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plant and equipment or it can return the cash to investors, who can then invest the
money for themselves by buying stocks and bonds in the capital market. The return that
investors could expect to earn if they invested in the capital market is called the cost of
capital. A firm that earns more than the cost of capital makes its investors better off: it
is earning them a higher return than they could obtain for themselves. A firm that earns
less than the cost of capital makes investors worse off: they could earn a higher return
simply by investing their cash in the capital market. Naturally, therefore, financial man-
agers are concerned whether the firm™s return on its assets exceeds or falls short of the
cost of capital. Look, for example, at the third column of Table A.15, which shows the
return on assets for our sample of companies. Microsoft had the highest return on as-
sets at nearly 53 percent. Since the cost of capital for Microsoft was probably around
14 percent, each dollar invested by Microsoft was earning almost four times the return
that investors could have expected by investing in the capital market.
Let us work out how much this amounted to. Microsoft™s total capital in 1997 was
$7.2 billion. With a return of 53 percent, it earned profits on this figure of .53 — 7.2 =
$3.8 billion. The total cost of the capital employed by Microsoft was about .14 — 7.2 =
$1.0 billion. So after deducting the cost of capital, Microsoft earned 3.8 “ 1.0 = $2.8
billion. This is called Microsoft™s residual income. It is also known as economic value
RESIDUAL INCOME
added, or EVA, a term coined by the consultancy firm Stern Stewart, which has done
(ALSO CALLED
much to develop and promote the concept.
ECONOMIC VALUE
The final column of Table A.15 shows the economic value added for our sample of
ADDED OR EVA) The
large companies. You can see, for example, that while GE has a far lower return on as-
net profit of a firm or division
sets than Microsoft, the two companies are close in terms of EVA. This is partly because
after deducting the cost of
GE was less risky and investors did not require such a high return, but also because GE
the capital employed.
had far more dollars invested than Microsoft. General Motors is the laggard in the EVA
stakes. Its positive return on assets indicates that the company earned a profit after de-
ducting out-of-pocket costs. But this profit is calculated before deducting the cost of
capital. GM™s residual income (or EVA) was negative at “$4.1 billion.
Residual income or EVA is a better measure of a company™s performance than
accounting profits. Profits are calculated after deducting all costs except the cost of
capital. EVA recognizes that companies need to cover their cost of capital before they
add value. If a plant or division is not earning a positive EVA, its management is likely
to face some pointed questions about whether the assets could be better employed
elsewhere or by fresh management. Therefore, a growing number of firms now calcu-
late EVA and tie managers™ compensation to it.



The Role of Financial Ratios
In this material we have encountered a number of measures of a firm™s financial posi-
tion. Many of these were in the form of ratios; some, such as market value added and
economic value added, were measured in dollars.
Before we leave the topic it might be helpful to emphasize the role of such account-
ing measures. Whenever two managers get together to discuss the state of the business,
there is a good bet that they will refer to financial ratios. Let™s drop in on two conver-
sations.

Conversation 1. The CEO was musing out loud: “How are we going to finance this
expansion? Would the banks be happy to lend us the $30 million that we need?”
152 APPENDIX A


TABLE A.16
Rating on long-term debt and financial ratios

Three-Year (1996“1998) Medians AAA AA A BBB BB B CCC
EBIT interest coverage ratio 12.9 9.2 7.2 4.1 2.5 1.2 0.9
EBITDA interest coverage 18.7 14.0 10.0 6.3 3.9 2.3 0.2
Funds flow/total debt (%) 89.7 67.0 49.5 32.2 20.1 10.5 7.4
Free oper. cash flow/total debt (%) 40.5 21.6 17.4 6.3 1.0 (4.0) (25.4)
Return on capital (%) 30.6 25.1 19.6 15.4 12.6 9.2 (8.8)
Oper. income/sales (%) 30.9 25.2 17.9 15.8 14.4 11.2 5.0
Long-term debt/capital (%) 21.4 29.3 33.3 40.8 55.3 68.8 71.5
Total debt/capital (incl. STD) (%) 31.8 37.0 39.2 46.4 58.5 71.4 79.4

Note: EBITDA, earnings before interest, taxes, depreciation, and amortization; STD, short-term debt.
Source: From Standard & Poor™s Credit Week, July 28, 1999. Used by permission of Standard & Poor™s.




