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 structure The Financial Leverage Its limits FF - LFC/LG/LGM - 2Sem_2013/2014 01

THE PROFITS (1/3) Companies can be viewed as entities that were given a set of resources (capital and others) used in the 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. In this context is important to analyze the various levels of profits that the company generates. FF - LFC/LG/LGM - 2Sem_2013/2014 02

THE PROFITS (2/3) + Revenues - Cost of goods sold = Gross profit + Other Revenues (services) - External supplies and services - Labor costs - Other costs = EBITDA (Earnings before Interest, Taxes and Depreciation and Amortization) - Depreciation = EBIT (Earnings before Interest and Taxes) - (Finance expenses – Finance income) = EBT (Earnings before Taxes) - Taxes = Net Income FF - LFC/LG/LGM - 2Sem_2013/2014 03

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 EBITDA (Earnings before Interest, Taxes and Depreciation and Amortization) 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) Represents the profit already taking into account the way the business is financed, but still before taxes. Net Income Net profit FF - LFC/LG/LGM - 2Sem_2013/2014 04

THE NOPLAT The EBIT represents the operating income (profit) of the business, ignoring the way it is financed. However it also 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 EBIT x (1-t) *The taxes are here calculated over the EBIT and not over the EBT t is the company’s tax rate FF - LFC/LG/LGM - 2Sem_2013/2014 05

FROM PROFITS TO PROFITABILITY 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. 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 06

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 ones it had available) and the profits (operating) obtained. 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 A value of 0.2, for example, indicates that the business is generating a return of 20% FF - LFC/LG/LGM - 2Sem_2013/2014 07

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 keep it in the company to be reinvested for the future. 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 A value of 0.1, for example, indicates that the share capital invested in the company generated a return of 10%. FF - LFC/LG/LGM - 2Sem_2013/2014 08

THE RETURN AND CAPITAL STRUCTURE (1/5) Every company, to raise funds for the business, may choose for share capital (equity) or debt capital (liabilities). 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% (20- 8) for them, but did not have to invest any capital of their own! (ROE would be ∞!) FF - LFC/LG/LGM - 2Sem_2013/2014 09

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 (return on equity) 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) FF - LFC/LG/LGM - 2Sem_2013/2014 10

THE RETURN AND CAPITAL STRUCTURE (3/5) To calculate the ROE is necessary to calculate the net income first 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) FF - LFC/LG/LGM - 2Sem_2013/2014 11

THE RETURN AND CAPITAL STRUCTURE (4/5) Imagine now that it intends to increase the weight of debt capital: 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. FF - LFC/LG/LGM - 2Sem_2013/2014 12

THE RETURN AND CAPITAL STRUCTURE (5/5) Consider  a new way to calculate the ROE: Applying to the two previous situations : FF - LFC/LG/LGM - 2Sem_2013/2014 13

FINANCIAL LEVERAGE 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). Thus, the Financial Leverage is given by: FF - LFC/LG/LGM - 2Sem_2013/2014 14

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. 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. FF - LFC/LG/LGM - 2Sem_2013/2014 15