Financial Analysis: the determinants of performance

Cross sectional Analysis:

A type of analysis an investor, analyst or portfolio manager may conduct on a company
in relation to that company's industry or industry peers. The analysis compares one
company against the industry it operates within, or directly against certain competitors
within the same industry, in an attempt to discover the best of the breed.

When conducting a cross-sectional analysis, the analyst seeks to identify, by using

comparative metrics, the valuation, debt-load, future outlook and/or operational
efficiency of the target company. This allows the analyst to evaluate the target
company's efficiency in these areas, and to make the best investment choice among a
group of competitors or the industry as a whole.

When comparing the target firm to competitors, the analyst must be careful to consider
the unique operating characteristics of each company and how that will affect any
comparative metrics used.

Financial analysis: Time-series and cross-sectional analysis

In conducting financial analysis, it is important to refer not simply to individual ratios, but
to ratios in relation to comparable ratios. The parameters of comparison are:
• The aggregate economy.
• The industry or the major competitors within the industry called cross
sectional analysis.
• The firm’s past performance known as time-series analysis.
The comparison of the firm to the economy enables analysts to understand the
influence of economic fluctuations on a firm’s performance i.e. how the firm reacts to the
business cycle.

In cross-sectional analysis, analysts compare the firm either to the average industry
value (if the firms in the industry are homogenous in terms of technology, products,
markets) or to a set of firms in the industry comparable in terms of structural
characteristics e.g. size, geographical market, product market, etc.

Note: For multi-industry firms, analysts often refer to a rival that operates in many of
the same industries, or alternatively they construct a composite industry average ratio
based on the proportion of total sales derived from each industry.

Finally, in time-series analysis, analysts examine a firm’s relative performance over time
to determine whether it is improving or deteriorating.

Business profitability: Return on Net Operating Assets (RNOA)

Firms raise cash from capital markets to invest in financing assets that are then turned
into operating assets. They then use the operating assets in operations. This involves
buying inputs from suppliers and applying them with operating assets to produce the
goods and services to be sold to customers. Operating activities thus involve trading
with customers and suppliers in the product/services and input markets. In contrast,
financing activities involve trading in financial markets.

The comparison of the flows from operating activities to the relevant operating stocks
yields a ratio that measures business profitability as a rate of return, the return on net
operating assets (RNOA), which can be measured as follows:
RNOA = OI
NOA (BP)

Where OI = Operating income (after taxes);

NOA = Net operating assets i.e. OA – OL at the beginning period

More commonly, financial analysts define RNOA by looking at the average between
NOA at the beginning of the period (BP) and NOA at the end of the period (EP), or
rather:
RNOA = OI
Av. NOA (BP)
Where Av. NOA (BP) = ½ [NOA (BP) + NOA (EP)]

The operating profitability measure (RNOA) gives the percentage return of the net
operating assets (NOA), and therefore measures how profitably a company is able to
deploy its operating assets to generate operating profits. As such, RNOA expresses the
return to all the claimholders (both shareholders and debt-holders).

Superior aspect of RNOA:

RNOA enables us to analyze business profitability effectively for two reasons.
1. It considers clean surplus i.e. income on a comprehensive basis.
2. It appropriately distinguishes between operating and financing activities.
Interest-bearing financial assets are treated as negative financial obligations, and
thus they do not affect the operating profitability. Instead operating liabilities
reduce the needed investments in operating assets providing for operating
liability leverage (OLL, calculated as operating liabilities divided by net operating
assets), and thus are subtracted from the denominator.

Return on Assets (ROA)

An alternative measure of business profitability is ROA (return on assets), which is
calculated as:
ROA = NI + IE
TA
Where; NI = net income; IE = interest expenses; TA = total assets.

Draw backs of ROA:

It considers net income rather than comprehensive earnings; also it mixes up financing
and operating activities. Some draw backs are as follows:
 1. Interest income, which is part of the financing activities, is included in the
numerator.
2. Total assets, that include both financing and operating assets, constitute the
denominator
3. Operating liabilities instead are excluded from the denominator.

Difference between RNOA and ROA:

It follows clearly that the difference between ROA and RNOA is explained by the
operating liability leverage and the amount of financial assets relative to total assets.

The RNOA measure is closer to what we typically think of as average business

profitability. Conversely, the ROA measure is below what we would expect the cost of
capital for the firm to be, and seems more in line with a debt capital rate.

