Corporate Finance Assignment

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Solution

The percentage growth in the sales of ketchup and sauces was 5233/4608 − 1 = 13.6%. Similarly, growth in meals and snacks was 4.6%, infant/nutritional foods was 4.9%, and other categories were 10.0%. Thus, ketchup and sauces showed the highest growth.

If these growth rates continue for another year, sales of ketchup and sauces will be 5233 × 1.136 = $5945 million, and the other categories will be $4686 million, $1292 million, and $776 million, respectively, for total revenues of $12.7 billion.

CONCEPT CHECK

1.

Where do off-balance sheet transactions appear in a firm’s financial statements?

2.

What information do the notes to financial statements provide?

2.6 Financial Statement Analysis

Investors often use accounting statements to evaluate a firm in one of two ways:

1. Compare the firm with itself by analyzing how the firm has changed over time. 2. Compare the firm to other similar firms using a common set of financial ratios.

In this section we will describe the most commonly used ratios—related to profitability, liquidity, working capital, interest

coverage, leverage, valuation, and operating returns—and explain how each one is used in practice.

Profitability Ratios

The income statement provides very useful information regarding the profitability of a firm’s business and how it relates to the value of the firm’s shares. The gross margin of a firm is the ratio of gross profit to revenues (sales):

(2.8)

A firm’s gross margin reflects its ability to sell a product for more than the cost of producing it. For example, in 2012, Global

had gross margin of 33.3/186.7 = 17.8%.

Because there are additional expenses of operating a business beyond the direct costs of goods sold, another important profitability ratio is the operating margin, the ratio of operating income to revenues:

(2.9)

The operating margin reveals how much a company earns before interest and taxes from each dollar of sales. In 2012, Global’s operating margin was 10.4/186.7 = 5.57%, an increase from its 2011 operating margin of 7.1/176.1 = 4.03%. We can similarly compute a firm’s EBIT margin = (EBIT/Sales).

By comparing operating or EBIT margins across firms within an industry, we can assess the relative efficiency of the firms’ operations. For example, Figure 2.1 compares the EBIT margins of four major U.S. airlines from 2007 to 2012. Notice the impact on profitability from the financial crisis during 2008–2009, as well as the consistently low profits of the largest and oldest of the carriers, United-Continental (UAL), relative to its competitors.

FIGURE 2.1 EBIT Margins for Four U.S. Airlines

Annual (last twelve month) EBIT margins for four U.S. airlines: Alaska Airlines (ALK), JetBlue (JBLU), Southwest (LUV), and United-Continental (UAL). Note the decline in profitability for all airlines in the wake of the 2008 financial crisis, followed by a recovery by mid-2010. Note also the consistently lower profitability of the legacy carrier, United-Continental, relative to its younger peers.

Source: Capital IQ

In addition to the efficiency of operations, differences in operating margins can result from corporate strategy. For example, in December 2011, high-end retailer Nordstrom (JWN) had an operating margin of 11.5% over the past year; Wal-Mart Stores (WMT) had an operating margin of only 5.9%. In this case, Wal-Mart’s lower operating margin was not a result of its inefficiency. Rather, the low operating margin is part of Wal-Mart’s strategy of offering low prices to sell common products in

high volume. Indeed, WalMart’s sales were over 41 times higher than those of Nordstrom.

Finally, a firm’s net profit margin is the ratio of net income to revenues:

(2.10)

The net profit margin shows the fraction of each dollar in revenues that is available to equity holders after the firm pays interest and taxes. In 2012, Global’s net profit margin was 2.0/186.7 = 1.07%. One must be cautious when comparing net profit margins: While differences in net profit margins can be due to differences in efficiency, they can also result from differences in leverage, which determines the amount of interest expense, as well as differences in accounting assumptions.

Liquidity Ratios

Financial analysts often use the information in the firm’s balance sheet to assess its financial solvency or liquidity. Specifically, creditors often compare a firm’s current assets and current liabilities to assess whether the firm has sufficient working capital to meet its short-term needs. This comparison can be summarized in the firm’s current ratio, the ratio of current assets to current liabilities:

Notice that Global’s current ratio increased from 48/44 = 1.09 in 2011 to 57/48 = 1.19 in 2012.

