1 Calculate and interpret the market value and market value added of a public corporation.
2 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity.
3 Calculate and interpret key measures of operating efficiency, leverage, and liquidity.
4 Show how profitability depends on the efficient use of assets and on profits as a fraction of sales.
5 Understand how a company’s sustainable growth depends on both its payout policy and its return to equity.
6 Compare a company’s financial standing with its competitors and its own position in previous years.
Corporate Performance
Chapter 4 Outline
Corporate Performance Measured
Market Value Added
Economic Value Added
Book Rates of Return: Return on Capital, Return on Assets, Return on Equity
Financial Ratios
Assessing the Investment Decisions: Measuring Efficiency, Measuring Profitability
Assessing the Financing Decisions: Measuring Leverage, Measuring Liquidity
The Du Pont System
Calculating Sustainable Growth
The Role of Financial Ratios and Transparency
Basic idea of this chapter: The financials (balance sheet, income statement) and market values act as the foundation. Financial ratios are the building blocks that help diagnose corporate performance.
Corporate Performance Measured
Three Primary Ways to Measure Corporate Performance:
·
Market Value Add:
Market capitalization minus book value of equity.
·
Economic Value Add:
Operating income minus a charge for the cost of capital employed. Also called residual income.
·
Book Rates of Return:
Measure the firm’s profits per dollar of assets. Also known as accounting rates of return because they are based on accounting information (specifically company financials). Three common measures are the return on capital (ROC), the return on equity (ROE), and the return on assets (ROA).
Market Value Added
What is it?
Why is it useful?
Defined:
Definitions:
·
Market Capitalization —Total market value of equity, equal to share price times the number of shares outstanding
·
Market Value Added —Market Capitalization – Book Value of Equity
MVA Discussion
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Consider AT&T and Home Depot
Similar MVA, Different Market-to-Book Ratio
Why?
Market Capitalization
= Total market value of equity, equal to share price times the number of shares outstanding
Market Value Added
= Market Capitalization – Book Value of Equity (i.e. does the market believe the firm’s value exceeds its book value)
Market-to-Book Ratio
= (Market Value of Equity)/(Book Value of Equity)
Limitations of MVA:
1. Market value reflects investors’ expectations about future performance, complete with the imprecisions that come with all forecasting.
2. Market value fluctuates frequently due to reasons outside of the financial manager’s control.
3. Privately owned corporations do not have a public market value.
Economic Value Added
What is it?
Why is it important?
Why is it called residual income?
Defined:
Economic Value Added = Operating Income minus the product of cost of capital and total capitalization
Operating Income = Net Income + After-tax Interest
Cost of Capital = The minimum acceptable rate of return on capital investment
Total Capitalization = Total Long-term Capital = Equity + Bonds + other Long-term capital [all capital committed by debt and equity investors]
EVA: Discussion
TABLE 4.4
Consider Coca-Cola and Google
Similar EVA, Different Return on Capital
Why?
Economic Value Added = Operating Income minus the product of cost of capital and total capitalization
Operating Income = Net Income + After-tax Interest
Cost of Capital = The minimum acceptable rate of return on capital investment
Total Capitalization = Total long-term capital = Equity + Bonds + Other Long-term Capital [all capital committed by debt and equity investors]
Return on Capital = (Operating Income)/(Total Capitalization)
Book Rates of Return*
What do they measure?
Book Rates of Return
= Accounting Rates of Return = Measures of the firm’s profits per dollar of assets.
Return on Capital
= (after-tax operating income)/(total capitalization)
Return on Assets
= (after-tax operating income)/(average total assets)
or = (after-tax operating income)/(start of year total assets)
Return on Equity
= (net income)/(average equity)
or = (net income)/(start of year equity)
Average Assets
= (end of period assets + beginning of period assets)/2
Average Equity
= (end of period equity + beginning of period equity)/2
Calculating Return on Capital
Lowe’s Return on Capital
Lowe’s Balance Sheet (in $m)
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Return on Capital
= Net income plus after tax interest (this sum is known as operating income) as a percentage of long-term capital (known as total capitalization)
Average Total Capitalization
= The average of the beginning and end of year value of equity and long-term debt
Calculating Return on Assets
Lowe’s Return on Assets
Lowe’s Balance Sheet (in $m)
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Return on Assets = Net income plus after-tax interest (this sum is known as operating income) as a percentage of (average) total assets
Calculating Return on Equity
Lowe’s Return on Equity
Lowe’s Balance Sheet (in $m)
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Return on Equity = Net income as a percentage of average total equity
Financial Ratios and Shareholder Value
Shareholder value depends on good investment and financing decisions.
Financial Ratios help measure the success and soundness of these decisions.
Investment Decision – The allocation of limited resources among competing opportunities (projects) through the capital budgeting process.
Financing Decision — The form and amount of financing of a firm’s investments.
Efficiency Ratios
OR*
How does this ratio measure efficiency?
