Not Sensible Examine Roe Without Operating Non Operating Finance Essay - Free Essay Example

As an investor, it is always better to examine RNOA in a deeper manner by placing further importance on the two components which are margin and turnover. RNOA = Net Operating Profit After Taxes / Average Net Operating Assets Which can be re-written as: RNOA = (Net Operating Profit Margin / Sales)   X (Sales / Net Operating Asset Turnover) Therefore: RNOA = Net Operating Profit Margin (NOPM)   X   Net Operating Asset Turnover (NOAT) Example: (Numbers assumed) Consider a big retail company as X Suppose we originally calculate Xs RNOA = NOPAT/Average NOA = $15,572/$109,894= 14.17% Say Net Operating Profit Margin (NOPM)= NOPAT/Revenue =$15,572/$401,196 = 3.88 % Here the NOPM seems to be small for a big retail player as it implies that for every dollar sale , X only earns 3.8 cents as the operating profit after tax. However, the margin alone does not make sense without considering the turnover figures. Therefore lets consider: Net Operating Asset Turnover (NOAT) = Revenue/ Average NOA=$401,196/$109,894 = 3.65 Now, multiplying (NOPM) x (NOAT) = 3.88 x 3.65 = 14.17 % (The RNOA) Therefore a high margin firm does not ensure good returns for but it depends on the achieved turnover given the level of margin. Suppose the ROE for X is 19.87 % The operating returns for X =RNOA / ROE = 14.17/19.87 = 71.3% which is a very healthy figure. By calculating firms RNOA, we can seperate the portion of ROE arising due to operations of the business. ROE= Operating Return + Non operating Return. Investors and the management running the company should focus on the operating portion of return, which is Operating Return (RNOA) = Net Operating Profit After Taxes (NOPAT) / Average NOA Mostly companies break their operating results on their financials because management is judged based on the firms operating results. Also the debt to equity ratio should probably be monitor ed by investors. While analyzing a companys statement of cash flows, you notice that the cash balance decreased over a period. Explain and discuss why this is this is not necessarily bad for the company? (3 Points) Ans: Profit or loss indicates the results for a particular year or period of business. An Increase or Decrease in cash is liquidity during a period. Increase in cash always does not mean profit, it is only indicative of the fact that liquidity in shape of cash increased in comparison to cash balance as on the start of period/year. Therefore Profit/Loss and Increase/Decrease in cash are two different things in respect of a financial statement. Increase in assets decreases cash balance. Decrease in assets increases cash balance. Therefore the decrease in the cash balance may be because the company is acquiring more assets and possibly expanding its business, which is obviously not bad for the company , in fact the company seems to be growing. Ans: a. Why does Williams Sonoma add back depreciation to compute net cash provided by operating activities? Is depreciation a source of cash? The cash flow statement explains that if you made a profit where did the profit go. So depreciation and amortization that are not expenses that are paid in cash have to be added back as adjustments. For example when you sell a fixed asset say a vehicle you might get a check for $600 but have a value of what you paid for it less accumulated depreciation of a different amount. Therefore you have to adjust to represent why you have the money in a different value. Depreciation is added back as a reconciling item to net income when using the indirect method of cash flows. The net income was reduces by the depreciation expense without the effect of reducing your cash. Therefore, in order to reconcile net income to cash flows from operations, depreciation and similar non-cash expenses are added back. These other items to be added back include discount amortization and equity in earnings of an investment. Therefore the positive depreciation amount reported on the statement of cash flows is only one of the adjustments needed to convert the accrual net income to the cash provided from operating activities. So depreciation is not a source of cash. b. Williams Sonoma reports cash flows associated with accounts receivable. In 2007, this item is a cash inflow of $1,070 thousand and in 2006 this item is a cash outflow of $6,829. Explain why this item is on the statement. Why is it a cash inflow one year and a cash outflow the other year? Accounts receivable represent are the sales that have not been collected as cash yet. You sell your merchandise or services in exchange for a customers promise to pay you at a certain time in the future. If your business is credit based, then the payment of accounts receivable is likely to be the single most important source of cash inflows. The accounts receivable incr eases when the company sells merchandise or does a service on credit, and it decreases when the customer pays its