Unit 2
Profitability and risk analysis
Universitat Jaume I
Degree in Finance and Accounting
FC1030 – Business Valuation
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PART A: Profitability analysis
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• Evaluates whether managers are effectively
executing a firm’s strategy
• Helps to develop an understanding of a firm’s
performance to enable forecasts of future
performance
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• Independent of firm’s financing decisions
• Unusual or nonrecurring items may be removed,
net of tax
• Return on Assets is calculated as:
Net Income (1 - Tax Rate)(Interest Expense)
Average Total Assets
• It should adjust net income for nonrecurring
charges 4
ROA Profit Margin for ROA x Assets Turnover
where :
Net Income
Profit Margin
Sales
Sales
Assets Turnover
Average Total Assets
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• Three elements of risk help in understanding
differences across firms and changes over time in
ROAs:
• Operating leverage: Refers to proportion of fixed
costs relative to variable costs.
• Cyclicality of Sales: Are sales sensitive to economic
conditions.
• Product Life Cycle: Relates to the stage and length of
firm’s product life.
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• Measures the return to common stock holders
after subtracting operating expenses and costs of
debt financing.
• It should adjust net income for nonrecurring
charges, as in ROA.
• ROE is calculated as:
Net Income - Minority Interest in Earnings
Average Shareholder' s Equity - Minority Interest
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ROE can be further disintegrated into:
ROE = Profit Margin for ROE x Assets Turnover x Capital Structure Leverage
Average
Net Income to Common Sales Total Assets
Sales Average Average Common
Total Assets Shareholders’ Equity
• Leverage refers to use of debt to increase return to
common stockholders
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PART B: Risk analysis
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• Measures a firm’s ability to generate sufficient
cash to supply operating working capital needs
and to service debts
• Short-term liquidity problems can arise from the
following:
• Untimed cash inflows and outflows
• High Degree of long-term leverage
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Financial statement ratios
• Current ratio: It indicates the amount of cash
available and other current assets of the firm,
relative to obligations coming due
Current Assets
Current Ratio
Current Liabilities
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Financial statement ratios
Quick ratio:
• Also called as Acid Test Ratio
• Includes in only those current assets the firm could
convert quickly into the cash (Cash, Marketable
securities & Receivables)
Cash Marketable Securities Accounts Receivable
Quick ratio
Current Liabilities
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• Operating cash flow to current liabilities: It
indicates the amount of cash from operations
after funding working capital needs
Cash flow from Operations
OCFtoCL ratio
Average Current Liabilities
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• Working capital activity ratios: Rate of activity measures used to
study cash-generating ability of operations and short-term
liquidity risk of a firm are:
• Accounts Receivable Turnover
• Inventory Turnover
• Accounts Payable Turnover
Sales 365
ART ; Days Receivables Outstanding
Average Accounts Receivable ART
Cost of Goods Sold 365
I ; Days Inventory Held
Average Inventories I
Purchases 365
APT ; Days Accounts Payable Outstanding
Average Accounts Payable APT
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• Days revenue held in cash (DRHC):
• It measures the number of days sales the firm
has on hand as available cash
• Useful for forecasting financial statements
365
DRHC
Revenues
Average Cash
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• Examines a firm’s ability to make interest and
principal payments on long-term debt and similar
obligations
• Three measures used to examining long-term
solvency risk are:
• Debt ratios
• Operating cash flow to total liabilities ratio
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• Debt Ratios:
• It is used to measure the amount of liabilities,
particularly long-term debt in a firm’s capital
structure
• The higher this proportion, the greater the long-term
solvency risk
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• Commonly used measures of Debt Ratios
Total Liabilities
Liabilities to Assets Ratio
Total Assets
Total Liabilities
Liabilities to Shareholders’ Equity Ratio
Total Shareholders’ Equity
Long - Term Debt
Long - Term Debt to Shareholders’ Equity Ratio
Total Shareholders’ Equity
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• Operating cash flow to total liabilities ratio
(OCF to L):
• Considers the firms ability to generate cash flow
from operations to service debt
Cash Flow from Operations
OCFtoL
Averge Total Liabilities
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