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the fourth terms are equal to 1.0 and the return on equity is identical to the return on
assets. If the firm is leveraged, the first term is greater than 1.0 (assets are greater than
equity) and the fourth term is less than 1.0 (part of the profits are absorbed by interest).
Thus leverage can either increase or reduce return on equity. Leverage increases ROE
when the firm™s return on assets is higher than the interest rate on debt.

a. Sappy Syrup has a profit margin below the industry average, but its ROA equals the
Self-Test 4
industry average. How is this possible?
b. Sappy Syrup™s ROA equals the industry average, but its ROE exceeds the industry
average. How is this possible?

Each of the financial ratios that we have described involves accounting data only. But
managers also compare accounting numbers with the values that are established in the
marketplace. For example, they may compare the total market value of the firm™s shares
with the book value (the amount that the company has raised from shareholders or
reinvested on their behalf). If managers have been successful in adding value for stock-
holders, the market-to-book ratio should be greater than 1.0.

10 There is a complication here because the amount of taxes paid depends on the financing mix. It would be
better to add back any interest tax shields when calculating the firm™s profit margin.
Financial Statement Analysis 147

You can probably think of a number of other ratios that could provide useful insights
into a company™s health. For example, a retail chain might compare its sales per square
foot with those of its competitors, a steel producer might look at the cost per ton of steel
produced, and an airline might look at revenues per passenger mile flown. A little
thought and common sense should suggest which measures are likely to provide in-
sights into your company™s efficiency.

Using Financial Ratios
Many years ago a British bank chairman observed that not only did the bank™s accounts
show its true position but the actual situation was a little better still.11 Since that time
accounting standards have been much more carefully defined, but companies still have
considerable discretion in calculating profits and deciding what to show in the balance
sheet. Thus when you calculate financial ratios, you need to look below the surface and
understand some of the pitfalls of accounting data. The nearby box discusses some ways
in which companies can manipulate reported earnings.
For example, the assets shown in Pepsi™s 1998 balance sheet include a figure of
$8,996 for “intangibles.” The major intangible consists of “goodwill,” which is the dif-
ference between the amount that Pepsi paid when it acquired several companies and the
book value of their assets. Pepsi writes off a proportion of this goodwill from each
year™s profits. We don™t want to debate whether goodwill is really an asset, but we
should warn you about the dangers of comparing ratios of firms whose balance sheets
include a substantial goodwill element with those that do not.
Another pitfall arises because many of the company™s liabilities are not shown in the
balance sheet at all. For example, the liabilities include leases that meet certain tests”
for example, leases lasting more than 75 percent of the leased asset™s life. But a lease
lasting only 74 percent of asset life escapes the net and is shown only in the footnotes
to the financial statements. Read the footnotes carefully; if you take the balance sheet
uncritically, you may miss important obligations of the company.

We have shown you how to calculate the principal financial ratios for Pepsi. In practice
you may not need to calculate all of them, because many measure essentially the same
thing. For example, if you know that Pepsi™s EBIT is 8.0 times interest payments and
that the company is financed 39 percent with long-term debt, the other leverage ratios
are of relatively little interest.
Once you have selected and calculated the important ratios, you still need some way
of judging whether they are high or low. A good starting point is to compare them with
the equivalent figures for the same company in earlier years. For example, you can see
from the first two columns of Table A.13 that while Pepsi was somewhat more prof-
itable in 1998 than in the previous year, it was also substantially less liquid. It had neg-
ative working capital and a much lower cash ratio than in 1997.
It is also helpful to compare Pepsi™s financial position with that of other firms. How-
ever, you would not expect companies in different industries to have similar ratios. For

11 Speechby the chairman of the London and County Bank at the Annual Meeting, February 1901. Reported
in The Economist, 1901, p. 204, and cited in C. A. E. Goodhart, The Business of Banking 1891“1914 (Lon-
don: Weidenfield and Nicholson, 1972), p. 15.

