Growth Analysis Flashcards
Is profit (absolute number) a good measure of profitability?
No. We must relate it to something for it to be valuable:
- margins = profit relative to sales
- returns = profit relative to capital
Why are margins a good way to express profitability for divisions/cost centers?
Because managers may be responsible for the income statement but not the balance sheet
What margin do we use in this course?
Profit margin = EBIE / sales
What are pros and cons of using EBITDA in margins?
Pros:
+ Measures both profit and cash flows at the same time (excludes non-cash items)
+ Is not influenced by the choice of depreciation method
+ Better comparability between companies
Cons:
- Not counting all expenses overestimates performance. A positive EBITDA may still result in a negative operating profit
- Does not take into account the capital needed
What are items affecting comparability and how should we handle them?
Revaluations, restructuring, impairments, legal risk (scandals).
Need to consider their size and frequency.
- If the items occur in the same magnitude each year, we may as well include them in the operating profitability (as they don’t seem to be that special).
- If they are different in particular years we may exclude them for short term comparisons. Over the long-term value creation we must however include them.
Items affecting comparability are NOT equal to other comprehensive income.
How will a firm that grows by M&A move in the DuPont graph?
To the left; acquires capital of other firm (including for example goodwill)
Which point in time of the balance sheet should we use in different cases?
- Liquidity ratios: Closing balance
- Financial strength: Closing balance
(want to know how well they are prepared for the future) - Profitability: Opening balance
(want to know how they performed over the last year)
What do we assume to work with growth?
The clean surplus relation. We can assume NI = 0, but include dividends
What determines how a firm finances its growth?
The initial position, and if they want to keep D/E stable, or for example increase equity if debt is already high (consider risks)
What is growth in financial balance?
CE, E and D all grow by the same percentage
How can we work out the level of profit needed to finance our desired growth?
By comparing the equity in the beginning of the year to the desired equity at the end of the year
Why do we want to transform our growth ambitions into for example profit margin?
Because it is something that lower levels are responsible for and understands
What are the five steps of growth relationship?
- Growth in sales, assets, employees as a result of a strategy, plan, business development
- Financial strength (equity ratio)
- Owners (dividend policy, new issues)
- Requirement on return on equity and net profit
- Requirement on return on capital employed, margins and turnover of capital
How can we assess if desired growth is possible?
By looking at the previous performance. If growth seems suspicious/unsupported, it needs to be revised
How do we think of a good profitability?
Consider long-term perspective.
- Returns should be able to pay market price for loans and risk capital
- Returns should be able to satisfy owners while supporting growth without additional risk (growth with good financial position). Owners assess the investment based on what they would earn if they invested somewhere else. Required return = risk-free rate + risk premium. Profitability is good if ROE > required return
Other factors:
- Past returns - benchmark!
- Industry return average - benchmark!
- Future returns, market potential, internal efficiency