Q. 1- The following information is from reformulated financial statements (in millions £):
2020 2019
Operating Assets 2,700 2,000
Short-term debt securities 100 400
Operating liabilities (300) (100)
Bonds payable (1,300) (1,400)
Book Value 1,200 900
Sales 2,100
Operating expenses (1,677)
Interest Revenue 27
Interest Expense (137)
Tax Expenses (Tax Rate @ 34%) (106)
Earnings (net) 207

Calculate:
1. The dividends, net of capital contributions for 2020
2. ROCE for 2020; use average book value in the denominator.
3. RNOA for 2020; use the average net operating assets in the denominator.
Q. 2- A firm whose shares traded at three times their book value on December 31,
2020, had the accompanying financial statements. Amounts are in millions of £. The
firm’s marginal tax rate is 33%. There are no dirty-surplus income items in the equity
statement.

(a) The firm paid no dividends and issued no shares during 2020, but it repurchased
some stock. Calculate the amount of stock repurchased.
(b) Calculate the following:
1. ROCE
2. RNOA
3. Free cash flow
(c) Does it make sense that this firm’s shares should trade at three times book
value?
Balance Sheet, December 31, 2012
Assets 2020 2019 Liabilities 2020 2019
Operating cash 50 20 Accounts Payable 215 205
Short-term Investment 150 150 Long-term debt 450 450
Accounts Receivable 300 250 Common Equity 1,095 1,025
Inventories 420 470
Property & Plant (net) 840 790

1,760 1,680 1,760 1,680

Income statement, Year ended December 31, 2020 (fig in £)

Sales 3,295
Interest Income 9
Operating Expenses 3,048
Interest expenses 36
Tax expenses 61 (3,145)
Net Income 159
Operating income
In order to calculate operating income, we need to make a distinction based on the
presence of dirty- or clean-surplus accounting.
In presence of dirty-surplus accounting:
OI = CE + NFE

Where NFE = net financial expense (after taxes)

= [financial expense (FE) on financial obligations – financial revenue (FR)
on financial assets].

In presence of clean-surplus accounting: (when CE = NI)

OI = OR – OE = NI + NFE

Where OR = operating revenue; OE = operating expenses (after taxes).

Operating income is an accounting measure of net value added from operations. If

everything goes well and the firm adds value, operating income is a positive value.

Q. Why does OI represent a measure of operating value added?

A. Let us refer to the business process of the firm. Trading with suppliers involves giving
up resources and this loss of value is named operating expenses. The inputs purchased
have value because they can be combined with the operating assets to yield products
and services to be sold to customers. The sale of these products and services
generates operating revenues. The difference between operating revenues and
operating expenses represents operating income and is a measure of value added by
operating activities.

The benchmark to evaluate RNOA: the cost of capital for the firm
Payoffs must be discounted at a rate that reflects their risk, and the risk for operations
may be different from the risk for equity (measured by the cost of equity). The risk in
operations is referred to as firm risk (or operational risk) and arises from factors that
may affect business profitability.

For Example: The operational risk is relatively high for airline companies in comparison
with other industries. In fact, people fly less during recessions and fuel costs are subject
to shocks in oil prices. The required return that compensates for this operational risk is
the firm’s cost of capital, which is denoted by (r) (and is also referred to as normal rate
of return or cost of capital for operations). Since this is the required return for operating
activities, it is the benchmark against which to evaluate RNOA.

In the long run, the value of the firm depends on where RNOA stands relative to this
norm (r), as implied in the measure of abnormal operating income. In the long run, and
in the absence of any barriers to competitive forces i.e. the possibility of achieving the
competitive equilibrium status, RNOA will tend to be pushed towards the cost of the
firm’s capital (r). Therefore the cost of capital for operations represents the benchmark
against which to evaluate the RNOA of a given company. Note that the implication is
that since rE is lower than r, then RNOA tends to be pushed to a lower level than ROCE.

Computing the cost of capital for the firm

The cost of capital for operations (r) is sometimes referred to as the weighted average
cost of capital (WACC), where capital consists of all financial claims. If the capital
structure consists solely of debt and equity capital, the required return to invest in
operations is calculated as the weighted average of the required return of the
shareholders and the cost of net financial debt, and the weights are given by the relative
values of equity and debt in the value of the firm. As interest payments can be used to
reduce corporate taxes, the WACC can be derived as:

WACC = r = VE X rE + VD X rD X (1-t)
VE + VD VE + VD

Where VE = market value of equity

VD = market value of debt
rD = cost of debt capital
t = tax rate

Points to be consider while calculating WACC:

• Weights assigned to the cost of debt and equity represents their respective
fractions of total capital, measured at market values.
• The market value of debt can be reasonably approximated by the book value
of debt, if interest rates have not changed significantly since the time the debt
was issued.
• Otherwise, the market value of debt can be estimated by discounting the future
payouts at the current market interest rates appropriate for the specific firm.

