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Ch 12.docx

12 Pages

Rotman Commerce
Course Code
Martin Ralph

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Ch 12 15/04/2013 12:04:00 PM Understanding the business 1. Operating activities 2. Underlying economics and risks in the industry 3. Overall strategy followed by the company  Low Cost producer -They need to have a high volume of goods at the lower prices  Product/ Service differentiation - Specializing to make a higher profit margin; they can success with a low volume Recent achievements and future goals/expectations can be found in the annual report. a. Description of the company; highlights of the year; letter to the shareholders. b. Management Discussion and Analysis; many aspects of the company’s financial performance in detail. c. Financial statement & the Auditor’s report (second half of the A.P.); pay attention to the accounting policies Reading the Financial Statements - Auditor’s Report: the financial statement gives a true and fair view of the company’s financial position and the results of its operations in accordance with accounting principles. It is presented before the financial statements. - Three parts 1. Opinions on the financial statements 2. State their justifications 3. Outline the specific procedures they use Retrospective vs. Prospective Analysis • Prospective analysis (forward-looking): use the past trends and operations stated in a financial statement to forecast future outcomes • Retrospective analysis: analysis that are used to determine past trends; this method may be less reliable when something fundamental has changed in the economic environment to make it unlikely that past results will predict the future. *Economic environment must also be understood. 1. • Time Series Analysis: the analyst examines information from different time periods; to look for any patterns in the data over time. - Many companies provide five- or ten- year summaries to assist in making this analysis -Then the analyst will further analyze the performance and the reasons for the low level of net income and assess whether the company will be able to repay the additional debt 2. • Cross-sectional analysis compares the data from one company with another company. - Different industries might have different accounting principles; gives industry trends of how well a company performs relative to its competitors. - It is common for investment analysts to consider the return versus risk trade-off across companies from different industries and countries. Data to be used 1. • Raw Financial Data: data that appear directly in the financial statements. - Useful in a time-series analysis 2. • Common Size Data: Elements of the raw data are compared with other elements using percentages - Relationships between numbers can be easily understood. Ex. Compare the cost of goods sold expressed as a proportion of the sales revenue. Common Size statement of earnings: - All line items are expressed as percentages of net revenues - If sales are rising proportionately to the increase in cost? - Common size analysis can also be used with the balance sheet and the cash flow statement - Useful in cross-sectional analysis; it allows you to compare companies in different sizes. 3. Ratio Data -Ratios compare a data element from one statement with another. It can be used in bot time-series or cross-sectional analysis - They reveal the relationships between the financial statements. Ratios - Often several ways to calculate a given ratio Ratios can be divided into 4 general categories: 1. Performance Ratio  • Net Profit Margin measures the company’s profitability relative to its revenues, it provides information about the company’s ability to control all costs. = Net Earnings/ Revenues - The current sources and types of earnings are important  • Gross Profit Margin measures the proportion of sales revenue available to pay all other operating costs after the costs of goods sold. The more the company retains on each dollar of sales to service its other costs and obligations. = Gross Profit / Revenue = Revenue – Costs of Goods Sold/ Revenue = (Money for other costs)/ Revenue - The costs of goods sold is usually grouped with other operating costs - Profit margin and cost of goods sold are reciprocal figures - If ∆GP> ∆NP: the company has less money available after producing its goods to pay other costs . Thus the company is doing a better job of controlling its other costs - Poor cost controls?  • Return on Equity (ROE): measures the return to shareholders; the performance of their investment  • Return on Assets (ROA): measures the profitability of the investment in assets. a. 2 fundamental business decision  The type of assets in which should the company invest?  Should it seek more financing to increase the amount that it can invest in assets? Financing decision. b. ROA excludes the effects of the financing decision & focuses on the investment decision. c. What type of return is earned on assets? d. Since net earnings is obtained by after deducting the interest expense paid to debt holders, it must be adjusted so the financing effects are removed to produce a measure of earnings generated by assets e. Because net income is on an after-tax basis, interest must be placed on a net/ after tax basis f. = Earnings before Interest/ Average total assets = Net Earnings + Interest expense – Tax saving of Interest Average total assets = Net Earnings + [Interest expense * (1 – Tax Rate)] Average total assets  Tax rate = Income tax expense/ income before tax  The Profit Margin Ratio indicates a change in the product’s profitability and may indicate changes in the company’s cost structure or pricing policy  The Total Asset Turnover is the ratio of sales to total assets, dollars of sales generated per dollar of investment in assets. Changes indicate an increase/ decrease in sales volume or changes in the level of investment  Declining efficiency of assets/ investment have not reached its full potential  • Discount retailor operates on smaller profit margin and large sale volume. They usually less invested  Full-price retailers have larger investments in assets relative their sales volume (lower asset turnover) thus they charge higher prices (high profit margin) to achieve a probable ROA e. • Ratio on Equity (ROE): the return that shareholders can earn on their investment (common share);  Any payments to the other classes of shares should be deducted from net earnings  = Net Earnings – Preferred Dividends/ Ave C.S. Equity  Minority Interest is not included in common shareholders’ equity f. • Leverage: some of the funds obtained to invest in assets came from debt holders rather than shareholders; highly leveraged: the company has a larger portion of debt to shareholders’ equity  Totally shareholder-financed company is a company with no debt; ROE = ROA  The key is the relationship between the after-tax cost of borrowing and the return on assets; with the after-tax costs of borrowing  If the cost to borrow (after-tax borrowing rate)< ROA, the company is increasing its wealth  *Interest expense is tax deductible and it generates tax savings. It is the tax rate times the interest expense.  Say the company borrows $400 with 10% interest rate; 40% tax rate: Net cost of borrowing = Interest Expense – (Tax* Int exp.) = 40 - ( 40*.4) = $24  When ROE>ROA, it means the company is able to borrow at an after-tax interest rate that id less than the rate it could earn by investing in assets  The advantage & risk of leverage: Shareholders can improve their return (ROE) if the company can borrow funds at an after-tax borrowing rate< ROA. A company is committed to making
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