Financial Management 2
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chapter_2_1.pptEvaluating Financial Performance
Chapter Two
Copyright © 2016 by McGraw-Hill Education. All rights reserved.
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How can financial levers be compared to controls in a 747?
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Levers of Financial Performance
Return on Equity: The most popular measure of financial performance
= 11.1%
Why does this definition make sense?
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The 3 Determinants of ROE
How is this a measure of leverage?
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TABLE 2.1 ROE and Levers of Performance for 10 Diverse Companies, 2013
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Questions about Table 2.1
Differences in ROE across firms is less than differences in components. Why?
What is the role of competition in ROE differences?
Is there any reason why profit margin and asset turnover are negatively related?
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Profitability Ratios
Profit margin: The fraction of each sales dollar realized as profits
Return on assets: The combined effect of profit margin and asset turnover
Gross margin: The contribution to fixed costs and profits
Are COGS fixed or variable?
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Profitability Ratios
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Breakeven Sales
Use gross margin to calculate Stryker’s breakeven sales volume
Assume COGS are variable and operating expenses are fixed.
Stryker’s 2013 operating costs were $4,920 million.
Since 69% of sales goes to cover operating costs, breakeven sales volume = $4,920/0.69 = $7,130 million.
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You try it. Calculate breakeven sales volume for Apple Inc. for 2014.
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Gross margin=70,537/182,795=38.6%. Breakeven=18,034/0.386=$46,720.
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Turnover-Control Ratios
Asset turnover: Sales generated per dollar of assets
Inventory turnover: Number of times inventory turns over per year
Collection period: Average number of days to collect receivables
What if you don’t know credit sales?
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More Turnover-Control Ratios
Days’ sales in cash: Availability of cash relative to sales
Payables period: Average number of days to pay accounts payable
Fixed-asset turnover: Sales generated per dollar of fixed assets
What if you don’t know credit purchases?
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Turnover-Control Ratios
Does a higher fixed-asset turnover indicate higher or lower capital intensity?
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Fixed Assets vs. Current Assets
Which is likely to be more sensitive to external events, current assets or fixed assets?
What is a self-liquidating loan?
Loan to support current assets
What happens to AR and inventory when sales go up?
What happens to AR and inventory when sales go down?
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Financial Leverage
What does increased financial leverage do to ROE?
Is increased leverage a good thing?
Electricite de France vs. Google 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 ROE and Levers of Performance for 10 Diverse Companies, 2013
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Leverage and Liquidity Ratios 1 Balance Sheet Ratios
Debt-to-assets ratio: Percent of assets paid for by creditors
Debt-to-equity ratio: Financing supplied by creditors for every dollar from shareholders
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Leverage and Liquidity Ratios 2 Coverage Ratios
Times interest earned: Income available in relation to interest payments
Times burden covered: Income available in relation to all debt service
Which coverage ratio is more important? Why?
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Stryker’s tax rate is $206/$1,212 = 17%
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Leverage and Liquidity Ratios 3 Market Value Leverage Ratios
Market debt-to-equity ratio: Today’s value of financial burdens compared to shareholders’ expected value
Market debt-to-assets ratio: Today’s value of financial burdens compared to value of expected future income
What if you don’t know the market value of debt?
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Leverage and Liquidity Ratios 4 Liquidity Ratios
Current ratio: Liquid assets compared to imminent debts
Acid test (Quick ratio): Very liquid assets compared to imminent debts
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ROE: The Timing Problem
Is ROE forward-looking?
Does ROE have a long-term perspective?
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ROE: The Risk Problem
Does ROE take into account business risk?
What is the impact of leverage on ROE?
Return on invested capital: A measure of return on capital independent of the amount of leverage
= 9.1%
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ROIC Is Not Distorted by Company Financing
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ROE: The Value Problem
Should we calculate return on book equity or market equity?
Earnings yield: ROE using market value of equity instead of book value
Price-to-earnings ratio: Inverse of earnings yield; commonly used measure of performance
Is this a better measure of performance than ROE?
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ROE or Market Price?
Which is the better way to measure financial performance?
Value creation for investors involves market values.
Line of sight (for managers)?
Asymmetric information, in that managers know more than investors?
External effects, economy, other stocks, etc.?
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Scatter Plots
Price-to-book vs. ROE (weighted-average)
Figures 2.1 and 2.2 coming up
Slope and dispersion (R-squared)?
Where is Stryker’s relative to others in Figure 2.1?
Where are Apple and Amazon in Figure 2.2?
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FIGURE 2.1 M/B vs. ROE for 34 Medical Technology Firms
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FIGURE 2.2 M/B vs. ROE for 87 Large Corporations
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Using Ratios Effectively
Ratio values need to be understood in context.
Usually, no “correct” values for ratios
Important to compare ratios to something else
Comparable companies
Changes in a company’s ratios over time
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FIGURE 2.3 The Levers of Performance Suggest One Road Map for Ratio Analysis
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Example of Ratio Analysis
Analyze the profitability measures
What do the various measures tell you?
What’s Stryker’s trend over time?
How does Stryker compare to the industry?
Analyze the levers of ROE
Which levers explain the changes in ROE over time?
Analyze the control ratios
Is Stryker managing assets efficiently?
How do they compare to prior performance and industry performance?
Analyze the leverage ratios
What’s the trend in their use of debt?
How do they compare to the industry?
Is their amount of leverage concerning?
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TABLE 2.2 Ratio Analysis of Stryker Corporation
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Common Size Financial Statements
Add insight in analyzing a company
Helps in recognizing trends over time
Can compare to other companies without scale effects
What do common-size figures tell you compared to typical ratios?
For example, collection period vs. AR/Assets
For example, inventory turnover vs. Inventory/Assets
What do you learn about working capital
Fraction of assets that are short-term
What do you learn about COGS?
Small changes in percentages can be large relative to net income
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TABLE 2.3 Stryker Corporation, Common-Size Balance Sheets
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TABLE 2.3 Stryker Corporation, Common-Size Income Statements
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TABLE 2.4 Definitions of Principal Ratios Appearing in Chapter
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TABLE 2.4 Definitions of Principal Ratios Appearing in Chapter (cont.)
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