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percent in that year, its ROE in 1998 went up to 15.6 percent.
324 Financial Analysis

Financial Analysis

Even though TJX had a very high spread in 1998, it did not exploit this advantage due
an inef¬cient ¬nancial strategy. Because the company had a large cash balance in 1998,
in effect it had negative net ¬nancial leverage. As a result, the company had a lower ROE
than its operating ROA. As a result of its ineffective ¬nancial management, even though
TJX™s operating ROA in 1998 was almost four times as large as Nordstrom™s, its ROE was
only about twice as large as Nordstrom™s in that year.

Assessing Operating Management: Decomposing Net Profit Margins
A ¬rm™s net pro¬t margin or return on sales (ROS) shows the pro¬tability of the compa-
ny™s operating activities. Further decomposition of a ¬rm™s ROS allows an analyst to as-
sess the ef¬ciency of the ¬rm™s operating management. A popular tool used in this
analysis is the common-sized income statement in which all the line items are expressed
as a ratio of sales revenues.
Common-sized income statements make it possible to compare trends in income
statement relationships over time for the ¬rm, and trends across different ¬rms in the in-
dustry. Income statement analysis allows the analyst to ask the following types of ques-
tions: (1) Are the company™s margins consistent with its stated competitive strategy? For
example, a differentiation strategy should usually lead to higher gross margins than a
low cost strategy. (2) Are the company™s margins changing? Why? What are the under-
lying business causes”changes in competition, changes in input costs, or poor overhead
cost management? (3) Is the company managing its overhead and administrative costs
well? What are the business activities driving these costs? Are these activities necessary?
To illustrate how the income statement analysis can be used, common-sized income
statements for Nordstrom and TJX are shown in Table 9-5. The table also shows some
commonly used pro¬tability ratios. We will use the information in Table 9-5 to investi-
gate why Nordstrom had a net income margin (or return on sales) of 4.1 percent in 1998
and 3.8 percent in 1997, while TJX had a net margin of 5.3 percent.

GROSS PROFIT MARGINS. The difference between a ¬rm™s sales and cost of sales is
gross pro¬t. Gross pro¬t margin is an indication of the extent to which revenues exceed
direct costs associated with sales, and it is computed as:
Sales “ Cost of sales
Gross profit margin = ----------------------------------------------------
Gross margin is in¬‚uenced by two factors: (1) the price premium that a ¬rm™s prod-
ucts or services command in the marketplace and (2) the ef¬ciency of the ¬rm™s procure-
ment and production process. The price premium a ¬rm™s products or services can
command is in¬‚uenced by the degree of competition and the extent to which its products
are unique. The ¬rm™s cost of sales can be low when it can purchase its inputs at a lower
cost than competitors and/or run its production processes more ef¬ciently. This is gen-
erally the case when a ¬rm has a low-cost strategy.
Financial Analysis

9-9 Part 2 Business Analysis and Valuation Tools

Table 9-5 Common-Sized Income Statement and Profitability Ratios

Nordstrom Nordstrom TJX
1998 1997 1998
Line Items as a Percent of Sales
Sales 100% 100% 100%
Cost of Sales (66.5) (67.9) (74.9)
Selling, general, and admin. expense (28.0) (27.3) (16.2)
Other income/expense 2.1 2.2 ”
Net interest expense/income (0.9) (0.7) ”
Income taxes (2.6) (2.5) (3.4)
Unusual gains/losses, net of taxes ” ” (0.1)
Net Income 4.1% 3.8% 5.3%
Key Pro¬tability Ratios
Gross pro¬t margin 33.5% 32.1% 25.1%
EBITDA margin 10.4% 9.7% 10.6%
4.7% 4.3% 5.3%
NOPAT margin
Net Margin 4.1% 3.8% 5.3%

Table 9-5 indicates that Nordstrom™s gross margin in 1998 increased slightly to
33.5 percent, validating the company™s stated intention in its annual report of focusing
on pro¬tability. Consistent with Nordstrom™s premium price strategy, its gross margins
in both 1998 and 1997 were signi¬cantly higher than TJX™s gross margin in 1998, which
stood at 25.1 percent.

general, and administrative (SG&A) expenses are in¬‚uenced by the operating activities
it has to undertake to implement its competitive strategy. As discussed in Chapter 2,
¬rms with differentiation strategies have to undertake activities to achieve differentia-
tion. A company competing on the basis of quality and rapid introduction of new prod-
ucts is likely to have higher R&D costs relative to a company competing purely on a cost
basis. Similarly, a company that attempts to build a brand image, distribute its products
through full-service retailers, and provide signi¬cant customer service is likely to have
higher selling and administration costs relative to a company that sells through ware-
house retailers or direct mail and does not provide much customer support.
A company™s SG&A expenses are also in¬‚uenced by the ef¬ciency with which it man-
ages its overhead activities. The control of operating expenses is likely to be especially
important for ¬rms competing on the basis of low cost. However, even for differentia-
tors, it is important to assess whether the cost of differentiation is commensurate with
the price premium earned in the marketplace.
Several ratios in Table 9-5 allow us to evaluate the effectiveness with which Nord-
strom and TJX were managing their SG&A expenses. First, the ratio of SG&A expense
326 Financial Analysis

