P R O F . G . M O D U G N O U N I V E R S I T Y O F T R I E S T E

Ratio Analysis

Guido Modugno

2

Financial Statement Analysis

� The examination of both the relationships among financial statement numbers and the trends in those numbers over time.

� Examples: ¡ Assets’ profitability; ¡ Stock turnover ¡ % change of sales ¡ % composition of operating expenses

3

1.  Making  an  investment  in  a  firm’s  stock.  2.  Extending  credit  (short  or  long-­‐term)  3.  Assessing  the  opera@ng  performance  

and  financial  posi@on  of  a  supplier,  customer,  or  compe@tor.    

4.  Valuing  a  firm  as  an  acquisi@on  candidate.  

Common reasons for performing financial statement analysis:

Guido Modugno

Guido Modugno

4

1.  Identify the economic characteristics of the particular industry.

Examine: �  Porter’s Five Forces �  Industry Market Structure �  Competition �  Role of Technology �  Industry Growth Rate �  Value Chain Analysis

The context of Financial Statement Analysis:

Guido Modugno

5

2. Identify the strategies that a particular firm pursues to gain competitive advantage.

Examine: �  Nature of product or service �  Degree of integration within Value Chain �  Degree of Geographical and Industrial

Diversification

The Context of Financial Statement Analysis:

Guido Modugno

6

1.  Assess the firm’s financial position: i.e. the firm’s ability to meet its obligations.

2.  Assess the firm’s financial performance: i.e. “profitability”

3.  Find out information about the level of risk of the firm.

The Purposes of Financial Statement Analysis:

Guido Modugno

7

Method

NO YES

OVERVIEW OF THE WHOLE “PICTURE”

RECOGNITION OF POTENTIAL WEAKNESSES:

HORIZONTAL AND VERTICAL ANALYSIS

CALCULATION OF RATIOS FOR MORE DETAILED ANALYSIS

ANALYSIS OF CAUSES

RECOGNITION OF POSSIBLE SOLUTIONS

CONFIRM THE

PROBLEM? STOP

FINANCIAL STATEMENTS

Horizontal and Vertical Analysis

RECOGNITION OF “POTENTIAL WEAKNESSES”

Guido Modugno

9

Horizontal Analysis

� The study of percentage changes in comparative statements is called horizontal analysis

� Computing a percentage change in comparative statements requires two steps: ¡  Computing the € amount of the change from the base period

to the later period ¡  Dividing the € amount of change by the base-period amount

Guido Modugno

10

Horizontal Analysis in Mattel Inc.

� Use the horizontal analysis to infer the % change of the operating revenues and expenses of Mattel.

Guido Modugno

11

Horizontal Analysis

� Trend percentages ¡  Are a form of horizontal analysis that examine more than a

two- or three-year period ¡  Use a selected base year whose amounts are set equal to 100

percent ¡  To compute trend percentages, each item for following years is

divided by the corresponding amount during the base year

€ Year Base€Any Year

% Trend =

Guido Modugno

12

Vertical Analysis

�  Vertical analysis of a financial statement reveals the relationship of each statement item to a specified base, which is the 100% figure

�  Every other item on the financial statement is then reported as a percentage of that base

�  When an income statement is analyzed vertically, net sales is usually the base

Guido Modugno

13

Vertical Analysis

� Vertical analysis of balance sheet amounts are shown as a percentage of total assets

� The next exhibit shows the vertical analysis of Mattel’s Balance Sheet as a percentage of total assets

Guido Modugno

14

Vertical and Horizontal Analysis in Mattel

Guido Modugno

15

Common-size Statements

�  A common-size statement simplifies the comparison of different companies because their amounts are stated in percentages

�  On a common-size income statement, each item is expressed as a percentage of the net sales amount

�  In the balance sheet, the common size is total assets or the sum of total liabilities and stockholders’ equity

