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Financial Analysis Using Ratios

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Agenda

Ratio analysis and EVA Briggs case Cash flow statement analysis Free cash flow

Four Analysis Categories

Evaluate performance relative to a peer group, and period-over-period, to identify strengths and weaknesses in four areasProfitabilityAsset managementSolvency riskEconomic Value-added

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Key Uses of Ratio Analysis

Consider impact of financial performance on cash flow and stock priceMeasure value-added

Set targets for projected performance to improve valuation

Assist in formulating a cash flow planning forecast

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I. Profitability

Traditional DuPont Model Adjusted DuPont Model Margin analysis

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  Unlevered Levered

Assets $10,000 $10,000

Debt $0 $5,000

Equity $10,000 $5,000

# Shares 400 200

Tax Rate 40% 40%

Interest rate 5%

Unlevered Levered

  Poor Expected Strong Poor Expect Strong

EBIT $-500 $1,000 $1,500 $-500 $1,000 $1,500

Interest $0 $0 $0 $250 $250 $250

Taxes $-200 $400 $600 $-300 $300 $500

Net Income $-300 $600 $900 $-450 $450 $750

ROA -3.0% 6.0% 9.0% -4.5% 4.5% 7.5%

ROE -3.0% 6.0% 9.0% -9.0% 9.0% 15.0%

EPS $-0.75 $1.50 $2.25 $-2.25 $2.25 $3.75

Which outperformed? Operating performance?

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Traditional DuPont Model

Return onEquity

Return onAssets

MarginsOn Sales

AssetUtilization

FinancialLeverage

x =x

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Profitability summary using the Dupont Model

EquityAvg

AssetsAvg

AssetsAvg

Sales

Sales

NI

EquityAvg

NI

ROE = Return on Equity: rate of return to stockholders

NPM = Net Profit Margin: efficiency in expense control (income statement)

TAT = Total Asset turnover: asset management (balance sheet)

LR = Leverage Ratio (‘financial leverage’; tradeoff is insolvency risk)

ROE NPM TAT LR

Return on Assets

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EquityAvg

AssetsAvg

AssetsAvg

Sales

Sales

NI

EquityAvg

NI

EquityAvg

NI

EquityAvg

AssetsAvg

AssetsAvg

NI

ROAROE

ROA = Return on Assets: summarizes income statement and balance sheet efficiency, before incorporating financial leverage

LR

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DuPont mixes operating and financial decisions

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A problem with this approach is that because net income is biased by financing choice, the equation provides a poor summary of operating performance (e.g. success in product positioning, production efficiency, distribution, overhead control, etc.)

Companies with high debt have low net profit margin, low ROA, but higher ROE, all else equal

Traditional Balance Sheet

Current Assets Current Liabilities

PP&E Long-term Debt

Stockhoders Equity

= Total Assets = Total Liab + Equity

Our objective as financial managers is to enhance the value of the debt and equity capital that we’ve raised in the market, on which the investors require a rate of return.

Let’s show a balance sheet that isolates this investor capital.

Managerial Balance Sheet

+ Current Assets - Oper. Current Liab.

+ PP&E + Debt (L.T. + S.T.)

+ Equity

= Invested Capital

Net Working Capital

= Invested Capital

Invested Capital can be calculated both inside and outside the box

Net Working Capital (NWC) NWC = Current Assets minus Operating Current

Liabilities

Operating Current Liabilities grow spontaneously with the firm’s assets not motivated by a return on investment (non-interest) include Accts Payable, Accrued Expenses, Tax Payable exclude short-term interest-bearing debt that is part of

current liabilities on the traditional balance sheet This S.T. debt is now outside the box as a part of the Debt Capital

Invested Capital (IC)

IC is raised to acquire assets inside the box

IC = NWC + PP&E inside the box

IC also = Debt + Equity outside the box

The overall rate of return required by investors on the Invested Capital is known as theWeighted Average Cost of Capital

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Net Operating Profit After Taxes

+ Earnings Before Interest and Taxes

X (1 – cash tax rate)

= NOPAT

This is the after-tax income earned on the Invested Capital

By using earnings before Interest to calculate NOPAT, we exclude the influence of debt funding on earnings

