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LESSON 5 – SUMMARY – COMPANY’S
RETURN ANALYSIS
The different levels of profits

The profits and performance measurement: the
concept of return


The profitability of the business: GROSS ROA

The profitability for the shareholders: ROE
The relationship between return and capital
FF - LFC/LG/LGM - 2Sem_2013/2014

structure


The Financial Leverage
Its limits
01
THE PROFITS

(1/3)
Companies can be viewed as entities that were given
funding of a pool of assets that enables them to
implement the business.

The degree of success of this business can be
measured by the profits it generates.

FF - LFC/LG/LGM - 2Sem_2013/2014
a set of resources (capital and others) used in the
In this context is important to analyze the
various levels of profits that the company generates.
02
THE PROFITS
(2/3)
+ Revenues
- Cost of goods sold
+ Other Revenues (services)
- External supplies and services
- Labor costs
- Other costs
= EBITDA (Earnings before Interest, Taxes and Depreciation
and Amortization)
- Depreciation
FF - LFC/LG/LGM - 2Sem_2013/2014
= Gross profit
= EBIT (Earnings before Interest and Taxes)
- (Finance expenses – Finance income)
= EBT (Earnings before Taxes)
- Taxes
= Net Income
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THE PROFITS
(3/3)
Gross profit
Reflects the gross profit of the business, i.e., the difference
between sales and direct costs of goods sold
Translates the profits generated by the business and that will be
transformed into cash flow, since it is computed before depreciation
(the only cost that doesn’t mean any cash outflow)
EBIT (Earnings before Interest and Taxes)
Represents the profits generated by the business, taking into account
the annual cost of using the non-current assets.
EBT (Earnings before Taxes)
FF - LFC/LG/LGM - 2Sem_2013/2014
EBITDA (Earnings before Interest, Taxes and Depreciation and
Amortization)
Represents the profit already taking into account the way the
business is financed, but still before taxes.
Net Income
Net profit
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THE NOPLAT

The EBIT represents the operating income (profit) of the
ignores the effect of taxation.

NOPLAT – Net Operating Profit Less Adjusted Taxes
represents the net profit the company would have,
ignoring how it is financed or, equivalently, as it was all
financed by equity (no debt: no finance expenses)

NOPLAT = EBIT- tax expense* or
FF - LFC/LG/LGM - 2Sem_2013/2014
business, ignoring the way it is financed. However it also
EBIT x (1-t)
*The taxes are here calculated over the EBIT and not over the EBT
t is the company’s tax rate
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FROM PROFITS TO
PROFITABILITY

The notion of performance, in economic terms, is
translated by the concept of profitability or return,
which measures the efficiency of the company when
using the resources it had available for the business.
FF - LFC/LG/LGM - 2Sem_2013/2014

The profits, whatever their level, always
represent an absolute value, not giving much
information if we don’t compare them with the
investment needed or undertook to obtain them. A
profit of € 500,000, for example, does not
indicate much about the performance of the company,
whether it was high or only fair.
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THE BUSINESS RETURN

When analyzing the profitability of the business, we evaluate the relationship
(ratio) between the assets that the company allocated to the business (from the

The profit for this analysis is the EBIT because we do not want to evaluate, for
now, the way the company decided to finance its business (a decision reflected
in the finance expenses), but only to evaluate the strength of the business
itself.

RATIO

Return of the business
GROSS ROA: Return On Assets
E
B
I
T
G
R
O
S
S
R
O
A

A
S
S
E
T
S

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ones it had available) and the profits (operating) obtained.
A value of 0.2, for example, indicates that the business is generating a
return of 20%
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THE RETURN FOR THE
SHAREHOLDERS

The capital holders (shareholders or partners) are those who are entitled to the
net income of the company, can choose to receive that income (dividends) or to


Thus, the equity represents, in essence, the amount invested by shareholders
/ partners in the company, either directly (issued share capital) or indirectly
(retained earnings, which stay in the company)
RATIO

Shareholders’ Return
ROE: Return On Equity
N
e
tI
n
c
o
m
e
R
O
E

E
q
u
ity

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keep it in the company to be reinvested for the future.
A value of 0.1, for example, indicates that the share capital invested in the
company generated a return of 10%.
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THE RETURN AND CAPITAL
STRUCTURE
(1/5)

Every company, to raise funds for the business, may choose for share

The option for a greater use of one kind of fund source and less of the
other, can positively or negatively influence the level of the return on
equity (ROE).