A more stringent test of the firm’s liquidity is the quick ratio, which compares only cash and “near cash” assets, such as short- term investments and accounts receivable, to current liabilities. In 2012, Global’s quick ratio was (21.2 + 18.5)/48 = 0.83. A higher current or quick ratio implies less risk of the firm experiencing a cash shortfall in the near future. A reason to exclude inventory is that it may not be that liquid; indeed an increase in the current ratio that results from an unusual increase in inventory could be an indicator that the firm is having difficulty selling its products.

Ultimately, firms need cash to pay employees and meet other obligations. Running out of cash can be very costly for a firm, so firms often gauge their cash position by calculating the cash ratio, which is the most stringent liquidity ratio:

Of course, all of these liquidity ratios are limited in that they only consider the firm’s current assets. If the firm is able to generate significant cash quickly from its ongoing activities, it might be highly liquid even if these ratios are poor.

EXAMPLE 2.4 Computing Liquidity Ratios

Problem

Calculate Global’s quick ratio and cash ratio. Based on these measures, how has its liquidity changed between 2011 and

2012?

Solution

In 2011, Global’s quick ratio was (19.5 + 13.2)/44 = 0.74 and its cash ratio was 19.5/44 = 0.44. In 2012, these ratios were 0.83 and 21.2/48 = 0.44, respectively. Thus, Global’s cash ratio remained stable over this period, while its quick ratio improved slightly. But although these liquidity measures have not deteriorated, a more worrisome indicator for investors regarding Global’s liquidity might be its ongoing negative cash flow from operating and investing activities, shown in the

statement of cash flows.

Working Capital Ratios

We can use the combined information in the firm’s income statement and balance sheet to gauge how efficiently the firm is utilizing its net working capital. To evaluate the speed at which a company turns sales into cash, firms often compute the

number of accounts receivable days—that is, the number of days’ worth of sales accounts receivable represents:8

(2.11)

Given average daily sales of $186.7 million/365 = $0.51 million in 2012, Global’s receivables of $18.5 million represent 18.5/0.51 = 36 days’ worth of sales. In other words, on average, Global takes a little over one month to collect payment from its customers. In 2011, Global’s accounts receivable represented only 27 days’ worth of sales. Although the number of receivable days can fluctuate seasonally, a significant unexplained increase could be a cause for concern (perhaps indicating the firm is doing a poor job of collecting from its customers or is trying to boost sales by offering generous credit terms).

There are similar ratios for accounts payable and inventory. For these items, it is natural to compare them to the firm’s cost of sales, which should reflect the total amount paid to suppliers and inventory sold. Therefore, accounts payable days is defined as:

(2.12)

Similarly, inventory days = (inventory/average daily cost of sales).9

Turnover ratios are an alternative way to measure working capital. We compute turnover ratios by expressing annual revenues or costs as a multiple of the corresponding working capital account. For example,

(2.13)

Global’s inventory turnover in 2012 is 153.4/15.3 = 10.0×, indicating that Global sold roughly 10 times its current stock of inventory during the year. Similarly, accounts receivable turnover = (annual sales/accounts receivable) and accounts payable turnover = (annual cost of sales/accounts payable). Note that higher turnover corresponds to shorter days, and thus a more efficient use of working capital.

While working capital ratios can be meaningfully compared over time or within an industry, there are wide differences across industries. While the average large U.S. firm had about 45 days’ worth of receivables and 65 days’ worth of inventory in 2012, airlines tend to have minimal accounts receivable or inventory, as their customers pay in advance and they sell a transportation service as opposed to a physical commodity. On the other hand, distillers and wine producers tend to have very large inventory (over 300 days on average), as their products are often aged prior to sale.

Interest Coverage Ratios

Lenders often assess a firm’s ability to meet its interest obligations by comparing its earnings with its interest expenses using an interest coverage ratio. One common ratio to consider is the firm’s EBIT as a multiple of its interest expenses. A high ratio indicates that the firm is earning much more than is necessary to meet its required interest payments.