Guido Modugno

16

Benchmarking

Benchmarking is the practice of comparing a company’s performance with a standard set by: �  other companies �  or the industry average �  or the company’s previous years’ performance Managers, investors, and creditors need to know how one company compares with similar companies and with past results

Guido Modugno

17

¡ The next exhibit gives the common-size income statement of Bristol-Myers Squibb Company compared with the average for the pharmaceuticals industry

¡ Its gross profit percentage is much higher than the industry average

¡ Its percentage of net income is significantly higher that the industry average

Benchmarking

Guido Modugno 18

Net sales

Cost of products sold

Gross profit

Operating expenses

Earnings from continuing operation Before Income Tax

Income tax expense

Earnings from continuing operations

Special items (discontinued operations, extraordinary gains and losses, and effect of accounting changes) Net earnings

100.0%

26.6

73.4

50.1

23.3 6.1

17.2

17.2%

100.0%

54.7

45.3

36.5

8.8 2.3

6.5

1.4 5.1%

Bristol-Myers Squibb Industry Avg.

BRISTOL-MYERS SQUIBB COMPANY

Common-Size Income Statement for Comparison with Industry Avg. Year Ended December 31, 1998

Guido Modugno

19

�  Common-size statements are also used to compare the company to another specific company.

�  The next exhibit presents the common-size income statements of Bristol-Myers Squibb and Procter & Gamble

�  Bristol-Myers Squibb has higher percentages of gross profit, earnings from continuing operations, and net earnings

Benchmarking Against a Key Competitor

Guido Modugno 20

Net sales

Cost of products sold

Gross profit

Operating expenses

Earnings from continuing operation before income tax

Income tax expense

Earnings from continuing operations

Special items (discontinued operations, extraordinary gains and losses, and effect of accounting changes) Net earnings

100.0%

26.6

73.4

50.1

23.3 6.1

17.2

17.2%

100.0%

56.7

43.3

27.9

15.4 5.2

10.2

10.2%

Bristol-Myers Squibb Procter & Gamble

BRISTOL-MYERS SQUIBB COMPANY Common-Size Income Statement for Comparison with Key Competitor

Year Ended December 31, 1998

Use Of Accounting Information In Decision Making

ACCOUNTING RATIOS

Guido Modugno

22

Ratio Analysis

�  The way to compare companies of different sizes is to use standard measures

�  Financial ratios are standard measures that enable analysts to compare companies of different sizes

Guido Modugno

23

Using Ratios To Make Business Decisions

1.  Ratios that measure the company’s ability to pay current liabilities

2.  Ratios that measure the company’s ability to manage the working capital

3.  Ratios that measure the company’s ability to pay long-term debt

4.  Ratios that measure the company’s profitability 5.  Ratios that assess the risk of the company

Guido Modugno

24

Measuring A Company’s Ability To Pay Current Liabilities: NWC

Working Capital (or Net Working Capital) is defined as follows:

WC = Current Assets – Current Liabilities

The Operating NWC is also calculated as the

difference between non financial current assets and current liabilities arising from operations: it is also called Working Capital Requirement (WCR)

WCR = (Inventory + Acc. Rec.) – (Acc.Payables)

Guido Modugno

25

�  Working Capital is widely used to measure a business’s ability to meet its short-term obligations with its current assets

�  The larger the working capital, the more likely the company will meet its short term debts…

�  …but: what if inventory or account receivables are very big? Is this a signal of health for the company?

Measuring A Company’s Ability To Pay Current Liabilities

Guido Modugno

26

Working Capital Financing Policies

�  Moderate: Match the maturity of the assets with the maturity of the financing.

�  Aggressive: Use short-term financing to finance permanent assets.

�  Conservative: Use permanent capital (i.e. equity, long term financing, spontaneous current liabilities) for permanent assets and temporary assets.

Guido Modugno

27

Years

$

Permanent Current Assets

Fixed Assets

Temporary Curr.Assets

Lower dashed line, more aggressive.

S-T Loans

L-T Financing: Stocks, Bonds, Loans, Spontaneous Current Liab.

