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4-4-11
Lecture 4: Measuring Corporate Performance
4-4-22
Corporate Performance
4-4-33
Corporate Performance Measured•Market Value Add: Market capitalization minus book value of equity.•Economic Value Add: Operating income minus a charge for the cost of capital employed. Also called residual income.•Book Rates of Return: Measure the firm’s profits per dollar of assets. Also known as accounting rates of return because they are based on accounting information (specifically company financials). Three common measures are the return on capital (ROC), the return on equity (ROE), and the return on assets (ROA).
4-4-44
Market Value Added
Book ValueMarket Value Added [Share Price Shares Outstanding] - Equity
What is it?
Why is it useful?
Defined:
•Market Capitalization —Total market value of equity, equal to share price times the number of shares outstanding•Market Value Added —Market Capitalization – Book Value of Equity
4-4-55
MVA: Discussion
Consider AT&T and Home Depot
Similar MVA, Different Market-to-Book Ratio Limitations of MVA:
1. Market value reflects investors’ expectations about future performance, complete with the imprecisions that come with all forecasting.
2. Market value fluctuates frequently due to reasons outside of the financial managers control.
3. Privately owned corporations do not have a public market value.
Book ValueMarket Value Added [Share Price Shares Outstanding] - Equity
TABLE 4.3
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Economic Value AddedEconomic Value Added = Operating Income minus the product of cost of capital and total capitalization
Operating Income = Net Income + After-tax Interest
Cost of Capital = The minimum acceptable rate of return on capital investment
Total Capitalization = Total Long-term Capital = Equity + Bonds + other Long-term capital [all capital committed by debt and equity investors]
Defined:Economic Value Added Operating Income* - [Cost of Capital Total Capitalization]
4-4-77
EVA: Discussion
Consider Coca-Cola and Google
Similar EVA, Different Return on Capital
Why?
Economic Value Added Operating Income - [Cost of Capital Total Capitalization]
TABLE 4.4
* Operating Income = Net Income + After-tax Interest; ROC = Return on Capital
4-4-88
Book Rates of Return*
*Book Rates of Return are also referred to as Accounting rates of Return
• Book Rates of Return = Accounting Rates of Return = Measures of the firm’s profits per dollar of assets.
• Return on Capital = (after-tax operating income)/(total capitalization)
• Return on Assets = (after-tax operating income)/(average total assets) or = (after-tax operating income)/(start of year total assets)
• Return on Equity = (net income)/(average equity) or = (net income)/(start of year equity)
• Average Assets = (end of period assets + beginning of period assets)/2
• Average Equity = (end of period equity + beginning of period equity)/2
4-4-99
Calculating Return on CapitalAssets 2009 2008
Current assets: Cash and cash equivalents $ 632 245 Short-term investments 425 416 Merchandise inventory - net 8,249 8,209 Deferred income taxes - net 208 105 Other current assets 218 215
Total current assets 9,732 9,190
Property less acc. depreciation 22,499 22,722 Long-term investments 277 253 Other assets 497 460 Total assets $ 33,005 32,625
Liabilities and Shareholders' Equity 2009 2008
Current liabilities: Short-term borrowings $ - 987 Current maturities of long-term debt 552 34 Accounts payable 4,287 4,109 Accrued comp./employee benefits 577 434 Deferred revenue 683 674 Other current liabilities 1,256 1,322
Total current liabilities 7,355 7,560
Long-term debt, excl. current maturities 4,528 5,039 Deferred income taxes - net 598 599 Other liabilities 1,455 1,372
Total liabilities 13,936 14,570
Shareholders' equity: - - Common stock - $.50 par value 729 735 Capital in excess of par value 6 277 Retained earnings 18,307 17,049 Acc. other comprehensive income 27 (6)
Total shareholders' equity 19,069 18,055
Total liabilities and shareholders' equity $ 33,005 32,625 Lowe’s Balance Sheet (in $m)
