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1、Outline of todays lecture,Value of a firm to investors and creditorsAnalysis of profitability:ROAAnalysis of profitability:ROCEAnalysis of profitability:EPS,The value of a firm to equity investors,V=D1/(1+r)+D2/(1+r)2+D3/(1+r)3.,profitability,risk,The value of a firm to creditors,V=I1/(1+r)+I2/(1+r)
2、2+I3/(1+r)3+P/(1+r)3 Ii:interest revenues in period iP:return of principal,profitability,risk,Financial Statement Analysis,1.Understand the relation between the expected return and risk of investment alternatives,and the role of analysis in providing risk and return information.2.Understand the usef
3、ulness of the rate of return on assets(ROA)as a measure of a firms operating profitability.3.Understand the usefulness of the rate of return on common shareholders equity(ROCE)as a measure of profitability.4.Understand the strengths and weaknesses of earnings per common share as a measure of profita
4、bility.,What to compare?,1.The planned ratio for the period2.The corresponding ratio from a prior period(time-series analysis)3.The corresponding ratio for another firm in the same industry(cross-section analysis)4.The average ratio for other firms in the same industry(cross-section analysis),Analys
5、is of Profitability,Return on assets(ROA):return to the firm as a wholeReturn on common equity(ROCE):return to common shareholders onlyEarnings per common share,Analysis of Profitability,ROA:return to the firm,ROCE:return to common Shareholders only,Return on Assets(ROA),ROA presents profitability i
6、ndependent of the source of financingDoes not consider leverageMeasure of how well the firm uses its assets to generate incomeAs if the firm is financed by equity alone,Horrigan Corporation,Horrigan Corporation-assuming no debts,Horrigan Corporation ROA,Average total assets of this company in year 4
7、(520+650)/2=585,Then ROA=71.2/585=12.2%Why add back interest income net of income tax savings in the numerator?1)If all equity,the firm wont pay$16 interest expense,which increase net income by$16;2)at 30%tax rate,government will collect an additional amount of$4.8(16*30%)as tax,then the actual incr
8、ease of net income is(16 4.8).,Disaggregating ROA,ROA=Profit Margin ratio*Asset turnover ratio,ATO measures the firms Ability to generate salesAt a given level ofInvestment in assets,PM measures the Firms ability to Control cost andExpenses at a givenLevel of sales Activity.,How to increase ROA?,At
9、the current asset base,increase sales?But increased sales increases ATO while decreases PMA dilemma!So one has to increase sales and at the same time hold down costs and expenses,i.e.,hold PM at certain level.,How to increase ROA?-2,The evolution of ROA in the U.S.the graphs in the next few slides a
10、re from Penman and Nissim Review of Accounting Studies,2001,RNOA:Return on net operating assetsRegression to the mean（回归到平均值）,Profit margin,Asset turnover,Revenue growth,Disaggregate PM,PM=(sales COGS SGA depreciation.)/SalesCOGS-to-Sales ratioSelling,General and administrative(SGA)expense-to-sales
11、ratioEtc.By observing the time series and cross-section of each expense-to-sales ration,one can identify abnormal ratios and investigate the reasons,in order to control costs and expenses to increase PM,Disaggregate ATO,ATO=Sales/average total assets Average total assets=(average account receivables
12、+average inventory+average fixed assets+average other assets),Accounts receivable turnover,Measures how quickly a firm collects cash.If A.R.turn over twice a year,then they average one half of a year in collection.Less time is preferred to more.A high turnover is preferred to a low one.The days of o
13、utstanding for account receivables:365 days/accounts receivable turnover,Inventory turnover,Indicates how fast firms sell merchandise.If inventory turn over twice a year,then they average one half of a year in inventory.Holding inventory is costly because the funds invested in inventory could be use
14、d elsewhere.A high turnover is preferred to a low one.Day of inventory in warehouse:365/Inventory turnover,Fixed asset turnover,Measures the relation between investment in long-term or fixed assets(such as property,plant,equipment)and sales.Efficient use of fixed assets would be associated with high
15、 sales.If fixed assets turn over every four years,then each dollar invested in fixed assets is generating a quarter of a dollar in sales per year.A high turnover is preferred to a low one.,Return on Common Equity(ROCE),The numerator measures return as net income reduced by any payments to preferred
16、shareholders as these dividends are not available to the common shareholder and have not been deducted from net income.The denominator is the average amount contributed by common shareholders which includes Common stock at par,Additional paid in capital,andRetained earnings.,Relation between ROA and
17、 ROCE,ROCE is the residual return which goes to the common shareholders.Since it may be low in poor years but high in good years,it has a risk,that is,the residual return is not known.Debt is characterized by a definite schedule of payments,so there is little risk to the debt holders.Preferred stock
18、 is like debt,the dividends are specified.However,debtors must be paid before preferred shareholders and if the money runs out,then they arent paid.,Relation between ROA and ROCE,ROA can be divided intoReturn to creditors or debtorsReturn to preferred shareholders,andReturn to common shareholders(RO
19、CE)Because the return to debtors and preferred shareholders are fixed,in good years when the firm has high returns,there is a lot of profit left over for the common shareholders;in poor years when returns are low,there is little or maybe no profit left over.,Relation between ROA and ROCE,Thus,if ROC
20、E and ROA were both linear,then ROCE would have a greater slope than ROA,that is,it is more highly levered.A prudent firm will borrow funds only when the return on those marginal funds exceed the cost of borrowing giving a net positive return to the common shareholder.ROCE can be disaggregated into
21、three related ratios1.Profit margin ratio2.Total assets turnover3.Leverage ratio,Relation between ROA and ROCE,The first two have been previously defined.Leverage ratio indicates the relative proportion of capital provided by common shareholders as distinct from that provided by creditors(debtors)or
22、 preferred shareholders.,Relation between ROA and ROCE,A high leverage ratio means that the firm has a lot of assets at its command,but that the shareholders have less of their own investments at risk.This is good in good years because the common shareholders capture all profits over what is needed
23、to service the debt.This is bad in poor years because the debt has to be serviced whether or not the common shareholders make a profit.Therefore,borrowing is only beneficial when ROA is greater than the cost to borrow money,The evolution of ROCE and net borrowing cost(NBC)in the U.S.,Debit-to-Equity
24、 ratio(leverage)in the U.S.,Earnings per Share(EPS)of Common Stock,This ratio is the profit that goes to each share of common stock.It would be simply the net income less preferred dividends divided by the number of common shares.However,the number of common shares is complicated by certain securiti
25、es that may become(convert to)a common share.How to account for these is a complex issue.For example,if there are 100 common shares but 50 preferred shares that could convert to 50 common shares,do you divide earnings by 100 or 150?The answer depends on how likely it is that the convertible securiti
26、es will convert.,Earnings per Share(EPS)of Common Stock,EPS does not consider the amount of assets or capital required to generate earnings.EPS is of limited use in comparing two firms.For investment purposes,the price to earnings ratio is sometimes used(P/E ratio).This is the return to the purchaser of a share.P/E=(market price of a share of stock)/(EPS)A low P/E is preferred to a high P/E,same earnings at a lower price.,Northwest Airlines 2001,