Aggressive Financing Policy

Guido Modugno

28

Conservative Financing Policy

Fixed Assets

Years

$

Permanent Current Assets L-T Financing: Stocks, Bonds, Spontaneous Current Liab.

Marketable Securities Zero S-T debt

Guido Modugno

29

What is short-term credit, and what are the major sources?

�  S-T credit: Any debt scheduled for repayment within one year.

�  Major sources:

¡ Accounts payable (trade credit) ¡ Short term bank loans ¡ Accrued expenses

Guido Modugno

30

What is trade credit?

� Trade credit is credit furnished by a firm’s suppliers.

� Trade credit is often the largest source of short-term credit, especially for small firms.

� Spontaneous, easy to get, but cost can be high.

Guido Modugno

31

Current Ratio

� The current ratio ¡  Is the ratio of any entity's current assets to its current

liabilities ¡  Measures the company’s ability to pay current

liabilities with current assets

sLiabilitie Current Total AssetsCurrent Total

Ratio Current =

Guido Modugno

32

NOKIA: calculate the Current and the Quick Ratio for 2005 and 2006

Guido Modugno

33

ACID TEST RATIO (Quick Ratio)

The acid-test (or quick ratio)

¡  Indicates whether the entity could pay all its current liabilities if

they came due immediately

¡  Is computed by Current Assets, net of Inventory, by current

liabilities

sLiabilitieCurrent TotalInventory - AssetsCurrent Total RatioQuick =

Guido Modugno

34

Inventory Turnover

Inventory turnover is

¡  A measure of the number of times a company sells its average

level of inventory during a year

¡  Computed by dividing the cost of goods sold by the average

inventory for the period

oryAvg.InventCOGSurnover InventoryT =

Guido Modugno

35

�  A high rate of turnover indicates relative ease in selling

inventory; a low turnover indicates difficulty in selling

�  In general, companies prefer a high inventory turnover

�  Inventory turnover varies widely with the nature of the

business

Inventory Turnover

Guido Modugno

36

Acc. Receivable Turnover and DSO

¡ This ratio measures a company’s ability to collect cash from credit

customers

¡ The resulting ratio indicates how many times during the year the

average level of receivables was turned into cash

¡ The inverse ratio is often called DSO (Days of Sales Outstanding)

Receivable Acc.Avg.Sales

Turnover Rec. Acc. =

365×=Sales

Receivable Avg.Acc. DSO

Guido Modugno

37

�  In general, the higher the ratio, the more

successfully the business collects cash and the

better off its operations

�  A receivable turnover that is too high may

indicate that credit is too tight, causing the loss

of sales to good customers

Accounts Receivable Turnover

Guido Modugno

38

D.S.O.

The Days of Sales Outstanding ratio tells

¡ How many sales’ days remain in Accounts Receivable

¡ It can also be computed by a two-step process

÷ First, divide net sales by 365 days to figure the average sales amount for one day

÷ Second, divide this average day’s sales amount into

the average net accounts receivable

Guido Modugno

39

Measuring A Company’s Ability To Pay Long-term Debt

The most widespread indicators of a business’s ability

to pay long-term liabilities are the:

1.  Debt ratio (or Gearing Ratio) 2.  Times-interest-earned ratio

(Interest Coverage Ratio)

Guido Modugno

40

Debt Ratio

�  The debt ratio ¡  Is the ratio of total liabilities to total assets

¡  Measures a business’s ability to pay both current and long-term debts

¡  Sometimes this ratio is defined as Long-term liabilities divided by

Total assets

A low debt ratio is safer than a high debt ratio

AssetsTotalsLiabilitie Total

Ratio Debt =

Debt to Equity Ratio (or Leverage Ratio)

Guido Modugno

41

�  The functional reclassification of the Balance Sheet is often used nowadays.

�  In the sources of capital, only equity and debts (long term and short term borrowings) are represented.

