FINANCIAL STATEMENT

ANALYSIS (FSA)

Unit 3: Financial Analysis I

Academic Year 2024-2025

2nd semester
1 10/02/2025
3.1 Introduction
3.2.Return on equity
3.3 Decomposing ROE: profit drivers
3.4 The impact of financial leverage
3.5 Operating management: decomposing
profit margin

Ref. PHP Chapter 5

BW Chapter 11

2 10/02/2025
1. Introduction
 Main tools of financial analysis:
⚫ ratio analysis (units 3 and 4) and
⚫ cash flow analysis (unit 5)
 The value of a firm is determined by its profitability
and growth.
 Ratio analysis tries to evaluate the effectiveness of
the firm in achieving its profit and growth targets.
Two main factors:
⚫ product market strategy: operating policies and
investments decisions.
⚫ financial strategy: financing and dividend
policies
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 Growth and
profitability

Product market Financial market

strategy strategy

Operating Investment Financing Dividend

management management decisions policy

Managing Managing WC Managing Managing

Revenues and Debt Pay-out
And expenses Non current assets and Equity
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Techniques of ratio analysis
 A ratio is a comparison between two figures ► how
various line items in a firm´s financial statements
relate to one another. The ratio analysis implies:
⚫ Time-series comparison (firm-specific factors
constant)
⚫ Cross-sectional comparison (industry-level factors
constant)
⚫ Ratios to a benchmark (difficult, but: return and
cost of capital…)
 Simple techniques:
⚫ Year-to-year growth analysis (2 or 3 years):
horizontal analysis
⚫ Common size statements (in BS: % of total
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assets, in IS:% of total revenues): vertical analysis
 Year-to-year growth analysis
20X4 20X3 Change Change
(€) (%)
Net €659,347 €466,194 €193,153 41.4%
revenues
Cost of 272,939 205,596 70,343 34.2%
revenues
Gross 383,408 260,598 122,810 47.1%
profit
…..
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 Some issues
Some items: 20X4 20X3 Change (€) Change (%)

Net income €4,500 (€1,500) €6,000 ----

Change in
sign with
negative
base
Notes 10,000 ------ 10,000 ----
receivable No figure in
base year!

Notes ---- € 8,000 (€8,000) (100%)

payable

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Common size statements
Year x %
Sales € 125 100
Cost of goods sold 50 40
Admin expenses 20 16
Operating profit 55 44
Financial expenses 15 12
Profit before tax 40 32

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  PROFITABLITY ratios compare the return of an
investment with the investment or with the funds
invested.
 Numerator : Income statement, it could be
⚫ Operating profit
⚫ Financial profit
⚫ Profit before taxes
⚫ Net income…
 Denominator: Balance sheet, it could be
⚫ Total assets or total funding (Equity and liabilities)
⚫ Operating assets
⚫ Net operating assets
⚫ Financial assets
⚫ Net financial assets
⚫ Business assets
⚫ Equity
 Better use average values in the denominator 10/02/2025
9
 2 ROE vs ROA
 ROE measures the overall profitability of a firm (to the shareholders)
ROE = net income / shareholders´ equity
 Captures how well managers are employing the funds invested by the
shareholders to generate return
 can be compared to the cost of equity capital, it is the benchmark that
would be observed in a long-run competitive equilibrium
 deviations can be due to industry conditions (barriers to entry) and
competitive strategy that cause a firm to generate supernormal (or below
normal) economic profits, or accounting distortions (understated assets)

 ROA measures the profitability of a firm regardless how is financed,

allowing comparisons. There are different ways to calculate it
ROA = (profit before taxes + financial expenses ) /total assets
 Captures the return derived from using all assets = all funds (E & L)
 But
1) what about taxes?
10 10/02/2025
2) do all liabilities convey a financial expense that appears in the IS?
 3 Decomposing ROE: profit drivers
4 The impact of financial leverage
 Two main drivers: 1) how profitably the firm employs its
assets, and 2) how the firm finances its assets

ROE = Net income / shareholders’ equity =

Net income/Total Assets x Total Assets/ Shareholders’ equity =
Net income/TA x Financial leverage

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 1) How profitable is the firm employing its assets.