bills. Therefore it can be a cash inflow one year and an outflow the other year. Accounts payable are debts that must be paid off within a given period of time in order to avoid default. For example, at the company level, it refers to short-term debt payments to suppliers and  banks. The accounts payable for Williams Sonoma decreased during the year  2006-07 as the value decreased from 14,365(2006) to 11,981 (2007). The cash flow statement (CFS) records the amounts of cash and cash equivalents entering and leaving a firm. The CFS allows investors and management to understand how the firms operations are running, where is the money coming from and on what is it being spent. Determinants of cash flow are core operations, investing and financing. The concept of profit is somewhat narrow, and only looks at income and expenses at a certain point i n time. Cash flow is more dynamic and is concerned with the movement of money in and out of a business. Cash flow is also concerned with the time at which the movement of the money takes place. Concept of cash flow is more realistic. Trade-Off between Margin and Turnover: A companys business model largely affects Operating Profit Margin (PM) and Net operating Asset Turnover (AT). Infinite number of combinations of net operating PM and net operating AT yields a given RNOA For capital intensive industries with relatively low operating AT there is a need for higher PM For food chains and retail businesses there are less assets but large AT and the PM is low and sufficient RNOA. It is important to be careful while comparing the performance of companies par industries. A capital intensive company must earn high PM to offset lower AT and achieve an equivalent RNOA. For an industry it is important to achieve an acceptable ROI to attract investors. Tradeoff between PM and AT is relatively straightforward when comparing companies in same industry ( called pure-form firms) However, Analyzing conglomerates more challenging: Conglomerates PM and AT rates are a weighted average of the PMs and AT rates for the various industries in which they operate. Formulae: ROE = operating RNOA + nonoperating activities RNOA = NOPM X NOAT DuPont Formula: Further breakdown gives: ROE Limitation: The DuPont formula is flawed in its  inability to separate the decisions regarding both operating and financing changes RNOA, successfully separates financing and operating decisions and measures their effectiveness. RNOA = Operating Income (After Tax) / Net Operating Assets (NOA) Therfore by isolating the NOA, correct conclusions can be drawn from the ratio analysis, thus repairing the flaw in the DuPont model. Isolating the components also means that changing debt levels do not change operating assets (OA), the profit before interest expense, and the RNOA. ROE = RNOA + (FLEV X Spread)   Ãƒâ€šÃ‚  Ãƒâ€šÃ‚  Ãƒâ€šÃ‚  Ãƒâ€šÃ‚  Ãƒâ€šÃ‚  Ãƒâ€šÃ‚  Ãƒâ€šÃ‚  Ãƒâ€šÃ‚  Ãƒâ€šÃ‚  Ãƒâ€šÃ‚   OR   Ãƒâ€šÃ‚  Ãƒâ€šÃ‚  Ãƒâ€šÃ‚  Ãƒâ€šÃ‚  Ãƒâ€šÃ‚  Ãƒâ€šÃ‚  Ãƒâ€šÃ‚  Ãƒâ€šÃ‚   = Return From Operating Activities + Return From Non-Operating Activities (Financing) Effect of FLEV on ROE A company can increase its profit with the addition of debt, and thus its ROE. Then the reason for the increased ROE is that the company borrows certain amount and invests those funds in assets. FLEV = Av.NNO/ Av Equity NNO= Non operating (liabilities- assets) Higher FLEV means greater NNO which means higher liabilities than assets which is not good for the financial health of a firm. A restructuring charge is an expense for planned cost cuts..It includes cost of asset write downs, employee layoffs, facility closings etc. Thus it is an accrual made in advance of actual cash outlays. Restructuring charges dissipate shareholder wealth by reducing the shareholders claim on net assets and thus the amount of future potential dividends. Whether restructuring charges provide information or simply allow managers to manipulate future earnings numbers is the concern of SEC The pronouncements of SEC require greater detail about restructuring charges and asset write offs i n the annual report to enhance financial statement transparency. Effects on Financial statements: Income Statement: Adds an operating expense when the charge is taken. No expense when future cash outlays are made. Balance Sheet: Creates a restructuring liability when the charge is taken. The liability is reduced by amount of cash outlays when made. Cash Flow Statement: Non cash portion increases operating activities when charge is taken. Cash outlays when made decrease operating activities. Some firms include in restructuring charges costs more appropriately expensed as part of future operations. This will make future operations appear more profitable. Analysts can undo the timing of a charge either by (1) removing the after-tax effects of the charge from net income or (2) running expenditures through the income statement in the period they flow through the restructuring liability. A company would deliberately