Week6Tutorial Solutions PDF

Preview

Summary

Download Week6Tutorial Solutions PDF

Description

Tutorial in Week 6 (based on Week 5 Lecture) beginning 8th April 2019 TOPIC: Ratio Analysis This tutorial focuses on the attribution of ROCE between operating and financial drivers and the determination using ratio analysis of the drivers of operating performance. There are eight questions of which at least three are included for self-learning outside the tutorial. Q1 and Q2 are simple ratio computation and they should be completed prior to the tutorial and solutions are now on the LMS. Q8 is a case-study of Harvey Norman, only the main concepts will be discussed in the tutorial, the mechanical computations will be provided in the solutions. Q1 Baseline Ratio Computation For Analysis of Financial Statements The company Barooga Ltd financial statements have been reformulated and classified into operations and financing. For this company compute ROCE, RNOA, FLEV and SPREAD and show that the financial leveraging equation holds for this firm (ROCE = RNOA + (FLEV*SPREAD)

Reformulated Balance Sheets NOA NFO CSE

2017 1,395 300 1,095

2016 1,325 300 1,025

Average 1,360 300 1,060

Reformulated Income Statement, 2017 Sales Operating Expenses Tax reported Tax on NFE OI Net interest Tax on interest at 33% NFE Net Income

Solution

159 ROCE = 1,060 = 15.0% 177 RNOA = 1,360 = 13.0%

3,295 3,048 247 61 9

70 177

27 9 18 159

300 FLEV = 1,060 = 0.283 SPREAD = RNOA – NBC

= 13.0% - 6.0% = 7.0%

[

NBC =

NFE 18 = NFO 300

]

ROCE (15%) = 13% + (0.283 *7.0%)

Q2 Analysis of Profitability: The Coca-Cola Company See the reformulated (into operation and financing) profit and loss statement (attached as an appendix) and balance sheet (below) of Coca-Cola Company. Using these statements (a) Compute RNOA and NBC (Net Borrowing Costs) (b) Compute FLEV (c) Show that ROCE = RNOA + FLEV*SPREAD (d) Calculate profit margin and asset turnover and show that RNOA = PM *ATO Coca-Cola Company Reformulated Income Statement in millions Sales Cost of Sales Gross Margin

2007 28,857 10,406 18,451

Advertising Expense Admin Expense Other expenses

2,800 8,145 81

Operating Income from Sales Tax Operating income from sales after tax Equty Income from bottling subsidiaries

7,425 1,972 5,453 668

Net Operating Income Net Financial Expenses

6,121 140

Net Profit

5,981

Average balance sheet amounts are as follows:

Net operating assets Net financial obligations

2007 $26,858 5,114

2006 $18,952 2,032

Ave $22,905 3,573

Common shareholders’ equity

$21,744

$16,920

$19,332

a. RNOA = 6,121/22,905 = 26.72% NBC = 140/3,573 = 3.95% b. FLEV = 3,573/19,332 = 0.185 c. ROCE = RNOA + [FLEV  (RNOA – NBC)] = 26.72% + [0.185 × (26.72% - 3.95%)] = 30.93 % = 5,981/19,332 d. PM = 6,121/28,857 = 21.21% ATO = 28,857/22,905 = 1.26 RNOA = 21.21% × 1.26 = 26.72% e Gross margin ratio = 18,451/28,857 = 63.94% Q3 Corporation's return on net operating assets (RNOA) is 10% and its tax rate is 40%. Its net operating assets ($4 million) are financed entirely by common shareholders' equity. Management is considering its options to finance an expansion costing $2 million. It expects return on net operating assets to remain unchanged. There are two alternatives to finance the expansion: 1. Issue $1 million bonds with 12% coupon, and $1 million common stock. 2. Issue $2 million bonds with 12% coupon. Required: a. b. c. d.

Determine net operating income after tax (NOPAT) and net income for each alternative. Compute return on common shareholders' equity for each alternative (use ending equity). Calculate the FLEV for each alternative. Compute return on net operating assets and explain how the level of leverage interacts with it in helping determine which alternative management should pursue.

