Introductory Corporate Finance: Financial Statement Analysis - Limitations of Financial Ratios

What This Is

Financial ratios are essential tools in corporate finance for evaluating a company's performance and making informed decisions. However, they have limitations that must be considered when interpreting results. For instance, consider Tesla's debt-to-equity ratio of 0.5, which might indicate a high level of debt. However, if Tesla's debt is primarily used to finance growth initiatives, such as expanding its electric vehicle production capacity, the ratio might not accurately reflect the company's financial health.

Key Formulas & Models

• WACC = wd × rd(1?T) + wps × rps + we × re – weighted average cost of capital; used as discount rate.
• wd: proportion of debt in capital structure
• rd: cost of debt
• T: corporate tax rate
• wps: proportion of preferred stock in capital structure
• rps: cost of preferred stock
• we: proportion of equity in capital structure
• re: cost of equity
• DOL = Q(P?V) / (Q(P?V)?F) – degree of operating leverage; measures EBIT sensitivity to sales.
• Q: sales
• P: price per unit
• V: variable costs per unit
• F: fixed costs
• DFL = EBIT / (EBIT + I) – debt-free leverage; measures EBIT sensitivity to interest payments.
• EBIT: earnings before interest and taxes
• I: interest payments
• Sustainable Growth Rate = ROE × (1 - Retention Ratio) – measures a company's ability to sustain growth.
• ROE: return on equity
• Retention Ratio: proportion of earnings retained in the business
• FCFF = EBIT(1 - T) + Depreciation - Capital Expenditures – free cash flow to the firm; measures a company's ability to generate cash.
• EBIT: earnings before interest and taxes
• T: corporate tax rate
• Depreciation: non-cash expense
• Capital Expenditures: investments in property, plant, and equipment
• FCFE = FCFF - Net Borrowing – free cash flow to equity; measures a company's ability to generate cash for shareholders.
• FCFF: free cash flow to the firm
• Net Borrowing: change in debt
• EBITDA = EBIT + Depreciation + Amortization – earnings before interest, taxes, depreciation, and amortization; measures a company's operating performance.
• EBIT: earnings before interest and taxes
• Depreciation: non-cash expense
• Amortization: non-cash expense

Step-by-Step Calculation

1. Calculate the weighted average cost of capital (WACC) using the formula WACC = wd × rd(1?T) + wps × rps + we × re.
2. Determine the degree of operating leverage (DOL) using the formula DOL = Q(P?V) / (Q(P?V)?F).
3. Calculate the debt-free leverage (DFL) using the formula DFL = EBIT / (EBIT + I).
4. Compute the sustainable growth rate using the formula Sustainable Growth Rate = ROE × (1 - Retention Ratio).
5. Calculate the free cash flow to the firm (FCFF) using the formula FCFF = EBIT(1 - T) + Depreciation - Capital Expenditures.
6. Determine the free cash flow to equity (FCFE) using the formula FCFE = FCFF - Net Borrowing.

Common Mistakes

• Mistake: Using book value instead of market value for WACC.
• Correction: Use market value for WACC to reflect the current market price of the company's securities.
• Counterexample: If a company has a high book value but low market value, using book value would result in an incorrect WACC.
• Mistake: Ignoring flotation costs when calculating WACC.
• Correction: Include flotation costs in the WACC calculation to reflect the true cost of capital.
• Counterexample: If a company has high flotation costs, ignoring them would result in an incorrect WACC.
• Mistake: Confusing sunk cost with opportunity cost.
• Correction: Use opportunity cost when making decisions, not sunk cost.
• Counterexample: If a company has invested in a project with a sunk cost of $100,000, the opportunity cost would be the next best alternative use of the funds.

Exam / CFA Tips

• Tip: Be able to distinguish between M&M Proposition I (no taxes) and M&M Proposition II (with taxes).
• Tip: Understand the difference between IRR and NPV ranking.
• Tip: Be able to explain the concept of dividend irrelevance and bird-in-hand.
• Tip: Practice calculating WACC, DOL, and DFL using different scenarios.

Quick Practice Problem

A company has EBIT of $10M, interest $2M, tax 25% – compute DFL.

Answer: DFL = $10M / ($10M + $2M) = 0.83 Explanation: The company's debt-free leverage is 0.83, indicating that 83% of its EBIT is sensitive to interest payments.

Last-Minute Cram Sheet

• In M&M Proposition I (no taxes), firm value is independent of capital structure – but with taxes, value increases with debt due to the interest tax shield.
• WACC = wd × rd(1?T) + wps × rps + we × re
• DOL = Q(P?V) / (Q(P?V)?F)
• DFL = EBIT / (EBIT + I)
• Sustainable Growth Rate = ROE × (1 - Retention Ratio)
• FCFF = EBIT(1 - T) + Depreciation - Capital Expenditures
• FCFE = FCFF - Net Borrowing
• EBITDA = EBIT + Depreciation + Amortization
• Ignore sunk cost when making decisions, use opportunity cost instead.