8Accounts receivable days can also be calculated based on the average accounts receivable at the end of the current and prior year.

9As with accounts receivable days, these ratios can also be calculated using the average accounts payable or inventory balance from the

current and prior year.

As a benchmark, creditors often look for an EBIT/Interest coverage ratio in excess of 5×for high-quality borrowers. When EBIT/Interest falls below 1.5, lenders may begin to question a company’s ability to repay its debts.

Depreciation and amortization expenses are deducted when computing EBIT, but they are not actually cash expenses for the firm. Consequently, financial analysts often compute a firm’s earnings before interest, taxes, depreciation, and amortization, or

EBITDA, as a measure of the cash a firm generates from its operations and has available to make interest payments:10

EBITDA = EBIT + Depreciation and Amortization (2.14)

We can similarly compute the firm’s EBITDA/Interest coverage ratio.

EXAMPLE 2.5 Computing Interest Coverage Ratios

Problem

Assess Global’s ability to meet its interest obligations by calculating interest coverage ratios using both EBIT and EBITDA.

Solution

In 2011 and 2012, Global had the following interest coverage ratios:

2012: and

2011: and

In this case Global’s low—and declining—interest coverage could be a source of concern for its creditors.

Leverage Ratios

An important piece of information that we can learn from a firm’s balance sheet is the firm’s leverage, or the extent to which it relies on debt as a source of financing. The debt-equity ratio is a common ratio used to assess a firm’s leverage. We calculate this ratio by dividing the total amount of short- and long-term debt (including current maturities) by the total stockholders’ equity:

(2.15)

10Because firms often do not separately list depreciation and amortization expenses on the income statement, EBITDA is generally calculated

by combining EBIT from the income statement and depreciation and amortization from the statement of cash flows. Note also that because the

firm may ultimately need to invest to replace depreciating assets, EBITDA is best viewed as a measure of the firm’s short-run ability to meet

interest payments.

We can calculate the debt-equity ratio using either book or market values for equity and debt. From Table 2.1, Global’s debt in 2012 includes notes payable ($3.5 million), current maturities of long-term debt ($13.3 million), and long-term debt ($99.9 million), for a total of $116.7 million. Therefore, its book debt-equity ratio is 116.7/22.2 = 5.3, using the book value of equity. Note the increase from 2011, when the book debt-equity ratio was only (3.2 + 12.3 + 76.3)/21.2 = 91.8/21.2 = 4.3.

Because of the difficulty interpreting the book value of equity, the book debt-equity ratio is not especially useful. Indeed, the book value of equity might even be negative, making the ratio meaningless. For example, Domino’s Pizza (DPZ) has, based on the strength of its cash flow, consistently borrowed in excess of the book value of its assets. In 2012, it had debt of $1.6 billion, with a total book value of assets of only $600 million and an equity book value of −$1.4 billion!

It is therefore most informative to compare the firm’s debt to the market value of its equity. Recall from Example 2.1 that in 2012, the total market value of Global’s equity, its market capitalization, is 3.6 million shares × $14/share = $50.4 million.

Therefore, Global’s market debt-equity ratio in 2012 is 116.7/50.4 = 2.3, which means Global’s debt is a bit more than

double the market value of its equity.11 As we show later in the text, a firm’s market debt-equity ratio has important

consequences for the risk and return of its stock.

We can also calculate the fraction of the firm financed by debt in terms of its debt-to-capital ratio:

(2.16)

Again, this ratio can be computed using book or market values.

While leverage increases the risk to the firm’s equity holders, firms may also hold cash reserves in order to reduce risk. Thus,

another useful measure to consider is the firm’s net debt, or debt in excess of its cash reserves:

Net Debt = Total Debt − Excess Cash & Short-term Investments (2.17)

To understand why net debt may be a more relevant measure of leverage, consider a firm with more cash than debt

outstanding: Because such a firm could pay off its debts immediately using its available cash, it has not increased its risk and

has no effective leverage.