SOLUTION First alternative: NOPAT = $6,000,000 * 10% = $600,000 Net income = $600,000 – [$1,000,000*12%](1-.40) = $528,000 Second alternative: NOPAT = $6,000,000 * 10% = $600,000 Net income = $600,000 – [$2,000,000*12%](1-.40) = $456,000 b. First alternative: ROCE = $528,000 / $5,000,000 = 10.56% Second alternative: ROCE = $456,000 / $4,000,000 = 11.40% c. First alternative: NFO-to-Equity = $1,000,000 / $5,000,000 = 0.2 Second alternative: NFO-to-Equity = $2,000,000 / $4,000,000 = 0.5 d. This can be explained by attribution of ROCE = RNOA + [FLEV  (RNOA – NBC)] First, let’s compute return on assets (RNOA): First alternative: $600,000 / $6,000,000 = 10% Second alternative: $600,000 / $6,000,000 = 10% Second, notice that the interest rate is 12% on the debt (bonds). More importantly, the after-tax interest rate is 7.2% (12% x (1-0.40)), which is the NBC and is less than RNOA. Hence, the company earns more on its assets than it pays for debt on an after-tax basis. That is, it can successfully trade on the equity—use bondholders’ funds to earn additional profits. Finally, since the second alternative uses more debt, as reflected in the FLEV ratio in c, the second alternative is probably preferred. The shareholders would take on additional risk with the second alternative, but the expected returns are greater as evidenced from computations in b. Q4 A firm has financial assets invested in short-term government bonds but has no financial obligations (for example Apple Inc for long time had no financial obligations but had approx. $70 billion of financial assets). Suppose that RNOA exceeds ROCE. Explain how this can be due to the investment in financial assets. This is a case of negative leverage. Rather than the firm borrowing the firm has lent. This effectively implies a certain percent of shareholders funds have been lent to other parties and is not being used for investment in operations. FLEV will be negative in the financing leverage equation ROCE = RNOA + [FLEV  (RNOA – NBC)]. The negative leverage yields an ROCE below RNOA provided that the RNOA is greater than the return on financial assets.

Q5 A What-If Question: Grocery Retailers. Many supermarket have shifted from regular storewide sales to issuing membership in discount and points programs. A supermarket chain with $120 million in annual sales an asset turnover of 6.0 ponders whether to institute a customer membership program. It currently earns a profit margin of 1.6 percent on sales. Its marketing research indicates that a customer membership would increase sales by $25million and would require an additional investment in inventories of $2 million but no additional retail floor space. Costs to run the membership program, including the discounts offered to members, would reduce profit margins to 1.5 percent. What would be the effect on the firm’s return on net operating assets of adopting the customer membership program? Solution Net operating assets for $120 million in sales and an ATO of 6.0 are $20 million. An increase in sales of $25 million and an increase in inventory of $2 million would 120  25 increase the ATO to 20  2 = 6.59.

With a profit margin of 1.5%, the RNOA would be: RNOA = 1.5%  6.59 = 9.89% The current RNOA is: RNOA = 1.6%  6.0 = 9.6% So the membership program would increase RNOA slightly.

Q6 Profit Margins, Asset Turnovers, and Return on Net Operating Assets: A What-If Question. A firms earns profit of 3.8 percent on sales of $435million and employs net operating assets of $150 million to do so. It considers adding another product line that will earn a 4.8 percent profit margin with an asset turnover of 2.3. What would be the effect on the firm’s return on net operating assets of adding the new product line? SOLUTION The effect would be (almost) zero. ATO = 435/150 = 2.9 Existing RNOA = PM ATO = 3.8%  2.9 = 11.02% RNOA from new product line is RNOA = 4.8% 2.3 = 11.04%

Q7 Lets see what the smart guys are doing. I have attached three analysts reports: a J.P Morgan report on JB Hi-Fi Limited/Harvey Norman. A Macquarie Wealth Management report on Harvey Norman and a Macquarie Wealth Management report on Woolworths. Read these reports very lightly and discuss the main performance drivers of ROCE that the analysts focus on? What performance determinant do the analysts discuss that are not very well disclosed in statutory financial reports? What components of ROCE = RNOA + Leverage * Spread (where RNOA = PM*ATO) are not frequently discussed and why? A significant focus of analysts is on profit margins and sales growth. Profit margins are simply Price less Cost and analysts will in-turn focus on fundamental determinants of both (for example competition and efficiency gains respectively). Thus in regard to ROCE = RNOA + Leverage * Spread; the bulk of analysis is focused on the drivers of RNOA (PM and sales growth in the numerator of ATO) as leverage can be sticky and the most uncertain component of spread (RNOANBC) is RNOA. A fundamental determinant of performance is the level of operating leverage. Changes in core sales PM are determined by how costs change as sales change. Some costs are fixed cost: they do not change as sales change. Other costs are variable costs: They change as sales change. Operating leverage can be measured by the ratio of fixed to variable expenses and provides an indicator of the sensitivity of income to change in sales. The benefits of operating leverage in good times is that if a firm has fixed costs then as sales increase, costs stay constant, and margins improve and in turn so does ROCE (of course in bad time the opposite will hold….sales will decrease but the firm will still incur the fixed costs).

