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Profitability
Trimester II
Financial Analysis
Lecture XI
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Financial Analysis: Group-work II
Report on The Home Depot Inc.
Part I of Report (Case Study)Already circulated in a case on The Home Depot. The case wasprepared in the 80s, less than a decade after the company was setup in 1978. There are 4 questions at the end of the case. Theanswers should be submitted in hard copy to me by 5.30 pm on30th November 2012
Part II of ReportUsing information available on the internet including the companywebsite, please submit a report in hard copy to cover the aspectsmentioned in the next slide to me also by 5.30 pm on 30thNovember 2012
Main Reference
https://corporate.homedepot.com
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Part II of Report
The Home Depot Inc. today
Home Improvement Industry in the US
Major players in the industry and their marketpositioning/share
Financial Position of The Home Depot
Financial and Operating Performance of the companyduring the last fiscal
SWOT analysis of the company
Strategy of the company
Main Reference
https://corporate.homedepot.com/wps/portal
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Profitability Measures
Exclude items of income notarising from
normal operations
Discontinued operations
Extraordinary items
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Net Profit MarginNet Income after excluding non-recurring items
= --------------------------------------------------------------
Net Sales
Also referred to as return on sales
Reflects net income generated by each dollar ofsales
Potential distortion can be caused by other incomeor loss, as these do not relate to net sales i.e. thedenominator
Other income or loss can times be significant
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Total Asset Turnover
Measures the activity of the assets and the
ability of the firm to generate sales through
the use of the assets
Potential distortion
Investments
Construction in progress
Other assets that do not relate to net sales
Net SalesAverage Total Assets
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Return on Assets
Net Income after excluding non-recurring items= --------------------------------------------------------------
Average Total Assets
Measures the ability to utilize assets to create
profits
Average total assets Internal analysis: month-end amounts
External analysis: beginning and ending amounts
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Concept of Dupont Return on Assets
The Net Profit Margin, the Total Assets
Turnover and the Return on Assets are
usually reviewed together because of the
direct influence that the first two ratios
have on Return on Assets
Please see the next slide
When these ratios are reviewed together, it
is called the Dupont Return on Assets
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DuPont Return on Assets(Concept of Minority Interest explained in next slide)
Return on Assets = Net Profit Margin Total Asset Turnover
Net Income Before Net Income BeforeMinority Share of Minority Share of Earnings and Earnings and
Nonrecurring Items Nonrecur=
Average Total Assets
ring Items Net Sales
Net Sales Average Total Assets
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Minority interest Minority interest represents shares owned by third parties when Company A
acquires Company B. In other words, minority interest represents the equity
interest of outside shareholders in consolidated subsidiaries. Under US GAAP, if Company A owns 50% or more of Company B, the two
companies are treated as if they were one for financial statement purposes.
Thus an account- namely, minority interest - must be presented to indicate
that not all the assets and liabilities are related to Company A, the parent
company. Minority interest ordinarily appears on the balance sheet between liabilities
and shareholders equity. On the income statement, minority interest in the
income of a consolidated subsidiary is shown as a deduction of
consolidated net income.
If Company A has a minority interest of less than 50% in Company B, thenminority interest does not appear on the balance sheet or income statement
of Company A, and other methods are used to account for its minority
interest
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DuPont Return on Assets (contd) DuPont analysis separates return on assets into net profit margin and total
asset turnover
Separating the ratio into the two elements allows evaluation of the causesfor the change in return on assets
Return on Net Profit Total AssetAssets = Margin Turnover
Firm AYear 1 10% = 4.0% 2.5Year 2 8% = 4.0% 2.0
FIRM BYear 1 10% = 4.0% 2.5Year 2 8% = 3.2% 2.5
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DuPont Analysis Variation
Consider only operating assets and income Operating assets exclude
Construction in progress Long-term investments
Intangibles Operating income includes only
Net sales Operating expenses
Operating ratios may give significantlydifferent results from Net earnings ratios insome cases
Reflective of ROA from primary business
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Operating Income Margin
Use operating income in the numerator
Operating IncomeNet Sales
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Operating Asset Turnover
Measures the ability of operating assets to
generate sales revenue
Net SalesAverage Operating Assets
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Return on Operating Assets
Measures the ability of operating assets to