NOPAT is the net income that would be earned if there were no debt

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Return on Invested Capital

ROExED

ETrx

ED

DROIC d

)1(

ROETrxE

D

E

EDROICx d

)1(

Multiply both sides by: E

ED

ROIC is a weighted return on Invested Capital:

ROETrxE

D

E

DxROIC d

)1(1

ROETrROICxE

DROIC d )1(

ROIC = ; rd=interest rate on debtCapital

NOPAT

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Return on Invested Capital (ROIC)

ROIC intersects efficiency on the income statement with the productivity of assets on the balance sheet

ROIC provides a summary measure of operating performance

A financial performance analysis begins with ROIC, and drills down from there

ROIC = NOPAT x Sales

Sales IC

Net Oper. Margin x

Capital Turnover

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Adjusted Dupont Model (isolates operating and financial leverage effects on ROE)

The second term isolates the increase in ROE resulting solely from leverage differences

This term also captures the tax break on interest (1-t) that we ignored when we calculated NOPAT

)1( TrROICxEquity

DebtROICROE d

rd = interest rate on debt

Pure leverage effect

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  Unlevered Levered

Assets $10,000 $10,000

Debt $0 $5,000

Equity $10,000 $5,000

# Shares 400 200

Tax Rate 40% 40%

Interest rate 5%

Unlevered Levered

  Poor Expected Strong Poor Expect Strong

EBIT $-500 $1,000 $1,500 $-500 $1,000 $1,500

Interest $0 $0 $0 $250 $250 $250

Taxes $-200 $400 $600 $-300 $300 $500

Net Income $-300 $600 $900 $-450 $450 $750

ROA -3.0% 6.0% 9.0% -4.5% 4.5% 7.5%

ROE -3.0% 6.0% 9.0% -9.0% 9.0% 15.0%

EPS $-0.75 $1.50 $2.25 $-2.25 $2.25 $3.75

Which company performed better?

Adjusted Dupont Model

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)1( TrROICxEquity

DebtROICROE d

000,10

600

000,5

000,5

000,10

6005% (1-.40)[ ]+ x -

6% 1.0 6% 3%=9% + x -[ ] From an operating perspective the companies are

identical, earning a 6% ROIC The levered company adds another 3% to its ROE as a

result of its debt usage Ultimately the answer to which is better depends largely

on which debt mix is appropriate given the industry’s operating risk (variability in EBIT)

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Increasing Leverage and ROE

Note that the hurdle rate for increasing ROE (same for EPS) by increasing leverage is very low: ROIC > Int (1-T) Returns to capital > after-tax cost of debt only To increase value need ROIC > weighted average cost of debt and equity

Cost of both debt and equity are rising as debt increases

Goal should not be max ROE

)1( TrROICxEquity

DebtROICROE d

Margin analysis

Gross Margin: ability to mark-up

product and control production

expenses

Net Operating Margin: control of overhead expenses (SG&A) as well

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Sales

profitGross

Sales

NOPAT

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Profits Summary Start with ROIC as a summary measure of

operating performance

Explain ROIC results using Margins on income statement Capital turnovers from balance sheet

Explain ROE result using ROIC and Leverage

Also consider growth’s impact on value

Value Drivers

The three keys to value are 1) ROIC; 2) growth in NOPAT; 3) Risk

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II. Asset Management (turnovers)

Capital Turnover Accts. Receivable Days Inventory Holding Period Working Capital Turnover PP&E Turnover

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365/Sales

receivableAccountsAvg

365/COGS

InventoryAvg

CapitalInvestedAvg

Sales

EPPNetAvg

Sales

&

Measure the efficiency with which the company invests in its assets (e.g. efficiency in collecting receivables, turning inventory, and utilizing PP&E capacity)

NWCAvg

Sales

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III. Solvency risk

Debt-to-EBITDA

Debt-to-Capital

Interest Coverage or Times Interest Earned

EquityDebtLTDebtST

DebtLTDebtST

ExpenseInterest

EBIT

Measure whether the company has an appropriate level of debt in its capital mix, or the risk of becoming insolvent

Tradeoff: There are many considerations that drive this decision, but the primary tradeoff is that while higher debt increases insolvency risk and the cost of capital, it also can boost the return to stockholders (ROE).