Analogous to the debt-to-capital ratio, we can use the concept of net debt to compute the firm’s debt-to-enterprise value ratio:

(2.18)

11In this calculation, we have compared the market value of equity to the book value of debt. Strictly speaking, it would be best to use the

market value of debt. But because the market value of debt is generally not very different from its book value, this distinction is often ignored

in practice.

Given Global’s 2012 cash balance of $21.2 million, and total long- and short-term debt of $116.7 million, its net debt is 116.7

− 21.2 = $95.5 million.12 Given its market value of equity of $50.4 million, Global’s enterprise value in 2012 is 50.4 + 95.5 =

$145.9 million, and thus its debt-to-enterprise value ratio is 95.5/145.9 = 65.5%. That is, 65.5% of Global’s underlying business activity is financed via debt.

12While net debt should ideally be calculated by deducting cash in excess of the firm’s operating needs, absent additional information, it is

typical in practice to deduct all cash on the balance sheet.

A final measure of leverage is a firm’s equity multiplier, measured in book value terms as Total Assets/Book Value of Equity.

As we will see shortly, this measure captures the amplification of the firm’s accounting returns that results from leverage. The market value equity multiplier, which is generally measured as Enterprise Value/Market Value of Equity, indicates the

amplification of shareholders’ financial risk that results from leverage.

Valuation Ratios

Analysts use a number of ratios to gauge the market value of the firm. The most common is the firm’s price-earnings ratio

(P/E):

(2.19)

That is, the P/E ratio is the ratio of the value of equity to the firm’s earnings, either on a total basis or on a per-share basis. For

example, Global’s P/E ratio in 2012 was 50.4/2.0 = 14/0.556 = 25.2. In other words, investors are willing to pay over 25 times Global’s earnings to purchase a share.

The P/E ratio is a simple measure that is used to assess whether a stock is over- or undervalued based on the idea that the

value of a stock should be proportional to the level of earnings it can generate for its shareholders. P/E ratios can vary widely across industries and tend to be highest for industries with high expected growth rates. For example, in January 2012, the

average large U.S. firm had a P/E ratio of about 17. But software firms, which tend to have above-average growth rates, had an average P/E ratio of 32, while automotive firms, which were still feeling the effects of the recession, had an average P/E

ratio of only 9. The risk of the firm will also affect this ratio—all else equal, riskier firms have lower P/E ratios.

Because the P/E ratio considers the value of the firm’s equity, it is sensitive to the firm’s choice of leverage. The P/E ratio is therefore of limited usefulness when comparing firms with markedly different leverage. We can avoid this limitation by instead

assessing the market value of the underlying business using valuation ratios based on the firm’s enterprise value. Common ratios include the ratio of enterprise value to revenue, or enterprise value to operating income, EBIT, or EBITDA. These ratios

compare the value of the business to its sales, operating profits, or cash flow. Like the P/E ratio, these ratios are used to make intra-industry comparisons of how firms are priced in the market.

COMMON MISTAKE Mismatched Ratios

When considering valuation (and other) ratios, be sure that the items you are comparing both represent amounts related to the entire firm or that both represent amounts related solely to equity holders. For example, a firm’s share price and market

capitalization are values associated with the firm’s equity. Thus, it makes sense to compare them to the firm’s earnings per share or net income, which are amounts to equity holders after interest has been paid to debt holders. We must be careful,

however, if we compare a firm’s market capitalization to its revenues, operating income, or EBITDA because these amounts are related to the whole firm, and both debt and equity holders have a claim to them. Thus, it is better to compare revenues,

operating income, or EBITDA to the enterprise value of the firm, which includes both debt and equity.

EXAMPLE 2.6 Computing Profitability and Valuation Ratios

Problem

Consider the following data as of May 2012 for Wal-Mart Stores and Target Corporation (in $ billion):

Wal-Mart Stores (WMT) Target Corporation (TGT)

Sales 446.9 69.9

EBIT 26.6 5.3

Depreciation and Amortization 8.1 2.1

Net Income 15.7 2.9

Market Capitalization 200.9 38.4

Cash 6.6 0.8

Debt 58.4 17.5

Compare Wal-Mart’s and Target’s EBIT margins, net profit margins, P/E ratios, and the ratio of enterprise value to sales, EBIT, and EBITDA.

