Finance for Entrepreneurship

Shyam V. Sunder
Visiting Associate Professor
Indian School of Business
Disclaimer

This presentation is part of the lecture series for the Indian

School of Business – Technology Entrepreneurship
Program (ISB-TEP). Please do not reference or quote
without permission of ISB-TEP. The contents are meant for
education and should not be taken to be business advice
for a specific set of conditions.
Session agenda
• Objectives
– Generating value from project selection
– Forecasting financial needs
– Understanding cost structure
– Tools for evaluating business performance
• Key takeaways
– Pick projects that will add value on an expected basis
– Forecast financial needs using reasonable
assumptions
– Analyze costs to decide on production and pricing
– Measure performance by financial and operational
strategies
Session plan

SESSION 4
Measuring Risk and Performance

SESSION 3
Cost Structure and Decision Making

SESSION 2
Financial forecasting

SESSION 1
Project selection
How to evaluate whether an idea would generate value for
investors?

PROJECT SELECTION
Value Generation

Sales Revenue

Costs

Profit
V
Vaalluue
e ggeen
neerraa
tteedd
Assets ffoorr o
owwnneer
rss
Liabilities Owners Equity Profit
Value Loss

Loss

Sales Revenue Va
lue
los
Costs t for
ow
ne
rs

Assets

Liabilities Owners Equity Loss

How is value generated?

• In general in the long run a business must generate profits to

increase value beyond the amounts invested in assets
• As the famous investor Warren Buffet said – “Rule No.1:
Never lose money. Rule No.2: Never forget rule No.1”
• However, new businesses are not expected to be profitable
from day 1, year 1, or even in the short term
• But its important to understand that investments are
eventually expected to generate profits that make their
owners better off
• We will use this framework to understand how to decide on
making an investment
 Situation
• Assume that you made a loan to a friend. You will be
repaid in two payments, one at the end of each year
over the next two years. Which option makes sense to
you?
Today End of Year Beginning of
Date 0 Year 1  1 Year Year 2- 2
Case I

Cash Flow -Rs.20,000 Rs.10,000 Rs.10,000

Date 0 1 2
Case I I

Cash Flow -Rs.20,000 Rs.15,000 Rs.15,000

Discussion

• Case II makes more economic sense because you get

back Rs.10,000 more than in Case I (Case I is
Rs.20,000 and Case II is Rs.30,000).
• Case I is even more unattractive because value of
money is decreasing over time so that getting the same
amount back means you are actually getting less!
• Suppose prices are increasing at the rate of 10%.
• What is the implication of your friend returning the
amount lent after one year and after two years?
Time value of money

Case I

Today End of Year Beginning of Year

 Year 1   Year 2  2

Cash Flow -Rs.20,000 Rs.10,000 Rs.10,000

10,000
  Rs.9,090
1
(1.10)
10,000
  Rs.8,264
2
(1.10)

For every Rs.1 lent to your friend you should receive Rs.1.10 after one year
because the available interest rate is 10%. Another way of saying the same
thing is that for every Rs.1 returned after 1 Year, the actual amount received
today is only Rs.0.90 when the interest rate is 10%.
Time value of money

Case II
End of Year Beginning of Year
 Year 1   Year 2 
Today
2

Cash Flow -Rs.20,000 Rs.15,000 Rs.15,000

15,000
  Rs.13,636
1
(1.10)
15,000
  Rs.12,397
2
(1.10)
 Future value

Can you calculate the amount that will make you

indifferent between lending at 10% versus depositing in
the same amount in the bank at 10% rate of interest?
Today End of Year 1 Beginning of Year 2
Date 0 1 2

Cash Flow -Rs.20,000 Rs.10,000 Rs.10,000

9,090
  𝑥 (1.10)1

2
8,264
  𝑥 ( 1.10 )

If you were to lend Rs.17,354 today against a promise by your

friend to repay Rs.10,000 each year when interest rate is 10%
it would make you indifferent between the two options.
Decision rules

Rule 1:
Compare
values at the
same point in
time   Rule 2: To Rule 3: To
compute values   compare vales
at same point in at the same
the future use point in the
compounding present you
Future Value = must discount
the values
Present Value
=
Net Present Value (NPV)

• Usually it is easier to evaluate decisions in present value

terms because decisions are made now (today!)
• Net Present Value compares the present value of cash
inflows (benefits) to the present value of cash outflows
(costs).
• Calculating the NPV of future cash flows allows us to
evaluate an investment decision.
Example