This link is based on the comparison between the return of the
business (GROSS ROA) and the cost of the debt capital (r).

Imagine that the GROSS ROA is 20% and the r is 8%.
Thus, we know that each unit of asset generates a return of
20%. We can finance that asset with a unit of equity and
shareholders will get those 20% for themselves. The other
option is to fund the same asset with a unit of debt capital. In
this case, the shareholders will end up having only 12% (208) for them, but did not have to invest any capital of their own!
(ROE would be ∞!)
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capital (equity) or debt capital (liabilities).
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THE RETURN AND CAPITAL
STRUCTURE
(2/5)

So whenever GROSS ROA> r, the greater the weight of debt
capital in relation to the equity, the higher will be the ROE



This increase in ROE is due to the fact that the exchange
of equity for debt capital will generate a non investment from the
shareholders but where they can still benefit from a profit for
themselves (because GROSS ROA> r).
EXAMPLE

EBIT – 10,000

ASSETS – 50,000

EQUITY– 25,000

DEBT– 25,000

r – 10%

t – 30% (income tax)
GROSS ROA is 20% ( 10,000/50,000)
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(return on equity)
10
THE RETURN AND CAPITAL
STRUCTURE
(3/5)


Finance costs= 25,000 x 0.1 = 2,500

EBT = 10,000 – 2,500= 7,500

Taxes= 7,500 x 0.30 = 2,250

NET INCOME = 7,500 – 2,250 = 5,250
Thus, ROE is 21% (5,250/25,000)
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
To calculate the ROE is necessary to calculate the net income first
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THE RETURN AND CAPITAL
STRUCTURE
(4/5)


Equity– 20,000

Debt– 30,000
Calculating the new net income

Finance Costs = 30,000 x 0.1 = 3,000

EBT = 10,000 – 3,000= 7,000

Taxes = 7,000 x 0.30 = 2,100

NET INCOME = 7,000 – 2,100 = 4,900

ROE is now 24.5% (4,900/20,000)

Thus, the change in capital structure increased the ROE.
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
Imagine now that it intends to increase the weight of debt capital:
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THE RETURN AND CAPITAL
STRUCTURE
(5/5)

Consider a new way to calculate the ROE:
Applying to the two previous situations :
2
5
,
0
0
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
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
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.
2

(
0
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
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(
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3
)

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.
2
1


2
5
,
0
0
0


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

D
E
B
T
R
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
G
R
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S
R
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(
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)
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(
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
3
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2

(
0
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
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(
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
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2
4
5


2
0
,
0
0
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

13
FINANCIAL LEVERAGE

Thus, the Financial Leverage is given by:


D
E
B
T
(
G
R
O
S
S
R
O
A
r
)



E
Q
U
I
T
Y


FF - LFC/LG/LGM - 2Sem_2013/2014

This formula illustrates the effect of the financial leverage, i.e.,the
effect of the debt on the ROE. Note that departing from the
GROSS ROA value, there is an increase or decrease on the return
depending on the difference (ROA GROSS - r) being positive or
negative. And that plus or minus is greater as greater is the value
of debt (borrowed capital) when compared to the value
of equity (share capital).
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FINANCIAL LEVERAGE – ITS
LIMITS

The use of the financial leverage should take into account
several limits, in particular :
It ignores the effect that the increase in debt has in the level of the r:
if debt increases, the risk of the company also increases and therefore it is likely
that lenders (creditors of the company) start demanding a higher interest rate.

Shareholders are also sensitive to the risk, that is, if the debt increases,
they would require a higher ROE and in many cases the increase in ROE due to
the use of the financial leverage may not be sufficient to offset that increased
risk.

FF - LFC/LG/LGM - 2Sem_2013/2014

The financial leverage is a relevant concept only to be used in
small changes in the capital structure, where the limitations outlined
above are minimized.
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