Solution

Wal-Mart had an EBIT margin of 26.6/446.9 = 6.0%, a net profit margin of 15.7/446.9 = 3.5%, and a P/E ratio of 200.9/15.7 = 12.8. Its enterprise value was 200.9 + 58.4 − 6.6 = $252.7 billion, which has a ratio of 252.7/446.9 = 0.57 to

sales, 252.7/26.6 = 9.5 to EBIT, and 252.7/(26.6 + 8.1) = 7.3 to EBITDA.

Target had an EBIT margin of 5.3/69.9 = 7.6%, a net profit margin of 2.9/69.9 = 4.1%, and a P/E ratio of 38.4/2.9 = 13.2. Its enterprise value was 38.4 + 17.5 − 0.8 = $55.1 billion, which has a ratio of 55.1/69.9 = 0.79 to sales, 55.1/5.3 = 10.4 to

EBIT, and 55.1/(5.3 + 2.1) = 7.4 to EBITDA.

Note that while Target trades for a significantly higher multiple of sales than Wal-Mart (not surprising given its higher profit margins), the other valuation multiples are quite close, despite the large difference in the size of the two firms.

The P/E ratio, or ratios to EBIT or EBITDA, are not meaningful if the firm’s earnings are negative. In this case, it is common to look at the firm’s enterprise value relative to sales. The risk in doing so, however, is that earnings might be negative because

the firm’s underlying business model is fundamentally flawed, as was the case for many Internet firms in the late 1990s.

Operating Returns

Analysts often evaluate the firm’s return on investment by comparing its income to its investment using ratios such as the firm’s

return on equity (ROE):13

(2.20)

Global’s ROE in 2012 was 2.0/22.2 = 9.0%. The ROE provides a measure of the return that the firm has earned on its past investments. A high ROE may indicate the firm is able to find investment opportunities that are very profitable.

13Because net income is measured over the year, the ROE can also be calculated based on the average book value of equity at the end of the

current and prior year.

Another common measure is return on assets (ROA), which we calculate as:14

(2.21)

The ROA calculation includes interest expense in the numerator because the assets in the denominator have been funded by

both debt and equity investors.

As a performance measure, ROA has the benefit that it is less sensitive to leverage than ROE. However, it is sensitive to

working capital—for example, an equal increase in the firm’s receivables and payables will increase total assets and thus lower

ROA. To avoid this problem, we can consider the firm’s return on invested capital (ROIC):

(2.22)

The return on invested capital measures the after-tax profit generated by the business itself, excluding any interest expenses (or

interest income), and compares it to the capital raised from equity and debt holders that has already been deployed (i.e., is not held as cash). Of the three measures of operating returns, ROIC is the most useful in assessing the performance of the underlying business.

EXAMPLE 2.7 Computing Operating Returns

Problem

Assess how Global’s ability to use its assets effectively has changed in the last year by computing the change in its return on assets and return on invested capital.

Solution

In 2012, Global’s ROA was (2.0 + 7.7)/177.7 = 5.5%, compared to an ROA in 2011 of (1.9 + 4.6)/148.9 = 4.4%.

To compute the return on invested capital, we need to calculate after-tax EBIT, which requires an estimate of Global’s tax

rate. Because Net income = Pretax income × (1 − tax rate), we can estimate (1 − tax rate) = Net income/Pretax income. Thus, EBIT × (1 − tax rate) = 10.4 × (2.0/2.7) = 7.7 in 2012, and 7.1 × (1.9/2.5) = 5.4 in 2011.

To compute invested capital, note first that Global’s net debt was 3.2 + 12.3 + 76.3 − 19.5 = 72.3 in 2011 and 3.5 + 13.3 +

99.9 − 21.2 = 95.5 in 2012. Thus, ROIC in 2012 was 7.7/(22.2 + 95.5) = 6.5%, compared with 5.4/(21.2 + 72.3) = 5.8% in 2011.

