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Friday, September 04, 2009

Finance Chapter 4

Def - Market Capitalization. Total market value of equity, Share price times number of shares. (Shares X Price)

Def - Market Value Added. The difference between total Market Cap and Total Shareholder's equity. How much value that a company has added to total shareholders equity. (Mkt Cap - Book Value of equity)

Def - Book Value of Equity.  Total shareholder's equity as listed in balance sheet.

Def - Market to Book Ratio. Market Value of Equite (Mkt Cap/Book Value of equity)

4.2 Measuring profitability
Def - Economic Value Added (Residual income) - (Net income - a charge for the cost of capital employed). EVA is how you measure a corps profitability. EVA is the profit after deducting all costs, including the cost of capital.. EVA is a better measure of performance than accounting profits as it includes cost of equity. EVA = Net Income - (cost of equity X equity)

Def - Return on Equity (ROE) = NetIncome/Equity: Return for shareholders.
Def - Return on Capital (ROC) = (NetIncome + interest)/(long-term debt + equity) Return to investors that includes long term debt.
Def - Return on Assets (ROA) = (NetIncome + interest)/total assets Return to investors based on total assets.

4.3 Measuring Efficiency - Always over specific time period, so look at income statement
Def - Asset Turnover = Sales/Total Assets. Shows how much sales are generated per dollar of asset
Sometimes done over averages assets over period instead. Measures how efficiently the business is using its entire asset base.

Def - Inventory Turnover = COGS/inventory. Show how efficient at clearing inventory. Good to clear inventory efficiently.  High turnover = good operations/logistics

Def - Avg days in inventory = inventory at start/daily COGS in period = XX days. higher number of days = less efficient

Def - Recievables Turnover = sales/recieveables at start of period. high number is efficient AR/credit team.

Def - Avg collection period = receivables at start of yr/avg daily sales = XX days. higher number of days = less efficient credit team.

4.4 Measuring Return on Assets (Du Pont)
Def - Profit Margin = NetIncome/Sales
Def - Operating Profit Margin = (NetIncome + interest)/sales. This is better measure of operating as it isolates performance from interest. Debt/Financing decisions are not included. 

Dupont System
Def - ROA = (NetIncome + interest)/assets = Sales/assets x (NetIncome + interest)/sales
Def - ROA = Asset Turnover x operation profit margin

The Dupont Formula implies strategy. For example, a company with high asset turnover, but slim margin is probably in mass market retail. As opposed to one with low asset turnover and high margin (specialty/luxury retail).
Fast Food Chains - high turnover (due to nature of food inventory) with low margin

4.5 Measuring Financial Leverage
When a firm borrows money, it promises to make a series of intereste payments and then to replay the amount it's borrowed. If profits rise, the debtholders(lenders) continue to recieve only the fixed interest payments and gains return to shareholders. If profits fall, shareholders bear most of the pain. If times are really hard, the firm may not be able to repay it's debts is forced into bankruptcy and shareholders lose most or all of their investment.

Financial Leverage is a measure of how reliant a firm is on debt to finance it's operations.
Leverage ratios measure how much leverage a firm has taken on.

Debt Ratios
Def - Long-term Debt Ratio =  long-term debt/(long-term debt + equity) [14% for Pepsi)
Def - Long-term Debt Equity Ratio = long-term debt/equity [17% for Pepsi]

Pepsi is not leveraged all that much.
For a highly leveraged company the ratios are higher.
Typically for manufacturing companyies, LTDR is about 30%.
Firms can buyout other firms through leveraged buyouts (see ch 21)

Note short-term debt is ignored in these ratios

Def - Total debt ratio = total liabilities/total assets. [Pepsi is 49%]

Times Interest Earned Ratio
Def - Times Intereste Earned Ratio: the extent to which interest obligations are covered by earnings. If it's high, then more earnings are being used to pay off interest.  Better to have low.

Def - Times Interest Earned Ration = Earnings Before Interest and Taxes (EBIT)/interest payments
Pepsi's is 30.2 because they are conservatively financed

Cash Coverage Ratio
Def - Cash Coverage Ratio is like Times Interest Earned, but keeps depreciation in the equation
Def - Cash Coverage Ratio = EBIT + depreciation/interest payments

Dupont formula in 4 parts
ROE = NetIncome/Equity
= leverage ratio X asset turnover X operating profit margin X Debt burden
= Assets/Equity X sales/assets X (NetIncome + interest)/sales X netIncome/(NetIncome + interest)

4.6 Measuring Liquidity
Def - liquidity: access to cash or assets that can be turned into cash on short notice

while generally liquidity is seen as a good thing, too high levels indicate sloppy use of capital.

Def - Net Working Capital to Total Assets Ratio = NetWorkingCapital/Total Assets [PEpsi's is 8%]
Def - Current ratio = CurrentAssets/CurrentLiabilities
Def - Quick (Acid-Test) Ratio = cast+marketable securities+receivables/current liabilities [This doesn't count inventory]
Def - Cash Ratio = cash+marketable securities/current liabilities [this is the companies most liquid assets]

4.7 Calculating Sustainable Growth
Def - Sustainable Rate of Growth: steady rate at which a firm can grow without changing leverage.

NOTE: Table 4-7 is very good reference!!



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