Note: Both short-term and long-term financing debt should be considered as part
of capital when computing WACC, whereas for internal consistency operating
liabilities such as accounts payable and accruals should not be included.

Market value of equity: It is very complicated to calculate in a forward-looking

perspective. It represents the very amount that analysts try to estimate through all the
valuation process, but it is required to get the valuation itself. To solve this problem,
1. A common approach used by analysts is to insert the target ratio of debt to capital
[VD/(VD + VE)) and equity to capital (VE/(VD+VE)] in the WACC calculation.
2. An alternative approach to solve the problem is to use a reasonable approximation
of the value of equity (based for example on multiples of next year’s earnings
forecasts). In a valuation process, this approximation can be used as a weight in
an initial calculation of WACC, which in turn can be used in the discounting
process to generate an initial estimate of the value of the firm. This initial estimate
of the value of equity can then be used in place of the guess to arrive at a new
measure of WACC, on the basis of which a new value can be estimated. The
 process can be repeated until the value used in the WACC calculation and the
estimated values of the firm converge.

Cost of Debt Capital: The cost of debt (rD) should be based on current market interest
rates.
rD = Interest (1-t)
Value of Debt
Note: The cost of debt should be expressed on a net-tax basis, because we use this
cost of capital as a benchmark for RNOA, which is calculated on the basis of operating
income after taxes.

In a forward-looking perspective the current interest rate on debt will be an appropriate

proxy for the future expected cost of debt, if the assumed capital structure in future
periods is the same as the historical structure. However, when the analyst projects a
change in the capital structure, it is essential to estimate the expected cost of debt given
the new level of the debt-to-capital ratio.

One method of estimation could be based on the estimation of the expected credit
rating for the firm at the new level of debt, and consequently on the use of the
appropriate debt interest rate for that category.

Q. 3- From the following data calculate the cost of capital for operations (WACC). Use
the capital asset pricing model to estimate the cost of equity capital.
Government bonds (long term) 4.3%
Market risk premium 5.0%
Equity beta 1.3
Per-share market price £40.70
Shares outstanding 58 million
Net financial obligations on balance sheet £1,750 million
Weighted-average borrowing cost 7.5%
Statutory tax rate 36.0%
Explain why the cost of capital for operations is different from that for equity.
Q. 4- A firm with a required return of 10% for operations has a book value of net debt of
£2,450 million with a borrowing cost of 8% and tax rate of 37%. The firm’s equity is
worth £8,280 million. What is the required return for its equity?

Abnormal (residual) operating income (AOI)

Abnormal operating income (AOI), also referred to as residual operating income (ReOI),
can be defined as the operating income in excess of the operating income required for
the net operating assets in the balance sheet to be earning at the relevant cost of
capital. It can thus be viewed as the ‘actual’ operating income minus the normal
operating income, which can be thought of as the charge for using net operating assets.

AOI = OI – r X NOA(BP)
Where; OI = After-tax operating income.
r = Required Rate of return
NOA(BP) = Net Operating Assets Beginning period

Abnormal operating income is also referred to as economic profit or economic

value added.

Drivers of abnormal (residual) earnings:

We know that
RNOA = OI
NOA (BP)
And; OI = RNOA X NOA(BP)

Substituting this in AOI equation :

AOI = RNOA X NOA(BP) – r X NOA(BP)
= (RNOA–r)NOA(BP)
= (ARNOA) NOA(BP)
From this equation, it is clear that the drivers of residual operating income
are: ARNOA and NOA.
ARNOA: 3 different situations can occur:
1. AOI = 0 Where RNOA = r
2. AOI > 0 Where RNOA > r (The firm is creating economic value)
3. AOI < 0 Where RNOA < r (The firm is destroying economic value)

Link between business and bottom-line profitability

The bottom-line profitability is known as ROCE is affected both by operating activities
and financing activities. The first level of breakdown of ROCE allows us to distinguish
the profitability of operating and financing activities, and also to distinguish the effect of
financial leverage.
Formally, this decomposition of ROCE can be written as:

ROCE = RNOA + FLEV(RNOA – NBC)

= RNOA + (FLEV*SPREAD)
Drivers:
RNOA = OI
NOA (BP)
FLEV = NFO
CSE
Spread = Operating Spread
= RNOA – NBC

In short, ROCE is determined by operating profitability, financial leverage and the

operating spread.
Financial leverage levers the ROCE up or down through financing liabilities. This means
that the extent to which NOA is financed by CSE or NFO affects ROCE.

