Chap002

2-12-1

Evaluating Financial

Performance

Evaluating Financial

Performance

CH

AP

TE

R 2

CH

AP

TE

R 2

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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IntroductionIntroduction

• Analogy to flight cockpit.

• Indicators and levers.

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Levers of Financial PerformanceLevers of Financial Performance

• ROE is Net Income divided by Shareholders’ equity.

• Why is this a sensible definition?• 3 determinants of ROE are

1. Profit margin -- Net income / Sales2. Asset turnover -- Sales / Assets3. Financial leverage -- Assets / Shareholders’

equity

• Compare different companies on these.

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TABLE 2-1 ROEs and Levers of Performance for 10 Diverse Companies, 2007*TABLE 2-1 ROEs and Levers of Performance for 10 Diverse Companies, 2007*

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ComparisonsComparisons

• Differences in ROE across firms is less than differences in components.

• Why?

• Role of competition?

• Is there any reason why profit margin and asset returns are negatively related?

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ROAROA

• How defined?

• Net income / Assets

• What does this measure?

• Net income + interest / Assets?

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Gross MarginGross Margin

• Gross Profit / Sales

• Gross profit = ?

• Are COGS variable or fixed?

• Why is it important to distinguish between variable and fixed costs?

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Asset TurnoverAsset Turnover

• Take another look at Table 2-1.

• Which companies have high asset turnovers?

• Which is likely to be more sensitive to external events, current assets or fixed assets?

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TABLE 2-1 ROEs and Levers of Performance for 10 Diverse Companies, 2007TABLE 2-1 ROEs and Levers of Performance for 10 Diverse Companies, 2007

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• What is a self-liquidating loan? – What happens to AR and inventory when

sales go up?– What happens to AR and inventory when

sales go down?

• What does a ratio like AR/Sales tell us?

• Collection period (DSO)?

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Inventory TurnsInventory Turns

• COGS / Ending inventory

• What are the turns?

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Days’ Sales in CashDays’ Sales in Cash

• Cash + Securities / Sales per day

• What does this ratio measure?

• Cash as a substitute?

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Payables PeriodPayables Period

• AP / Credit purchases per day

• COGS as a proxy for Credit purchases.

• Inventory changes do what?

• Labor costs do what?

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Fixed Asset TurnoverFixed Asset Turnover

• Sales / Net PP&E

• Capital intensity?

• What’s the wheel analogy?

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Financial LeverageFinancial Leverage

• What does increased financial leverage do to ROE?

• Is increased leverage a good thing?

• Florida Power vs. Netflix and Genentech in Table 2-1?

• JPMorgan Chase?

• Have a look, and describe what you see, along with an explanation.

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TABLE 2-1 ROEs and Levers of Performance for 10 Diverse Companies, 2007TABLE 2-1 ROEs and Levers of Performance for 10 Diverse Companies, 2007

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Balance Sheet RatiosBalance Sheet Ratios

• Debt-to-assets = Total liabilities / Total assets

• Debt-to-equity = Total liabilities / Shareholders’ equity

• What do these ratios measure?

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Coverage RatiosCoverage Ratios

• TIE = EBIT / Interest expense

• Times burden covered = EBIT divided by the sum of interest and principal repayment/1- tax rate.– Includes repayment of principal– Adjusts for differential impact of what in

respect to tax?

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• Which coverage ratio is more important?

• How much coverage is enough?

• Cash, borrowing capacity, salable assets, business risk

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Market Value Leverage RatiosMarket Value Leverage Ratios

• D/E and D/A

• What do they represent?

• Coverage ratios?

• Growth prospects and future coverage potential?

• Rollover risk?

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Liquidity RatiosLiquidity Ratios

• Current ratio = Current Assets / Current Liabilities

• Acid test removes inventory from current assets to yield the quick ratio.

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Is ROE a Reliable Yardstick?Is ROE a Reliable Yardstick?

• Timing– Forward looking and long-term perspective?

• Risk– Impact of leverage– ROIC = EBIT(1-Tax rate) / Interest Bearing Debt +

Equity– AP excluded

• Value– Book value vs. market value– Earnings yield, inverse of P/E

• Back to ROIC.

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ROIC Is Not Distorted by Company FinancingROIC Is Not Distorted by Company Financing

A BDebt @ 10% Interest 900$ $ 0Equity 100 1,000 Total assets 1,000$ 1,000$

EBIT 120$ 120$ - Interest expense 90 0Earnings before tax 30 120 - Tax @ 40% 12 48 Earnings after tax 18$ 72$

ROE 18.0% 7.2%ROA 1.8% 7.2%ROIC 7.2% 7.2%

Company

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ROE or Market Price?ROE or Market Price?

• Which is the better way to measure financial performance?– Value creation for investors involves market

values.– Line of sight?– Asymmetric information?– External effects, economy, other stocks, etc.?

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Scatter PlotsScatter Plots

• Price-to-book vs. ROE (weighted average)

• Figures 2-1 and 2-2 coming up.