Lowe’s Return on Capital
After-Tax Operating Income 1,964ROC 8.4%
Average Total Capitalization 23,336.5
Lowe's Income Statement 2009Net sales 47,220 Cost of sales 30,757 Gross margin 16,463 Expenses:Selling, general and administrative 11,688 Store opening costs 49 Depreciation 1,614 Interest - net 287 Total expenses 13,638 Pre-tax earnings 2,825 Income tax provision 1,042 Net earnings 1,783
After Tax Operating Income = Net Income + After-Tax Interest
= 1,783 + 181 = 1,964
Average Total Capitalization = Average Long-Term Debt + Equity
(23,579 23,094)23,336.5
2
4-4-1010
Calculating Return on Assets
Assets 2009 2008
Current assets: Cash and cash equivalents $ 632 245 Short-term investments 425 416 Merchandise inventory - net 8,249 8,209 Deferred income taxes - net 208 105 Other current assets 218 215
Total current assets 9,732 9,190
Property less acc. depreciation 22,499 22,722 Long-term investments 277 253 Other assets 497 460 Total assets $ 33,005 32,625
Liabilities and Shareholders' Equity 2009 2008
Current liabilities: Short-term borrowings $ - 987 Current maturities of long-term debt 552 34 Accounts payable 4,287 4,109 Accrued comp./employee benefits 577 434 Deferred revenue 683 674 Other current liabilities 1,256 1,322
Total current liabilities 7,355 7,560
Long-term debt, excl. current maturities 4,528 5,039 Deferred income taxes - net 598 599 Other liabilities 1,455 1,372
Total liabilities 13,936 14,570
Shareholders' equity: - - Common stock - $.50 par value 729 735 Capital in excess of par value 6 277 Retained earnings 18,307 17,049 Acc. other comprehensive income 27 (6)
Total shareholders' equity 19,069 18,055
Total liabilities and shareholders' equity $ 33,005 32,625
Lowe’s Balance Sheet (in $m)Lowe’s Return on Assets
After-Tax Operating Income 1,964ROA 6.0%
Average Total Assets 32,815
After-Tax Operating Income 1,964ROA = 6.0%
Total Assets 32,625Year Beginning
or
Lowe's Income Statement 2009Net sales 47,220 Cost of sales 30,757 Gross margin 16,463 Expenses:Selling, general and administrative 11,688 Store opening costs 49 Depreciation 1,614 Interest - net 287 Total expenses 13,638 Pre-tax earnings 2,825 Income tax provision 1,042 Net earnings 1,783
After Tax Operating Income = Net Income + After-Tax Interest
= 1,783 + 181 = 1,964
(33,005 32,625)Average Total Assets =
232,815
4-4-1111
Calculating Return on Equity
Assets 2009 2008
Current assets: Cash and cash equivalents $ 632 245 Short-term investments 425 416 Merchandise inventory - net 8,249 8,209 Deferred income taxes - net 208 105 Other current assets 218 215
Total current assets 9,732 9,190
Property less acc. depreciation 22,499 22,722 Long-term investments 277 253 Other assets 497 460 Total assets $ 33,005 32,625
Liabilities and Shareholders' Equity 2009 2008
Current liabilities: Short-term borrowings $ - 987 Current maturities of long-term debt 552 34 Accounts payable 4,287 4,109 Accrued comp./employee benefits 577 434 Deferred revenue 683 674 Other current liabilities 1,256 1,322
Total current liabilities 7,355 7,560
Long-term debt, excl. current maturities 4,528 5,039 Deferred income taxes - net 598 599 Other liabilities 1,455 1,372
Total liabilities 13,936 14,570
Shareholders' equity: - - Common stock - $.50 par value 729 735 Capital in excess of par value 6 277 Retained earnings 18,307 17,049 Acc. other comprehensive income 27 (6)
Total shareholders' equity 19,069 18,055
Total liabilities and shareholders' equity $ 33,005 32,625
Lowe’s Balance Sheet (in $m)Lowe’s Return on Equity
Net Income 1,783ROE 9.6%
Average Total Equity 18,562
Net Income 1,783ROE = 9.9%
Equity 18,055Year Beginning
or
Lowe's Income Statement 2009Net sales 47,220 Cost of sales 30,757 Gross margin 16,463 Expenses:Selling, general and administrative 11,688 Store opening costs 49 Depreciation 1,614 Interest - net 287 Total expenses 13,638 Pre-tax earnings 2,825 Income tax provision 1,042 Net earnings 1,783
(19,069 18,055)Average Total Equity =
218,562
4-4-1212
Financial Ratios and Shareholder Value
Shareholder value depends on good investment and financing decisions.