PepsiCo Coca-Cola
Financial ratios for PepsiCo
and Coca-Cola 1998 1997 1998
Leverage ratios
Long-term debt ratio .39 .42 .08
Total debt ratio .72 .65 .56
Times interest earned 8.0 7.5 90.6
Liquidity ratios
Net working capital to assets “.16 .10 “.12
Current ratio .55 1.47 .74
Quick ratio .36 1.18 .40
Cash ratio .05 .68 .21
Interval measure (days) 56.1 215.5 96.0
Efficiency ratios
Asset turnover 1.05 .99 1.04
Fixed asset turnover 3.29 3.39 5.08
Average collection period (days) 37.6 38.6 32.1
Inventory turnover 10.7 10.8 6.0
Profitability ratios
Net profit margin (%) 10.3 8.8 19.1
Return on assets (%) 10.8 8.7 19.9
Return on equity (%) 29.8 22.0 45.1

example, a soft drink manufacturer is unlikely to have the same profit margin as a jew-
eler or the same leverage as a finance company. It makes sense, therefore, to limit com-
parison to other firms in the same industry. For example, the third column of Table A.13
shows the financial ratios for Coca-Cola, Pepsi™s main competitor.12 Notice that Coke is
also operating with negative working capital, but, unlike Pepsi, it has very little long-
term debt.
When making these comparisons remember our earlier warning about the need to
dig behind the figures. For example, we noted earlier that Pepsi™s balance sheet contains
a large entry for goodwill; Coke™s doesn™t, which partly explains why Coke has the
higher return on assets.
Financial ratios for industries are published by the U.S. Department of Commerce,
Dun & Bradstreet, Robert Morris Associates, and others. Table A.14 contains ratios for
some major industry groups. This should give you a feel for some of the differences be-
tween industries.

Look at the financial ratios shown in Table A.14. The retail industry has a higher ratio
Self-Test 5
of net working capital to total assets than manufacturing corporations. It also has a
higher asset turnover and a lower profit margin. What do you think accounts for these

12 It
might be better to compare Pepsi™s ratios with the average values for the entire industry rather than with
those of one competitor. Some information on ratios in the food and drink industry is provided in Table A.14.

Think of a Number
Then there are corporate pension funds. The value of
The quality of mercy is not strain™d; the quality of Amer-
these has soared thanks to the stock market™s vertigi-
ican corporate profits is another matter. There may be a
nous rise and, as a result, some pension plans have be-
lot less to the published figures than meets the eye.
come overfunded (assets exceed liabilities). Firms can
Warren Buffett, America™s most admired investor,
include this pension surplus as a credit in their income
certainly thinks so. As he sagely put it recently, “ A grow-
statements. Over $1 billion of General Electric™s re-
ing number of otherwise high-grade managers” CEOs
ported pretax profits of $13.8 billion in 1998 were
you would be happy to have as spouses for your chil-
“ earned” in this way. The rising value of financial assets
dren or as trustees under your will” have come to the
has allowed many firms to reduce, or even skip, their
view that it is OK to manipulate earnings to satisfy what
annual pension-fund contributions, boosting profits. As
they believe are Wall Street™s desires. Indeed many
pension-fund contributions will almost certainly have to
CEOs think this kind of manipulation is not only OK, but
be resumed when the bull market ends, this probably
actually their duty.”
paints a misleading impression of the long-term trend of
The question is: do they under- or overstate profits?
Unfortunately different ruses have different effects. Take
Mr. Buffett is especially critical of another way of
first those designed to flatter profits. Thanks mainly to a
dampening current profits to the benefit of future ones:
furious lobbying effort by bosses, stock options are not
restructuring charges (the cost, taken in one go, of a
counted as a cost. Smithers & Co., a London-based re-
corporate reorganization). Firms may be booking much
search firm, calculated the cost of these options and
bigger restructuring charges than they should, creating
concluded that the American companies granting them
a reserve of money to draw on to boost profits in a dif-
had overstated their profits by as much as half in the
ficult future year.
1998 financial year; overall, ignoring stock-option costs
has exaggerated American profits as a whole by one to Source: The Economist, September 11, 1999, pp. 107“108. © 1999
three percentage points every year since 1994. The Economist Newspaper Group, Inc. Reprinted with permission.
Further reproduction prohibited. www.economist.com.

