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Pepsi has enough liquid assets to finance operations for 56.1 days even if it does not sell
another bottle.

Financial analysts employ another set of ratios to judge how efficiently the firm is using
its assets.

Asset Turnover Ratio. The asset turnover, or sales-to-assets, ratio shows how hard the
firm™s assets are being put to use. For Pepsi, each dollar of assets produced $1.05 of sales:
Sales 22,348
= = 1.05
Average total assets (22,660 + 20,101)/2
A high ratio compared with other firms in the same industry could indicate that the firm
is working close to capacity. It may prove difficult to generate further business without
additional investment.

Notice that since the assets are likely to change over the year, we use the average of
the assets at the beginning and end of the year. Averages are often used when a flow fig-
ure (in this case annual sales) is compared with a snapshot figure (total assets).
Instead of looking at the ratio of sales to total assets, managers sometimes look at
how hard particular types of capital are being put to use. For example, they might look
at the value of sales per dollar invested in fixed assets. Or they might look at the ratio
of sales to net working capital.5
Thus for Pepsi each dollar of fixed assets generated $3.29 of sales:
Sales 22,348
= = 3.29
Average fixed assets (7,318 + 6,261)/2

Average Collection Period. The average collection period measures the speed with
which customers pay their bills. It expresses accounts receivable in terms of daily sales:
average receivables (2,453 + 2,150)/2
Average collection period = = = 37.6 days
average daily sales 22,348/365
On average Pepsi™s customers pay their bills in about 38 days. A comparatively low fig-
ure often indicates an efficient collection department. Sometimes, however, it is the re-
sult of an unduly restrictive credit policy, so that the firm offers credit only to customers
that can be relied on to pay promptly.6

Inventory Turnover Ratio. Managers may also monitor the rate at which the com-
pany is turning over its inventories. The financial statements show the cost of invento-
ries rather than what the finished goods will eventually sell for. So we compare the cost
of inventories with the cost of goods sold. In Pepsi™s case,
cost of goods sold 9,330
Inventory turnover = = = 10.7
average inventory (1,016 + 732)/2
Efficient firms turn over their inventory rapidly and don™t tie up more capital than they
need in raw materials or finished goods. But firms that are living from hand to mouth
may also cut their inventories to the bone.
Managers sometimes also look at how many days™ sales are represented by invento-
ries. This is equal to the average inventory divided by the daily cost of goods sold:
average inventory (1,016 + 732)/2
Days™ sales in inventories = = = 34.2 days
cost of goods sold/365 9,330/365
You could say that on average Pepsi has sufficient inventories to maintain sales for 34

The average collection period measures the number of days it takes Pepsi to collect its
Self-Test 3
bills. But Pepsi also delays paying its own bills. Use the information in Tables A.7 and
A.9 to calculate the average number of days that it takes the company to pay its bills.

5 Pepsi™s net working capital is negative and so therefore is the ratio of sales to net working capital.
6 If possible, it would make sense to divide average receivables by average daily credit sales. Otherwise a low

ratio might simply indicate that only a small proportion of sales was made on credit.
7 Thisis a loose statement, because it ignores the fact that Pepsi may have more than 34 days™ supply of some
materials and less of others.
Financial Statement Analysis 143

Profitability ratios focus on the firm™s earnings.

Net Profit Margin. If you want to know the proportion of revenue that finds its way
into profits, you look at the profit margin. This is commonly defined as
net income 1,990
Net profit margin = = = .089, or 8.9%
sales 22,348
When companies are partly financed by debt, the profits are divided between the
debtholders and the shareholders. We would not want to say that such a firm is less prof-
itable simply because it employs debt finance and pays out part of its profits as inter-
est. Therefore, when calculating the profit margin, it seems appropriate to add back the
debt interest to net income. This would give
net income + interest 1,990 + 321
Net profit margin = = = .103, or 10.3%
sales 22,348
This is the definition we will use.
Holding everything constant, a firm would naturally prefer a high profit margin. But
all else cannot be held constant. A high-price and high-margin strategy typically will re-
sult in lower sales. So while Bloomingdales might have a higher margin than J. C. Pen-
ney, it will not necessarily enjoy higher profits. A low-margin but high-volume strategy
can be quite successful. We return to this issue later.

Return on Assets (ROA). Managers often measure the performance of a firm by the
ratio of net income to total assets. However, because net income measures profits net of
interest expense, this practice makes the apparent profitability of the firm a function of
its capital structure. It is better to use net income plus interest because we are measur-
ing the return on all the firm™s assets, not just the equity investment:8
net income + interest 1,990 + 321
Return on assets = = = .108, or 10.8%
average total assets (22,660 + 20,101)/2
The assets in a company™s books are valued on the basis of their original cost (less any
depreciation). A high return on assets does not always mean that you could buy the
same assets today and get a high return. Nor does a low return imply that the assets
could be employed better elsewhere. But it does suggest that you should ask some
searching questions.
In a competitive industry firms can expect to earn only their cost of capital. There-
fore, a high return on assets is sometimes cited as an indication that the firm is taking
advantage of a monopoly position to charge excessive prices. For example, when a pub-
lic utility commission tries to determine whether a utility is charging a fair price, much

8 Thisdefinition of ROA is also misleading if it is used to compare firms with different capital structures. The
reason is that firms that pay more interest pay less in taxes. Thus this ratio reflects differences in financial
leverage as well as in operating performance. If you want a measure of operating performance alone, we sug-
gest adjusting for leverage by subtracting that part of total income generated by interest tax shields (interest
payments — marginal tax rate). This gives the income the firm would earn if it were all-equity financed. Thus,
using a tax rate of 35 percent for Pepsi,
net income + interest “ interest tax shields
Adjusted return on assets =
average total assets
1,990 + 321 “ (.35 — 321)
= = .103, or 10.3%
(22,660 + 20,101)/2

of the argument will center on a comparison between the cost of capital and the return
that the utility is earning (its ROA).

