1. Business Finance
Michael Dimond

2. Meaningful Ratio Analysis
Analysis means to break something down to understand it.
Ratio analysis should be used to answer a specific question or set of questions.
If you were examining the financial statements for a company, you might start with this basic question:
“Is this a good use of investors’ money?”
What financial ratio would answer this question?
How about Return on Equity?
How do you compute Return on Equity (ROE)?

3. Analyzing ROE
ROE = NI ÷ Equity and answers the question, “is this a good use of investors’ money?”
If you were to break this down, there are three basic questions to answer:
How profitable is this business?
How efficiently are assets being used?
How much does financial leverage help the investors?
What financial ratios would answer these questions?
Profit Margin (PM)
Total Asset Turnover (TAT)
Equity Multiplier (EM)

4. Drivers of ROE
Profit Margin (PM) = NI ÷ Sales and answers the question, “How profitable is this business?”
Total Asset Turnover (TAT) = Sales ÷ Total Assets and answers the question, “How efficiently are assets being used?”
Equity Multiplier (EM) = Total Assets ÷ Equity and answers the question, “How much does financial leverage help the investors?”

5. The DuPont Identity
ROE is directly driven by profitability, efficiency and leverage.
ROE = PM x TAT x EM
How does that work?
The numerators and denominators cancel to reduce the equation to NI ÷ Equity

6. A word about ROA ROA = Return on Assets
What’s the difference between Equity & Assets?
Leverage
What’s the difference between ROE & ROA?
ROE = PM x TAT x EM
EM represents leverage
ROA = PM x TAT
No leverage

7. Digging Deeper with Financial Ratios
How would you analyze profitability, efficiency and leverage?
How do profitability, efficiency and leverage relate?
What affects profitability?
What drives sales?
What is the composition of assets?
How were assets paid for?
How are liabilities managed?
Where shall we begin?

8. Common-Size Financial Statements
Shows each line item as a percent of an appropriate total.
Common-size balance sheet
% of Total Assets
Shows the composition of assets
Liabilities & equity items are also shown as % of total assets
Debt Ratio = Total Liabilities ÷ Total Assets
Common-size income statement
% of Sales
PM = Net Income as % of Sales

10. Vertical & Horizontal Analysis
Vertical Analysis compares figures as a percent of a relevant total (“common size” financial statements)
Horizontal Analysis compares the same figure over a series of periods (showing % change or % growth)

11. Measuring growth Financial figures change from year to year
To find the % change (“% growth”) over a 1-year period, divide the difference of the two figures by the first year’s value:
[ending – beginning] / [beginning] OR
[ending] / [beginning] - 1
Measuring growth over more than one period means we need to find the average growth during that time.

12. CAGR: Compound Annual Growth Rate
The CAGR is the result of compounded increase over time at a specific average rate
(133.1/100)^(1/3)-1=0.10
It can be tested by plugging the result into a compounding formula using the same figures
100*(1+0.10)^3=133.10
It can be figured using the TVM functions on your calculator
PV = FV = n = 3 PMT = 0 solve for I = 10%

13. Categories of Financial Ratios
Most finance texts group ratios into categories like these:
Profitability ratios
Efficiency (or Activity) ratios
Liquidity ratios
Debt ratios
Market ratios
It is usually more helpful to think of the questions to be answered rather than just crunching a bunch of numbers.
Uses critical thinking
Easier to read
Less time consuming
Uses fewer resources

14. Profitability Ratios
PM = Net Income ÷ Sales (Sometimes called “Net Profit Margin”).
This also is the bottom line on a common-size income statement
The author makes a distinction for Earnings Available to Common Shareholders.
Gross Margin = Gross Profit ÷ Sales
Gross Profit = Sales – COGS
Also called the “Gross Profit Margin”
Operating Margin = Operating Profit ÷ Sales
Also called the “Operating Profit Margin”

15. Efficiency Ratios Average Collection Period or Days in Receivables
TAT = Sales ÷ Total Assets
How hard do specific assets work?
Inventory Turnover
Inventory Turnover = Sales ÷ Inventory
The label “Inventory Turnover” is also used for COGS ÷ Avg. Inventory
These two ratios answer different questions:
How hard is inventory working? (Sales/Inventory)
How many times/year is inventory replaced? (COGS/Average Inventory)
How would you convert this into “Days in Inventory?”
Average Collection Period or Days in Receivables
Days to Collect AR = Avg. Accts Receivable ÷ Avg. Daily Sales
Average Daily Sales = Sales ÷ 365
The sales figure should exclude sales paid for in cash, use only sales creating AR