• Slope and dispersion (R-squared)?

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FIGURE 2-1 Market Value to Book Value of Equity versus Return on Equity for 37 Household Products and Related CompaniesFIGURE 2-1 Market Value to Book Value of Equity versus Return on Equity for 37 Household Products and Related Companies

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FIGURE 2-2 Market to Book Value of Equity versus Return on Equity for 87 Large Corporations

FIGURE 2-2 Market to Book Value of Equity versus Return on Equity for 87 Large Corporations

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Using Ratios EffectivelyUsing Ratios Effectively

• Ratio values need to be understood in context.

• Usually, no “correct” values for ratios.

• Rely on rule of thumb assessment techniques, such as comps and own time series changes.

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Figure 2-3 The Levers of Performance Suggest One Road Map for Ratio Analysis

Figure 2-3 The Levers of Performance Suggest One Road Map for Ratio Analysis

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Scotts Miracle-GroScotts Miracle-Gro

• Time series of Scotts ROE?– Recap in 2007? Quality?

• ROIC?

• Profit margin?– Puzzle?

• Gross margin?– How strong a brand?

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Asset TurnoverAsset Turnover

• Asset turnover.– Low or high?– Good or bad?

• Fixed asset turnover?

• Inventory turnover?

• Collection period?

• Days’ sales in cash?

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Leverage and Liquidity Ratios?Leverage and Liquidity Ratios?

• Impact of recap?

• TIE or TBurdenCovered?

• Compare Scotts to industry averages: see next slide.

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TABLE 2-2 Ratio Analysis of Scotts Miracle-Gro Co., 2003-2007, and Industry Averages, 2007TABLE 2-2 Ratio Analysis of Scotts Miracle-Gro Co., 2003-2007, and Industry Averages, 2007

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Common Size Financial Statements

Common Size Financial Statements

• Collection period, inventory turnover vs. ratios of AR and inventory to assets?– Sales/assets?

• Working capital? – Fraction of assets that are short-term?

• COGS– Small %s can be large relative to net income.

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TABLE 2-3 Scotts Miracle-Gro Co., Common-Size Financial Statements, 2003 –2007 and Industry Averages for 2007

TABLE 2-3 Scotts Miracle-Gro Co., Common-Size Financial Statements, 2003 –2007 and Industry Averages for 2007

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TABLE 2-3 Scotts Miracle-Gro Co., Common-Size Financial Statements, 2003 –2007 and Industry Averages for 2007 (continued)

TABLE 2-3 Scotts Miracle-Gro Co., Common-Size Financial Statements, 2003 –2007 and Industry Averages for 2007 (continued)

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Opportunities for Cash?Opportunities for Cash?

• A challenge?

• Examine statement of cash flows, contrasting cash flows from operations to cash flows from investment.

• Excess cash?

• Recap + distribution to shareholders?

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TABLE 2-4 Selected Ratios for Representative Industries, 2006 (upper-quartile, median and lower-quartile values)

TABLE 2-4 Selected Ratios for Representative Industries, 2006 (upper-quartile, median and lower-quartile values)

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TABLE 2-4 Selected Ratios for Representative Industries, 2006 (upper-quartile, median and lower-quartile values) (continued)

TABLE 2-4 Selected Ratios for Representative Industries, 2006 (upper-quartile, median and lower-quartile values) (continued)

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TABLE 2-5 Definitions of Principal Ratios Appearing in ChapterTABLE 2-5 Definitions of Principal Ratios Appearing in Chapter

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TABLE 2-5 Definitions of Principal Ratios Appearing in Chapter(continued)

TABLE 2-5 Definitions of Principal Ratios Appearing in Chapter(continued)

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AppendixInternational Differences

AppendixInternational Differences

• In the upcoming table, look at the UK, Germany and Japan.

• Asset turns and profit margins in Asia and Latin America?

• Japanese collection periods, payables periods, and keiretsu.

• Leverage and liquidity across the globe?

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Public CompaniesPublic Companies

• Indebtedness in Latin America vs. U.S., Europe, and Japan?

• Indebtedness in Korea, Thailand, Indonesia?– Controlling families, state-owned banks, and

the state– Use of banks to foster top-down directed

development

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TABLE 2A-1 Ratio Analysis of Companies in Various Countries and Regions, 2007, Median ValuesTABLE 2A-1 Ratio Analysis of Companies in Various Countries and Regions, 2007, Median Values

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TABLE 2A-1 (Continued)TABLE 2A-1 (Continued)

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Figure 2A.1 Average Interest Coverage Ratio, 1996

Figure 2A.1 Average Interest Coverage Ratio, 1996

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IFASIFAS

• International Financial Accounting Standards.

• 2005, Europe adopts IFAS.• Post Enron and WorldCom, U.S. will adopt

IFAS.• Consolidated balance sheets vs. those of

parent, expensing R&D, fair value accounting.

• Principles vs. rules.