Presentation Gb530 Session 2 Profits and Leverage

Presentation Gb530 Session 2 Part 1. Profit Planning

Marginal Analysis Income Statement To reach earnings before interest and taxes (Operating Income) Revenues 10000 Variable costs 60% 6000 Marginal contribution 4000 Fixed costs 1200 EBIT 4800

Break-even Analysis The minimum position that allows continued operations. Key terms: Break-even Point. The level of operations with neither a profit or loss. Variable Cost. The cost of producing goods or delivering services. Fixed Cost. Cost that does not vary with the level of activity.

Marginal Contribution The direct profit from operations. In Dollars. Revenues – variable costs. As a Percent. Revenues – variable costs Revenues or (Rev – VC)/Rev

B/E Dollars or Units The break-even point may be calculated in dollars or units: B/E_$ = level of revenues needed to cover fixed costs. B/E_units = number of units sold needed to cover fixed costs

Break-even Formula -- Dollars The break-even point in dollars is calculated by the formula: B/E_$ = FC/(MC%) where B/E_$ = Revenues at the break-even point. MC% = marginal contribution as a percent [(Rev-VC)/Rev]

Break-even Formula -- Units The break-even point in units sold is calculated: B/E_units = FC/(MC$) where MC$ = Rev-VC

Profit-volume Analysis This is a modification of break-even analysis. Profits are added to fixed costs. B/E_Revs = (FC + Profit)/MC% B/E_Revs equals the dollars of sales needed to achieve a desired profit.

Marginal Analysis This is the application of profit-volume analysis: Varying the Level of Revenues. Forecasting profits at different sales levels while holding selling price and costs constant. Varying Price. Forecasting profits at different prices. Varying Fixed and Variable Costs. Trading one category of cost for another.

Profit Planning and Stock Price Investors link a firm’s profits to the market price of its stock. Key terms: Earnings per Share (EPS). Net income divided by outstanding shares of stock. Price-earnings Ratio (P/E). Market price divided by EPS.

Normal P/E Multiple A normal P/E multiple exists when EPS meets two conditions: A firm has a satisfactory return on its capital. Investors are not disturbed by unusual psychological or economic factors.

Estimating Normal P/E The normal P/E for a company or industry is estimated by analyzing: Historical data. Similar firms. Industry norms. National markets Common sense.

Question How do know when we have found the normal P/E?

Answer Nobody knows.

Presentation Gb530 Session 2 Part 2. Leverage

Operating Leverage Changes in revenues produce greater changes in operating income. Degree is related to fixed costs. Above B/E, all marginal contribution becomes operating income. Greatest leverage near B/E where small change in sales has the opposite effect on profits.

Financial Leverage When both of the following exist: Limited Cost Securities. Debt with fixed or variable rate of interest. ROI Is Not Equal to Cost of Debt. The firm's ROI must not be equal to the interest rate.

Financial Leverage Impact Three situations: ROI Is Greater than Interest Rate. Firm has favorable financial leverage. ROI Equals Interest Rate. No leverage. ROI Is Less than Interest Rate. Unfavorable financial leverage.

Profitability Ratios These measure the short-term (One year) success or failure. EBIT (also called Operating income) Net income. Level of sales and assets Costs.

Profit Margin Formula: Compares profit to the level of sales. High Ratio. Profit on sales provides adequate return to investors. Low Ratio. Profit on sales is inadequate.

Asset Turnover Formula: Revenues/Total Assets Compares revenues to assets. Low Ratio. May show idle or inefficient assets. High Ratio. May show efficient use of assets.

Return on Investment Formula: EBIT/Total Assets Compare profit to assets. High Ratio. May show acceptable return from assets. Low Ratio. May show unacceptable return from assets.

Question What happens if we multiply profit margin by asset turnover? PM = EBIT/Revenues AT = Revenues/Total Assets

Answer We get ROI. EBIT x Sales Sales Assets

Question What is the weaknesses of profit margin?

Answer Profit margin ignores the level of assets. Revenues may be too small to provide adequate profits on a large asset base.

Question What is the weaknesses of asset turnover?

Answer Asset turnover ignores profits. Sales may be high compared to assets but may not produce an adequate profit.

Return on Equity Formula: Net Income/Total Equity Compares after-tax profit with invested capital. High Ratio. May show adequate return on capital invested by owners. Low Ratio. May show inadequate return.

Question A firm has a high return on investment but a low return on equity. How can this happen?

Answer The differences between ROI and ROE are: Interest paid on debt. Taxes.

Question What are the possible causes (not symptoms) of a low return on equity?

Answer (1) Possible causes affecting ROI: Low Prices. Affects profit margin. High Costs. Affects profit margin. Excessive Assets. Affects asset turnover. Low Sales Volume. Affects asset turnover. .

Answer (2) Possible causes affecting ROE: High Interest Rates. Affects ROE. High Debt Level. Affects ROE. High Taxes. Affects ROE.