A reader of statutory financial report will find it difficult to distinguish fixed and variable costs. While the depreciation and amortization component of fixed costs can be found in the cash flow statement reconciliation the other fixed costs such as fixed salaries, rent expense and administrative expenses are aggregated with variables costs in different line items on the income statement.

Q8 Obtain Harvey Normans financial reports for the past three years. Reformulate the P&L and the balance sheet into operations and financing activities. Calculate NOPAT both including and excluding non-recurring items. Compute ROCE for each of the past three years and then perform ratio analysis to understand the primary drivers of any change in ROCE across time (we will use RNOA including non-recurring items as there is little difference between recurring and non-recurring RNOA). The tutorial will focus on the attribution of Harvey Norman between operations and financing and computation of aftertax financing expenses, there will be a brief discussion of items that could be non-recurring (as we discussed this last week and suggested items will be provided in solutions) and then we will focus on an explanation of the ROCE ratio drivers.

For attribution of Harvey Norman activities between financial and operational (and recurring and nonrecurring) and the subsequent ratio computation see attached excel spreadsheet.

Return on Common Shareholders’ Equity

ROCE NPAT Avg CSE

30-Jun-15 10.65% 268,914.0 2,523,983.0

30-Jun-16 13.40% 351,340.0 2,622,767.0

30-Jun-17 16.47% 452,966.0 2,750,790.5

30-Jun-18 13.22% 380,050 2,875,419

CAGR 12.20% 4.4%

Background Observations HVN’s ROCE has improved over the four-year period. This has been due to HVN increasing its NPAT (12.20%) at a faster rate than its invested capital (4.4%). Its NPAT has grown, primarily because of growth in sales (7.2%) and also an increase in gross profit margin (from 30.32% to 33.48%). Growth in CSE has been due to: HVN retaining comprehensive income (not paying out 100% of comprehensive income as dividends) and increases in reserves (due to positive other comprehensive income items such as revaluations). Components and drivers of the change in ROCE To examining HVN’s ROCE we can break it down as follows: ROCE=RNOA + Leverage x Spread.

ROCE

30-Jun-15 10.65%

30-Jun-16 13.40%

30-Jun-17 16.47%

30-Jun-18 13.22%

CAGR

RNOA Leverage Spread

8.99% 25.43 6.55%

11.29% 23.04 9.14%

13.74% 22.11 12.34%

10.79% 26.23% 9.26%

6.3%

HVN’s ROCE is higher than its RNOA in every year. Why is this the case? This is because HVN has a small amount of leverage of 25 to 26%. As the spread is positive this gives rise to additional return to shareholders.

Return on Net Operating Assets (including non-recurring items)1

RNOA NOPAT Avg NOA

30-Jun-15 8.99% 284,545.7 3,165,934.5

30-Jun-16 11.29% 364,329.9 3,227,132.50

30-Jun-17 13.74% 461,447.20 3,358,862.5

30-Jun-18 10.79% 391,551 3,629,776

CAGR2 11.2% 4.7%

Profit Margin and Asset Turnover (including non-recurring items)

RNOA PM ATO

30-Jun-15 8.99% 17.60% 0.51

30-Jun-16 11.29% 20.29% 0.56

30-Jun-17 13.74% 25.17% 0.55

30-Jun-18 10.79% 19.64% 0.55

CAGR 3.7% 2.5%

HVN’s RNOA has grown over the four-year period. To understand why, decompose RNOA into profit margin and asset turnover. We can see that HVN is performing well on both metrics. Its profit margin has increased from 17.60% to 19.64%. Its asset turnover has increased from 0.51 to 0.55. These results imply that HVN has generated more sales as well as operating more efficiently. The net profit margin improvement is due to both an improvement in gross profit margin and HVN’s sales increasing at a faster rate than its total operating expenses. The improvement in the gross margin from 30.3% in FY15 to 33.48% in FY18 implies Harvey Norman have been able to improve their mark-up which is 1 The ratios as substantially similar when excluding non-recurring items, so only the ratios including nonrecurring items are discussed 2 CAGR = compound annual growth rate. For example, the CAGR for NOPAT is calculated as (391,551/284,546)1/3 – 1.