✓ ROCE is levered up if there is financial leverage

Means if RNOA > NBC and spread is +ve
✓ If a firm has zero FLEV, then ROCE = RNOA.
✓ If a firm has +ve FLEV, then the difference between ROCE and RNOA is
determined by the very amount of FLEV and the operating spread.
✓ If the spread is positive i.e. RNOA > NBC, it is commonly said to have favourable
leverage (or favourable gearing). This implies that the RNOA is levered up to
generate a higher ROCE.
✓ If the spread is negative i.e. RNOA < NBC, the FLEV effect is negative.

To the presence of financial leverage can be attached alternatively good or bad news.
There is good news (financial leverage generates greater return to shareholders) if the
firm earns more on its operating assets than its borrowing costs. Conversely, financial
leverage hurts shareholders’ return, if it doesn’t.
Q. 5- The following financial statements were reported for a firm for fiscal year 2020 (in
million £):
Balance Sheet
2020 2019 2020 2019
Operating Cash 60 50 Accounts Payable 1,200 1,040
Short-term Investment 550 500 Accrued Liabilities 390 450
Accounts Receivable 940 790 Long-term debt 1,840 1,970
Inventory 910 840
Property and Plant 2,840 2,710 Common Equity 1,870 1,430
5,300 4,890 5,300 4,890

Statement of shareholder’s Equity

Balance, end of fiscal year 2019 1,430
Share issues 822
Repurchase of 24 million shares (720)
Cash Dividend (180)
Unrealized gain on debt investments 50
Net income 468
Balance, end of fiscal year 2020 1,870

The firm’s income tax rate is 35%. The firm reported £15 million in interest income and
£98 million in interest expenses for 2020. Sales revenue was £3,726 million.
a. Prepare a reformulated balance sheet and comprehensive income statement
b. Calculate free cash flow for 2020.
c. Calculate the operating profit margin, asset turn over, and return on net operating
asset for 2020 (take beginning period balance in denominator).
d. Show the financing leverage holds for the firm.
e. Calculate after tax borrowing cost. If this borrowing cost were to be sustained in
the future, what would the rate of return f common equity (ROCE) be if operating
profitability (RNOA) fell to 6% and financial leverage to 0.8?
Determinants of business profitability
In the second level of breakdown, the focus is specifically on the drivers of operating
profitability. The decomposition of business profitability (called also the Du Pont model)
leads to:
RNOA = OI = OI x Sales = PM X ATO
NOA Sales NOA
Where; PM = Profit Margin
ATO = Net Operating Asset turnover

The profitability of operations comes from two sources:

• Profit margin or Profitability measure: RNOA is higher the more of each pound of
sales ends up in operating income.
• Net operating asset turnover or an efficiency measure: RNOA is higher the more
sales are generated from net operating assets.
Note that an analogous decomposition is possible for ROA, which can be thought as the
product of two factors:

ROA = NI x Sales = ROS x AT

Sales Assets
Where; ROS = Return on sales (also known as net profit margin),
AT = Asset turnover.
The return on sales indicates how much the firm is able to keep as net income for each
pound of sales. Asset turnover indicates how many pounds of sales the firm is able to
generate from each pound of its assets.

Profit margin
Profit margin measures how much the firm is able to keep as operating profits (after
taxes) for each pound of sales it makes. In short, it reveals the profitability of each
pound of sales. Formally, it is calculated as:

PM = OI (after Tax)
Sales
Over time, profit margin is a more variable measure than operating asset turnover. This
happens because profit margin, like ROCE, tends to be driven by competition to
‘normal’ levels over time.

Q. 6- A firm earns a profit margin 3.8% on sales of £435 million and employs net
operating assets of £150 million to do so. It considers adding another product line that
will earn a 4.8% profit margin with an asset turnover of 2.3.
What would be the effect on the firm’s return on net operating assets of adding the new
product line?
Q. 7- Below are summary from reformulated balance sheet for 2020 and 2019 for
Kimberly-Clark Corporation, The paper products company, along with numbers from the
reformulated income statement for 2020 (in millions):
2020 (£) 2019 (£)
Operating Assets 18,057.0 16,796.2
Operating Liabilities 6,011.8 5,927.2
Financial Assets 382.7 270.8
Financial Obligations 6,496.4 4,395.4
Operating Income (After Tax) 2,740.1
Net Financial Expenses (After Tax) 147.1
a) Calculated the following for 2020 and 2019:
1) Net operating assets
2) Net Financial obligations
3) Shareholders’ equity
b) Calculate return on common equity (ROCE), return on net operating assets
(RNOA), financial leverage (FLEV), and net borrowing cost (NBC) for 2020. Use
beginning –of-period balance sheet numbers in denominators.
c) Show that the financing leverage equation works with your calculations.
d) Calculate the operating profit margin (PM) and asset turnover (ATO) for 2020
and show RNOA = PM X ATO. Sales for 2020 were £18,266 million.

