three - Introduction to Corporate Financial Analysis...

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Unformatted text preview: Introduction to Corporate Financial Analysis Introduction to Corporate Financial Analysis by George W. Blazenko All Rights Reserved 2008 Chapter 3 Corporate Dimensions of Risk Most of us would rather risk catastrophe than read the directions. Mignon McLaughlin, US journalist and author Risk comes from not knowing what you're doing. Warren Buffett 121 Corporate Dimensions of Risk Chapter Three Contents (3.1) 124 (3.2) 124 3.2.1 127 3.2.2 129 3.2.3 130 3.2.4 131 (3.3) 132 3.3.1 134 122 Introduction to Corporate Financial Analysis 3.3.2 135 (3.4) 139 3.4.1 141 (3.5) 143 (3.6) 143 (3.7) 143 (3.8) 149 IF BREAK-EVEN SALES INCREASE, IT MUST BE BECAUSE FIXED COSTS HAVE INCREASED OR CONTRIBUTION MARGIN HAS DECREASED. EITHER CHANGE WILL INCREASE DOL. 149 THIS RESULT INDICATES THAT DOL CAN BE CALCULATED AS THE RATIO OF TWO CORPORATE MARGINS: CONTRIBUTION MARGIN PER DOLLAR SALES AND THE EBITDA-MARGIN. 150 IN THE PROBLEM AT HAND, THEREFORE, DOL = 3.2/0.2 = 1.6. 150 (3.9) 154 123 Corporate Dimensions of Risk (3.1) In the introductory chapter, we identified three questions a financial analyst investigates for any investment: expenditure, return, and risk. In the chapter on using financial statements, we studied how to measure the investment in business activity made by firms and the investment in financial assets by financial asset-holders (i.e., invested capital). We also studied how to measure investment returns for firms: the rate of return on invested capital and the rate of return on equity. In this chapter, we introduce and investigate two characteristics of a firm that alter its risk: operating leverage and financial leverage . (3.2) In an earlier chapter, we defined EBITDA as Sales less Cost of Sales less General, and Administrative Expenses (before depreciation and amortization). Cost of Sales measures expenses associated with production. General and Administrative Expenses measures outlays required for commercial operations not directly related to production (advertising, for example). The financial statement decomposition of expenses into Cost of Sales and General and Administrative Expenses is a convenient way to measure the efficiency of production (under this rule, we use the gross profit margin). There are other useful ways, however, to decompose expenses. A second decomposition is to separate fixed expenses from variable expenses. Variable expenses vary with the level of a firms sales and fixed expenses do not. The usual financial statement decomposition of expenses into Cost of Sales versus General and Administrative Expenses is not the same as the decomposition of expenses into variable expenses versus fixed expenses because some commercial (general) expenses vary with the level of sales. One example is advertising: higher sales should be associated with higher advertising expenditure....
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three - Introduction to Corporate Financial Analysis...

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