You are deciding to invest in a start-up project that requires

an investment of Rs.10,00,000. You will receive
Rs.5,00,000 at the end of each of the next three years. You
could alternatively deposit Rs.10,00,000 in a bank deposit
and earn 10% per year on your money. Should you invest
in the start-up?
Today
Date 0 1 2 3

-Rs.10,00,000 Rs.5,00,000 Rs.5,00,000 Rs.5,00,000

5,00,000
  5,00,000
  5,00,000
 
-Rs.10,00,000 1 2 3
(1.10) (1.10) (1.10)
-Rs.10,00,000 Rs.4,54,545 Rs.4,13,223 Rs.3,75,657

NPV = Rs.2,43,425 (i.e. Rs.12,43,425 – Rs.10,00,000)

Discussion

• Relative to investing in a bank fixed deposit the start-up will

generate more value for you.
• The computation of the present value puts a number on the
excess benefit in today’s money terms.
• You will earn Rs.2,43,425 more in today’s rupee terms by
investing in the start-up.
• But remember, you expectation of generating the value is only
as good as your assumptions. We have assumed that inflows
from the start-up are certain in each of these three years.
• To the extent the inflows are uncertain we would describe it as
risky and we will have to understand how this affects our
calculations.
Takeaways
The
n
rule et pre
the hel sent
dec ps to valu
If th ision mak e
pos e the to in e
will itive t NPV vest.
gen he i is
inve atee r n v est
o
To s ting v alue r
eva pro in th by
p lua ject e
r
gen ojec e if t .
era tw a
i t e il l
eva mport value
lu an its
the ate va t to
Value sam lues
e ti a
gener me t
atio
increa n
owner ses
s
i.e. the equity,
ow
invest ners
ment
Internal Rate of Return (IRR)

• Suppose you know the present value and cash flows of

an investment opportunity, but you are interested in
evaluating the rate of return from the project.
• A measure for that is the internal rate of return (IRR),
which is the interest rate that sets the net present value
of the cash flows equal to zero.
• For example take the Case II, what is the IRR?
Case II IRR computation
Today
2

Cash Flow Rs.15,000

-Rs.20,000 Rs.15,000
15,000
  Rs.13,636
1
(1.10)
15,000
  Rs.12,397
2
(1.10)
 NPV= 0 = -20,000+

Solving for r, gives us the rate of return as 31.87%. This means that
lending to your friend who promises to pay Rs.15,000 each year for
two years will yield an annual rate of interest of 31.87%. This is
higher than depositing money in the bank at a rate of return of 10%
per year.
Thought question: At 31.87% interest rate what is the present value
of Rs.15,000 received each year for two years?
Example

• Suppose you have an investment idea that requires an

investment of Rs.250 lakh and is expected to generate
cash flows of Rs.35 lakhs per year, starting at the end of
the first year and lasting forever.
• The NPV of the project is calculated as: NPV   250  35
r
For various values of r, the
NPV for the project has been
computed. The IRR is 14% at
which NPV is Rs.0. If the
interest rate is 10% then the
project will have a positive
NPV and should be
undertaken.
Summary

Projects
should be
selected
taking into
account
value Positive value
generation generation
Positive NPV or
must be after
IRR higher than
accounting for l
cost of funds wil
the time value
indicate projects
of money
that should be
undertaken
How to forecast cash flows for evaluating projects

FINANCIAL FORECASTING
Why forecast cash flows?

• As we saw in the earlier module on project selection,

decision making is dependent on knowing future cash
flows from the investment.
• However, there is no crystal ball of prediction.
• In this module we will learn about a simple approach to
forecasting.
• It requires understanding of, (a) forecasting sales, (b)
using financial ratios to forecasts costs and resources
required, and (c) making financial projections.
 Preparing a financial plan
Starting Costs
Estimate Current Assets Rs.30,000
Estimate Capital Assets Rs.1,00,000
Estimate Start-up Expenses
Rs.30,000
Estimate how much of the required
funds will be raised from lenders and
how much you can contribute
Income Statement
Start-up Expenses (from box 1) 3
Rs.30,000
Forecast Revenue Rs.50,000
Forecast Cost of Goods Rs.40,000
Forecast Overhead Expenses Rs.5,000
Revenue – Expenses = Net Profit
-Rs.25,000
1 Estimate what assets are required and
expenses required to be paid to get the
business off the ground.
Starting Balance Sheet 2
Total Assets (from box 1) Rs.1,60,000
Planned Investment (Equity) Rs.60,000
Planned Loans (Liabilities) Rs.1,00,000
Balance Sheet Formula
Assets = Liabilities + Equity
The first period profit is going to be
negative usually because of the
start-up expenses.
Forecast required cash balance

