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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.