generate operating income DuPont analysis of the return on operatingassets:
Operating IncomeAverage Operating Assets
DuPont Return Operating Operatingon = Income Asset
Operating Assets Margin Turnover
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Sales to Fixed Assets
Measures the ability to make productive use
of property, plant, and equipment bygenerating sales
Exclude construction in progress
Some possible distortions/differences
Old fixed assets
Labor-intensive vs. Capital-Intensive industry
Net SalesAverage Net Fixed Assets
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Return on Investment (ROI)
Measures the earnings on investment (Long-
term liabilities + Equity) and indicates how
well the firm utilizes its asset base Evaluates earnings performance of the firm
without regard to the way the investment is
financed
Net Income Before Minority Share ofEarnings and Nonrecurring Items+ Interest Expense 1-Tax Rate
Average Long-Term Liabilities + Equity
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Return on Common Equity
Measures the return to the common stockholder Common equity:
Total stockholders equity less preferred
capital
Net Income Before Nonrecurring Items- Preferred Dividends
Average Common Equity
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Gross Profit Margin
Sales Cost of Goods Sold
= Gross Profit
Beginning Inventory+ Purchases of Inventory
Ending Inventory
Gross ProfitNet Sales
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Gains and Losses from Prior Period
Adjustments as per US GAAP
Charged directly to retained earnings
Changes in accounting principles
Correction of errors originating in prior periods
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Comprehensive Income as per US GAAP
Following items are not included in net income but reported as a
separate component of stockholders equity
Foreign currency translation adjustments
Unrealized holding gains and losses from available-for-
sale marketable securities Changes to stockholders equity resulting from
additional minimum pension liability adjustments
Unrealized gains and losses from derivative
instruments
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Ratios for the Investor
Financial Analysis
Lecture XII Part I
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Financial Leverage
The use of debt (financing with a fixed charge
such as interest) is referred to as financial
leverage
Interest as related to debt financing A contractual obligation
Must be paid regardless of entitys current profits
Contrast with dividends which are discretionary Interest is tax deductible
Reduces taxable income, and therefore
Reduces income tax
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Operating Leverage The existence of fixed operating costs is referred to as
Operating Leverage which also affects earnings
The higher the percentage of fixed operating costs,the greater the variation in net income as a result of
variation in sales (revenue) Interest (on most debt) is a fixed charge, which is
dependent on the amount of financial principal andrate of interest; as such, financial leverage can be
easily computed from published financial statements On the other hand, operating leverage cannot be
readily computed from published financialstatements
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DOWELL COMPANY (Exhibit 9-1)Financial Leverage
Partial Income Statement to Illustrate Magnification Effects
20% Decrease 10% Increasein Earnings in Earnings
Base Year Before Interest Before InterestFigures and Tax and Tax
Earnings before interest and tax $1,000,000 $ 800,000 $1,100,000Interest (200,000) (200,000) (200,000)Earnings before tax 800,000 600,000 900,000Income tax (40%) (320,000) (240,000) (360,000)Net income $ 480,000 $ 360,000 $ 540,000
Percentage change in net income [A] 25.0% 12.5%Percentage change in earnings before
Interest and tax [B] 20.0% 10.0%Degree of financial leverage [A B] 1.25 1.25
Net income increase [A] is greater than change in EBIT [B] due to
the fixed nature of interest expense
The concept of Degree of Financial Leverage is clarified further
in the next slide
Financial Leverage and Magnification Effects
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Computation of the Degree of
Financial Leverage% Change Net Income
% Change EBITThe degree of financial leverage is themultiplication factor by which the net
income changes in respect to changes
in EBIT
Degree of financial leverage
calculations should exclude
Nonrecurring items
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Earnings per Share
Required disclosure for corporate incomestatements
Pertains only to common stock
Per-share amounts are disclosed (as per USGAAP) for
Income from recurring items
Discontinued operations
Extraordinary items
Net income
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Basic Earnings per Share
Net Income - Preferred DividendsWeighted Average Number ofCommon Shares Outstanding
Earnings pertain to an entire fiscal period
Average of common shares outstanding is used forcomputation of the EPS
What is computed is a weighted average, as shown in
the next slide
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Weighted Average Common Outstanding
Months Shares Shares Fraction of Year WeightedAre Outstanding Outstanding Outstanding = Average
JanuaryJune 10,000 6/12 = 5,000JulySeptember 12,000 3/12 = 3,000OctoberDecember 15,000 3/12 = 3,750
11,750
Think as to why we compute such a
weighted average!
What do we do in case of stockdividends and stock splits? This is
explained in the next slide.
