1. Presentation
Gb530
Session 2
Profits and Leverage

2. Presentation
Gb530
Session 2
Part 1.
Profit Planning

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

4. 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.

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

6. 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

7. 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]

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

9. 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.

10. 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.

11. 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.

12. 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.

13. 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.

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

15. Answer
Nobody knows.

16. Presentation
Gb530
Session 2
Part 2.
Leverage

17. 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.

18. 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.

19. 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.

20. 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.

21. 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.

22. 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.

23. 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.

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

25. Answer
We get ROI.
EBIT x Sales
Sales Assets

26. Question
What is the weaknesses of profit margin?

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

28. Question
What is the weaknesses of asset turnover?

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

30. 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.

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

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

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

34. 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. .

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