Wealthy Education

DISCLAIMER
LEGALLY REQUIRED DISCLAIMER – THIS COURSE CONTAINS THE PERSONAL IDEAS AND OPINIONS OF THE COURSE
PROVIDERS. THE INFORMATION CONTAINED IN THIS COURSE IS FOR EDUCATIONAL PURPOSES ONLY. THERE IS NO
RECOMMENDATION OR ADVICE ON MAKING ANY INVESTMENT DECISIONS, BUYING OR SELLING ANY TYPES OF STOCKS,
SECURITIES OR INVESTMENTS DISCUSSED IN THIS COURSE. THE COURSE PROVIDERS ARE NEITHER STOCK BROKERS NOR
REGISTERED INVESTMENT ADVISORS. WE DO NOT RECOMMEND MAKING ANY INVESTMENT DECISIONS PROPOSED IN
THIS COURSE. INDIVIDUALS SHOULD FIND REGISTERED INVESTMENT ADVISORS TO HELP THEM MAKE INVESTMENT
DECISIONS. ALTHOUGH THE COURSE PROVIDERS HAVE STRIVED FOR PROVIDING THE MOST ACCURATE INFORMATION,
THERE IS NO GUARANTEE OR WARRANTY CONCERNING THE RELIABILITY, ACCURACY AND COMPLETENESS OF THE
PROVIDED INFORMATION. INDIVIDUALS SHOULD BE CAUTIOUS ABOUT MAKING THEIR OWN INVESTMENT DECISIONS.
INDIVIDUALS ARE SOLELY RESPONSIBLE FOR THEIR INVESTMENT DECISIONS. THE COURSE PROVIDERS ARE NOT
RESPONSIBLE FOR ANY LIABILITIES AND LOSSES, WHICH MAY ARISE FROM THE USE AND APPLICATION OF THE
INFORMATION AND STRATEGIES PROPOSED IN THIS COURSE.

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FINANCIAL STATEMENT ANALYSIS

THE ADVANCED FINANCIAL STATEMENT ANALYSIS
MODULE 1: OPERATING PROFITABILITY ASSESSMENT
LEARNING MATERIAL – TAKEAWAY NOTE

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What is Operating Profitability?

 Operating profitability is the cash that a company generates from
its normal business activities.
 It excludes unusual and one-time income and expenses, such as
the cost of settling a lawsuit or the proceeds from selling assets.
 It also speaks fundamentally to how well a company “does what it
does” and how well it executes its core business model.

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Operating Profitability Ratios

 We will use eight ratios to measure operating profitability:

 Gross Profit Margin  Return on Common Equity

 Operating Profit Margin  Return on Debt
 Net Profit Margin  Return on Capital Employed
 Cash Return on Assets  Return on Retained Earnings

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Operating Profit Margin Ratio - In a Nutshell

 The operating profit margin (OPM) is an indicator of how

efficiently a company controls the costs associated with its
routine operations.
 It considers only ordinary (sometimes referred to as operating)
income, which excludes income or expenses that are not related
to the company’s core business.

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Formula & Calculation

Operating Income
Operating Profit Margin =
Net Sales

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Real-world Examples

Halliburton (HAL) Schlumberger (SLB) Microsoft (MSFT)

Operating Income $630.81 million $2.08 billion $21.18 billion

Total Revenue $15.97 billion $28.18 billion $87.25 billion

OPM 3.95% 7.39% 24.28%

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Real-world Examples

Revenue OPM

Schlumberger $28.18B 7.39%

Halliburton $15.97B 3.95%

Baker Hughes $9.43B -9.53%

Weatherford $5.55B -21.37%

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Things to Take Away!

 Key points for this ratio:
 All data points are found on the income statement
 Operating income includes depreciation and amortization but
not interest or taxes
 Net sales removes discounts and allowances for returned
goods

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Things to Take Away!

 Key points for this ratio:
 OPM looks at a company’s performance in its core business
but can differ significantly from net income
 Significant differences in revenue will skew OPM comparison
even within the same industry

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Net Profit Margin Ratio (NPM) - In a Nutshell

 Net profit margin (NPM) is what the average person has in mind
when they think of the “profitability” of a company.
 While the NPM can be significantly affected by income or
expenses, the money it represents is however what profits the
company produced in a given period even taking into account
extraordinary items.