Cash Flow
Estimate Monthly Sales +Rs.50,000
Adjust Monthly Sales for AR -Rs.10,000
Account for loans & investments +Rs.1,60,000 Capital to be raised
Calculate Total Receipts Rs.2,00,000

Estimate Monthly Purchase -Rs.50,000

Adjust for AP +Rs.10,000
Estimate Monthly Overheads -Rs.5,000
Estimate Loan Repayment -Rs.5,000
Start-up Costs -Rs.30,000
Startup assets -Rs.1,00,000
Calculate Disbursements -Rs.1,80,000

Starting Balance + Receipts – Disbursement Rs.20,000

= Ending Balance
Forecasted financial statements

• The prior exercise in forecasting is an easy approach to

making a forecast of cash requirements.
• However, most investors including banks require a more
formal presentation will full-fledged financial statements
forecasted for upto five years.
• In order to do that we will have to make some
assumptions about the financial ratios.
• Financial ratios relate items of the income statement and
balance sheet to the activity level such as sales.
• Sales forecasts are the starting point. In this module we
will not cover forecasting of sales in detail.
Role of the sales forecast

• Every business plan must identify the customer need,

the product and service proposed to meet the customer
need, the size of the market opportunity, and the fraction
of the market opportunity your business proposes to
capture.
• The financial projections are usually required to be made
for a period of 5 years. The first two years are done
carefully and the remaining three are not expected to be
very accurate but indicative.
• Sales forecasting involves estimating the level of sales
and the expectation of sales growth.
 Role of sales forecast

Profit and Loss Balance Sheet

Statement Sales
Forecast Cash
Sales Working Capital
Cost of Goods Sold Long Term Assets
Operating Expenses Debt
. .
. .
. .
 Income Statement

Item Forecast Basis Computation Year 1 Year 2

Sales Market Base year x Sales growth 10,000 11,000
(assume:10%) x1.10
Cost of Goods % of Sales Sales x rate (assume: 60%) 6,000 6,600
Sold
Expenses % of Expenses Sales x rate (assume: 20%) x0.60
2,000 2,200
Depreciation % of Assets Fixedassets x rate (assume: 20%)
x0.20 500 550
EBIT Computation 1,500 1,650
Interest % of debt Debt x rate (assume: 12%) 300 300
Tax % of EBT EBT x rate (assume:33.33%) 400 400
Net Income Computation 800 950

*All numbers are in Rs. and are mostly rounded to the nearest hundred
 Forecast Balance Sheet
Assets Forecast Basis Computation Year 1 Year 2
Cash % of (expenses + working capital 20% (2000+1200) 600 700
w/o cash) 20%(2200+1400)
Receivables Receivable turnover Sales * 45 days 1,200 1,400
(ART=365/DSO)
Inventory Inventory turnover (INVT=365/DSI) COGS*30 days 500 500
Less Payables Payable turnover (APT=365/DPO) Purchases*25 days 500 500
(assume Rs.7,000)
Working Capital Computation 1,800 2,100
Fixed Assets Asset turnover (Sales/Fixed Sales/ATO of 4 - 2,000 2,200
Assets) depreciation
Total Assets Computation 3,800 4,300
Debt Target debt % Total assets*60% 2,300 2,600
Owner’s Equity Computation 1,500 1,700

*All numbers are in Rs. and are mostly rounded to the nearest hundred
 Forecast Cash Flows
Year 1 Year 2
Net Income 800 950 From I/S
Add Depreciation 500 550 From I/S – non cash expense
Change in A/R -1,200 -200 From B/S – increase in A/R
Change in Inventory -500 0 From B/S
Change in A/P 500 0 From B/S
CFO 100 1,300 Computation
Capital expenditure -2,500 -750 Assets required-Depreciation
CFI -2,500 -750 Computation
Debt 2,300 300 From B/S – increase in debt
Equity 700 0 From B/S
Dividend 0 -750 Equity+ Profit- Required Equity
CFF 3,000 -450 Computation
*All numbers are in Rs. and are mostly rounded to the nearest hundred
 Checking forecasted statements