EquityDebts    Ratio  Equity  to  Debt =

Guido Modugno

42

Times-Interest-Earned Ratio (or: Interest Coverage Ratio)

�  The Times-Interest-Earned ratio (or Interest Coverage Ratio) measures the number of times that operating income covers the interest expenses. ¡  A high times-interest-earned ratio indicates ease in paying interest

expense

¡  A low value suggests difficulty

exp.Interest EBIT I.C.R.)(or T.I.E. =

Guido Modugno

43

Risk Analysis

1.  Business risk: it depends on business factors

such as competition, product liability, and

operating leverage.

2.  Financial risk: it depends only on the capital

structure of the company. More debt, more

financial risk.

Guido Modugno

44

What Is Business Risk?

Probability

EBIT E(EBIT) 0

Low risk

High risk

Uncertainty about future EBIT, i.e., how well can we predict operating income?

Note that business risk does not include financing effects.

Guido Modugno

45

Business risk is affected primarily by:

� Uncertainty about demand (sales). � Uncertainty about output prices. � Uncertainty about costs. � Operating leverage.

Profitability & Risk: The Operating Leverage Sales  Volume:  1.000   A   B  Turnover = p x Q0 = 10 x 1.000   10.000   10.000  Variable costs = unit var. cost x Q0   -3.000   -6.000  Contribution Margin   7.000   4.000  Fixed costs   -5.000   -2.000  Operating Income   2.000   2.000  Sales  Volume:  800   A   B  Turnover = p x Q0 = 10 x 1.000   8.000   8.000  Variable costs = unit var. cost x Q0   -2.400   -4.800  Contribution Margin   5.600   3.200  Fixed costs   -5.000   -2.000  Operating Income   600   1.200  

-­‐  70%   -­‐40%  

46

Guido Modugno

Profitability & Risk: The Operating Leverage

0

2000

4000

6000

8000

10000

12000

0 100 200 300 400 500 600 700 800 900 1000

COST STRUCTURE A

revenues

var. costs

fixed costs

total cost

0

2000

4000

6000

8000

10000

12000

0 100 200 300 400 500 600 700 800 900 1000

COST STRUCTURE B 47

Guido Modugno

Guido Modugno

48

What is operating leverage, and how does it affect a firm’s business risk?

�  Opera@ng  leverage  is  the  use  of  fixed  costs  rather  

than  variable  costs.  

�  If  most  costs  are  fixed,  hence  do  not  decline  when  

demand  falls,  then  the  firm  has  high  opera@ng  

leverage.  

Guido Modugno

49

Probability

EBITL

Low operating leverage

High operating leverage

Typical situation: Can use operating leverage to get higher E(EBIT), but risk increases.

EBITH

Operating Leverage

A Furniture’s Manufacturer: Profitability & Risk

2009   2008  1.  Net  Sales   4.561.119   100,0   5.776.780   100,0  

2.  change  in  inventories  of  finished  products  and  work  in  progress   19.191   0,4   -­‐40.544   -­‐0,7  

4.  other  opera@ng  revenues     218.422   4,8   226.409   3,9  

5.  cost  of  goods  materials  and  services   4.216.888   92,5   5.214.635   90,4  

a)  cost  of  goods  and  material  sold,  and  cost  of  materials  used     3.365.527   73,8   4.084.498   70,7  

b)  cost  of  services   851.361   18,7   1.130.137   19,6  

6.  Labour  costs   644.443   14,1   712.445   12,3  

7.  Other  labour  costs   235.849   5,2   155.988   2,7  

8.  other  opera@ng  expenses   12.433   0,3   44.440   0,8  

OPERATING  PROFIT  OR  LOSS     -­‐310.880   -­‐6,8   -­‐164.864   -­‐2,9  

1.  Is  this  a  risky  company  because  of  its  cost  structure?  2.  The  company  has  a  nega@ve  and  declining  profitability:  what  might  be  the  main  reasons?  3.  What  should  the  company  do  in  such  cases?    

