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Key ratios for financial analysis
- 1. Keys Ratios for Financial Analysis
João Carvalho das Neves
Professor, ISEG School of Economics and Management
Technical University of Lisbon
1
- 2. Operational performance analysis
ROCE = Margin × Capital Turnover
ROCE = Return on Capital Employed = EBIT / Capital Employed
Margin = EBIT / Revenue
Capital Turnover = Revenue / Capital Employed
Capital Employed = Financial Debt + Equity
High
Margin No
rm
al
Low
Low High
Capital Turnover
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© João Carvalho das
- 3. Margin and Return explained
• EBIT margin is a measurement of what proportion of a company's revenue
is left over after paying all operating costs such as wages, raw materials,
overhead, depreciation and amortization, selling, general, and
administrative expenses, advertising, etc.
• A healthy EBIT margin is required for a company to be able to pay for its
interest on debt and dividends to shareholders. It is comparable to
competitors that use similar technologies and are in the same market
segments
• Capital turnover is the amount of sales generated for every euro invested
in the company by shareholders and debtholders. It measures the firm's
efficiency in using the capital employed to generate revenue. The higher
the turnover the better.
• Margin and Turnover is used to understand the pricing strategy and capital
intensity: companies with low margins tend to have high turnover, while
those with high margins have low turnover.
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© João Carvalho das
- 4. Value creation
+
I on
ati
cre
Val
u e II
n
ROCE 0 uctio
d estr
Va lue
III
-
0 WACC +
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© João Carvalho das
- 5. Value creation explained
• The Return on Capital Employed ratio (ROCE) shows how much
profit the company earns from the capital invested by
shareholders and debtholders
• The cost of the capital employed is the Weighted Average Cost of
Capital (WACC)
• WACC = [After-tax cost of debt] x [% debt financing] + [Cost of
equity] x [% equity financing]
• You create (shareholder) value when you make decisions that
consistently earn a return on capital employed (ROCE) that
exceeds the cost of the capital employed. In that case:
– ROCE- WACC >0 or;
– Value Creation Index = ROCE / WACC >1
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© João Carvalho das
- 6. Financial liquidity analysis
NLB/R = 0
+
III II NLB WC WCR
= −
R R R
I
WCR/R 0
Cash Cycle IV
V VI
-
NLB – Net Liquid Balance
WC – Working Capital - 0 +
WCR – Working Capital Requirement
R - Revenue WC/R
WC = Equity + Long Term Debt – Fixed Assets
WCR = Accounts receivables + Inventory + Other operational receivables – Accounts
payables – Taxes payables – Other operational payables
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© João Carvalho das
- 7. Financial liquidity analysis
I, V and VI – Balanced Liquidity
II, III and IV – Unbalanced Liquidity
I – WC and WCR > 0 (Balanced liquidity. Most common in healthy companies)
V – WC and WCR < 0 (Balanced liquidity but high risk if market conditions changes)
VI – WC>0 and WCR <0 (Excess of liquidity. Very few industries. Advise: Reduce long term
debt or equity or pay dividends.)
II – WC and WCR > 0 (Unbalanced liquidity. Could be a result of aggressive financial policy if
the profitability is high. This is the case in healthy companies. It can also be a sign of
liquidity risk, specially if profitability is low or even negative).
IV – WC and WCR < 0 (Unbalanced liquidity. Could be a result of aggressive financial policy
if the profitability is high. This is the case in healthy companies. It can also be a sign of
liquidity risk, specially if profitability is low or even negative. Existence of liquidity risk.
High risk if market condition changes. Advise: Increase equity and/or Long term debt).
III – WC and WCR <0 (Excess deficit of liquidity. High financial risk, specially if
profitability is low or negative. Advise: Increase equity and/or Long term debt ASAP).
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© João Carvalho das
- 8. Definitions
• Working capital requirement (WCR) is the amount of cash required
by the operational cycle.
• There is no ideal working capital requirement but the ratio WCR/R
can be compared with other companies in the same industry to
analyze the efficiency in managing the operational cash cycle.
