Evaluating

CHAPTER 2

Financial
Performance

2-1

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
 Introduction
• Analogy to flight cockpit.
• Indicators and levers.

2-2
 Levers 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 / Sales
2. Asset turnover -- Sales / Assets
3. 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*

2-4
 Comparisons
• 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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 ROA
• How defined?
• Net income / Assets
• What does this measure?
• Net income + interest / Assets?

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 Gross 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 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, 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 Turns
• COGS / Ending inventory
• What are the turns?

2-11
 Days’ Sales in Cash
• Cash + Securities / Sales per day
• What does this ratio measure?
• Cash as a substitute?

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 Payables 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 Turnover
• Sales / Net PP&E
• Capital intensity?
• What’s the wheel analogy?

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 Financial 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, 2007

2-16
 Balance Sheet Ratios
• Debt-to-assets = Total liabilities / Total
assets
• Debt-to-equity = Total liabilities /
Shareholders’ equity
• What do these ratios measure?

2-17
 Coverage 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 Ratios
• D/E and D/A
• What do they represent?
• Coverage ratios?
• Growth prospects and future coverage
potential?
• Rollover risk?

2-20
 Liquidity 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?
• 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 Financing
Company
A B
Debt @ 10% Interest $ 900 $ 0
Equity 100 1,000
Total assets $ 1,000 $ 1,000

EBIT $ 120 $ 120

- Interest expense 90 0
Earnings 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%

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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?
– Asymmetric information?
– 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)?

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FIGURE 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

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 Using 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

2-29
 Scotts 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 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?
• 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, 2007

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 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

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 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?
• 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)

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 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 Chapter

2-40
 TABLE 2-5 Definitions of Principal Ratios Appearing in Chapter
(continued)

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 Appendix
International 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 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 Values

2-44
TABLE 2A-1 (Continued)

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 Figure 2A.1 Average Interest Coverage Ratio,
1996

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 IFAS
• 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.
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