“I™ve been looking into that,” the financial manager replies. “Our current debt ratio
is .3. If we borrow the full cost of the project, the ratio would be about .45. When we
took out our last loan from the bank, we agreed that we would not allow our debt ratio
to get above .5. So if we borrow to finance this project, we wouldn™t have much leeway
to respond to possible emergencies. Also, the rating agencies currently give our bonds
an investment-grade rating. They too look at a company™s leverage when they rate its
bonds. I have a table here (Table A.16) which shows that, when firms are highly lever-
aged, their bonds receive a lower rating. I don™t know whether the rating agencies would
downgrade our bonds if our debt ratio increased to .45, but they might. That wouldn™t
please our existing bondholders, and it could raise the cost of any new borrowing.
“We also need to think about our interest cover, which is beginning to look a bit thin.
Debt interest is currently covered three times and, if we borrowed the entire $30 mil-
lion, interest cover would fall to about two times. Sure, we expect to earn additional
profits on the new investment but it could be several years before they come through.
If we run into a recession in the meantime, we could find ourselves short of cash.”
“Sounds to me as if we should be thinking about a possible equity issue,” concluded
the CEO.

Conversation 2. The CEO was not in the best of moods after his humiliating defeat
at the company golf tournament by the manager of the packaging division: “I see our
stock was down again yesterday,” he growled. “It™s now selling below book value and
the stock price is only six times earnings. I work my socks off for this company; you
would think that our stockholders would show a little more gratitude.”
“I think I can understand a little of our shareholders™ worries,” the financial manager
replies. “Just look at our return on assets. It™s only 6 percent, well below the cost of
capital. Sure we are making a profit, but that profit does not cover the cost of the funds
that investors provide. Our economic value added is actually negative. Of course, this
doesn™t necessarily mean that the assets could be used better elsewhere, but we should
certainly be looking carefully at whether any of our divisions should be sold off or the
assets redeployed.
“In some ways we™re in good shape. We have very little short-term debt and our cur-
rent assets are three times our current liabilities. But that™s not altogether good news be-
cause it also suggests that we may have more working capital than we need. I™ve been
Financial Statement Analysis 153


looking at our main competitors. They turn over their inventory 12 times a year com-
pared with our figure of just 8 times. Also, their customers take an average of 45 days
to pay their bills. Ours take 67. If we could just match their performance on these two
measures, we would release $300 million that could be paid out to shareholders.”
“Perhaps we could talk more about this tomorrow,” said the CEO. “In the meantime
I intend to have a word with the production manager about our inventory levels and with
the credit manager about our collections policy. You™ve also got me thinking about
whether we should sell off our packaging division. I™ve always worried about the divi-
sional manager there. Spends too much time practicing his backswing and not enough
worrying about his return on assets.”




Summary
What are the standard measures of a firm™s leverage, liquidity, profitability, asset
management, and market valuation? What is the significance of these measures?
If you are analyzing a company™s financial statements, there is a danger of being
overwhelmed by the sheer volume of data contained in the income statement, balance
sheet, and statement of cash flow. Managers use a few salient ratios to summarize the
firm™s leverage, liquidity, efficiency, and profitability. They may also combine accounting
data with other data to measure the esteem in which investors hold the company or the
efficiency with which the firm uses its resources.
Table A.17 summarizes the four categories of financial ratios that we have discussed in
this material. Remember though that financial analysts define the same ratio in different
ways or use different terms to describe the same ratio.
Leverage ratios measure the indebtedness of the firm. Liquidity ratios measure how
easily the firm can obtain cash. Efficiency ratios measure how intensively the firm is using
its assets. Profitability ratios measure the firm™s return on its investments. Be selective in
your choice of these ratios. Different ratios often tell you similar things.
Financial ratios crop up repeatedly in financial discussions and arrangements. For
example, banks and bondholders commonly place limits on the borrower™s leverage ratios.
Ratings agencies also look at leverage ratios when they decide how highly to rate the firm™s
bonds.