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Formula & Calculation

Net Profit
Net Profit Margin =
Revenue

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Real-world Examples

Wal-Mart Stores Amazon.com

Target Corp. (TGT)
(WMT) (AMZN)

Revenue $487.51 billion $69.32 billion $142.57 billion

Net Profit $13.60 billion $2.79 billion $2.58 billion

NPM 2.79% 4.02% 1.81%

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Further Explanation
 NPM is a key indicator for many reasons, foremost of which is
the fact that it represents how much money the company made
or lost for a given period.
 NPM is subject to distortion in the short term by non-recurring
events, so it is more revealing to look at NPM trends over time.

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Further Explanation
 If NPM is stable or improving, that is a positive sign.
 If NPM is declining, that is obviously negative.
 If NPM swings wildly from period to period, look closely at the
notes to the financial statements to what unusual events or
items are causing the variations.

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Further Explanation
 NPM is an important ratio for a company’s management as well as
for investors, because it is an easy way to forecast profits based
on projected revenues.
 While NPM comparisons should only be made within the same
industry, significant differences in revenue are not an issue as they
can be with Operating Profit Margin.

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Things to Take Away!

 Key points for this ratio:
 All data points are found on the income statement
 Unlike OPM, the NPM calculation includes interest and taxes
but excludes depreciation and amortization
 NPM comparisons should be made only within the same
industry, but significant differences in revenue are not an issue

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Things to Take Away!

 Key points for this ratio:
 NPM can be distorted in the short term by non-recurring
events
 A company’s NPM trend over time is a better indicator than
NPM for a single fiscal period

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Cash Return on Assets Ratio - In a Nutshell

 The cash return on assets ratio (cash ROA) is a measure of
performance efficiency.
 Because it compares actual cash flows rather than any measure
of income, it is much less subject to distortion by accounting
methods such as revenue recognition.

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Formula & Calculation

Cash Flows from Operations

Cash Return on Assets =
Total Assets

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Real-world Examples

Lockheed Martin General Dynamics Raytheon Company

Corp. (LMT) (GD) (RTN)

CFO $5.19 billion $2.14 billion $2.85 billion

Total Assets $47.81 billion $33.17 billion $30.05 billion

Cash ROA 10.90% 6.40% 9.50%

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Further Explanation
 ROA could appear more favorable than cash ROA
 The only significant way to manipulate operation cash flows is to
wait longer to pay accounts payable.
 Borrowing money does not affect cash ROA, as loan proceeds
will hit the cash flow statement in the Cash Flows from Financing
section, not in Cash Flows from Operations.

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Things to Take Away!

 Key points for this ratio:
 While net income can be manipulated through accounting
methods, a company’s cash flows are what they are
 Cash ROA eliminates potential distortion by using cash flow
from operations rather than net income

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Things to Take Away!

 Key points for this ratio:
 Cash ROA is a measure of cash generated per dollar of assets
and is thus an assessment of performance efficiency
 ROA that is somewhat higher than cash ROA is normal, as
many companies have accounts receivable

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Things to Take Away!

 Key points for this ratio:
 A significant divergence between ROA and cash ROA be a
warning that the company is manipulating its net income
 The main way to manipulate cash flow is to wait longer to pay
A/P, so the trend in A/P balances should be compared to the
trend in cash ROA

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Return on Common Equity Ratio - In a Nutshell

 Return on common equity (ROE) is a profitability measurement
that calculates the amount of profit generated by each dollar
that shareholders have invested in the company.
 This version allows you to make equivalent comparisons of
companies even when one has preferred stock and one does not.

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Formula & Calculation

(Net Income – Preferred Dividends)

Return on Common Equity =
Common Equity

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Real-world Examples

Hovnanian Meritage Homes

Lennar Corp. (LEN)
Enterprises (HOV) (MTH)

Net Income ($2.82 million) $912 million $150 million

Preferred Dividends 0 0 0

Common Equity ($129 million) $7.03 billion $1.42 billion

ROE −2.20% 13.00% 10.60%

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Further Explanation
 The ROE trend over time is generally more informative than a single
snapshot of ROE at any given time.
 It is also helpful to see how the industry and segment averages
change during the same time period in order to account for
macroeconomic conditions that affect all companies.
 High-growth companies (and industries) typically show a higher ROE.

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Things to Take Away!

 Key points for this ratio:
 ROE is a profitability measure that shows dollars of profit
earned per dollar of equity
 Using common equity allows you to compare companies that
have issued preferred stock to those that have not

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Things to Take Away!

 Key points for this ratio:
 Because ROE measures dollars of profit produced, a
company that has a net loss will have a negative ROE even if
equity is also negative
 High-growth companies and industries tend to have higher
ROE than mature companies and industries

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Return on Debt Ratio (ROD) - In a Nutshell

 The return on debt ratio (ROD) is a performance measurement
showing dollars of profit generated by each dollar of debt that a
company has.
 The use of ROD is in an adjusted present value of cash flows
calculation to value levered assets, usually for the valuation of a
company that is the target of a leveraged buyout.

