0:15

>> Let's move on now and think about the income statement.

Okay? So now we're going to talk about financial ratios

that we're going to calculate using data

from the income statement.

The first thing we need to think

about is what does the income statement measure?

Okay? Here you have an example

of an income statement for DirecTV, okay.

First thing is there is this term LTM.

Which is defined here in the bottom.

What this means is that it's the data for the latest 12 months.

So if this is March 31, 2015, this means is

that you have the data from April 1

of 2014 to March 31 of 2015.

Okay? So it's a year, right?

And so in many cases the most current data

that you can get is going to be the latest 12 month figure.

Right? So essentially what you have an income statement is data

on profits and costs.

So you have revenue, right?

You have cost, your profits, right?

And so the key formation really that you can get

from the income statement is profitability.

How profitable a company is.

1:34

The asset turnover, they are defined here.

Asset turnover, net profit margin, return on assets,

and return on equity, and you can see that for some

of these ratios we are going

to use this important measure which I call OPAT.

1:59

Okay? And as we are going to discuss next,

OPAT is a really good measure to use when you're trying to figure

out how profitable a company is.

Okay? The return on equity measure

which is measure number 4 uses net income instead of OPAT.

That we're going to talk-- the first thing for us to talk

about is what is the difference between OPAT and net income,

and to do that let's look

at Cablevision's income statement again.?

Okay? So here you have the latest 12 month figures.

Okay, let's use those.

Right? You have revenues, costs, profits,

operating income is here.

2:39

It's at the top of the income statement.

Okay? That's the key thing.

Operating income is right there at the top

so it only includes operating revenues and costs.

Okay? So revenues and costs that we really have

to do with the business.

Right? For a company that Cablevision,

they sell digital TV and Internet, right?

So these are the revenues that they get from their customers

and those of the cost of operating the company.

Right? Operating income is going to be a measure of that.

And then after that we're going

to have the non-operating expenses and revenues.

Right? So we have interest expense,

we have interest income, okay?

And you can see here that there is a net interest expense.

That's the amount of interest that the company paid.

So your net income is going to be a profit figure

that is reported after interest payments

and other non-operating items.

Net income is at the bottom of the income statement.

Okay? If you work out the math here, right,

what would be your OPAT,

your OPAT would be the operating income minus taxes, right?

I've done the calculation there for you,

so the OPAT for Cablevision

in this latest 12 month period would be $764 million.

4:01

Right? And if you do the math, you know, the interest is 100--

sorry, the interest is $580 million so you can check that in

and come is approximately OPAT minus interest.

The difference between OPAT and net income is mostly

that net income is in after interest measure.

4:22

Okay? So, was the right way to think about that we if you think

about OPAT and ratios that are based off of Pat like ROA,

what you're going to keep doing is measuring profitability

for the company as a whole.

4:39

Right? So they're up there and income statement for Cablevision

for example, you're measuring the profit

for the entire company.

If you use net income, or return on equity, you're going

to be measuring profitability

from the perspective of shareholders only.

4:57

Okay? Because net income is a profit measure that is reported

after interest and ROE is a financial ratio

that is based off of net income, so we're not going

to be including-- essentially,

we're going to be deducting interest payments

and other non-operating stuff from your profit measure.

Okay? So, this might be okay,

but as we Artie discussed a little bit in this course,

net income is at the bottom of the income statement

so one problem is that net income is busily affected

by accounting manipulation and one-time items.

Right? So if the company has a one-time expense,

you know like a legal settlement, for example,

if Cablevision gets sued in a given year,

that has to be reported in your income statement, and it's going

to reduce your net income, right?

And there are many ways

that companies can manipulate the accounts

to change your net income.

Operating income is usually a more solid measure.

Okay? So for many companies, ROA is going to be a better measure

of profitability then net income because of these two reasons.

Okay? It's based-- it computes profits for the entire company

and since it's at the top of the income statement, it's a measure

that is a little bit harder to manipulate then net income.

6:21

And here comes a question for you.

All right?

We talked about using the market value of assets

and the market value of equity

to compute leverage ratios, right?

We just did leverage ratios, and that if you want to figure

out how solvent a company is, we have to use the market values.

Okay? Now we are computing profitability ratios.

Right? So, for example, you know,

just to give an example here for you

to understand what we're talking about, ROA is going

to be defined as OPAT assets, right?

7:28

Okay? Why you want to compare profits to capital

that is invested in the company.

Okay? And remember that a company's market value is going

to measure the company's total value, right.

It also increase the value of future cash flows.

7:46

Okay? So it's not really a measure

of how much capital has been invested in that company,

it's not a measure of how many dollars investors putting

[phonetic] in that company, really is a measure

of the value of the company.

Okay? One way to think about this, let me go back here,

because this is an important idea, okay?

If you use market values to measure profitability,

what you would be doing, right,

so in the numerator you have current profits.

8:39

Right? So a company that is--

you know, suppose you find a company

that has a lot of future profits.

Okay? That, you know, and you use market value of assets,

this companies going to have low profitability ratios,

9:07

you have to use book value of assets and book value of equity

if you can in the denominator.

Okay? Let us now give some examples

for Cablevision and DirecTV.

Here I have a simplified snapshot

of the Cablevision balance sheet for you.

Again, so you can see the value of assets.

We already computed OPAT, which is down there, right,

OPAT for Cablevision is $764 million.

Right? So what you need to do is divide OPAT by the total value

of assets if you want to compute ROA.

So the assets, the value of assets is here.

It should be really simple.

Cablevision ROA should be 0.11.

And you can get the data that I provided

and of course I will provide these calculations as well

for you, see you can get the data and verify

that you can get these numbers.

Which should be really easy to compute.

10:13

Right? ROE.

Let's go back here again, okay.

ROE is what?

ROE is net income divided by equity, and remember,

do we use market equity or book?

10:35

But we know that book equity for these companies is negative.

Okay? Book equity for these companies is negative.

So you really could not use ROE to measure profitability

for our Cablevision and DirecTV.

So it's a measure that does not make much sense.

It would be very useful for you.

Okay? And it's, you know, this is a common problem.

Book equity is a problematic figure to use.

And that is why in general, I prefer, okay I prefer to look

at profitability measures that measure profits

for the company as a whole, like ROA.

ROE is going to prompt.

Okay? Finally, let's talk about earnings-per-share.

11:22

Okay? This is a profit measure that we talked

about in the beginning of this module already, right?

Is essentially net income divided by shares outstanding.

It looks like a stock price, right?

But it's based off of net income instead

of the market value of equity.

Okay? And we discussed already some of the problems

with net income, okay?

So, of course, you're going to have some of the same problems

as ROE because you're basing all profitability on that income

which is after interests, so it does not compute profits

for the company as a whole, it is subject

to manipulation and all that.

It's affected by one-time items, okay?

In addition to that, there is an additional problem which is

that you are dividing net income by shares outstanding.

12:15

Okay? And as we already discussed,

shares outstanding can be easily manipulated.

It's very easy to change the number of shares outstanding

that a company has with something

as simple as a stock split.

12:28

Okay? And then, of course, the one thing you could do is

to just your profitability measures.

Try to get at the actual profits, but, you know,

it's much simpler just to not use earnings-per-share

to compare profitability across firms.

Okay? You know, so my recommendation is

that we do not use earnings-per-share

to compare profitability, you know, since the number

of shares can be easily changed.

You know, it's not-- we're not going to be able to say

that a company that has higher EPS

than another company is more profitable.

Okay? So EPS is not a great measure of profitability,

at least the way I see it.