Well, in this part,
we will talk about ratios that allow us to study the companies and project performance.
So this is Ratio Analysis (III),
Operating Performance.
Well, first of all,
the clearest first ratio is profit margin,
which is as you can,
see this is net income to net sales.
Well again, now you can see how important it is
to stay within the ballpark of industry standard,
because some industries they have very high profit margin,
some of them, they have very low profit margins.
And the fact that one company shows a lower ratio,
that kind does not mean that it is doing poorly.
For example again, jumping ahead towards fourth course,
we will see that no one else have leverage buyout,
we observed the same situation that the company
part of the bigger company that was doing well but still,
this doing well was not satisfied for the standards of the bigger holding company and
that could have potentially resulted in conflict that could be
resolved only by the buyout of this company.
And now, the next set of ratios,
this is returns, return on investment,
I will put it like this because that's a huge area.
And clearly, it's very important for us
because investors are the people who provide capital
in the hope of receiving some expected return on that.
And if they see historical numbers on the returns
provided in this company or by this project,
then there are, let's say,
more likely to base their expectations on
this past performance and or they can compare
that to the other potential ways to invest their capital.
So let's start with return on assets,
that is net income plus after tax interest cost and divided by average total assets.
Well, we can also provide the, let's say,
the after interest return on assets
which is just earnings before taxes divided by total assets.
Here, I will drop the average, it's always average.
So, this is for overall.
But when we talk about the return total assets that means that
this is a return on the portfolio of debt and equity.
Remember, from the accounting equation,
total assets are always equal to total liabilities plus total equity.
And basically, this is the amount that goes to the whole pool of investors and we would
oftentimes like to really find what goes to equity holders and what goes to debt holders.
And therefore, an important ratio is the return on common equity,
and that is net income less preferred dividends
because they do not go to common equity holders,
and then average common equity.
And then, in general return on equity that is
net income divided by average total equity.
Here, equity goes not only for common but also going to preferred shareholders.
So on the next page,
I'd like to show a simple diagram how all that gets combined.
So here, we have total debt and then,
here we have total equity,
taken together that gives us total assets.
Now, these total assets,
they produce some operating net in operating income like this.
Then from here, we subtract interest.
And again, what is interest?
Interest that goes to debt holders as they return.
And then, if we subtracted that results in our net income.
And now see what happens,
so this part, this is return on assets.
And this part, this is return on equity.
Now, you can always draw any more sophisticated diagrams but
the idea is always to keep in mind what goes to
whom or who pockets this or that part of return.
That is important because oftentimes it does depend upon
the breakdown of these debt holders and equity holders and then,
it's important who is satisfied with what kind of return.
So here, you have to be just careful.
Now, the next it's sort of quoted exercise that I'm offering to you
is the idea of desegregation or if you will break down of these returns.
So, there are many ways to desegregate several of these ratios to sort of
analyze what activity or what ratio in turn contributes to the final result.
Let me give you an example.
So I'll put disaggregation, sort of quoted.
Now, let me give you an example.
The return on equity can be written as return on assets plus,
and then goes a brace, and then there's brace,
return on assets less cost of that and then,
multiplied by debt to equity or the leverage ratio.
And that can be rewritten as return on assets,
less interest cost divided by total assets
and that multiplied by total assets to total equity.
Well, here I will pay up to put total debt to total equity otherwise,
D. And you can see basically,
that this formula you just take this part and that,
then you combine the two and you arrive to this.
So we are talking about some algebraic or even arithmetic manipulations here.
But sometimes, the focus on a certain part
of the activity or on a certain special component or special ratio within that.
Now, to show another thing to you,
I can give an example of disaggregation of return on equity in the following way.
So return on equity can be thought of as the combination of three things.
So this is sort of profitability,
then times activity,
and then times solvency.
I put that quote because you will see what I mean.
So profitable is net income divided to sales,
times sales divided by assets,
this is sort of activity and this times assets divided by equity.
So, you can see how this goes.
So this is basically, this cancels out and that cancels,
and the result of net income over equity.
But you can think about that,
this ratio shows to you how much income you generate from your sales.
This shows to you how much of your sales as you referred to assets,
that shows you how much of that assets to equity and then you can see this.
Now, the final set of ratios here,
I will produce two, earnings per share,
and then P/E ratio.
The important thing is that earnings per share,
this is again the ratio of net income for common shares
divided by common shares outstanding.
So, this is sort of a number taken from financial statements.
When the P/E ratio deals with not book values,
not financial statements but with the market value,
and this is the market price per share divided by EPS.
So these P/E ratios again we dealt with that in our corporate finance and then said that,
for no growth company,
the P/E ratio is the one over R,
where R is the rate of return.
For a growth company,
it may be one over R minus G and for companies
with fast growth,that can be quite high,
maybe as high as a couple of dozen,
maybe 50 or even 100.
So that must be kept in mind.
But like I said, we are not here
pursuing the goal of studying these ratios in greater detail.
There is a lot more information in your tax materials and references to
proper books but you have to really feel the flavor of that.
And the key story about financial statements like I was saying before,
this is the ability to reveal some trends
and to observe some signals that point at these trends.
You can see the dynamics of that and that oftentimes helps you in your analysis,
assessment, and valuation of projects and companies.
And in the next final episode of this week and
the final episode of the whole bunch of
the first three weeks that are devoted to financial accounting,
we will put everything together and we will draw some important conclusions about
why financial accounting is so important to us.
Konstantin KontorDirector and Professor of Finance and Strategy