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Stock dividends and Stock splits
In the event of Stock dividends and stock
splits
Retroactive recognition must be given to these
events for all comparative earnings per sharepresentations
Stock dividends and stock splits only change the
number of outstanding shares EPS should be related to the outstanding
common stock after these events
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EPS: Examples of Potentially dilutive securities:
ESOPS
Other Options on stocks
RightsWarrants
Convertible debentures
Convertible debt
Convertible preferred equity
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Price/Earnings Ratio
Measures the relationship between the market
price of a share of common stock and that stockscurrent earnings per share
Use of diluted earnings per share gives a higher PE Ratioi.e. a more conservative price/earnings ratio
Investors view the PE ratio as a gauge of future earningpower of the firm
It therefore stands to reason that the PE ratio should becomputed using diluted EPS for continuing/recurring
earnings per share
Market Price per Share
Diluted Earnings per ShareBefore Nonrecurring Items
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Price/Earnings Ratio (contd)
Compare with
Industry competitors
Industry average
Exchange (e.g., NSE) average
Interpretation
High-growth-potential firms have higher P/E
ratios
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Percentage of Earnings Retained
Reflects the proportion of current earnings
retained for internal growth Trend analysis is improved by exclusion of
nonrecurring items
Higher percentage typically found in
New firms Growing firms and firms perceived as growth firms
Net Income Before Nonrecurring
Items - All DividendsNet Income BeforeNonrecurring Items
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Dividend Payout
Measures the portion of current earnings percommon share being paid out in dividends
A stable dividend policy is developed byconsideration of recurring earnings
The term Diluted EPS is explained in the next slide
Lower payout typically found in New firms
Growing firms and firms perceived as growth firms
Dividends per Common ShareDiluted EPS Before Nonrecurring Items
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Dividend Yield
Indicates the relationship between the
dividends per common share and the marketprice per common share
The yield is a function of
The firms dividend policy Market price
Often around 1-2%
Dividends per Common ShareMarket Price per Common Share
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Book Value per Share
Market value vis--vis book value
Book value reflects past unrecovered asset costs
Market value reflects the potential of the firm
MV of securities does not approximate the BV
MV of some stocks may be below BV when investorsview it as lacking potential or when investors aregenerally pessimistic
There are times when many stocks are selling at morethan 5 to 6 times BV
Total Stockholders' Equity- Preferred Stock Equity
Number of Common Shares Outstanding
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Stock-Based Compensation
May be awarded through the use of
Stock options
Restricted stock
Stock appreciation rights(Explained in the next few slides)
Firms vary in their use of these methods ofgranting stock-based compensation
Select a single method Use two of the three methods
Use all three in combination
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Non-compensatory plans
A Non-compensatory plan attempts toraise capital or encourage widespreadownership by officers & employees
Officers and employees purchase thestock at a slight discount from fair valuesay up to 5%
These have issues relating neither tosubstantial dilution of existing stocks norto substantial compensation
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Valuation of Stock Options
Stock option is an option to buy the stock at a
predetermined price in accordance with the
vesting period
Stock option at fair value
Expensing is required at time of grant
Allocate option fair value to the service period
From date of grant through vesting date
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Restricted Stock
Sometimes offered to employees in lieu of
stock option plans
Restrictions
Employee cannot sell stock for a specified period
of time
Employee may forfeit the shares if they leave
employer Awards may be linked to financial goals
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Stock Appreciation Rights
Some firms grant key employees StockAppreciation Rights instead of or in additionto stock options
The employee receives compensation incash or stock or a combination of the two atsome future date based on the
Difference between the market price of thestock as on the date of exercise over a pre-established price
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Ratio Analysis
Banks Financial StatementsFA Lecture XII Part II
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BASIC ANALYSIS OF NET INCOME OF BANKS
NI [Net Income]= Net Interest Income i.e. NII (Interest incomeinterest expense)
+/- Gains(Losses) from investments
- Burden (Non interest expense non interestincome
- Provisions for Loan losses
- Taxes
The banks strategy can be inferred from thecontributory factors to net income
R ti f B k
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Ratios for Banks Many traditional ratios do not work for banks
Some important workable ratios for banks Return on assets (ROA)
Return on equity (ROE)
Capital Adequacy ratio (CAR)
Profitability related ratios
Net Interest Margin (NIM) = Net Interest Income/
Average Earning Assets
A key measure of bank profitability
Indicates managements ability to control the
spread between interest income and interest
expense
Profitability related ratios for Banks
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Profitability related ratios for Banks ..
Contd. Spread= (Interest Income/ Average
earning assets) - (Interest Expense/
Average interest bearing liabilities)
Burden ratio = (non interest expenseless non interest income)/ Average
Total Assets
Efficiency ratio= Non interest expense/(Net interest income + Non interest
income)