Chapter_11 - Chapter 11 Chapter 11 The Analysis of...

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Unformatted text preview: Chapter 11 Chapter 11 The Analysis of Profitability The Analysis of Profitability The Analysis of Profitability More profitability analysis is on the web page What you will learn from What you will learn from this chapter this chapter • How ratios aggregate to explain Return on Common Equity (ROCE) • How economic factors determine ratios • How financial leverage affects ROCE • How operating liability leverage affects ROCE • The difference between Return on Net Operating Assets (RNOA) and Return on Assets (ROA) • How profit margins, asset turnovers and their composite ratios drive RNOA • How borrowing costs are analyzed • How profitability analysis can be used to ask penetrating questions regarding the firm’s activities Analysis: Preamble to Analysis: Preamble to Forecasting and Valuation Forecasting and Valuation • Analysis establishes where the firm is now • Forecasting asks how it will be different in the future ( 29 [ ] 1 1 2 2 1 1 CSE p ROCE RE p RE p RE CSE V E-- = ↑---- + + + = Analyzing ROCE: The Scheme Analyzing ROCE: The Scheme Cutting to the Core: Cutting to the Core: ROCE Drivers ROCE Drivers ROCE is decomposed into drivers over three levels of analysis: 1. Analysis of Leverage 1. Analysis of Operating Profitability 1. Analysis of Net Borrowing Costs First-Level Breakdown: First-Level Breakdown: Analysis of Effects of Financial Analysis of Effects of Financial Leverage (FLEV) Leverage (FLEV) So, ROCE is a weighted return to operating activities and financing activities: or, RNOA = OI (After tax) / NOA (Return on Net Operating Assets) FLEV = NFO / CSE (Financial Leverage) NBC = NFE (after tax) / NFO (Net Borrowing Cost) SPREAD = RNOA – NBC (Operating Spread) NFO NOA Expense) Financial Net - (OI CSE Average Income ive Comprehens ROCE- = = = NBC x CSE NFO- RNOA x CSE NOA ROCE ( 29 ] NBC- RNOA x [FLEV RNOA ROCE T T T T T T T + = Spread The Financial Leverage Equation The Financial Leverage Equation ROCE = RNOA + FLEV x [RNOA – NBC] The equation says that ROCE is driven by three factors: 1. Profitability of Operations: RNOA 1. Financial Leverage: FLEV = NFO CSE 3. Operating Spread: RNOA - NBC ROCE = RNOA + [FLEV x SPREAD]-4%-2% 0% 2% 4% 6% 8% 0.00 0.25 0.50 0.75 1.00 1.25 1.50 1.75 2.00 FLEV Difference between ROCE and RNOA (ROCE-RNOA) SPREAD = 6% SPREAD = 4% SPREAD = 2% SPREAD = 1% SPREAD = 0% SPREAD = -1% SPREAD = -2% How Financial Leverage How Financial Leverage Explains the Difference Explains the Difference Between ROCE and RNOA Between ROCE and RNOA Financial Leverage: Financial Leverage: General Mills, Inc., 2004 General Mills, Inc., 2004 (In millions of dollars) NOA 12,578 OI 1,575 NFO 7,866 NFE 324 CSE 4,712 CI 1,251 FLEV = 1.670 ROCE = 26.5% RNOA = 12.5% NBC = 4.1% ROCE = RNOA + [FLEV + (RNOA – NBC)] = 12.5% + [1.670 (12.5% - 4.1%)] = 26.5% General Mills: What If?...
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This note was uploaded on 10/07/2010 for the course ECTCS ec12947322 taught by Professor Johnathayeri during the Spring '10 term at Life.

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Chapter_11 - Chapter 11 Chapter 11 The Analysis of...

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