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Formula & Calculation

Net Income
Return on Debt =
Long term Debt

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Real-world Examples

American Electric
Duke Energy (DUK) Oracle (ORCL)
Power (AEP)

Net Income $549 million $2.58 billion $8.90 billion

Long-Term Debt $17.38 billion $45.58 billion $39.11 billion

ROD 3.16% 5.66% 22.76%

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Real-world Examples

American Electric
Duke Energy (DUK) Oracle (ORCL)
Power (AEP)

Revenue $16.199 billion $22.743 billion $37.047 billion

Taxes ($74 million) $1.156 billion $2.541 billion

Effective Tax Rate −0.46% 5.08% 6.86%

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Things to Take Away!

 Key points for this ratio:
 ROD measures how much profit a company generated with its
debt
 ROD is a relatively complex measurement in some cases and
so is less commonly used

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Things to Take Away!

 Key points for this ratio:
 ROD is calculated using after-tax income because of the tax
impacts of debt
 Capital-intensive industries that tend to carry large amounts
of debt have lower average ROD ratios

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Return on Capital Employed Ratio - In a Nutshell

 The return on capital employed ratio (ROCE) measures how
profitable a company is and how efficiently it uses its capital.
 ROCE is a better measure than ROE
 If ROCE is lower than a company’s cost of capital, this means the
company is failing to effectively use its capital and is reducing,
not creating, shareholder value with it.

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Formula & Calculation

Earnings Before Interest & Taxes

Return on Capital Employed =
(Total Assets – Current Liabilities)

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Real-world Examples

AT&T (T) Verizon (VZ) Allstate Corp. (ALL)

EBIT $24.722 billion $25.362 billion $2.459 billion

Total Assets $403.821 billion $244.180 billion $108.61 billion

Current Liabilities $50.576 billion $30.340 billion $81.69 billion

ROCE 7.00% 11.86% 9.13%

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Things to Take Away!

 Key points for this ratio:
 ROCE is a measure of profitability and efficient use of capital
 ROCE is a better measure than ROE for companies in capital-
intensive industries with heavy debt loads
 ROCE is EBIT divided by capital employed, which is calculated
as total assets minus current liabilities

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Things to Take Away!

 Key points for this ratio:
 If ROCE is lower than the company’s cost of capital, this is a
significant negative sign
 Cost of capital should be discounted by the company’s
effective income tax rate since interest expense represents a
reduction in taxable income

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Return on Retained Earnings Ratio - In a Nutshell

 The return on retained earnings ratio (RORE) shows how
effectively the previous year’s profits less dividends (retained
earnings) produced profits in the current year.
 A company’s income can be used either to pay dividends or to
fuel future growth through reinvestment in operations. RORE
assesses how well that money was used.

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Formula & Calculation

∆ Profit
RORE = × 100%
(Total EPS – Total Dividends Paid per Share)

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Anthem Inc. HealthSouth Corp. Albemarle Corp.
(ANTM) (HLS) (ALB)
Real-world
EPS (2016) Examples
$9.45 $2.54 $3.43
EPS (2015) $9.53 $2.12 $3.80
EPS (2014) $9.22 $2.32 $3.21
Total EPS $28.20 $6.98 $10.44
Dividends (2016) $2.60 $0.94 $1.21
Dividends (2015) $2.50 $0.88 $1.15
Dividends (2014) $1.75 $0.78 $1.10
Total Dividends $6.85 $2.60 $3.46
Total Retained Earnings $21.35 $4.38 $6.98
∆ Profit $0.23 $0.22 $0.22
RORE 1.08% 5.02% 3.15%
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Things to Take Away!

 Key points for this ratio:
 RORE is used primarily by investors to evaluate the relative
merits of companies for investing purposes
 RORE must be calculated using earnings (and dividends) per
share, not the dollar value of total earnings

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Things to Take Away!

 Key points for this ratio:
 A longer time horizon, typically of five to ten years, is most
appropriate for calculating RORE
 The higher the RORE, the more effectively management is
utilizing retained earnings and the more likely the company’s
share price will appreciate

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WHAT YOU WILL LEARN?
• Fully Develop a Successful Entrepreneurial Mindset (Most Important)
• What does really mean ‘doing business’?
THANK YOU FOR READING!
• Create Multiple Streams of Income
• How to Start a Business Effectively
• Master in Using the Power of Leverage
• How to Build a Successful Business Plan