How does this ratio measure efficiency?
* Either equation is a legitimate way to calculate the asset turnover ratio
Efficiency Ratios
– Ratios which measure how efficiently a firm uses its assets.
Efficiency Ratios
How does this ratio measure efficiency?
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How does this ratio measure efficiency?
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How does this ratio measure efficiency?
Efficiency Ratios – Ratios which measure how efficiently a firm uses its assets.
Lowe’s Balance Sheet (in $m)
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Calculating an Efficiency Ratio
Lowe’s Asset Turnover Ratio
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Profitability Ratios
How does this ratio measure the firm’s profitability?
When is this ratio potentially more useful than just profit margin?
Profitability Ratio — Measures the profits generated from sales.
Note: ROC, ROA, ROA and EVA are also typically considered profitability ratios.
Lowe’s Balance Sheet (in $m)
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Calculating a Profitability Ratio
Lowe’s Operating Profit Margin
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Leverage Ratios
How does this ratio measure leverage?
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How does this ratio measure leverage?
Leverage Ratios – Measures the extent to which a firm is funded by debt
Measuring Leverage
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How does this ratio measure leverage?
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How does this ratio measure leverage?
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How does this ratio measure leverage?
Calculating a Leverage Ratio
Lowe’s Times Interest Earned Ratio
Lowe’s Balance Sheet (in $m)
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Note: COGS stands for Cost of Goods Sold. Expenses include selling, general and administrative costs (and “store operating costs” in this example).
Measuring Liquidity
How does this ratio measure liquidity?
How does this ratio measure liquidity?
Liquidity Ratios– Ratios which measure the extent to which the firm has sufficient liquidity in the coming year.
Net Working Capital = Current Assets – Current Liabilities
Liquidity Ratios
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How does this ratio differ from the current ratio? Why might a financial manager prefer it?
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How does this ratio differ from the current ratio? Why might a financial manager prefer it?
The Quick Ratio is sometimes referred to as the Acid-Test Ratio
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Creating a Liquidity Ratio
Lowe’s Balance Sheet (in $m)
Lowe’s NWC to Total Assets Ratio
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The DuPont System
What is it and what is it used for?
DuPont System:
A breakdown of ROE and ROA into component ratios
The DuPont System: ROA
Asset
Turnover
Operating Profit
Margin
ROA Decomposition by Industry
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Discussion: For a given level of ROA, which firms have returns driven by turnover? By margin?
The DuPont System: ROE
Leverage
Ratio
Debt
Burden
Operating
Profit
Margin
Asset
Turnover
The last ratio in the DuPont breakdown of ROE is a measure of the firm’s debt burden. The denominator represents free cash flow (Cash available for distribution to investors after the company has paid for any new capital investment or additions to working capital.). If the ratio is close to zero, the firm has a heavy debt burden—much of its free cash flow goes to interest payments.
Sustainable Growth
Definitions:
Growth in Equity from Plowback = Sustainable Growth = Growth that relies only on internal financing, keeping the long-term debt ratio constant.
Plowback Ratio + Payout Ratio = 1 (always)
Payout Ratio– The percent of each dollar earned that is paid to shareholders.
Plowback Ratio– The percent of each dollar earned that is retained by the corporation.
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The Role of Financial Ratios
Comparability
Discussion: after we have made all of these calculations, how do we know if the results are good or bad? Financial ratios can be used for:
1. Self-comparison (or trend analysis)-- is the company improving over its past performance?
2. Peer group comparison -- how is the company doing compared to peer companies? (in this case, Home Depot vs. Lowe’s)
3. Best practice -- how does the company compare to "best of breed" companies regardless of industry?
The most important role that ratio analysis plays is diagnostic. Ratio analysis points out areas of strengths and weaknesses in corporate performance. When an organization has an intense understanding of the operating processes that contribute to financial statement numbers, corrective action can be identified and hopefully implemented in a fairly short time frame. This is much like the medical doctor interpreting the results from a series of lab reports and recommending a course of action to correct the medical problem.
Notes: Discrepancies between calculations here and in previous slides are from rounding. Some measures can be calculated using average values or year beginning values.