Year 1 Year 2
Opening Balance 0 600
CFO 100 1300
CFI -2,500 -750
CFF 3,000 -450
Total change in cash 600 100
Closing Balance 600 700

The integrity check ensures that the numbers “line up” – the
change in cash in the balance sheet explains the cash
balance.
Discussion

• The forecasting exercise serves two important objectives:

– Necessary for the raising funds from investors.
– Provides a framework for a series of decisions relating to
operational decisions.
• For example:
– What is the operations strategy?
• What should be the Sale price? Volume? Credit terms?
• How much inventory to hold? Payment terms?
• How much assets to buy to support sales? Depreciation?
– How to fund the business?
• Mix of debt-to-equity? Interest rate? Dividends?
Cash is king!
• Forecasting must provide insight into the cash required.
• Most start-up ventures under-estimate the importance of
having enough cash.
– Many fail because they did not hold enough cash.
• Thought question – in our example the business owner
is paying out Rs.750 as dividend.
– Is this prudent? Would lenders agree to this? Can the
owner avoid this payout?
• If the owners don’t take the money out – cash balance
could be higher, debt could be repaid, suppliers could be
paid faster, more customer credit can be given, more
inventory can be held, or more assets can be purchased.
Summary

Forecasts of
financial
statements are
an important part
of a business
To make the
plan. forecasting
Forecasts involve a
series of decisions process credible
about the operating you must make
sh
and financial sure that the ca
strategy. balance and the
is
change in cash
explained each
period.
How to evaluate the costs to determine pricing, volume, and
profits?

COST STRUCTURE AND

DECISION MAKING
Cost-Volume-Profit Relationships

• To manage any business we must understand the nature

of costs in running the business.
• There are three important questions:
– How do costs change with changes in level of activity
in the business? Activity could be sales, production,
people,…
– What is the effect of the cost structure on profits?
Profits are the surplus left over from the revenue after
meeting costs …
– What should be the pricing and production volume
that maximizes profits given the cost structure ….
Activity (Volume) Index

• The activity that causes changes in the behavior of

costs.
• Examples:
– Sales rupees in retail company
– Kilometers driven in trucking company
– Room occupancy in hotel
– Classes taught at college
• Changes in level or volume of activity should be
correlated with changes in costs.
Types of costs

• There are three types of costs

– Variable – vary in total with the level of activity
– Fixed – do not vary in total with the level of activity
– Mixed – partly vary and are partly fixed with the level
of activity
 Variable Costs - in Total

• Costs that vary in total directly and proportionately with

changes in the activity level.

140
Variable Cost= Rs.10 per unit
 0 units = Rs.0= total
120
 2 units = Rs.20= total
Total Variable Cost in Rs.

100
 4 units = Rs.40= total
80
 6 units = Rs.60=total
60
 8 units = Rs.80=total
40
10units = Rs.100=total
20

0
0 2 4 6 8 10 12
Units
Variable Costs - per Unit

• Costs that remain the same per unit at every level of

activity.
Variable Cost per unit (Rs.)
12

Variable Cost= Rs.10 per unit

10
 0 units = Rs.0 per unit
 2 units = Rs.10 per unit
8
 4 units = Rs.10 per unit
6
 6 units = Rs.10 per unit
Rs.

 8 units = Rs.10 per unit

4 10units = Rs.10 per unit
2

0
1 2 3 4 5 6
Fixed Costs - in Total

• Costs that remain the same in total regardless of

changes in the activity level.
– Property Taxes
– Insurance
– Rent
– Supervisory Salaries
– Depreciation on building, equipment
Fixed Cost - in Total

Costs that remain the same in total regardless

of changes in the activity level.

Fixed Cost (Rs.)

40,000

35,000 Total Fixed Costs= Rs.10,000

2 units = Rs.10,000 per month
30,000
4 units = Rs.10,000 per month
25,000
Fixed Cost (Rs.)
6 units = Rs.10,000 per month
20,000 8 units = Rs.10,000 per month
Rs.

15,000
10units = Rs.10,000 per month
10,000

5,000

0
1 2 3 4 5 6
Fixed Cost - per Unit

Costs that very inversely with activity. As volume

increases, unit cost declines.