Return on Equity (ROE). Another measure of profitability focuses on the return on
the shareholders™ equity:
net income
Return on equity =
average equity
= = .298, or 29.8%
(6,401 + 6,936)/2

Payout Ratio. The payout ratio measures the proportion of earnings that is paid out
as dividends. Thus:
dividends 757
Payout ratio = = = .38
earnings 1,990
Managers don™t like to cut dividends because of a shortfall in earnings. Therefore, if a
company™s earnings are particularly variable, management is likely to play it safe by set-
ting a low average payout ratio.
When earnings fall unexpectedly, the payout ratio is likely to rise temporarily. Like-
wise, if earnings are expected to rise next year, management may feel that it can pay
somewhat more generous dividends than it would otherwise have done.
Earnings not paid out as dividends are retained, or plowed back into the business.
The proportion of earnings reinvested in the firm is called the plowback ratio:
earnings “ dividends
Plowback ratio = 1 “ payout ratio =
If you multiply this figure by the return on equity, you can see how rapidly sharehold-
ers™ equity is growing as a result of plowing back part of its earnings each year. Thus
for Pepsi, earnings plowed back into the firm increased the book value of equity by 19.3
earnings “ dividends
Growth in equity from plowback =
earnings “ dividends earnings

earnings equity
= plowback ratio — ROE
= .62 — .31 = .193, or 19.3%
If Pepsi can continue to earn 31 percent on its book equity and plow back 62 percent of
earnings, both earnings and equity will grow at 19.3 percent a year.9
Is this a reasonable prospect? We saw that such high growth rates are unlikely to per-
sist. While Pepsi may continue to grow rapidly for some years to come, such rapid
growth will inevitably slow.

9 Analysts sometimes refer to this figure as the sustainable rate of growth. Notice that, when calculating the
sustainable rate of growth, ROE is properly measured by earnings (in Pepsi™s case, $1,990 million) as a pro-
portion of equity at the start of the year (in Pepsi™s case, $6,401 million), rather than the average of the eq-
uity at the start and end of the year.
Financial Statement Analysis 145

The Du Pont System
Some profitability or efficiency measures can be linked in useful ways. These relation-
ships are often referred to as the Du Pont system, in recognition of the chemical com-
pany that popularized them.
breakdown of ROE and ROA
The first relationship links the return on assets (ROA) with the firm™s turnover ratio
into component ratios.
and its profit margin:
net income + interest sales net income + interest
ROA = =
assets assets sales
‘ ‘
asset profit
turnover margin
All firms would like to earn a higher return on their assets, but their ability to do so
is limited by competition. If the expected return on assets is fixed by competition, firms
face a trade-off between the turnover ratio and the profit margin. Thus we find that fast-
food chains, which have high turnover, also tend to operate on low profit margins. Ho-
tels have relatively low turnover ratios but tend to compensate for this with higher mar-
gins. Table A.11 illustrates the trade-off. Both the fast-food chain and the hotel have the
same return on assets. However, their profit margins and turnover ratios are entirely dif-
Firms often seek to improve their profit margins by acquiring a supplier. The idea is
to capture the supplier™s profit as well as their own. Unfortunately, unless they have
some special skill in running the new business, they are likely to find that any gain in
profit margin is offset by a decline in the asset turnover.
A few numbers may help to illustrate this point. Table A.12 shows the sales, profits,
and assets of Admiral Motors and its components supplier Diana Corporation. Both
earn a 10 percent return on assets, though Admiral has a lower profit margin (20 per-
cent versus Diana™s 25 percent). Since all of Diana™s output goes to Admiral, Admiral™s
management reasons that it would be better to merge the two companies. That way the
merged company would capture the profit margin on both the auto components and the
assembled car.

Fast-food chains and hotels

may have a similar return on Asset Turnover Profit Margin = Return on Assets
assets but different asset Fast-food chains 2.0 5% 10%
turnover ratios and profit Hotels 0.5 20 10

Millions of Dollars
Merging with suppliers or Asset Profit
customers will generally Sales Profits Assets Turnover Margin ROA
increase the profit margin, Admiral Motors $20 $4 $40 .50 20% 10%
but this will be offset by a Diana Corp. 8 2 20 .40 25 10
reduction in the turnover Diana Motors (the merged firm) 20 6 60 .33 30 10

The bottom line of Table A.12 shows the effect of the merger. The merged firm does
indeed earn the combined profits. Total sales remain at $20 million, however, because all
the components produced by Diana are used within the company. With higher profits and
unchanged sales, the profit margin increases. Unfortunately, the asset turnover ratio is
reduced by the merger since the merged firm operates with higher assets. This exactly
offsets the benefit of the higher profit margin. The return on assets is unchanged.
We can also break down financial ratios to show how the return on equity (ROE) de-
pends on the return on assets and leverage:
earnings available for common stock net income
ROE = =
equity equity
assets sales net income + interest net income
equity assets sales net income + interest
‘ ‘ ‘ ‘
leverage asset profit “debt
ratio turnover margin burden”
Notice that the product of the two middle terms is the return on assets. This depends
on the firm™s production and marketing skills and is unaffected by the firm™s financing
mix.10 However, the first and fourth terms do depend on the debt-equity mix. The first
term, assets/equity, which we call the leverage ratio, can be expressed as (equity + lia-
bilities)/equity, which equals 1 + total-debt-to-equity ratio. The last term, which we call
the “debt burden,” measures the proportion by which interest expense reduces profits.
Suppose that the firm is financed entirely by equity. In this case both the first and


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