50

Guido Modugno

After one year: Not Risky But Even Not Profitable…

2010   2009   2008  1.  Net  Sales   9.520.460  100,0   4.561.119  100,0   5.776.780   100  

2.  Change  in  inventories  of  fin.prod.  and  W.I.P.   -­‐26.061   -­‐0,6   19.191   0,4   -­‐40.544   -­‐0,7  

4.  Other  opera@ng  revenues     275.520   6,0   218.422   4,8   226.409   3,9  

5.  Cost  of  goods  materials  and  services   8.793.766   92,4   4.216.888   92,5   5.214.635   90  

a)  Cost  of  goods  and  mat.  sold,  cost  of  mat  used    

7.725.468   81,1   3.365.527   73,8   4.084.498   70,7  

b)  Cost  of  services   1.068.297   11,2   851.361   18,7   1.130.137   19,6  

6.  Labour  costs   875.892   9,2   644.443   14,1   712.445   12  

7.  Write  downs  in  value   83.643   0,9   235.849   5,2   155.988   2,7  

8.  Other  opera@ng  expenses   56.869   0,6   12.433   0,3   44.440   0,8  

OPERATING  PROFIT  OR  LOSS     -­‐40.250   -­‐0,4   -­‐310.880   -­‐6,8   -­‐164.864   -­‐2,9  

51

Guido Modugno

Decline In Profitability: Definition and Indicators

At   this   stage,   the   company   show   a   deteriora@on   of   performance,   even  though  not  irreversible:  �  Drop  in  Sales  �  Decline  of  Margins:  Added  Value,  Gross  Profit,  EBITDA,  Oper.  Income    �  Opera@onal  goals  are  not  achieved  

Sales revenues  Changes in inventory of finished prod. and W.I.P.  Work performed by the enterprise and capitalized  -Cost of goods, materials and services  ADDED VALUE  - Labour costs  EBITDA  -Depreciation and Amortization  -Provisions  EBIT  

52

Guido Modugno

Determinants Of Poor Performance: A First Analysis

EBIT declines

Sales Drop

Products’ Price Sales Volume

MKT MKT SHARE

Operating Expenses Increase

Unitary Cost of Inputs

Volumes of Inputs per

Output

Administrative and Selling Expenses

53

Guido Modugno

Determinants Of Poor Performance: Further Analysis

Main  Factor   Detail     Possible  Determinants   Time  

horizon  Possible  SoluNons  /  

Notes  

SALES  DROP  

Reduc@on  of  Products’  Price  

• Compe@@ve  Pressure  • Company’s  weakness  in  the  rela@onship  with  

clients  

Usually  Long  Term  

Differen@ate!  Sectors  where  price  is  the  main  compeFFve  

factor  

Company’s  Aggressive  Policy   Short  Term    

In  few  months  the  sales  volume  increase  should  more  than  compensate  

price  reducFons  

Sales  Volume  Reduc@on  

Demand  downturn   N.A.   Diversify    markets!  

Product’s  posi@oning   Usually  Long  Term  

InnovaFon:  Launch  new  products!  

Unfavorable  Exchange  Rate   Macroeconomic  factors   N.A.   Futures,  Forward,  

OpFons    

54

Guido Modugno

Guido Modugno

55

Sources of Sales Growth

� When a company reports increased sales over the previous year, what are the possible causes? ¡  Increasing sales of current products (price or volume) ¡  New product introductions ¡  Buy another company

If you were to rank these sources, which do you think are generally the most favorable, and which are generally the least favorable for shareholders?

Determinants Of Poor Performance: Further Analysis

Main  Factor   Detail     Possible  

Determinants   Time  horizon   Possible  SoluNons  /  Notes  

OPERATING  EXPENSES  INCREASE  

Unitary  Cost  of  

Produc@on  Factors  is  increasing  

Macro-­‐economic  Factors   N.A.  

• Futures  on  Materials  • Make  or  Buy  choices:  

outsourcing?  

