Profitability Analysis (Ch. 4)
Risk Analysis (Ch. 5)
May 31st, 2013
Return on common equity is net income less preferred stock dividends divided by the average common stockholder's equity. It measures the return to common shareholders. It adjusts net income for nonrecurring charges, as in ROA. It subtracts costs of debt financing and preferred stock dividends. ROCE should exceed the cost of equity capital - the rate of return that a common shareholder demands. Financial leverage is using the lower cost of debt capital to increase the return to common shareholders.
Earnings per share is one of the most frequently used measures of profitability. GAAP requires firms to disclose on the income statement. It is covered explicitly by the opinion of the independent auditor. There are two types of EPS - basic EPS (simple capital structure) and diluted EPS (complex capital structure).
Simple capital structure is for firms that do not have convertible bonds, convertible preferred stock, stock options, or warrants. It is net income less preferred dividends divided by the weighted average number of common shares outstanding. Complex capital structure is for firms that have convertible bonds, preferred stock, stock options, or warrants. It assumes the conversion and exercising of all dilutive shares.
Criticisms of EPS is that it does not consider the amount of assets or capital required to generate earnings. It cannot make comparisons accross firms because the value of each share can differ. The number of shares of common stock outstanding is a poor measure of the amount of capital in use. It remains one of the focal points of announcements and is frequently used to value firms.
Time series are ratios compared over a number of periods. It must consider changes in product / geographical mix, acquisitions and divestitures, changes in accounting methods, and unusual or non-recurring amounts. Cross sectional ratios are those that can be compared across different firms. They must take into account industry definition, how industry averages are computed, and how ratios are defined / computed.
Risk can be international due to exchange rate changes, host government regulations / attitudes, political unrest, expropriation of assets, and recessions. Domestic risk can be due to recessions, inflation or deflation, interest rate changes, demographic changes, and political changes. Industry risk can be due to technology, competition, regulation, availability and price of raw materials, labor and other input price changes, and unionization. Firm specific risk can come from management competence (i.e. lack thereof), strategic direction, and lawsuits.
Financial risk can arise from leverage (which is a technique to multiply gains and losses). Financial leverage multiplies gains through the use of debt. Disaggregating ROCE provides insight into the degree of benefit from leverage. The higher the leverage put in place the greater the financial risk that exists. Note that debt is a good thing until you reach the "tipping point" which puts you in danger to become bankrupt.
Short-term liquidity risk is the near term ability to generate cash to service working capital needs. It delays cash outflows for as long as appropriate and receives inflows as early as possible. Problems may occur, such as operating costs being greater than revenue, and a high degree of debt being incurred due to high carrying costs. Short-term borrowing can be line of credit or commercial paper.
Ratio analysis is often used to assess short-term liquidity risk, such as the current ratio, quick ratio, operating cash flow to current liability ratio, revenue to cash ratio, working capital turnover ratios (accounts receivable turnover, inventory turnover, & accounts payable turnover).
The current ratio is the level of cash and other current assets above short-term liabilities (calculated by dividing current assets by current liabilities). It should be greater than 1.0 but not too high. The quick ratio (acid test) is cash plus marketable securities plus accounts receivable divided by current liabilities. It only includes cash-like assets (cash equivalents). Appropriate results may differ by industry due to some subjectivity.
Return on Common Equity (ROCE): 0:37
Disaggregating ROCE: 4:16
Relating ROA to ROCE: 5:56
Earnings Per Share (EPS): 6:43
Yahoo Finance (EPS and learning how
to read and understand stock information): 10:59
Criticisms of EPS: 17:26
-- Time Series: 18:05
-- Cross-sectional: 19:12
Silence (skip this): 21:31
CHAPTER 5 BEGINS: 35:22
Analyze Profitability & Risk: 36:26
Causes of Risk: 37:40
Financial Risk: 39:33
Short-Term Liquidity Risk: 42:16
Short-Term Liquidity Ratios: 45:41
Working Capital Activity Ratios - Pepsi: 54:23
Long-Term Solvency Risk: 57:23
Debt Ratios: 59:34