Financial Ratios help measure the success and soundness of these decisions.
4-4-1313
Efficiency Ratios
SalesReceivables Turnover=
ReceivablesYear Beginning
SalesAsset turnover ratio =
Total AssetsYear Beginning
Sales=
Average Total AssetsOR*
How does this ratio measure efficiency?
How does this ratio measure efficiency?
* Either equation is a legitimate way to calculate the asset turnover ratio
• Efficiency Ratios – Ratios which measure how efficiently a firm uses its assets.
4-4-1414
Efficiency Ratios
InventoryAverage Days in Inventory=
(Cost of Goods Sold/365)Year Beginning
How does this ratio measure efficiency?
Cost of Goods SoldInventory Turnover Ratio=
InventoryYear Beginning
How does this ratio measure efficiency?
ReceivablesAverage Collection Period=
(Sales/365)Year Beginning
How does this ratio measure efficiency?
4-4-1515
Calculating an Efficiency RatioAssets 2009 2008
Current assets: Cash and cash equivalents $ 632 245 Short-term investments 425 416 Merchandise inventory - net 8,249 8,209 Deferred income taxes - net 208 105 Other current assets 218 215
Total current assets 9,732 9,190
Property less acc. depreciation 22,499 22,722 Long-term investments 277 253 Other assets 497 460 Total assets $ 33,005 32,625
Liabilities and Shareholders' Equity 2009 2008
Current liabilities: Short-term borrowings $ - 987 Current maturities of long-term debt 552 34 Accounts payable 4,287 4,109 Accrued comp./employee benefits 577 434 Deferred revenue 683 674 Other current liabilities 1,256 1,322
Total current liabilities 7,355 7,560
Long-term debt, excl. current maturities 4,528 5,039 Deferred income taxes - net 598 599 Other liabilities 1,455 1,372
Total liabilities 13,936 14,570
Shareholders' equity: - - Common stock - $.50 par value 729 735 Capital in excess of par value 6 277 Retained earnings 18,307 17,049 Acc. other comprehensive income 27 (6)
Total shareholders' equity 19,069 18,055
Total liabilities and shareholders' equity $ 33,005 32,625
Lowe’s Balance Sheet (in $m)
Lowe’s Asset Turnover Ratio
Sales 44,270Asset Turnover Ratio 1.4
Average Total Assets 32,815
Lowe's Income Statement 2009Net sales 47,220 Cost of sales 30,757 Gross margin 16,463 Expenses:Selling, general and administrative 11,688 Store opening costs 49 Depreciation 1,614 Interest - net 287 Total expenses 13,638 Pre-tax earnings 2,825 Income tax provision 1,042 Net earnings 1,783
(33,005 32,625)Average Total Assets =
232,815
4-4-1616
Profitability Ratios
How does this ratio measure the firm’s profitability?
When is this ratio potentially more useful than just profit margin?
Net Income After-Tax Interest Operating Profit Margin=
Sales
Net Income Profit Margin=
Sales
Note: ROC, ROA, ROE and EVA are also typically considered profitability ratios.