Net operating asset turnover

Net operating asset turnover indicates the ability of NOA to generate sales, or rather
how many pounds of sales the firm is able to generate for each pound of its NOA. The
formula for the ATO calculation is:
 ATO = Sales
NOA (BP)

Operating asset turnover (ATO) tends to be rather stable over time, in part because it is
so much a function of the technology used in an industry as well as the firm’s strategy,
which tend not to change very frequently.

Business profitability and free cash flows

The reformulated cash flow statement identifies the (operating and financing) flows over
a period. The cash flows associated with operating activities are cash from operations
(C) and cash investments in operations (I). By comparing these operating flows we get
the free cash flow (FCF), which can be calculated as:

FCF = Cash flow from operations – Cash investments in operations

=C–I

FCF represents the net cash generated (or absorbed) by operations, which determines
the ability of the firm to satisfy its debt- and equity holders.

• If FCF is (+) operating activities are generating net cash

• If FCF is (-) operating activities absorb net cash

The calculation of FCF starting from the GAAP statement of cash flow is complex
because it requires a reformulation to correct for the misclassification of some operating
and financing cash flows. However, if the balance sheet and the income statement are
appropriately reformulated (according to what has been explained in Chapter 3), the
calculation of FCF becomes straightforward.

By recalling equation FCF can be expressed as follows:

FCF = Operating income – Change in net operating assets
= OI – ΔNOA

This means that operations generate operating income, and FCF is the part of operating
income remaining after reinvesting some of it in NOA.
• If the investment in NOA > operating income, the FCF is (-ve). This implies that
an infusion of cash is required.
There emerges a clear link between FCF and business profitability. In fact, recalling that
RNOA = OI
NOA(BP)
This can be rearranged as:

FCF = RNOA – ΔNOA

NOA (BP) NOA (BP)
The calculation of FCF is important for preparing pro-forma future cash flow statements
for the discounted cash flow (DCF) analysis, the most common valuation technique,
which will be discussed in Chapter 8.

Q. 8- Here is a reformulated income statement for the C Ltd. for 2020 (in million £)
Sales 28,857
Cost of sales 10,406
Gross margin 18,451
Advertising expenses 2,800
General and administrative expenses 8,145
Other Expenses (net) 81
Operating income from sales (before tax) 7,425
Tax 1,972
Operating income from sales (after tax) 5,453
Equity income from bottling subsidiary (after tax) 668
Operating Income 6,121
Net financial expenses after tax 140
Earnings 5,981

Summary balance sheets for 2020 and 2019 are as follows (in million £)
2020 2019
Net operating assets 26,858 18,952
Net financial obligations 5,114 2,032
Common shareholder’s equity 21,744 16,920
For the following questions, use average balance sheet amounts,
a) Calculate return on net operating (RNOA) and net borrowing cost (NBC) for
2020.
b) Calculate financial leverage (FLEV).
c) Show that the financing leverage equation that explains the returns on common
equity (ROCE) holds for this firm.
d) Calculate the profit margin and asset turnover (ATO) for 2020 and show that
RNOA = PM X ATO.
e) Calculate the gross margin ratio, the operating margin ratio from sales, and the
operating profit margin ratio.
Q. 9-
a) a firm has a return on common equity of 13.4%, a net after-tax borrowing cost of
4.5% and a return of 11.2% on net operating assets of £405 million. What is the
firm’s financial leverage?
b) The same firm has a short-term borrowing rate of 4.0% after tax and return on
operating assets of 8.5%. What is the firm’s operating liability leverage?
c) The firm reported total assets of £715 million. Construct a balance sheet for this
firm that distinguishes operating and financial assets and liabilities.

Q. 10- In late 1990’s many grocery supermarkets shifted from regular storewide sales to
issuing membership discount and points programs, much like frequent flyer programs
run by the airlines.
A supermarket chain with £120 million in annual sales and an asset turnover of 6.0
ponders whether to institute a customer membership program. It currently earns a profit
margin of 1.6% on sales. Its marketing research indicated that a customer membership
program would increase sales by £25 million and would require an additional investment
in inventories of £2 million but no additional retail floor space. Costs to run the
membership program, including the discounts offered to members, would reduce profit
margin to 1.5%.
What would be the effect on the firm’s return on net operating assets of adopting the
customer membership program?