16. Efficiency Ratios Average Payment Period (Days in Payables)
Days to Pay AP = Avg. AP ÷ Avg Daily Purchases
Avg Daily Purchases = Purchases ÷ 365
Purchases = COGS + Ending Inventory – Beginning Inventory
If you know how long it takes a company to sell inventory, how long it takes to collect accounts receivable and how long to pay its bills, you can compute how long their business takes to function
Operating Cycle: Days in Inventory + Days in Receivables
Cash Cycle: Days in Inventory + Days in Receivables – Days in Payables

17. Efficiency Ratios
There is an easy and consistent way to compute and understand the components of the cash cycle.
Each of the “Days in…” figures represents a year divided by the appropriate turnover rate:
Days in Inventory = 365 ÷ Inventory Turnover Rate
Days in Receivables = 365 ÷ Receivables Turnover Rate
Days in Payables = 365 ÷ Payables Turnover Rate
This means the turnover rates can be simplified to these:
Inventory Turnover Rate = COGS ÷ Avg. Inventory
Receivables Turnover Rate = Sales ÷ Avg. Receivables
Payables Turnover Rate = Purchases ÷ Avg. Payables
…and the days in each can be computed as:
Days in Inventory = 365 ÷ (COGS ÷ Avg. Inventory)
Days in Receivables = 365 ÷ (Sales ÷ Avg. Receivables)
Days in Payables = 365 ÷ (Purchases ÷ Avg. Payables)

18. Liquidity Ratios The Current Ratio
Pretty much useless in my opinion, but memorize it anyway.
Current Assets ÷ Current Liabilities
Liquidity means something can be converted into cash immediately without significant loss of value. Current Assets includes inventory. Is inventory really liquid?
Quick Ratio (also called the “Acid Test”)
Answers the question, “how well can this firm meet its short-term obligations?”
[Current Assets – Inventory] ÷ Current Liabilities

19. Debt Management Ratios
Debt ratio = Total Liabilities ÷ Total Assets
Also called “Debt to Total Capital” ratio
Debt-to-Equity ratio = Total Liabilities ÷ Total Equity
EM (from DuPont) = 1 + D/E
Times Interest Earned ratio = EBIT ÷ Interest
NOTE: The book has a typo on page 78. It claims TIE = EBIT ÷ Tax, which is not correct.
TIE can be altered to cover any financial obligations.
TIE = EBIT ÷ Interest
:. TIE = (EBT + Interest) ÷ Interest
(EBT + Interest + Lease Pmts) ÷ (Interest + Lease Pmts) = Fixed Payment Coverage

20. Market Value Ratios
Price-to-Earnings ratio = Share Price ÷ Earnings per Share
Earnings per Share (EPS) = Earnings Available to Common Shareholders ÷ Number of Shares of Common Stock
If there is no preferred equity (or an insignificant amount), EPS can be NI ÷ Number of Shares
Because the Numerator and Denominator are both “per share,” the PE ratio can be computed as Market Capitalization ÷ Total Earnings Available
Market-to-Book ratio = Price per Share ÷ Book Value per Share
Book Value per Share = Common Equity on Balance Sheet ÷ Number of Shares
Common Equity = All equity except preferred equity
Again, because the Numerator and Denominator are both “per share,” the MB ratio can be computed as Market Capitalization ÷ Total Common Equity

21. Other useful analysis Dividends & Retained Earnings Growth Limitations
d: Dividend Payout Ratio = Dividends ÷ Net Income
b: Retention Ratio = 1 – d
Also called the “plowback ratio.” Why do you think that name is used?
Growth Limitations
SGR: Sustainable Growth Rate = b x ROE = b x PM x TAT x EM
IGR: Internal Growth Rate = b x ROA = b x PM x TAT
Breakeven
BE = Total Fixed Costs ÷ Contribution Margin
Contribution Margin = Price per unit – Variable Costs per unit
Operating, Accounting, and Financial breakevens all exist. The definition of “Fixed Costs” changes.
Degree of Operating Leverage
Looks a lot like an elasticity formula: %Δ Op. Income ÷ %Δ Sales
As firm approaches breakeven, DOL gets larger
A point estimate of DOL can be computed as Gross Profit ÷ Operating Income

22. Cash Flows NOPAT = Net Operating Profit After Taxes
EBIT(1-t)
OCF = Operating Cash Flow
NOPAT + Depreciation Expense
Why doesn’t this work: NI + Interest + Depreciation Expense
NOTE: Operating Cash Flow is not the same as Cash Flow from Operations
FCF = Free Cash Flow
OCF – Net Cash Investment in Operating Capital
Free Cash Flow: The cash generated which is available to satisfy the needs of lenders and the wants of investors.
FCFE = Free Cash Flow for Equity
FCF – Net Cash Flow to Debt
Free Cash Flow to for Equity: The cash generated which is available to satisfy the wants of investors.