report revenues for sales on consignment as gr oss instead of net to boast the sales figures.A company might be having its net income running in negative figures but still it may show the gross revenues as very high which misleads the investors with regards to the financial performance of the company. Example: Priceline.com This is not a fair method of reporting these sales as it does not give a real picture of the companys standing in terms of the actual or net profit earned and may misguide the investors. For example a gas station may be selling a bread made by some other bakery. The gross of the revenues that the gas station will show will be as if the bread is owned by the gas station but it is actually owned by the bakery and majority of the profits must be going to the bakery.The gas station may only be a kind of franchisee. Gross Profit Margin illustrates to us how efficient the management is in using its labor and raw materials in the process of production. Firms with high gross profit margin are more liqu id and have more cash flow to spend on R D expenses, marketing etc. More efficient companies will usually see  higher gross profit margins. For example, suppose that a company earned a revenue of $20 million from production of Shoes and incurred $10 million in COGS-related expense. Its gross profit margin would be 50%. This means that for every dollar that the company earns on shoes, it has only $0.50 at the end of the day. Although higher GPM does not necessarily imply that the company is a better performer because GPM is a measure of gross profit and sales. GPM = Gross Profit / Sales Therefore GPM could be high if Gross profit is high but the sales are not high at all(since it is a ratio) .Poor sales is not a symbol of a good performance of the company. This metric  can be  used to compare a company with its competitors (same industry). The amount of sales generated for every dollars worth of assets. It is calculated by dividing sales in dol lars by assets in dollars. Formula: It measures  a firms efficiency at using its assets in generating sales or revenue the higher the number the better. It also indicates pricing strategy: companies with low profit margins tend to have high asset turnover, while  those with high profit margins have low asset turnover. The change indicates that from year 2007 to 2008 there is slight decrease in IBMs efficiency at using its assets in generating sales. The cost incurred is reported by the company itself so there is a fair chance that the company may manipulate the costs incurred in order to vary the revenue. Also a company might be incurring costs less than the estimated value and would want to cover up some other expenses. An analyst would be interested in researching it further because a company might have manipulated its cost incurred in a view to recognize more revenue.Also the cost estimates do not reflect the actual value of costs incurred and hence there might be a deviation from the actual value. Transitory items are one time occurrences and do not really have significant effect on the future financial performance of the company. These items can only temporarily increase earnings (example asset write offs) or temporarily increase expenses (example restructuring expenses) and do not have long term effects on the financial performance of a company. Transitory items are one time occurrences and do not really have significant effect on the future financial performance of the company. These items can only temporarily increase earnings (example asset write offs) or temporarily increase expenses (example restructuring expenses) and do not have long term effects on the financial performance of a company. When a company is doing really bad and has no chance of meeting earning expectations, unscrupulous management would begin writing-off every expense and asset they could imagine. As a result, future expenses are reduced signific antly and naturally earnings increase. In other words, the company is taking a big bath in the worst year so it can wipe its slate clean. This almost always guarantees record-breaking earnings in subsequent years. Because one-time charges could very well be valid, sniffing out the smell of big bath accounting is not easy. One thing to look out for is the frequency of big baths. If one-time charges begin to show up every other year, this becomes a worrisome pattern. It is, therefore, crucial for an investor to not just look at the current year financial reports. The company may have taken a big bath two years ago and is still basking in the glory attributed to their turnaround of the century. Investors should focus on the management transparency. If earnings seem to meet analyst expectations every quarter, it may just be too good to be true. Many respected money managers recommend investors to pay more attention to cash flow because this number is harder to manipulate. After all, cash flow is the basis for determining the intrinsic value of a business.