Net income/Total Assets, sometimes called ROA ->

how much a firm obtains for each € of assets invested,
it does not consider how the assets have been funded
(it includes all assets: financial and operating, although
they can be separated)
⚫ But the numerator ONLY refers to the surplus for the
equity holders (we must introduce changes to make it
homogeneous, see slide 16)

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 2) how the firm finances its assets

Financial leverage= Total Assets/ Shareholders’ equity

It indicates how many € of assets the firm has for each €

invested by its shareholders

It considers how the firm is financed

Leverage can be also measured in some other ways (unit 4)

⚫ Remember: Total assets =Equity + Total liabilities

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 higher cost = less taxes
see for debt because they are a tax advantage

• Net income/TA can be decomposed :

Net income/Sales x Sales/Total assets = Profit margin x Asset
turnover
 Profit margin: how much profit the firm makes for each € of
sales
 Asset turnover: how many € of sales the firm can generate
for each € of assets

ROE = Profit margin x Asset turnover x Financial leverage

operating investment liability

management management management
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 X Y Z

Revenues 5,000,000 10,000,000 10,000,000

Net income 500,000 500,000 100,000

Assets 5,000,000 5,000,000 1,000,000

Net income /Revenue *100 10% 5% 1%

=Profit Margin

Revenue/Assets = Turnover 1 2 10

Net income/TA *100 10% 10% 10%

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In the ratio net income/assets, the two figures are not
comparable ►this ratio should be improved
The numerator should refer to the surplus for all
providers of funds (shareholders and creditors):
Adjusted NI = (NI + (1-t) x I) and the denominator
should be average: ATA
⚫ Where NI = Net income
⚫ t = tax rate
⚫ I = Interest expense
⚫ ATA = Average total assets
⚫ ROA = Adjusted NI/ATA
It provides a good indication of how much the company
could earn without any debt
If Minority interest exist it should be added to NI

ANOTHER RATIO TO APPRECIATE THE PERFORMANCE OF

THE BUSINESS IS
OROA = NET OPERATING PROFIT AFTER TAX/
16 AVERAGE NET OPERATING ASSETS 10/02/2025
Kothari 15.511 Corporate Accounting. Lecture 8 on FSA (www.oci.mit.edu)

 12
 Profitability Ratios:
 Return on Assets (ROA)

 􀂃Adding (1 –Tax Rate)(InterestExpense) to

 Net Income provides an estimate of income as if the
 company were not to have any debt. For example:
 􀂃With DebtW/out Debt
 􀂃Revenues:1,0001,000
 􀂃COGS:700700
 􀂃Interest:1000
 􀂃Inc b/ tax200300
 􀂃Tax (@40%)80120
 􀂃Net Income120180
 􀂃NI + (1 –Tax)(IntExp)120 + 60180
 􀂃Thus, the effect of leverage on ROA is neutralized

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 Income statement
GENERAL REFORMULATED
Sales Sales
-Returns and allowances -Returns and allowances
Net sales Net sales
-Cost of goods sold (COGS) -Cost of goods sold (COGS)
Gross margin Gross margin
-Operating expenses -Operating expenses
Operating profit Operating profit
-Interest expense -Income tax
Net profit before tax - Tax benefit of debt
- Income tax Net operating profit after tax
Net income after tax -Interest expense
+Tax benefit of debt
Net income after tax
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 Income statement
GENERAL REFORMULATED v1
Revenues 1,000 Revenues 1,000
- (COGS) (700) - (COGS) ( 700)
Gross margin 300 Gross margin 300
-Operating expenses 0 -Operating expenses 0
Operating profit b/ tax 300 Operating profit b/ tax 300
-Net interest expense (100) -Income tax ( 80)
Net income before tax 200 - Tax benefit of debt ( 40)
- Income tax ( 80) NOPAT 180
Net income after tax 120 -Interest expense (100)
+Tax benefit of debt 40
Net income after tax 120
2/10/2025
19
 Income statement
GENERAL REFORMULATED v2
Revenues 1,000 Revenues 1,000
- (COGS) (700) - (COGS) ( 700)
Gross margin 300 Gross margin 300
-Operating expenses 0 -Operating expenses 0
Operating profit b/ tax 300 Operating profit b/ tax 300
-Net interest expense (100) -Tax on operating income (120)
Net income before tax 200 NOPAT (*) 180
- Income tax ( 80) -Interest expense (100)
Net income after tax 120 +Tax on interest expense 40
Net interest expense after tax(**)(60)
20
Net income after tax (*)+(**) 10/02/2025120
 Return on Net Operating Assets: BS reclassification
Operating assets Operating liabilities Net Operating
Assets
Current  Current Operating WC
Accounts receivable, Accounts payable notes
inventories, prepaid payable, accrued expenses,
assets income taxes payable (Trade
and non-trade ST creditors)
Non-current  Non-current Net non-current
PP&E, goodwill, Deferred taxes (non-interest assets (derive from
trademarks bearing) investing activities)
Financial assets Financial obligations Net financial
obligations
Current -> Current Net current FO
Cash in excess, financial Notes payable (if interest
investments (marketable bearing), ST debt, current
secutities) portion of LT debt
Non-current -> Non-current Net non-current FO
Financial investments LT debt
21 Equity Equity 10/02/2025
 Some items:
 ST debtors due to non-current assets sold, and
 LT debtors due to non-current assets sold
⚫ Financial assets, both reduce financial obligations
Si le ROE est bien plus élevé que le ROA, cela signifie que l’entreprise utilise beaucoup de dette (effet de levier).
Un ROA et un ROE élevés indiquent une entreprise rentable et efficace.
Un ROA faible mais un ROE élevé peut signaler une entreprise très endettée, ce qui peut être risqué.