4-4-1717
Calculating a Profitability RatioAssets 2009 2008
Current assets: Cash and cash equivalents $ 632 245 Short-term investments 425 416 Merchandise inventory - net 8,249 8,209 Deferred income taxes - net 208 105 Other current assets 218 215
Total current assets 9,732 9,190
Property less acc. depreciation 22,499 22,722 Long-term investments 277 253 Other assets 497 460 Total assets $ 33,005 32,625
Liabilities and Shareholders' Equity 2009 2008
Current liabilities: Short-term borrowings $ - 987 Current maturities of long-term debt 552 34 Accounts payable 4,287 4,109 Accrued comp./employee benefits 577 434 Deferred revenue 683 674 Other current liabilities 1,256 1,322
Total current liabilities 7,355 7,560
Long-term debt, excl. current maturities 4,528 5,039 Deferred income taxes - net 598 599 Other liabilities 1,455 1,372
Total liabilities 13,936 14,570
Shareholders' equity: - - Common stock - $.50 par value 729 735 Capital in excess of par value 6 277 Retained earnings 18,307 17,049 Acc. other comprehensive income 27 (6)
Total shareholders' equity 19,069 18,055
Total liabilities and shareholders' equity $ 33,005 32,625
Lowe’s Balance Sheet (in $m)
Lowe’s Operating Profit Margin
Net Income + After-Tax Interest 1,783 181OPM 4.2%
Sales 47,220
Lowe's Income Statement 2009Net sales 47,220 Cost of sales 30,757 Gross margin 16,463 Expenses:Selling, general and administrative 11,688 Store opening costs 49 Depreciation 1,614 Interest - net 287 Total expenses 13,638 Pre-tax earnings 2,825 Income tax provision 1,042 Net earnings 1,783
4-4-1818
Leverage Ratios
Long Term DebtLong term debt ratio=
Long Term Debt+Equity
How does this ratio measure leverage?
Long-Term DebtLong-term Debt Equity Ratio=
EquityHow does this ratio measure leverage?
4-4-1919
Measuring LeverageTotal Liabilities
Total Debt Ratio=Total Assets
How does this ratio measure leverage?
EBITTimes Interest Earned=
Interest PaymentsHow does this ratio measure leverage?
EBIT+DepreciationCash Coverage Ratio=
Interest Payments
How does this ratio measure leverage?
4-4-2020
Calculating a Leverage RatioAssets 2009 2008
Current assets: Cash and cash equivalents $ 632 245 Short-term investments 425 416 Merchandise inventory - net 8,249 8,209 Deferred income taxes - net 208 105 Other current assets 218 215
Total current assets 9,732 9,190
Property less acc. depreciation 22,499 22,722 Long-term investments 277 253 Other assets 497 460 Total assets $ 33,005 32,625
Liabilities and Shareholders' Equity 2009 2008
Current liabilities: Short-term borrowings $ - 987 Current maturities of long-term debt 552 34 Accounts payable 4,287 4,109 Accrued comp./employee benefits 577 434 Deferred revenue 683 674 Other current liabilities 1,256 1,322
Total current liabilities 7,355 7,560
Long-term debt, excl. current maturities 4,528 5,039 Deferred income taxes - net 598 599 Other liabilities 1,455 1,372
Total liabilities 13,936 14,570
Shareholders' equity: - - Common stock - $.50 par value 729 735 Capital in excess of par value 6 277 Retained earnings 18,307 17,049 Acc. other comprehensive income 27 (6)
Total shareholders' equity 19,069 18,055
Total liabilities and shareholders' equity $ 33,005 32,625
Lowe’s Balance Sheet (in $m)
Lowe’s Times Interest Earned Ratio
EBIT 3,112Times Interest Earned 10.8
Interest 287
Lowe's Income Statement 2009Net sales 47,220 Cost of sales 30,757 Gross margin 16,463 Expenses:Selling, general and administrative 11,688 Store opening costs 49 Depreciation 1,614 Interest - net 287 Total expenses 13,638 Pre-tax earnings 2,825 Income tax provision 1,042 Net earnings 1,783
EBIT = Sales - COGS - Expenses - Depreciation
47,220 30,757 11,737 1,614 3,112
COGS stands for Cost of Goods Sold. Expenses include selling, general and administrative costs (and “store operating costs” in this example).
