BusiAna 6e Ch05 PowerPoint

For use with Business Analysis and Valuation 6e by Palepu, Healy and Peek 1
(ISBN 9781473779075) © 2022 Cengage EMEA

CHAPTER 5
Financial analysis
Key concepts
• There are two primary tools in financial analysis:

• Ratio analysis to assess how various line items in financial statements relate
to each other and to measure relative performance.
• Cash flow analysis to evaluate liquidity and the management of operating,

investing, and financing activities as they relate to cash flow.
Determinants of firm value and ratio
analysis
• Profitability and growth drive firm value.
• Managers can employ four levers to achieve growth and profit

targets:
• Operating management
• Investment management
• Financing strategy
• Dividend policy.
• Ratio analysis seeks to evaluate the firm’s effectiveness in these areas.
Drivers of profitability and growth
Ratio analysis
• Evaluating ratios requires comparison against some benchmark:
• Ratios over time from prior periods (time-series)
• Ratios of other firms in the industry (cross-sectional)
• Some absolute benchmark.
• Effective ratio analysis must attempt to relate underlying business

factors to the financial numbers.
• The text illustrates ratio analysis by applying it to European fast-

fashion retailers: H&M and Inditex.
Measuring overall profitability
• ROE is a comprehensive measure of and is a good starting point to
systematically analyze firm performance.
Profit or loss
ROE =
Shareholders′ equity
Decomposing profitability:
Traditional approach
ROE = ROA × Equity multiplier
Profit or loss Total assets

= ×
Total assets Equity
Decomposing profitability:
Alternative approach
• The traditional approach has some limitations imposed by the

composition of the denominator and numerator.
• An alternative approach computes ROE as ultimately being equal to:
ROE = Return on invested capital + Spread × Financial leverage
Detail of alternative ROE decomposition
NOPAT + NIPAT Interest expense after tax
ROE = −
Equity Equity
NOPAT + NIPAT Invested capital Interest expense after tax Debt

= × − ×
Invested capital Equity Debt Equity
NOPAT + NIPAT Debt Interest expense after tax Debt

= 1+ − ×
Invested capital Equity Debt Equity
= Return on invested capital + Return on invested capital − Effective interest rate after tax × Financial leverage
= Return on invested capital + Spread × Financial leverage
Detail of alternative ROE decomposition
NOPAT NIPAT
ROIC = +
Invested capital Invested capital
NOPAT Operating assets NIPAT Investment assets

= × + ×
Operating assets Invested capital Investment assets Invested capital
Operating assets Investment assets

= Return on operating assets × + Return on investment assets ×
Invested capital Invested capital
NOPAT Sales
Return on operating assets = ×
Sales Operating assets
Intermezzo: Definitions
H&M versus Inditex: ROE components
Discussion of results from profitability
analysis
• Note the differences between key components of the traditional
and alternative ROE decompositions:
H&M H&M Inditex Inditex
traditional alternative traditional alternative
Asset turnover 1.04 1.41 0.74 1.44
ROA 0.7% 1.6% 4.0% 8.2%
Financial leverage 3.23 1.48 1.86 0.46
Assessing operating management:
Income statement ratios
• Common-sized income statements facilitate comparisons of key line

items across time and different firms.
• Additionally, the following ratios are also helpful:

• Gross profit margin (by function only)
• EBITDA margin
• NOPAT margin
• Recurring NOPAT margin.
Gross profit margin
• Measures the profitability of sales, less direct costs of sales:
Revenue − Cost of Sales

Gross profit margin =
Revenue
• The gross profit margin is an indicator of:

• The price premium that a firm’s product commands in the market.
• The efficiency of a firm’s procurement and/or production process.
NOPAT and EBITDA margins
• The NOPAT margin provides a comprehensive measure of operations:

NOPAT
NOPAT margin =
Revenue
• The EBITDA margin eliminates the significant non-cash expenses of

depreciation and amortization along with interest and taxes:
Earnings before interest, taxes, depreciation and amortization
EBITDA margin =
Revenue
A comparison of key income statement
ratios for H&M and Inditex
Decomposing asset turnover
• Asset management is a key indicator of how effective a firm’s

management is.
• Asset turnover may be broken into two primary components:

• Working capital management
• Non-current asset management.
Working capital management
• Working capital is the difference between current assets and current
liabilities.
• Key ratios useful to analyzing the management of working capital include:

• Operating working capital to sales
• Operating working capital turnover
• Accounts receivable turnover
• Days’ receivables
• Inventory turnover
• Days’ inventory
• Accounts payable turnover
• Days’ payables.
Asset management ratios for H&M and
Inditex
Working capital management: Cash
conversion cycle for H&M and Inditex
Cash conversion cycle = Days′ inventories + Days′ receivables − Days′ payables
Financial leverage analysis
• Borrowing allows a firm to access to capital but increases the risk of
ownership for equity holders.
• Analysis of leverage can be performed on both current and non-

current debts:
• Liquidity analysis relates to evaluating current liabilities.
• Solvency analysis relates to long-term liabilities.
Liquidity analysis
• There are several ratios useful to evaluate a firm’s liquidity, including:
• Current ratio
• Quick ratio
• Cash ratio
• Operating cash flow ratio.
• Each of these ratios attempts to measure the ability of a firm to pay

its current obligations.
Liquidity analysis
• Knowing how the liquidity ratios are calculated allows the user to
understand how to interpret them:
Current assets
Current ratio =
Current liabilities
Cash and marketable securities + Trade receivables (net)