The Role of Financial Ratios
TRANSPARENCY
Appendix A: Average Ratios, by Industry
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Appendix B: Financial Ratios and Default Risk
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Corporate Performance
Market Value Add
Book Rates of Return
Economic Value Add
Investment Decisions
Financing Decisions
Leverage Ratios
Liquidity Ratios
Efficiency Ratios
Profitability Ratios
Shareholder Value
Corporate Performance
Underlying Data:
Corporate Financials & Market Values
Calculations:
Financial Ratios
Page 1 of 18
Dividends
Payout Ratio=
Earnings
Growth in equity from plowback = Plowbac
k Ratio ROE
Earnings - DividendsEarnings
EarningsEquity
´
=´
Earnings-Dividends
=
Equity
Book Value
Market Value Added [Share Price Shares
Outstanding] - Equity
=´
Economic Value Added Operating Income*
- [Cost of CapitalTotal Capitalization]
=´
Economic Value Added Operating Income -
[Cost of CapitalTotal Capitalization]
=´
Assets20092008
Current assets:
Cash and cash equivalents$632 245
Short-term investments 425 416
Merchandise inventory - net8,249 8,209
Deferred income taxes - net 208 105
Other current assets218 215
Total current assets9,732 9,190
Property less acc. depreciation 22,499 22,722
Long-term investments 277 253
Other assets497 460
Total assets$33,005 32,625
Liabilities and Shareholders' Equity20092008
Current liabilities:
Short-term borrowings$- 987
Current maturities of long-term debt552 34
Accounts payable4,287 4,109
Accrued comp./employee benefits 577 434
Deferred revenue683 674
Other current liabilities1,256 1,322
Total current liabilities7,355 7,560
Long-term debt, excl. current maturities 4,528 5,039
Deferred income taxes - net 598 599
Other liabilities 1,455 1,372
Total liabilities13,936 14,570
Shareholders' equity:--
Common stock - $.50 par value729 735
Capital in excess of par value6 277
Retained earnings18,307 17,049
Acc. other comprehensive income27 (6)
Total shareholders' equity19,069 18,055
Total liabilities and shareholders' equity$33,005 32,625
After Tax Operating Income = Net Income
+ After-Tax Interest
= 1,783 + 181 = 1,964
Average Total Capitalization = Average L
ong-Term Debt + Equity
(23,57923,094)
23,336.5
2
+
==
After-Tax Operating Income1,964
ROC8.4%
Average Total Capitalization23,336.5
===
Lowe's Income Statement2009
Net sales47,220
Cost of sales30,757
Gross margin16,463
Expenses:
Selling, general and administrative11,688
Store opening costs49
Depreciation1,614
Interest - net287
Total expenses13,638
Pre-tax earnings 2,825
Income tax provision 1,042
Net earnings1,783
After Tax Operating Income = Net Income
+ After-Tax Interest
= 1,783 + 181 = 1,964
(33,00532,625)
Average Total Assets =
2
32,815
+
=
After-Tax Operating Income1,964
ROA6.0%
Average Total Assets32,815
After-Tax Operating Income1,964
ROA = 6.0%
Total Assets32,625
YearBeginning
or
===
==
(19,06918,055)
Average Total Equity =
2
18,562
+
=
Net Income1,783
ROE9.6%
Average Total Equity18,562
Net Income1,783
ROE = 9.9%
Equity18,055
YearBeginning
or
===
==
Sales
Asset turnover ratio=
Total Assets
YearBeginning
Sales
=
Average Total Assets
Sales
Asset turnover ratio=
Total Assets
YearBeginning
Sales
=
Average Total Assets
Sales
Receivables Turnover=
Receivables
YearBeginning
Cost of Goods Sold
Inventory Turnover Ratio=
Inventory
YearBeginning
Cost of Goods Sold
Inventory Turnover Ratio=
Inventory
YearBeginning
Inventory
Average Daysin Inventory=
(Cost of Goods Sold/365)
YearBeginning
Receivables
Average Collection Period=
(Sales/365)
YearBeginning
(33,00532,625)
Average Total Assets =
2
32,815
+
=
Sales44,270
Asset Turnover Ratio1.4
Average Total Assets32,815
===
Net Income
Profit Margin=
Sales
Net IncomeAfter-Tax Interest
Operating Profit Margin=
Sales
+
Net Income + After-Tax Interest1,783181
OPM4.2%
Sales47,220
+
===
Long Term Debt
Long term debt ratio=
Long Term Debt+Equity
Long-Term Debt
Long-term Debt Equity Ratio=
Equity
Total Liabilities
Total Debt Ratio=
Total Assets
EBIT
Times Interest Earned=
Interest Payments
EBIT+Depreciation
Cash Coverage Ratio=
Interest Payments
EBIT = Sales - COGS - Expenses -Deprecia
tion
47,22030,75711,7371,6143,112
=---=
EBIT3,112
Times Interest Earned10.8
Interest287
===
Net Working Capital
NWC to Total Assets Ratio=
Total Assets
Current Assets
Current Ratio=
Current Liabilities
Cash + Marketable Securities + Receivabl
es
Quick ratio=
Current Liabilities
Cash + Marketable Securities
Cash Ratio=
Current Liabilities
Net Working Capital = 9,732-7,3552,377
=
NWC2,377
NWC to Total Assets 7.2%
Total Assets33,005
===
Net Income Interest
ROA=
Assets
+
SalesNet Income Interest
ROA=x
AssetsSales
+
Net Income
ROE=
Equity
AssetsSalesNet Income InterestNet Incom
e
ROE=xxx
EquityAssetsSalesNet Income Interest
+
+
Earnings-Dividends
Plowback Ratio=
Earnings
BeautifulFlower
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