4-4-2121
Measuring LiquidityNet Working Capital
NWC to Total Assets Ratio =Total Assets
Current AssetsCurrent Ratio=
Current Liabilities
How does this ratio measure liquidity?
How does this ratio measure liquidity?
• Liquidity Ratios– Ratios which measure the extent to which the firm has sufficient liquidity in the coming year.
• Net Working Capital = Current Assets – Current Liabilities
4-4-2222
Liquidity RatiosCash + Marketable Securities + Receivables
Quick ratio=Current Liabilities
How does this ratio differ form the current ratio? Why might a financial manager prefer it?
Cash + Marketable SecuritiesCash Ratio=
Current Liabilities
How does this ratio differ from the current ratio? Why might a financial manager prefer it?
4-4-2323
Calculating a Liquidity RatioAssets 2009 2008
Current assets: Cash and cash equivalents $ 632 245 Short-term investments 425 416 Merchandise inventory - net 8,249 8,209 Deferred income taxes - net 208 105 Other current assets 218 215
Total current assets 9,732 9,190
Property less acc. depreciation 22,499 22,722 Long-term investments 277 253 Other assets 497 460 Total assets $ 33,005 32,625
Liabilities and Shareholders' Equity 2009 2008
Current liabilities: Short-term borrowings $ - 987 Current maturities of long-term debt 552 34 Accounts payable 4,287 4,109 Accrued comp./employee benefits 577 434 Deferred revenue 683 674 Other current liabilities 1,256 1,322
Total current liabilities 7,355 7,560
Long-term debt, excl. current maturities 4,528 5,039 Deferred income taxes - net 598 599 Other liabilities 1,455 1,372
Total liabilities 13,936 14,570
Shareholders' equity: - - Common stock - $.50 par value 729 735 Capital in excess of par value 6 277 Retained earnings 18,307 17,049 Acc. other comprehensive income 27 (6)
Total shareholders' equity 19,069 18,055
Total liabilities and shareholders' equity $ 33,005 32,625
Lowe’s Balance Sheet (in $m)
Lowe’s NWC to Total Assets Ratio
Lowe's Income Statement 2009Net sales 47,220 Cost of sales 30,757 Gross margin 16,463 Expenses:Selling, general and administrative 11,688 Store opening costs 49 Depreciation 1,614 Interest - net 287 Total expenses 13,638 Pre-tax earnings 2,825 Income tax provision 1,042 Net earnings 1,783
Net Working Capital = 9,732-7,355 2,377
NWC 2,377NWC to Total Assets 7.2%
Total Assets 33,005
4-4-2424
The DuPont System
•DuPont System: A breakdown of ROE and ROA into component ratios
4-4-2525
The DuPont System: ROA
Sales Net Income InterestROA= x
Assets Sales
AssetTurnover
Operating ProfitMargin
Net Income InterestROA=
Assets
4-4-2626
ROA Decomposition by Industry
4-4-2727
The DuPont System: ROE
Assets Sales Net Income Interest Net IncomeROE= x x x
Equity Assets Sales Net Income Interest
LeverageRatio Asset
Turnover
OperatingProfit
Margin
DebtBurden
Net IncomeROE=
Equity
The last ratio in the DuPont breakdown of ROE is a measure of the firm’s debt burden. The denominator represents free cash flow (Cash available for distribution to investors after the company has paid for any new capital investment or additions to working capital.). If the ratio is close to zero, the firm has a heavy debt burden—much of its free cash flow goes to interest payments.
4-4-2828
Sustainable Growth
Earnings-DividendsPlowback Ratio=
Earnings
DividendsPayout Ratio=
Earnings
Growth in equity from plowback = Plowback Ratio ROE
Earnings - Dividends Earnings
Earnings Equity
Earnings-Dividends =
Equity
4-4-2929
The Role of Financial RatiosTable 4.8
4-4-3030
The Role of Financial Ratios
4-4-3131
Appendix A: Average Ratios, by IndustryTable 4.7
4-4-3232
Appendix B: Financial Ratios and Default Risk
Table 4.9