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1、Outline of todays lecture1. Value of a firm to investors and creditors2. Analysis of profitability: ROA3. Analysis of profitability: ROCE4. Analysis of profitability: EPSThe value of a firm to equity investorsV = D1/(1+r) + D2/(1+r)2 + D3/(1+r)3 . profitabilityriskThe value of a firm to creditorsV =
2、 I1/(1+r) + I2/(1+r)2 + I3/(1+r)3 + P/(1+r)3 Ii: interest revenues in period iP: return of principalprofitabilityriskFinancial Statement Analysis1.Understand the relation between the expected return and risk of investment alternatives, and the role of analysis in providing risk and return informatio
3、n.2. Understand the usefulness 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 commo
4、n share as a measure of profitability.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 indu
5、stry (cross-section analysis)Analysis of Profitabilitya.Return on assets (ROA): return to the firm as a wholeb. Return on common equity (ROCE): return to common shareholders onlyc.Earnings per common shareAnalysis of ProfitabilityROA: return to the firmROCE: return to common Shareholders onlyReturn
6、on Assets (ROA)ROA presents profitability independent of the source of financing Does not consider leverage Measure of how well the firm uses its assets to generate income As if the firm is financed by equity aloneHorrigan CorporationYear 4Sales Revenue$ 475Less expense: COGS 280 Selling 53 Administ
7、rative 22 Depreciation 18 Interest 16Total 389Next income before tax 86Income tax expense 26Next Income 60Horrigan Corporation-assuming no debtsYear 4Sales Revenue$ 475Less expense: COGS 280 Selling 53 Administrative 22 Depreciation 18 Interest 16 - 16Total 389 - 16 = 373Next income before tax 86 +
8、16 = 102Less Income tax expense 26 + 4.8 = 30.8Next Income 60 + 16 4.8 = 71.2Horrigan Corporation ROAAverage total assets of this company in year 4 (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
9、 $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 increase of net income is (16 4.8).Disaggregating ROAROA = Profit Margin ratio * Asset turnover ratioATO measures the firms Ability to gen
10、erate salesAt a given level ofInvestment in assetsPM measures the Firms ability to Control cost andExpenses at a givenLevel of sales Activity.How to increase ROA?1.At the current asset base, increase sales?2.But increased sales increases ATO while decreases PM3.A dilemma!4.So one has to increase sal
11、es and at the same time hold down costs and expenses, i.e., hold PM at certain level.How to increase ROA?-2The evolution of ROA in the U.S.the graphs in the next few slides are from Penman and Nissim Review of Accounting Studies, 2001RNOA: Return on net operating assetsRegression to the mean （回归到平均值
12、）Profit marginAsset turnoverRevenue growthDisaggregate PMPM = (sales COGS SGA depreciation .)/SalesCOGS-to-Sales ratioSelling, General and administrative (SGA) expense-to-sales ratioEtc. By observing the time series and cross-section of each expense-to-sales ration, one can identify abnormal ratios
13、and investigate the reasons, in order to control costs and expenses to increase PMDisaggregate ATOATO = Sales/average total assets Average total assets = (average account receivables + average inventory + average fixed assets + average other assets)Accounts receivable turnoverMeasures how quickly a
14、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 outstanding for account receivables: 365 days/accounts receivable turnoverInventory turnover Indicates how fast
15、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 used elsewhere. A high turnover is preferred to a low one. Day of inventory in warehouse: 365/Inventory turnove
16、rFixed 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 sales. If fixed assets turn over every four years, then each dollar invested in fixed assets is gene
17、rating 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 shareholders as these dividends are not available to the common shareholder and have not been dedu
18、cted from net income. The denominator is the average amount contributed by common shareholders which includes Common stock at par, Additional paid in capital, and Retained earnings.Relation between ROA and ROCE ROCE is the residual return which goes to the common shareholders. Since it may be low in
19、 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 is like debt, the dividends are specified. However, debtors must be paid before preferr
20、ed shareholders and if the money runs out, then they arent paid.Relation between ROA and ROCE ROA can be divided into Return to creditors or debtors Return to preferred shareholders, and Return to common shareholders (ROCE) Because the return to debtors and preferred shareholders are fixed, in good
21、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 ROCE and ROA were both linear, then ROCE would have a greater slope than ROA,
22、 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 three related ratios1. Profit margin ratio2. Total assets turnover3.
23、Leverage ratioRelation 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 preferred shareholders.Relation between ROA and ROCE A high lev
24、erage 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 to service the debt. This is bad in poor years because the debt
25、 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 moneyThe evolution of ROCE and net borrowing cost (NBC) in the U.S.Debit-to-Equity ratio (leverage) in the U.S.Earnings per Share (EPS) of Com
26、mon 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 securities that may become (convert to ) a common share. How t
27、o 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 securities will convert.Earnings per Share (EPS) of Co
28、mmon 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