Chapter 5 Financial Analysis Analysis 4 , 5 & 9 Discussion Questions 4.
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IBM
(A3ales
aleset Assets
""ecti/e ""ect i/e -ate
A"ter A"ter'3 '3a a:
Intere Interest st
et Financial ;e/era
(
9.06
2.$6
2.7#
2.$8
2.46
7.76
0.42
'0.7#
ROE can be decomposed as follows: - = peratin< -A > sprea : net "inancial le/era
Using this decomposition, ROE depends on a company’s return on assets (which can in turn be decomposed into return on sales and operating asset turnover), and leverage gain from leverage (which is driven by whether the firm can generate a higher return on assets than the after ta cost of debt financing and leverage ! "ifferences in these factors will drive differences in ROE! Return on #ales measures a firm’s profit per dollar of sales! $s a profitability measure, higher return on sales suggests possible greater efficiency of operations or lower ta rates! %learly, & BM*s return on sales of ' is uch
hi
/he differences in return on sales for the two firms could be driven by several factors! &t could arise if &01’s strategy was to focus on a higher margin business than *+! &01 has divested its low margin +% business and grown its higher margin e2uipment and consulting businesses! &n contrast, *+ continues to focus on e2uipment and the difficult +% business! $sset /urnover assesses how productively a firm uses its assets! $ higher asset turnover ratio suggests that a fied level of assets generates a greater level of sales, i!e!, the firm put its assets to more productive uses! /he differences for &01 and *+ also reflect differences in strategy! *+ has focused more on the low3margin, but high turnover +% business, whereas IBM is "ocuse on the hi
'!4)! Once again, the difference is the spread of - times its 8et 9inancial 5everage (!4)!
5. ?oe In/estor asserts, @A copany cannot
/he sustainable growth rate is the speed at which a company can epand without changing either its level of profitability or its financial policies! 1echanically, sustainable growth rate ; ROE ( < dividend payout ratio)! 9rom this e2uation, we see that ROE and the dividend payout ratio determine the funds remaining in the firm and available to finance the firm’s growth! &f a company wants to eceed its sustainable growth rate, it can:
a! increase its return on e2uity by improving its profitability (return on sales), b! increasing its asset turnover, c! increasing leverage, d! it can reduce its dividend payout rate, thereby increasing funds available for reinvestment!
9. hat are the potential enchar)s that you coul use to copare a copany*s "inancial ratios hat are the pros an cons o" these alternati/es Coparison to Fir*s (rior istory ! 0y comparing the company with itself over time, it is possible to document changes (improvements or declines) in the company’s performance! %hanges in capital structure or improvements in gross margins or return on assets may evolve slowly as the firm implements the necessary changes in operations and financing!
Only by loo.ing at the pattern of these changes over time can we see if the individual changes in financial ratios from year to year are permanent or temporary! *owever, this approach does not tell us how well the firm is doing compared to other companies! 9or eample, a firm may appear to have performed poorly (well) relative to its own historical performance, yet
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relative to other firms in the economy or its own industry, it may have performed 2uite well (poorly)! Coparison to Fir*s :pecte or Bu $re any differences consistent with the firm’s operating policies and goals> &ndustry comparisons can provide only a partial picture if the industry as a whole has performed well or poorly, or if the firm is following a different strategy from other firms in the industry! &t can also be 2uite difficult to assess what the appropriate industry comparison group is, since many firms operate in more than one business segment! Coparison to Mar)et! 0enchmar.ing the performance of an individual firm against the mar.et can be informative! Ultimately, investors want to allocate resources within the economy as a whole! $ firm that is a strong performer relative to its industry may therefore be a relatively wea. overall performer if its industry is underperforming! *owever, mar.et analysis can be difficult for many .ey financial ratios which are industry specific and do not lend themselves to cross3industry comparison or evaluation!
9or eample, important ratios for ban.s include those on regulatory capital, which are not relevant for most other industries! =or.ing capital ratios typically differ across industries, so that it ma.es little sense to compare days inventory or days receivable for a supermar.et relative to the same ratios for a steel manufacturer! 9inally, differences in ratios can arise because of differences in business ris. across industries! 9or eample, ROEs and leverage are li.ely to be very different for construction firms than for supermar.ets!
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