Income
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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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