Fixed cost per unit (Rs.)

6000

5000 Total Fixed Costs= Rs.10,000

2 units = Rs.5,000 per unit
4000
4 units = Rs.2,500 per unit
6 units = Rs.1,667 per unit
Axis Title 3000
8 units = Rs.1,250 per unit
2000 10units = Rs.1,000 per unit

1000

0
1 2 3 4 5
Mixed Costs

• Costs that contain both a variable and a fixed cost

element and change in total but not proportionately with
changes in the activity level.
• For example the rental of truck
– Rs.50 a day (Fixed Amount) +
– Rs.50 a mile (Variable Cost)
Behavior of a Mixed Costs
Contribution margin - Example

Total
Sales (500 units) Rs.2,50,000
Less: Variable expenses Rs.1,50,000
Contribution margin Rs.1,00,000
Less: Fixed expenses Rs.80,000
Net operating income Rs.20,000

Contribution Margin (CM) is the amount remaining

from sales revenue after variable expenses have
been deducted.
Contribution margin is used first to cover fixed
expenses. Any remaining contribution margin
contributes to net operating income.
Contribution margin – per unit

Total Per unit

Sales (500 units) Rs.2,50,000 Rs.500
Less: Variable Rs.1,50,000 Rs.300
expenses
Contribution margin Rs.1,00,000 Rs.200
Less: Fixed expenses Rs.80,000
Net operating income Rs.20,000

Sales, variable expenses, and contribution margin

can also be expressed on a per unit basis. If the
company sells an additional unit, Rs.200 more in
contribution margin will be generated to cover fixed
expenses and profit.
How much to produce? (units)

To breakeven, the company must generate Rs.80,000

in total CM each month to cover fixed costs.

Total Per unit

Sales (400 units) Rs.2,00,000 Rs.500
Less: Variable Rs.1,20,000 Rs.300
expenses
Contribution margin Rs.80,000 Rs.200
Less: Fixed expenses Rs.80,000
Net operating income Rs.0

If the company sells 400 units a month, it will

be operating at the break-even point.
Benefit of an incremental unit

If the company sells one more unit (401 units), net

operating income will increase by Rs.200.

Total Per unit

Sales (401 units) Rs.2,00,500 Rs.500
Less: Variable Rs.1,20,300 Rs.300
expenses
Contribution margin Rs.80,200 Rs.200
Less: Fixed expenses Rs.80,000
Net operating income Rs.200
C-V-P graphical approach

700000

600000

500000

it a re a
400000
Prof

300000
Break even point
200000 Margin of safety

100000
ss area
Lo
0
0 100 200 300 400 500 600 700 800 900 1000 1100 1200

Units Total Sales Fixed Cost Total cost

Target Net Income

• We know that at the break-even point no profit or loss

results for the company. By adding a factor for target net
income to the break-even equation, we obtain the formula
shown below for determining required sales.

Target
Required Variable Fixed
= + + Net
Sales Costs Costs
Income

• Required sales may be expressed in either sales

rupees or sales units.
Example

Suppose the company is targeting to make an income of

Rs.1,00,000. What is the sales required for the target
income?

If x is the sales in Rs. that is expected, the proportion of

variable cost to sale price is 0.6x since the per unit proportion
is 0.6 (i.e. Rs.300 to Rs.500).

x = 0.6x + Rs.80,000+Rs.1,00,000
0.4x = Rs.1,80,000
x = Rs.450,000

Or 900 units, as the selling price is Rs.500 per unit.

Effect of cost changes

• The framework of C-V-P is also useful to understand what

happens if business conditions change.
• For example, if the suppliers are going to increase costs by
20%, how many more units must be sold to achieve the
break even sales at the same sales price per unit?
X = 0.6x + 0.6x*20% + Rs.80,000
X= 0.72x+ Rs.80,000
X=Rs.80,000/0.28 = Rs.2,85,715 or 572 units (approximately)
• Alternatively, to maintain the volume as before the
company will have to increase the sale price per unit by
20% to Rs.560 per unit.
Rs.560x400units=Rs.300x(1.20)x400units+Rs.80,000
Decision making using costs