The improvement in Global’s ROA and ROIC from 2011 to 2012 suggests that Global was able to use its assets more

effectively and increase its return over this period.

14ROA is sometimes calculated as Net Income/Assets, inappropriately ignoring the returns generated by the assets that are being used to

support the firm’s debt obligations (see also the box on Mismatched Ratios on page 41). Also, the interest expense that is added back is

sometimes done on an after-tax basis in order to eliminate the benefit of the tax savings provided by debt. Finally, as with ROE, the average

book value of assets at the beginning and end of the year may be used.

The DuPont Identity

We can gain further insight into a firm’s ROE using a tool called the DuPont Identity (named for the company that

popularized its use), which expresses the ROE in terms of the firm’s profitability, asset efficiency, and leverage:

(2.23)

The first term in the DuPont Identity is the firm’s net profit margin, which measures its overall profitability. The second term is

the firm’s asset turnover, which measures how efficiently the firm is utilizing its assets to generate sales. Together, these terms determine the firm’s return on assets. We compute ROE by multiplying by a measure of leverage called the equity multiplier,

which indicates the value of assets held per dollar of shareholder equity. The greater the firm’s reliance on debt financing, the higher the equity multiplier will be. Applying this identity to Global, we see that in 2012 its asset turnover is 186.7/177.7 =

1.05, with an equity multiplier of 177.7/22.2 = 8. Given its net profit margin of 1.07%, we can compute its ROE as

ROE = 9.0% = 1.07% × 1.05 × 8

EXAMPLE 2.8 Determinants of ROE

Problem

For the year ended January 2012, Wal-Mart Stores had sales of $446.9 billion, net income of $15.7 billion, assets of $193.4 billion, and a book value of equity of $71.3 billion. For the same period, Target (TGT) had sales of $69.9 billion, net income

of $2.9 billion, total assets of $46.6 billion, and a book value of equity of $15.8 billion. Compare these firms’ profitability, asset turnover, equity multipliers, and return on equity during this period. If Target had been able to match Wal-Mart’s asset

turnover during this period, what would its ROE have been?

Solution

Wal-Mart’s net profit margin (from Example 2.6) was 15.7/446.9 = 3.51%, which was below Target’s net profit margin of 2.9/69.9 = 4.15%. On the other hand, Wal-Mart used its assets more efficiently, with an asset turnover of 446.9/193.4 =

2.31, compared to only 69.9/46.6 = 1.50 for Target. Finally, Target had greater leverage (in terms of book value), with an equity multiplier of 46.6/15.8 = 2.95, relative to Wal-Mart’s equity multiplier of 193.4/71.3 = 2.71. Next, let’s compute the

ROE of each firm directly, and using the DuPont Identity:

Note that due to its lower asset turnover, Target had a lower ROE than Wal-Mart despite its higher net profit margin and

leverage. If Target had been able to match Wal-Mart’s asset turnover, its ROE would have been significantly higher: 4.15% × 2.31 × 2.95 = 28.3%.

To conclude our discussion of financial ratios, Table 2.4 presents the various measures of profitability, liquidity, working

capital, interest coverage, leverage, valuation, and operating returns.

TABLE 2.4 A Summary of Key Financial Ratios

Profitability Ratios

Gross Margin

Operating Margin

EBIT Margin

Net Profit Margin

Liquidity Ratios

Current Ratio

Quick Ratio

Cash & Short-term Investments

Cash Ratio

Working Capital Ratios

Accounts Receivable Days

Accounts Payable Days

Inventory Days

Accounts Receivable Turnover

Accounts Payable Turnover

Inventory Turnover

Interest Coverage Ratios

EBIT/Interest Coverage

EBITDA/Interest Coverage

Leverage Ratios

Debt-Equity Ratio

Debt-to-Capital Ratio

Debt-to-Enterprise Value Ratio

Equity Multiplier (book)

Equity Multiplier (market)

Valuation Ratios

Market-to-Book Ratio

Price-Earnings Ratio

Enterprise Value Ratios

Operating Returns

Asset Turnover

Return on Equity (ROE)

Return on Assets (ROA)

Return on Invested Capital (ROIC)