 ST creditors due to the acquisition of non-current

assets
 LT creditors due to the acquisition of non-current
assets
Le ROE mesure la rentabilité des capitaux propres investis par les actionnaires. Il montre combien chaque euro/dollar investi par les actionnaires génère en bénéfices.

⚫ if interest bearing, both financial obligations,

otherwise operating liabilities
Le ROA mesure l’efficacité avec laquelle une entreprise utilise ses actifs pour générer du profit.
Il indique combien de bénéfices une entreprise réalise pour chaque euro/dollar d’actifs qu’elle possède.

 If individual accounts are considered instead of

consolidated accounts ►Financial investments in
dependents or associate companies 10/02/2025
22
⚫ Non-current operating assets
 Reformulatind the BS: definitions

 Operating Working Capital = Operating current assets –

Operating current liabilities = (Current assets –
cash&marketable securities) – (Current liabilities –Short-term
debt&current portion of long-term debt)
 Net non-current assets = Non-current assets –Non-interest
bearing long-term debt
 Net debt = Total interest bearing debts - cash&marketable
securities
 Net operating assets = Operating Working Capital + Net non-
current assets
 Net capital = Net debt + Shareholders´equity

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 Alternative Decomposition of ROE
As: Net income = NOPAT - Net interest expense after tax
Where: NOPAT = Net operating profit after tax
Net interest expense after tax = (Interest expense-Interest income)x(1-tax rate)

ROE = Net income/Equity = NOPAT/Equity - Net interest expense after tax/Equity =

= NOPAT/NOA x NOA/Equity - Net interest expense after tax/Net debt x Net

debt/Equity =
NOPAT/NOA x (Equity+Net debt)/Equity - Net interest expense after tax/Net debt x
Net debt/Equity =
= NOPAT/NOA x (1 + Net debt/Equity) - Net interest expense after tax/Net debt x
Net debt/Equity =

= OROA + (OROA – Net interest expense after tax/Net debt )x Net debt/Equity =

= OROA + Spread x Net financial leverage

Operating Economic Effect of financial 10/02/2025

24
Return with no debt Effect of debt leverage
 Decomposition of OROA

OROA = NOPAT/Sales x Sales/NOA=NOPAT margin x

operating asset turnover

 NOPAT margin: how profitable the sales of a company are

from an operating perspective
 Operating asset turnover: the extent to which a company is
able to use its operating assets to generate sales. It may be
further decomposed to examine turnover ratios of individual
assets
 Operating ROA is a superior measure than aggregated ROA
to know about the core business, as ROA mixes several
aspects into the same ratio
 The appropriate benchmark for evaluation Operating ROA is
the weighted average cost of debt and equity capital (WACC)
Unit 6 25 10/02/2025
 4 Operating Management:
decomposing profit margin
 Useful tool common-size income statements: all line items
are expressed as a ratio of sales. Some common ratios:
Gross profit margin = (sales-cost of sales)/sales
 Gross margin is influenced by two factors:

⚫ Price premium that products obtain in the market,

depends on the competition and the characteristics of the
product (Unique seller? product?)
⚫ Efficiency in the purchasing system and in production
process
 But…. cost of sales does not always appear in the IS

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Selling, general and administrative expenses/sales
 SG&A expenses are influenced by the operating activities
the firm needs to implement its competitive strategy.
⚫ A company competing on the basis of high quality product
will have higher R+D expenses, similarly a company that
wants to build a brand image and provide significant
customer service will have higher selling and
administrative expenses relative to a company that sells
through warehouse retailers

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NOPAT (net operating profit after taxes) margin = NOPAT / sales
EBITDA (earnings before interest, taxes, depreciation and
amortization) margin = EBITDA /sales
 Provide similar information but differ in the impact of taxes and
the treatment of some non-cash items (depreciation and
amortization)
 EBITDA is very popular among financial analysts (as it avoids
some accruals) but should be used carefully, it is not a real
cash ratio

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 Finally, one should look at taxes. There are two
interesting ratios:
Tax expense/sales
Effective tax rate = Tax expense/earnings before
taxes
 This last rate can differ from the statutory tax rate
due to the use of the tax advantages offered by
the tax authorities

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 Use of Non-financial information
 The number of employees can be compared with personnel
expenses, as well as with sales.

Personnel expenses-to-sales = Personnel expenses/sales x

Number of employees/Number of employees =
=Personnel expenses/ Number of employees x

Number of employees/Sales =
= Average cost per employee x 1/Employee productivity

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Palepu, Healy & Peek, p.193

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