Company’s  Weakness  in  

Rela@onship  with  Suppliers  

Usually  Long  Term    

• Improve  management  of  suppliers  porSolio  

• Transfer  price  increases  on  clients  

Volume  of  Input  per  Output    increased  

Old  Equipments   Long  term   Renovate!  

Poor  Quality  of  Inputs  /  Process  

Usually  Long  Term  

Implement  quality  control  on  input  and  

process  

Unfavorable  Exchange  Rate  

Macroeconomic  factors   N.A.   Futures,  Forward,  

OpFons    

56

Guido Modugno

Poor Performance: The Increase Of Operating Expenses

 Company  XZ    (Manufacturer  of  colors  for  building)   2007   %   VAR%   2006   %    

Net  Sales   8.720.054       15,9   7.524.502      

Change  in  the  inventory  of  products  &  w.i.p.   -­‐158.232       -­‐574,3   33.362      

Other  revenues   338.084       319,2   80.644      

VALUE  OF  PRODUCTION   8.899.906   100   16,5   7.638.508   100  

Materials  and  goods   6.109.700   68,6   23,6   4.941.649   55,5  

Services   1.363.558   15,3   1,0   1.349.658   15,2  

Other  opera@ng  expenses   210.703   2,4   812,4   23.093   0,3  

ADDED  VALUE   1.215.945   13,7   -­‐8,2   1.324.108   14,9  

Labour  Costs   997.893   11,2   6,2   939.165   10,6  

EBITDA   218.052   2,5   -­‐43,3   384.943   4,3  

Deprecia@on  and  amor@za@on   229.377   2,6   18,2   194.012   2,2  

EBIT  (OPERATING  INCOME)   -­‐11.325   -­‐0,1   -­‐105,9   190.931   2,1  

EBIT decreases notwithstanding the good performance on sales: to which expense can be attributed the downturn in profitability?

57

Guido Modugno

Poor Performance: The Increase Of Operating Expenses

Company  XZ     2007   %   Δ%   2006   %  

WEIGHTED  AVERAGE  CHANGE  EXPENSES  

VALUE  OF  PRODUCTION   8.899.906   100,0   16,51   7.638.508   100,0      

                           

Materials  and  goods   6.109.700   68,6   23,6   4.941.649   66,4   15,68  

services   1.363.558   15,3   1,0   1.349.658   18,1   0,19  

other  opera@ng  expenses   210.703   2,4   812,4   23.093   0,3   2,52  

Labour  Costs   997.893   11,2   6,3   939.165   12,6   0,79  

Deprecia@on  and  amor@za@on   229.377   2,6   18,2   194.012   2,6   0,47  

TOTAL  OPERATING  EXPENSES   8.911.231   100,0       7.447.577   100,0   19,65  

EBIT   -­‐11.325   -­‐0,1   -­‐105,9   190.931   2,1  

Opera@ng  Expenses  increases  by  19,65%  as  a  whole,  while  the  value  of  produc@on  increases  by  only  16,51%    Most  of  the  cost  increase  depends  on  materials  and  goods  (15,98%)  

58

Guido Modugno

Guido Modugno

59

Measuring A Company’s Profitability

� There are at least 5 rate-of-return measurements that help evaluate a company’s profitability:

¡  ROS: Rate of Return on net Sales ¡  ROA: Rate of Return on Total Assets ¡  ROE: Rate of Return on common stockholders’ Equity ¡  ROCE: Rate of Return on Capital Employed ¡  EPS: Earnings per share of common stock

Guido Modugno

60

Quality Of Earnings

�  The quality of earnings measures the sustainability of a firm’s earnings

�  It takes into consideration how net income is generated

�  Income from continuing operations is considered of higher quality than gains from selling off assets because it is a better predictor of future earnings

Guido Modugno

61

ROS: Return On Sales

�  The ROS shows the percentage of each sales € earned as operating (or also: net) income

R.O.S. = EBIT/ SALES

�  The higher the rate of return, the more net sales € are providing income to the business and the fewer net sales € are absorbed by expenses

Guido Modugno

62

ROA & ROCE (ROI)

� The ROA (return on assets) measures a company’s success in using its assets to earn a profit

R.O.A. = INCOME / ASSETS

� The ROCE (or ROI) uses the sum of interest expense and net income in the numerator and the value of funds provided by creditors and shareholders in the denominator

R.O.C.E.= (INC.+INT. EXP)/(EQUITY+DEBTS)

Guido Modugno

63

ROE (Return on Equity)

�  Profitability is the key to a company’s long-run survival.