• Working capital is the excess of long term capital (equity + long
term debt) after fixed assets has been financed that is available to
finance the operational cash cycle;
• Working capital should be enough to finance Working capital
requirements
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© João Carvalho das
- 9. Value creation
Risk-Return Analysis
High Value creation
High
ROE a l
rm ROE l
No rm
a
No
Low Value destruction Low
Low Value destruction
High
D/E Low High
High Value creation Debt-Pay-Years
ROE=Return on Equity = Net Profit / Equity
ROE l
orma D/E = Debt to Equity = Financial Debt / Equity
N Debt-Pay-Years = Financial Debt / Cash Flow
TIE = Times Interest Earnings =
Low = EBITDA / Financial Expenses
Value destruction
Value destruction
High TIE Low
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© João Carvalho das
- 10. Risk-Return from NN
Value creation
High
l
ROE rma
No
Low
Value destruction
Low High
High Risk
O indicador de risco a usar poderia ser o que resulta do nosso modelo:
- ou o indice
- ou os ratings AAA, AA, A, BBB, BB, B, etc. em sequência do modelo da Ning
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© João Carvalho das
- 11. Risk-Return trade-off explained
• The principle is that return tends to rise with an increase in risk. This
means that lower levels of uncertainty (low risk) are associated with lower
expected returns and higher levels of uncertainty (high risk) are
associated with higher expected returns.
• Consequently, the investor must be aware of his personal tolerance to risk
when choosing his investment portfolio. If he wants to make money, he
can't cut out all risks, but he can find the appropriate balance for his
profile.
• The proxies for risk used in the previous graphs are:
– Debt to Equity – A higher proportion of Debt in comparison to Equity has higher
financial risk
– Debt-Pay-Years – The higher the debt in comparison to cash-flow generated by
the business evidences an higher level of risk
– TIE – A lower TIE evidences more difficulty to pay interests than an higher TIE.
The lower the TIE the higher is the financial risk
– The index that results from the NN model
• The proxy for return is the Return on Equity (ROE)
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© João Carvalho das
- 12. Sustainable Growth Analysis
High Excess of cash
NPi ⋅ (1 − d i )
g* = Sustainable
Ei −1
Growth Rate
(g*)
NPi – Net Profit of the year
d – pay-out ratio = Dividends/NP Low Lack of cash to grow
Ei-1 – Equity in the beginning of the year Low High
Growth Rate (g)
Ri = Revenue of the year Ri
Ri-1 = Revenue of the previous year g= −1
Ri −1
Excess of cash: Search for growth opportunities, or pay debt, or pay
dividends, or reduce equity
Lack of cash to grow: Slow down or search for equity or long term loans
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© João Carvalho das
- 13. Sustainable Growth Rate explained
• Sustainable growth rate (g*) is the maximum growth rate of
revenues a company can afford without issuing new equity or
increase the debt ratio. Although it can grow at extremely high
rates for some time, it is not sustainable in the long term.
• If revenues are projected to grow by more than the Sustainable
Growth Rate, then the company must obtain the additional cash
required to finance the growth: It can issue new debt or equity,
increase the profit margin, pay less dividends or sell assets such as
subsidiaries, divisions and/or other assets.
• The cumulated gap between the company’s historic growth rate
and the sustainable growth rate evidences a need for additional
financial resources to continue fuel the growth. Otherwise the
company needs to slow down.
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© João Carvalho das
- 14. Size Effect
Di
se
High co
no
m
le ies
s ca of
of sc
es
ROCE mi ale
no
Eco
No economies of scale
Di
se Low
High co
no Low High
m Size
c ale ies
Cash Cycle o fs of
es sc Size = Revenue or Capital Employed
WCR/R omi ale
on or Number of Employees
Ec ROCE = Return on Capital Employed
No economies of scale (see page 2)
WCR/R = Cash Cycle (See page 3)
Low
Low High
Size
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© João Carvalho das
- 15. Is Bigger really Better?
Size effect explained
• There is a worldwide debate about the effects of expanding a business to
seek economies of scale. Economies of scale is a long run concept. It
refers to reductions in costs per unit as the size of a company increases.
• Some of the factors that may cause economies of scale are: labor costs,
marketing expenses, purchasing costs, managerial costs, interest expenses
and amount of investments compared to sales. The size may also improve
in the revenue side.
• However, in some cases it is also possible to find diseconomies of scale. In
this case the production is less in proportion to the inputs, which means
that there are inefficiencies within the firm that is resulting in the rising
of average costs.
• Proxies for efficiency in the previous graphs are:
– ROCE and Cash Cycle
• Proxies for size are as follows:
– Total Assets
– Revenues
– Number of employees
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© João Carvalho das