Quick ratio =
Current liabilities
Cash and marketable securities

Cash ratio =
Current liabilities
Cash flow from operations

Operating cash flow ratio =
Current liabilities
Comparison of H&M and Inditex:
Liquidity ratios
Debt and coverage ratios
• Solvency measures the ability of a firm to meet long-term obligations.
• Several useful ratios are used to analyze solvency:

Total liabilities
Liabilities−to−equity ratio =
Current debt + Non−current debt

Debt−to−equity ratio =
Current debt + Non−current debt

Debt−to−capital ratio =
Current debt + Non−current debt + Shareholders′ equity
More debt and coverage ratios
• Two ratios that specifically address the ability to pay interest on debts
are:
Profit or loss + Interest expense + Tax expense
Interest coverage earnings−based =
Interest expense
Cash flow from operations + Interest expense + Taxes paid

Interest coverage (cash flow−based) =
Interest expense
Comparison of H&M’s and Inditex’s debt
and coverage ratios
Assessing the sustainable growth rate
• A comprehensive measure of a firm’s ratios is the sustainable growth rate,
which uses ROE:
Sustainable growth rate = ROE x (1 − Dividend payout ratio)
where
Cash dividends paid

Dividend payout ratio =
Profit or loss
• Sustainable growth rate measures the ability of a firm to maintain its

profitability and financial policies.
Figure 5.6 Sustainable growth rate
framework for financial ratio analysis
Sustainable growth rates for H&M and
Inditex
Cash flow analysis
• The ratio analysis previously discussed used accrual accounting.
• Cash flow analysis can provide further insights into operating,

investing, and financing activities.
• All companies using IFRS Standards are required to include a

statement of cash flows in their financial statements.
Analyzing cash flow information
• A number of questions can be answered through analysis of the
statement of cash flows. For example:
• Operating activities
• How strong is the firm’s internal cash flow generation?
• How well is working capital being managed?
• Investing activities
• How much cash did the company invest in growth assets?
• Financing activities
• What type of external financing does the company rely on?
• Did the company use internally generated funds for investments?
• Did the company use internally generated funds to pay dividends?
Cash flow analysis
• Differences in reporting cash flow information allow for variation

across firms that complicate comparisons.
• Analysts can make adjustments to net income to arrive at free cash

flows, a commonly used metric for financial analysis.
• Table 5.10 in the next slide illustrates the various calculations using
financial information from H&M and Inditex.
Cash flow analysis for H&M and Inditex
Concluding comments
• There are two primary tools in financial analysis:
• Ratio analysis – to assess how various line items in financial statements relate
to each other and to measure relative performance.
• Cash flow analysis – to evaluate liquidity and the management of operating,

investing, and financing activities as they relate to cash flow.
• Both forms of analyses must be evaluated while considering whether firm

performance is consistent with the strategic initiatives of management.

BusiAna 6e Ch05 PowerPoint

Uploaded by

Copyright:

Available Formats

BusiAna 6e Ch05 PowerPoint

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

BusiAna 6e Ch05 PowerPoint

Uploaded by

Copyright:

Available Formats

For use with Business Analysis and Valuation 6e by Palepu, Healy and Peek 1

(ISBN 9781473779075) © 2022 Cengage EMEA

• There are two primary tools in financial analysis:

• Cash flow analysis to evaluate liquidity and the management of operating,

• Managers can employ four levers to achieve growth and profit

• Ratio analysis seeks to evaluate the firm’s effectiveness in these areas.

• Effective ratio analysis must attempt to relate underlying business

• The text illustrates ratio analysis by applying it to European fast-

Profit or loss Total assets

• The traditional approach has some limitations imposed by the

• An alternative approach computes ROE as ultimately being equal to:

ROE = Return on invested capital + Spread × Financial leverage

NOPAT + NIPAT Invested capital Interest expense after tax Debt

NOPAT + NIPAT Debt Interest expense after tax Debt

= Return on invested capital + Spread × Financial leverage

NOPAT Operating assets NIPAT Investment assets

Operating assets Investment assets

Asset turnover 1.04 1.41 0.74 1.44

ROA 0.7% 1.6% 4.0% 8.2%

Financial leverage 3.23 1.48 1.86 0.46

• Common-sized income statements facilitate comparisons of key line

• Additionally, the following ratios are also helpful:

Revenue − Cost of Sales

• The gross profit margin is an indicator of:

• The NOPAT margin provides a comprehensive measure of operations:

• The EBITDA margin eliminates the significant non-cash expenses of

• Asset management is a key indicator of how effective a firm’s

• Asset turnover may be broken into two primary components:

• Key ratios useful to analyzing the management of working capital include:

• Analysis of leverage can be performed on both current and non-

• Each of these ratios attempts to measure the ability of a firm to pay

Cash and marketable securities + Trade receivables (net)

Cash and marketable securities

Cash flow from operations

• Several useful ratios are used to analyze solvency:

Current debt + Non−current debt

Current debt + Non−current debt

Cash flow from operations + Interest expense + Taxes paid

Cash dividends paid

• Sustainable growth rate measures the ability of a firm to maintain its

• Cash flow analysis can provide further insights into operating,

• All companies using IFRS Standards are required to include a

• Differences in reporting cash flow information allow for variation

• Analysts can make adjustments to net income to arrive at free cash

• Cash flow analysis – to evaluate liquidity and the management of operating,

• Both forms of analyses must be evaluated while considering whether firm

You might also like