• Business decisions many times involve a choice among

alternative courses of action.
• The process used to identify the financial data that change
under alternative courses of action is called incremental
analysis.
• In some cases, both costs and revenues will change under
alternative choices. In other cases only costs or revenues
will vary.
• It is important to recognize that
– variable costs may not change under the alternatives,
and
– fixed costs may change.
An alternative view of costs

Suppose you are evaluating two alternative plans of action

under which revenues and costs are different.
• Often in choosing one course of action, the company must
give up the opportunity to benefit from some other course
of action. This lost benefit is referred to as opportunity
cost.
• Costs that have already been incurred and will not be
changed or avoided by any future decision are referred to
as sunk costs. Sunk costs are not relevant costs.
Example – choosing an order

• Assume a company produces 100,000 automatic units

per month, which is 80% of plant capacity. Variable
manufacturing costs are Rs.8 per unit, and fixed
manufacturing costs are Rs.400,000, or Rs.4 per unit.
The units are normally sold to retailers at Rs.20 each.
• The company has an offer from a customer to purchase
an additional 2,000 units at Rs.11 per unit. Acceptance of
this offer would not affect normal sales of the product,
and the additional units can be manufactured without
increasing plant capacity.
• Should the company accept the new order?
 Example (contd …)
If management makes its decision on the basis of total cost per unit
of Rs.12 (Rs.8 + Rs.4), the order would be rejected, because costs
(Rs.12) would exceed revenues (Rs.11) by Rs.1 per unit. However,
since the units can be produced within existing plant capacity, the
special order will not increase fixed costs. The relevant data for
the decision, therefore, are the variable manufacturing costs per
unit of Rs.8 and the expected revenue of Rs.11 per unit.

Reject Accept Net Income

Order Order Increase (Decrease)
Revenues Rs. -0- Rs. 22,000 Rs. 22,000
Costs Rs. -0- Rs. 16,000 Rs.(16,000)
Net income Rs. -0- Rs. 6,000 Rs. 6,000
Takeaways

Understandin
g activity
levels and
how costs
behave
relative to the Computing the
break even
activity. For decision
point helps to
making using
set the activity
incremental
level required
analysis focus
for value
on the relevant
generation.
costs and not
total costs.
How to measure risk, profitability, and efficiency of the business?

MEASURING RISK AND

PERFORMANCE
Performance measurement

• Business plans must be judged based on actual

performance.
• Business performance measures help to understand if
the business is at the correct level of activity, is pursuing
the right strategy, and whether it has the right amount of
resources.
• However performance is also dependent on risk where
risk captures the variability in performance.
• We will look at two ways of measuring performance
– Leverage to measure risk.
– Return on Equity to reflect success in strategy.
Operating leverage

• This measure the degree to which the company relies on

fixed operating expenses.
• One potential “effect” caused by the presence of
operating leverage is that a change in the volume of
sales results in a “more than proportional” change in
operating profit (or loss).
Operating leverage - Example
Company A Company B Company C
Sales Rs.10 Rs.11 Rs.19.50
Operating costs
Fixed Rs.7 Rs.2 Rs.14
Variable Rs.2 Rs.7 Rs.3
Operating profit Rs.1 Rs.2 Rs.2.50
Fixed to total cost 0.78 0.22 0.82
Fixed cost to 0.70 0.18 0.72
sales

If each firm experiences a 50% increase in sales for

next year. Which firm will be more “sensitive” to the
change in sales (i.e., show the largest percentage
change in operating profit)?
Effect of operating leverage
Company A Company B Company C
Sales Rs.15 Rs.16.5 Rs.29.25
Operating costs
Fixed Rs.7 Rs.2 Rs.14
Variable Rs.3 Rs.10.5 Rs.4.5
Operating profit Rs.5 Rs.4 Rs.10.75
% change in 400% 100% 330%
profit

A is the most “sensitive” firm since a 50% increase in

sales leads to a 400% increase in profit. The firm with
the largest absolute or relative amount of fixed costs
automatically does not show the most dramatic effects
of operating leverage.
Operating leverage

Degree of Operating Leverage (DOL) is the percentage

change in a firm’s operating profit (EBIT) resulting from a 1
percent change in output (sales).