How does the Du Pont formula help identify the determinants of the firm™s return
on its assets and equity?
The Du Pont system provides a useful way to link ratios to explain the firm™s return on
assets and equity. The formula states that the return on equity is the product of the firm™s
leverage ratio, asset turnover, profit margin, and debt burden. Return on assets is the
product of the firm™s asset turnover and profit margin.

What are some potential pitfalls of ratio analysis based on accounting data?
Financial ratio analysis will rarely be useful if practiced mechanically. lt requires a large
dose of good judgment. Financial ratios seldom provide answers but they do help you ask
the right questions. Moreover, accounting data do not necessarily reflect market values
properly, and so must be used with caution. You need a benchmark for assessing a
company™s financial position. Therefore, we typically compare financial ratios with the
company™s ratios in earlier years and with the ratios of other firms in the same business.
154 APPENDIX A


TABLE A.17
Leverage ratios
Summary of financial ratios
long-term debt
Long-term debt ratio =
long-term debt + equity
long-term debt
Debt-equity ratio =
equity
total liabilities
Total debt ratio =
total assets
EBIT
Times interest earned =
interest payments
EBIT + depreciation
Cash coverage ratio =
interest payments
Liquidity ratios
net working capital
NWC to assets =
total assets
current assets
Current ratio =
current liabilities
cash + marketable securities + receivables
Quick ratio =
current liabilities
cash + marketable securities
Cash ratio =
current liabilities
cash + marketable securities + receivables
Interval measure =
average daily expenditures from operations
Efficiency ratios
sales
Total asset turnover =
average total assets
average receivables
Average collection period =
average daily sales
cost of goods sold
Inventory turnover =
average inventory
average inventory
Days™ sales in inventories =
cost of goods sold/365
Profitability ratios
net income + interest
Net profit margin =
sales
net income + interest
Return on assets =
average total assets
net income
Return on equity =
average equity
dividends
Payout ratio =
earnings
Plowback ratio = 1 “ payout ratio
Growth in equity from plowback = plowback ratio — ROE
Financial Statement Analysis 155


How do measures such as market value added and economic value added help to
assess the firm™s performance?
The ratio of the market value of the firm™s equity to its book value indicates how far the
value of the shareholders™ investment exceeds the money that they have contributed. The
difference between the market and book values is known as market value added and
measures the number of dollars of value that the company has added.
Managers often compare the company™s return on assets with the cost of capital, to see
whether the firm is earning the return that investors require. It is also useful to deduct the
cost of the capital employed from the company™s profits to see how much profit the
company has earned after all costs. This measure is known as residual income, economic
value added, or EVA. Managers of divisions or plants are often judged and rewarded by
their business™s economic value added.



www.cfonet.com/html/Articles/CFO/1998/98JAtist.html A look at the Du Pont model
Related Web www.stockscreener.com/ How investors use financial analysis to value or screen firms
www.onlinewbc.org/docs/finance/index.html Basics of financial analysis, with tutorials and
Links
tools
http://profiles.wisi.com/ Detailed information on 18,000 companies
www.hoovers.com/ Hoover™s company directory reports on thousands of companies, IPOs, and
industries
biz.yahoo.com Useful financial profiles on thousands of firms
www.reportgallery.com Annual reports on thousands of companies
www.prars.com Public Register™s Annual Report Service is the largest annual report service in
the United States, providing annual reports, prospectuses, and 10-K reports
www.sternstewart.com Contains a good discussion of economic value added



Key Terms Du Pont system
income statement
market value added
common-size income statement
residual income
balance sheet
economic value added (EVA)
common-size balance sheet

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