Financial Performance and Decision-Making

Companies and investors use financial ratios to assess performance and make decisions. Common metrics include:

Net profit margin

The percentage of revenue that becomes profit (Net Income ÷ Revenue×100%). For example, $10 profit on $100 sales is a 10% profit margin. Higher margins mean the company keeps more of each sales dollar after covering costs.

Return on Investment (ROI)

Measures efficiency of an investment. It is calculated as (Gain from Investment – Cost of Investment) ÷ Cost of Investment. For example, if you invest $1,000 in a project and later receive $1,200, the ROI is ($200 gain ÷ $1,000 cost) = 20%. A positive ROI indicates profit; higher ROI projects are generally preferred. ROI helps compare different projects or investments easily.

Return on Equity (ROE)

Shows how well the company generates profit from shareholders’ equity. It is calculated as Net Income ÷ Shareholders’ Equity. For example, if a company earns $10,000 profit and has $50,000 equity, ROE = 20%. A higher ROE means management is using owners’ funds more effectively to produce profit.

Financial Leverage

Using debt to finance growth. Leverage can amplify returns: if a company borrows to invest and earns a return above the loan’s interest, equity holders benefit more. However, leverage also adds risk: if profits fall, the company still owes debt. For example, issuing bonds to buy equipment may increase the return on equity when business is good, but requires interest payments regardless of sales.

Valuation

Estimating a company’s worth. Investors use methods like discounted cash flow (present value of projected cash flows) or market multiples (e.g. price/earnings ratio). These help decide if a company is under- or over-valued and guide investment decisions.

By understanding these concepts and examples, new employees can better grasp how businesses operate financially and how decisions (like investments or budget cuts) impact the company’s health and strategy.

Investment Valuation Methods

Investment methods are categorized by whether they account for the time value of money.

Static Methods

• Payback (Plazo de Recuperación): Measures the time required to recover the initial investment ($P = A/Q$ if flows are constant).
  • Advantage: Very intuitive and useful for liquidity analysis.
  • Disadvantage: Ignores cash flows occurring after the recovery period and the different timing of flows.

Dynamic Methods

• VAN (NPV - Net Present Value): The sum of updated net cash flows minus the initial investment.
  • Formula: $$VAN = -A + \sum_{j=1}^{n} \frac{Q_j}{(1+k)^j}$$
  • Decision rule: Carry out only if $VAN > 0$ (creates value).
• TIR (IRR - Internal Rate of Return): The discount rate ($r$) that makes the VAN equal to zero.
  • Decision rule: Accept if $r > k$ (where $k$ is the required return or cost of capital).

Leverage and the fundamental theorem of financing

Financial leverage describes how debt impacts the return for shareholders.

Fundamental theorem

Increasing debt (leverage) increases the Return on Equity (ROE) only if the Return on Assets (ROA) is greater than the cost of the debt ($RE > Ki$). However, any increase in ROE through leverage always results in a corresponding increase in Financial Risk.

The relationship is expressed as: $$E(RF) = E(RE) + \frac{D}{S} [E(RE) - Ki]$$

Sensitivity analysis

Sensitivity analysis investigates how results change when one specific parameter is modified. This allows a company to isolate the impact of the most sensitive variables (e.g., market size or unit price) and identify primary financial risks.