Financial ratios for major industry groups, second quarter, 1998

Chemical Petroleum Electrical
All Food and Printing and and Machinery and
Manufacturing Kindred and Allied Coal Except Electronic Retail
Corporations Products Publishing Products Products Electrical Equipment Trade
Debt ratioa .36 .43 .39 .38 .35 .29 .23 .35
Net working capital
to total assets .08 .05 .06 .03 “.03 .17 .12 .16
Current ratio 1.32 1.23 1.34 1.14 .85 1.57 1.45 1.55
Quick ratio .68 .56 .88 .56 .44 .91 .82 .49
Sales to total assets 1.04 1.23 .82 .76 .85 1.19 1.02 2.06
Net profit margin (%)b 5.35 6.41 7.07 7.18 4.71 3.11 5.88 3.23
Return on total
assets (%) 5.58 7.86 5.80 5.45 4.02 3.71 5.99 6.66
Return on equity (%)c 16.83 18.09 12.20 20.78 14.39 15.47 12.23 12.57
Dividend payout ratio .48 .57 .45 .61 .67 .31 .34 .44

a Long-term debt includes capitalized Ieases and deferred income taxes.
b Reflects operating income only.
c Reflects nonoperating as well as operating income.

Source: U.S. Department of Commerce, Quarterly Report for Manufacturing, Mining and Trade Corporations, second quarter 1998.


Measuring Company Performance
The book value of the company™s equity is equal to the total amount that the company
has raised from its shareholders or retained and reinvested on their behalf. If the com-
pany has been successful in adding value, the market value of the equity will be higher
than the book value. So investors are likely to look favorably on the managers of firms
that have a high ratio of market to book value and to frown upon firms whose market
value is less than book value. Of course, the market to book ratio does not tell you just
how much richer the shareholders have become. Take the General Electric Company,
for example. At the end of 1997 the book value of GE™s equity was $59 billion, but in-
vestors valued its shares at $255 billion. So every dollar that GE invested on behalf of
its shareholders had increased 4.3 times in value (255/59 = 4.3). The difference between
the market value of GE™s shares and its book value is often called the market value
MARKET VALUE ADDED added. GE had added $255 “ $59 = $196 billion to the equity capital that it had in-
The difference between the vested.
market value of the firm™s Each year Fortune Magazine publishes a ranking of 1,000 firms in terms of their
equity and its book value. market value added. Table A.15 shows the companies at the top and bottom of Fortune™s
list and, for comparison, Pepsi. You can see that General Electric heads the list in terms
of market value added. General Motors trails the field: the market value of GM™s shares
was $14 billion less than the amount of shareholders™ money that GM had invested.
Measures of company performance that are based on market values have two disad-
vantages. First, the market value of the company™s shares reflects investor expectations.
Investors placed a high value on General Electric™s shares partly because they believed
that its management would continue to find profitable investments in the future. Sec-
ond, market values cannot be used to judge the performance of companies that are pri-
vately owned or the performance of divisions or plants that are part of larger compa-
nies. Therefore, financial managers also calculate accounting measures of performance.
Think again of how a firm creates value for its investors. It can either invest in new

Measures of company performance (companies are ranked by market value added)

Market Value Economic
Market-to- Added Return on Value Added
Book Ratio (billions of dollars) Assets, % (billions of dollars)
1. General Electric 4.3 196 17.3 1.9
2. Coca-Cola 15.4 158 36.3 2.6
3. Microsoft 17.6 144 52.9 2.8
4. Merck 5.6 107 23.2 1.9
5. Intel 5.2 90 42.7 4.8
24. PepsiCo 3.2 41 11.6 “.2
996. St. Paul Companies .7 “3 7.7 “.3
997. Digital Equipment Corp. .6 “4 .2 “1.3
998. RJR Nabisco .7 “10 5.4 “1.1
999. Loews Corp. .5 “10 4.7 “1.4
1000. General Motors .8 “14 4.4 “4.1

Source: Data provided by Stern Stewart & Co. and reproduced in Fortune, November 22, 1999.
Financial Statement Analysis 151


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