DOL at Q units of Percentage change in operating profit (EBIT)

output (or sales) =
Percentage change in output (or sales)

DOL = [(EBIT + FC)/EBIT]

Where, EBIT is the earnings before interest and tax and
FC is the fixed costs
DOL is a measure of business risk since it magnifies the
variability of operating profits.
Computing DOL

1,000 + 7,000
DOLRs.10,000 sales = = 8.0
1,000
2,000 + 2,000
DOLRs.11,000 sales = = 2.0
2,000
2,500 + 14,000
DOLRs.19,500 sales = = 6.6
2,500
The ranked results indicate that the firm most sensitive, and
“risky”, to the presence of operating leverage is Company A.
Company A DOL = 8.0
Company B DOL = 2.0
Company C DOL = 6.6
Measuring effectiveness of strategy

• The company makes three choices to deliver value

– What should be the percentage return for every Rs. of
sale (Profit Margin)
– What should be the asset utilizations to support a
level of sales (Asset Turnover)
– What should be the amount of borrowings versus
owner’s funds to buy assets (Financial Leverage)
• These are all strategy choices that a business has to
make
• One measure of the effect of these is called the Return
on Equity (ROE)
Return on Equity (ROE)

• ROE measures the earnings available to owners

(common equity shareholders) for the common equity
investment (shareholders’ equity).
Net Income Sales Total Assets
ROE = x x
Sales Total Assets Owners Equity
Profit Margin Asset Turnover Financial Leverage

• It is important that for the ROE to be positive, margin

must be positive.
• As asset turnover increases ROE will increase and as
degree of financial leverage increase ROE will increase.
Example
Income Statement Balance Sheet
Assets Year 1 Year 2
Item Year 1 Year 2
Sales 10,000 11,000 Cash 600 700
Cost of Goods 6,000 6,600 Receivables 1,200 1,400
Sold Inventory 500 500
Expenses 2,000 2,200 Less Payables 500 500
Depreciation 500 550 Working Capital 1,800 2,100
EBIT 1,500 1,650
Fixed Assets 2,000 2,200
Interest 300 300
Total Assets 3,800 4,300
Tax 400 400
Debt 2,300 2,600
Net Income 800 950
Owner’s Equity 1,500 1,700

This is the set of financial statements that we looked at in our module on

forecasting. How can we evaluate the performance in Year 2?
Computing ROE

Net Income Sales Total Assets

ROE = x x
Sales Total Assets Owners Equity
Net Income 950 11,000 4,300
= x x
Owners Equity 11,000 4,300 1,700

55.88% = 8.64% x 2.56 x 2.53

• The business is earning Rs.8.64 for every Rs.100 of sales.

• For every Rs.100 of assets it is generating sales of Rs.256
• For every Rs.100 invested by the owners it is able to buy
assets of Rs.253
Discussion

• The return that the owners can generate is based on:

– Increasing profit margins – increase sales (volumes),
increase price per unit of sales (better product adoption),
reducing costs (cost reduction)
– Increasing asset turnover – increase sales (volumes and
or price per unit), increase assets (expansion), reduce
assets without reducing sales (efficiency)
– Increasing financial leverage – increasing debt as
proportion of total assets (borrowing), reducing owners
stake (dividend payout)
• Each strategy must be evaluated such that it does not
adversely impact other outcomes.
What is the investment return
for owners?

What is the investment

return from operations using
resources of the company?
What is the
investment return for
owners by using
borrowings to acquire
Return on Equity
(ROE)
resources?
Return on Assets Non-Equity Financing
(ROA) Leverage Factor

Unlevered Profit M argin Asset Utilization Leverage Factor for

Leverage Factor for Earnings
(1 - Expense Ratios) (Asset Turnover) Balance Sheet

Cost of Goods Sold to Leverage from Op erating

Accounts Receivable Turnover
Revenue Liabilities

Selling, General & Leverage from Short-Term

Inventory Turnover
Administrative to Revenue Debt

Other Exp ense Items to Leverage from Long-Term

Other Current Asset Turnover
Revenue Debt

Income Tax Expense to

Fixed Asset Turnover Leverage from Preferred Stock
Revenue

Other Non-current Asset

Turnover
Big Picture – What explains success?
SUPPLIERS

4. Bargaining power
of suppliers
3. Threat of
new entrants
COMPETITORS
POTENTIAL
SUBSTITUTES
ENTRANTS
2. Rivalry among
5. Threat of substitute
existing firms
products or services

1. Bargaining power
of customers

BUYERS
Performance measurement ratios

Financial
risk
Operating Resource
risk utilization

Operating Economic
Growth
performance picture
Thank you