EBITDA

DebtLTDebtST

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III. Solvency risk: Liquidity focus

Current ratio

Quick ratio

sLiabilitieCurrent

AssetsCurrent

sLiabilitieCurrent

InventoryAssetsCurrent

Measure ability to meet near-term financial obligations by holding sufficient assets that are expected to convert to cash within the year

Inventory is the least liquid current asset, so exclude it in the quick ratio

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Liquidity interactions

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Tradeoff: By shrinking the current ratio companies can reduce Invested Capital requirements and thereby boost ROIC

But a lower current ratio indicates greater liquidity risk

Liquidity can also be located off the balance sheet in committed unused lines of credit

Companies that have less total debt and/or have stronger cash flow can afford to have lower liquidity

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IV. Economic Value Added EVA is a measure of periodic economic profit,

or single period $value-added to shareholders

Unlike Net Income, EVA measures residual income after deducting a charge for all of the Invested Capital used in the business (i.e. it charges for Equity capital) Net income fails to effectively capture the cost of an

inefficient balance sheet

EVA’s relation to value

Market value added, the difference between a company’s market value and its book value, is the present value of the company’s future expected EVAs EVA links profit measurement to valuation

Net Present Value (NPV) for a new capital investment is equal to the present value of the investment’s future expected EVAs EVA links profit measurement to capital budgeting

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Value-based management using EVA Focus managers on controlling capital investment

and beating the cost of capital “Incredibly, most corporate groups, divisions, and

departments have no idea how much capital they tie up or what it costs”— Fortune

Provide appropriate incentives for value-added growth investments, while divesting value-destroying business lines

Push accountability for capital charges down into profit centers at all levels of organization

Optimize the use of debt to minimize WACC

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Calculating EVA

EVA deducts a Capital (financing) Charge for the Investment Capital used to generate NOPAT

WACC = Weighted Average Cost of Capital WACC is an estimate of the % return

required by investors on the firm’s Invested Capital

$Capital Charge

CapitalWACCNOPATEVA $%$$

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ROIC > WACC = +EVA

Investments must generate an ROIC that exceeds the cost of financing $Capital captures the firm’s ability to find profitable growth

opportunities Recall that MVA is present value of future EVA

WACC captures risk The EVA spread can be compared across firms, but do not target max

CapitalWACCNOPATEVA $%$$

CapitalWACCCapital

NOPATEVA

CapitalWACCROICEVA

EVA spread %

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Overinvestment problem of net income focus

Only need to earn ROIC > Interest (1-T) x 50%, which here is 3.5%, to increase Net Income; need 12% for breakeven EVA; result is overinvestment

Assumptions: Net Income: EVA:Investment $100 EBIT $12.0 NOPAT $8.40EBIT $12 Interest Exp $5.0 Capital Charge 12.0Interest rate 10% EBT $7.0 EVA -3.6Tax rate 30% Taxes 2.1 ROIC 8.4%Equity Cost 17% Net Income 4.9WACC 12%

Assume capital structure is 50%/50% D/E:

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Should the investment be made?

Before Investment: New Investment: After Investment:Capital $1,000 $300 $1,300EBIT $340 $60 $400Tax rate 40% 40% 40%NOPAT 204 36 240ROIC 20.4% 12.0% 18.5%WACC 10% 10% 10%EVA $104 $6 $110

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EVA captures Equity cost risk effects not included in any measure of profitability, and encourages optimal capital structure

Captures differences in risk and associated financing cost side of the risk/return tradeoff via WACCseek optimal use of debt to minimize WACC include risk shifts in profit measurement

If use excessive debt to increase ROE, cost of Equity and Debt increase, resulting in higher WACC and capital charge in EVA calculation

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Accounting adjustments

Adjusts capital for accounting distortions that understate capital (e.g. leases, reserves on balance sheet) or discourage investment (e.g. R&D, advertising, and training expenses)

Key terms

NOPAT Invested Capital ROIC EVA WACC

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