�  A summary measure of profitability often used by investors is ROE.

�  This ratio measures the ability of a firm’s management to generate net income form the resources that owners provide.

The Du Pont analysis of ROE

Guido Modugno

64

AssetsSales

SalesIncome

EquityAssetsROE ××=

FINANCIAL LEVERAGE ROS ASSET

TURNOVER

Guido Modugno

65

What is Financial Leverage? Financial Risk?

�  Financial leverage arises from the use of debt. �  Financial risk is the additional risk concentrated

on stockholders as a result of financial leverage.

FIN. LEVERAGE = DEBTS/EQUITY

Financial Leverage and ROE

Guido Modugno

66

ROE = ROI+ DebtsEquity

× ROI- Inter. Exp.Debts

"

#$

%

&'

When the difference between the Return on Investments and the cost of borrowings (Int.exp./

Debts) is positive, an increase of the Leverage Ratio results in an increase in the Return on

Equity.

Profitability And The Structure Of Capital: The Financial Leverage

�  The Financial Leverage effect is the increased volatility in profitability (ROE) caused by the corporate use of sources of capital that carry fixed financial costs (long term debts, borrowings, preferred shares, bonds…).

�  ROE can be increased through the Financial Leverage under the condition that return on capital exceeds the cost of it (ROI > kd).

kd

D/E

%

ROI

ROE

67

Guido Modugno

Financial Leverage: The Concept

ROI – i > 0

ROE

D/E

68

Guido Modugno

Financial Leverage: A Formula

i)  -­‐  (ROI    ED

 ROI    ENI    ROE ×+==

     

When  this  difference  is  posi@ve,  the  company  increases  ROE  using  debts.    

The lever

The goal 69

Guido Modugno

Financial Leverage: An Example

    Current: Unlevered

Proposed: Levered

Assets    €      5.000.000      €      5.000.000     ROI   INT.  RATE   DIFFERENCE  Debt    €                                        -­‐      €      2.500.000     RECESSION   0,06   0,1   -­‐0,04  Equity    €      5.000.000      €      2.500.000     EXPECTED   0,13   0,1   0,03  Debt/Equity  Ra@o   0   1   EXPANSION   0,2   0,1   0,1  Share  Par    Value    €    10      €  10    

Shares  Outstanding   500.000   250.000  

Interest  rate   N/A   10%  

Current Capital Structure: No Debt Proposed Capital Structure: Debt = $2,5 million

    Recession Expected Expansion     Recession Expected Expansion

EBIT   €  300.000   €  650.000   €  1.000.000   EBIT   €  300.000   €  650.000   €  1.000.000  Interest   0   0   0   Interest   250.000   250.000   250.000  Net  Income   €  300.000   €  650.000   €  1.000.000   Net  Inc.   €  50.000   €  400.000   €  750.000  ROE   6,00%   13,00%   20,00%   ROE   2,00%   16,00%   30,00%  EPS   €  0,60   €  1,30   €  2,00   EPS   €  0,20   €  1,60   €  3,00  

Financial Leverage And Insolvency: A Brief Summary

Leverage ROI vs i Scenario Diagnosis High Positive Positive GOOD

Low Positive Positive Not risky, very good

High Negative Positive

The company has internal problems but also

opportunities from the context

Low Negative Negative Poor performance, but solid

High Negative Negative Close to DEFAULT: escape asap!

Low Negative Positive Profitability problems,

probably only in the short term

Low Positive Negative Early Impairments: need for a plan