impressive given increasing competition. The net profit margin has also increased because overhead expenses have grown at a slower rate than sales. This is an example of the benefits of operating leverage in good times. If a firm has fixed costs then as sales increase, costs stay constant, and margins improve and in turn so does ROCE (of course in bad time the opposite will hold….sales will decrease but the firm will still incur the fixed costs). The asset turnover improvement is due to HVN growing sales at a faster rate than the increase in average NOA. The lower increase in average NOA has been driven by a decrease in operating liabilities. Why have operating liabilities decreased? HVN’s operating liabilities decreased mainly because of the same renegotiation of its franchise agreement which also caused a large reduction in its ‘Trade and other payables’ account. HVN’s ‘Cash at bank and on hand’ as also decreased over time, perhaps due to better cash flow management. What Developments Lie Behind These Ratios? Segment Performance A good way to understand the performance of a company like HVN is to examine its segment disclosures (note 2 of the annual report). This is because HVN has operations in different countries, which might be experiencing differences in performance. It also has franchise and wholly-owned stores in Australia (all foreign stores are wholly-owned by HVN). HVN’s segment disclosures are somewhat complex, but a simplified version is as follows: Segment Revenue

Franchise stores3 Non-franchise stores: New Zealand Singapore & Malaysia Slovenia & Croatia Ireland & Nth Ireland Australia

30-Jun-15 870,919

30-Jun-16 939,950

30-Jun-17 968,854

CAGR 5.5%

761,644 397,395 96,087 236,565 153,333

832,367 444,111 106,986 282,366 166,831

908,966 423,605 110,453 271,963 160,057

9.2% 3.2% 7.2% 7.2% 2.2%

30-Jun-15 251,207

30-Jun-16 315,833

30-Jun-17 348,251

CAGR 17.7%

61,401 765 5,070 (8,349) 7,812

76,313 18,958 6,008 (520) 10,769

87,509 26,024 6,724 3,083 11,687

19.4% n.m.4 15.2% n.m. 22.3%

Segment EBITDA

Franchise stores Non-franchise stores: New Zealand Singapore & Malaysia Slovenia & Croatia Ireland & Nth Ireland Australia

3 This represents the fees that HVN collects from its independent franchisees. The actual sales of the franchise stores is considerably larger ($5.62bn in FY17). 4 N.m. is an abbreviation of ‘not meaningful’. In practice, it is common for analysts to describe an extreme figure as not meaningful, meaning it cannot be meaningfully interpreted. In this case, the CAGR for Singapore & Malaysia is 483.3%, but only because of an abnormally low base in FY15. The CAGR for Ireland & Northern Ireland cannot be calculated, as it has changed from negative to positive.

It is clear from the segment revenue that two of HVN’s segments combined contribute more than 60% of revenue: fees from its franchise stores in Australia and its wholly-owned New Zealand stores. A substantial portion of revenue also comes from its Singapore and Malaysia operations (about 15% of total revenue). HVN has experienced sales growth in every division over the three-year period, but growth has clearly been stronger in some divisions (e.g. New Zealand) than in others (Australian non-franchise stores). Fortunately for HVN, growth has been strong in its two largest divisions. HVN’s segment EBITDA is substantially more complex than its segment revenue. It is clear that the two largest revenue segments (franchise stores and New Zealand) also contribute the most EBITDA. They have also both experienced strong growth in excess of sales growth. Segment EBITDA for Singapore and Malaysia has been volatile with notably poor performance in FY15. The Ireland and Northern Ireland operation appears to be unsuccessful with losses in FY15 and FY16, and a very low margin in FY17. HVN’s annual reports do not provide much explanation for the results in Singapore & Malaysia and Ireland & Northern Ireland. What Developments Lie Behind These Ratios? Annual Report Commentary Another way to understand HVN’s performance is to read the textual discussion of HVN’s performance in the annual reports. HVN typically organises its discussion around its segments. There is a lot of information in these discussions. Some key points from the 2017 Annual Report include: 









Franchise stores (Australia) o Franchisees are rebounding from poor performance during the GFC o HVN’s franchise revenue is linked to franchisees’ sales revenue, which has been growing faster in recent years o Success of Omni-Channel selling strategy (online and offline retail) o Sales driven by new technology products:  Connected Devices category (e.g. smart watches/jewellery)  Successful launch of the Samsung Galaxy S8/S8+  Growth of smart TV category due to grow of online content  Launch of Virtual Reality products  Introduction of better notebook computers driving greater demand o Australian housing market growth has driven demand for homemaker products, such as furniture, bedding, appliances, etc. New Zealand o A strong economy and record net migration is driving strong demand o Multiple product categories are performing well o Effective promotional activities Singapore & Malaysia o HVN has been renovating and changing the location of its stores in both countries o Weakening of the Singapore dollar adversely affected the FY17 results when translated into Australian dollars Ireland o Improved performance of the Irish economy o HVN is expanding its store network o HVN appears to be focused on cutting costs, including through stronger supply ...