MEASURING CORPORATE PERFORMANCE

MEASURING CORPORATE PERFORMANCE

CHAPTER IN PERSPECTIVE

This chapter is a re-write of Chapter 17 from the previous edition, Financial Statement Analysis. Chapter 4 continues with the example of Pepsi’s financial statements in the previous chapter. For professors who wish to cover accounting measures early in the course, this section could easily follow after Chapter 3, Accounting and Finance.

Students tend to describe accounting and finance in a disconnected way and tend to misunderstand their relation. The excellent discussions in this chapter can help students conceptualizing the integrated and dynamic roles of accounting and finance in corporate finance:

Accounting data record the history of a business up to a point in time. The data provide the link between accounting and finance. Performance evaluation is backward looking, while financial decision is forward looking, and both rely on the data. The process is dynamic and constantly updating in dynamic business environments.

This chapter categorizes the scope of financial ratio analysis into six areas: (1) market value, (2) accounting measure of profitability or economic value added (EVA), (3) efficiency or turnover, (4) leverage, (5) liquidity, and (6) sustainable growth. Several ratios are covered for each area, including an explanation of why the ratio is a good proxy for the concept. Table 4.7 lists the ratios covered and what accounting and other data are needed for calculation. Table 4.8 presents a variety of ratios for several industries.

This new edition puts more emphasis on agency problems and corporate governance. This chapter stresses the importance of transparency in economies and financial markets in the Section 4.9, The Role of Financial Ratios – and a Final Note on Transparency.

CHAPTER OUTLINE

4.1 VALUE AND VALUE ADDED

4.2 MEASURING PROFITABILITY

Accounting Rates of Return

Problems with EVA and Accounting Rates of Return

4.3 MEASURING EFFICIENCY

4.4 ANALYZING THE RETURN ON ASSETS: THE DU PONT SYSTEM

The Du Pont System

4.5 MEASURING LEVERAGE

Leverage and the Return on Equity

4.6 MEASURING LIQUIDITY

4.7 CALCULATING SUSTAINABLE GROWTH

4.8 INTERPRETING FINANCIAL RATIOS

4.9 THE ROLE OF FINANCIAL RATIOS AND A FINAL NOTE ON TRANSPARENCY

TOPIC OUTLINE, KEY LECTURE CONCEPTS, AND TERMS

4.1 VALUE AND VALUE ADDED

A. Companies who earn positive NPVs on their investments most likely will have generated market value added, the extent to which market value of equity exceeds the book value of equity (Table 4.3).

B. Market value company performance indicators include:

1. Market-to-book ratio measures how much value has been added for each dollar that share holders have invested:

Market-to-book ratio = market value of equity / book value of equity

2. Market value added ($),the difference between the market value of a firm’s share and the amount of money that shareholders have invested in the firm.

C. Market value performance measures have two disadvantages:

1. They are based on expectations that positive NPV projects will continue to be made.

2. Market value-based indicators are difficult to estimate for privately held companies.

4.2 MEASURING PROFITABILITY

A. Net profits less the dollar cost of capital = economic value added or residual income.

1. Residual income or EVA is a better measure of company profits than accounting profit.

2. The return that shareholders are giving up by keeping their money in a company is their opportunity rate of return. Accounting profits do not recognize the cost of capital or the minimum return necessary to return shareholders their opportunity rate of return.

B. The return on equity measures the profitability of the common stockholder’s equity or return per dollar of invested equity capital:

Return on equity = earnings available for common / average equity

C. Return on capital is a measure of return to all investors. It is the net income plus interest as a percentage of long-term capital:

Return on capital = net income + interest / (long-term debt + equity)

D. Another performance measure of return to all investors is the return on total assets (current and fixed), or the EBIT - tax earned per dollar of average assets. This ratio is featured later in the Du Pont analysis:

Return on assets = net income + interest / average total assets

4.2 MEASURING EFFICIENCY

A. Another area of financial analysis, efficiency ratios, measures how effectively the business is using its assets. “Using” relates to liquidity or profitability or performance. The numerators used in efficiency ratios are activity-based items, such as sales, cost of sales, etc., while the denominators are generally some average balance sheet amount. Turnover ratios are often converted to a time-line focus by dividing turnover ratios into 365 days.

B. The asset turnover ratio measures the sales activity derived from total assets, or the revenue generated per dollar of total assets. The asset turnover is also an important component of asset profitability studied later, measuring the revenue per dollar invested:

Asset turnover ratio = sales / average total assets

Sales, a measure of activity, may be compared to a variety of balance sheet accounts (e.g. fixed assets, net working capital, stockholders equity, etc.) to measure the revenue generating efficiency of the account.

C. The inventory turnover ratio, using the cost of goods sold representing the cumulative amount of inventory sold in a period as the numerator and inventory at beginning of year as the denominator, measures the number of times the value of inventory turns over in a period:

Inventory turnover = cost of goods sold / inventory at start of year

The inventory turnover may be converted to a time line concept, the number of day sales in inventories, by finding the reciprocal (1/x) of the inventory turnover times 365 or:

Average days in inventory = inventory at start of year/ daily cost of goods sold

or

Days’ sales in inventories = 1 / inventory turnover x 365

E. The receivables turnover applies the same concept above to accounts receivable. The receivable turnover ratio measures the firm’s salves as a proportion of its receivable:

Receivable turnover = sales / receivable at start of year

If customers are quick to pay, the receivables turnover will be high.

D. The average collection period is the estimated number of days it takes to collect accounts receivable:

Average collection period = average receivable / average daily sales

= beg. + end. Receivables / 2

sales/365

The more days’ sales outstanding, the greater amount of capital is tied up in accounts receivable relative to sales.

4.4 ANALYZING THE RETURN ON ASSETS: THE DU PONT SYSTEM

A. Profitability refers to some measure of profit relative to revenue or an amount invested. The net profit margin measures the proportion of sales revenue that is profit available for sources of funds (EBIT-tax). Net profits after taxes is commonly used in this ratio:

Net profit margin = net income / sales

However, the net profits is biased by the relative amount of leveraging or debt financing in the business.

B. The Du Pont System is a process of analyzing component ratios, (also called decomposition) of the ROA and ROE to explain their level or changes.

C. The ROA is comprised of the product of the profit margin, what the firm earns on every dollar of sales, times the asset turnover or the extent to which a business utilizes its assets:

ROA = net income + interest = sales x net income + interest

total assets t. assets sales

Both the profit margin and asset turnover can be broken down in subcomponents (decomposed) to assess the cause of the level or changes in the ROA. The ability to earn on assets is comprised of expense control per sales (profit margin) and the effective use of assets to generate revenue (asset turnover). A level of ROA can be generated or changed by affecting the margin or turnover.

4.5 MEASURING LEVERAGE

A. The use of fixed cost financing, either debt or preferred stock, is called financial leverage. Financial leverage presents a debt/equity financing choice. Shareholders may magnify their earnings/returns by the use of fixed cost financing but, on the other hand, debt is a fixed cost, contractual commitment to pay regardless of the asset-earning rate.

B. Creditors, owners, and suppliers are interested in the extent to which a firm has sought the tax-shielded benefits from financial leverage producing debt.

C. Leverage ratios are two types: balance sheet ratios comparing leverage

...