Financial Analysis

to sales shows how much a company is spending to generate each sales dollar. We see
that Nordstrom has a signi¬cantly higher ratio of SG&A to sales than does TJX. This
should not be surprising given that TJX pursues a low-cost off-price strategy whereas
Nordstrom pursues a high service strategy. However, despite its stated goal to manage
its pro¬tability better, Nordstrom did not improve its cost management: its SG&A ex-
pense as a percent of sales increased marginally from 27.3 percent in 1997 to 28 percent
in 1998.
Given that Nordstrom and TJX are pursuing radically different pricing, merchandis-
ing, and service strategies, it is not surprising that they have very different cost struc-
tures. As a percent of sales, Nordstrom™s cost of sales is lower, and its SG&A expense is
higher. The question is, when both these costs are netted out, which company is perform-
ing better? Two ratios provide useful signals here: net operating pro¬t margin ratio and
EBITDA margin:
NOPAT margin = -----------------
Earnings before interest, taxes, depreciation, and amortization
EBITDA margin = ----------------------------------------------------------------------------------------------------------------------------------------------------
NOPAT margin provides a comprehensive indication of the operating performance of a
company because it re¬‚ects all operating policies and eliminates the effects of debt policy.
EBITDA margin provides similar information, except that it excludes depreciation and am-
ortization expense, a signi¬cant noncash operating expense. Some analysts prefer to use
EBITDA margin because they believe that it focuses on “cash” operating items. While this
is to some extent true, it can be potentially misleading for two reasons. EBITDA is not a
strictly cash concept because sales, cost of sales, and SG&A expenses often include non-
cash items. Also, depreciation is a real operating expense, and it re¬‚ects to some extent the
consumption of resources. Therefore, ignoring it can be misleading.
From Table 9-5 we see that Nordstrom™s NOPAT margin has improved a little between
1997 and 1998. However, even with this improvement, the company is able to retain only
4.7 cents in net operating pro¬ts for each dollar of sales, whereas TJX is able to retain
5.3 cents. TJX also has a slightly better EBITDA margin than Nordstrom, but the differ-
ence seems insigni¬cant. However, this comparison is potentially misleading because
TJX leases most of its stores while Nordstrom owns its; TJX™s leasing expense is in-
cluded in the EBITDA calculation, but Nordstrom™s store depreciation is excluded. This
is an example of how EBITDA margin can sometimes be misleading.

TAX EXPENSE. Taxes are an important element of ¬rms™ total expenses. Through a
wide variety of tax planning techniques, ¬rms can attempt to reduce their tax expenses.7
There are two measures one can use to evaluate a ¬rm™s tax expense. One is the ratio of
tax expense to sales, and the other is the ratio of tax expense to earnings before taxes
(also known as average tax rate). The ¬rm™s tax footnote provides a detailed account of
why its average tax rate differs from the statutory tax rate.
Financial Analysis

9-11 Part 2 Business Analysis and Valuation Tools

When evaluating a ¬rm™s tax planning, the analyst should ask two questions: (1) Are
the company™s tax policies sustainable, or is the current tax rate in¬‚uenced by one-time
tax credits? (2) Do the ¬rm™s tax planning strategies lead to other business costs? For
example, if the operations are located in tax havens, how does this affect the company™s
pro¬t margins and asset utilization? Are the bene¬ts of tax planning strategies (reduced
taxes) greater than the increased business costs?
Table 9-5 shows that Nordstrom™s tax rate did not change signi¬cantly between 1997
and 1998. Nordstrom™s taxes as a percent of sales were somewhat lower than TJX™s. An
important reason for this is that TJX™s pretax pro¬ts as a percent of sales were higher. In
fact, the average tax rate (ratio of tax expense to pretax pro¬ts) for both Nordstrom and
TJX were the same, 39 percent.
In summary, we conclude that Nordstrom™s small improvement in return on sales is
primarily driven by a reduction in its cost of sales. In all other areas, Nordstrom™s per-
formance either stayed the same or worsened a bit. TJX is able to earn a superior return
on its sales despite following an off-price strategy because it is able to save signi¬cantly
on its SG&A expenses.

Evaluating Investment Management: Decomposing Asset Turnover
Asset turnover is the second driver of a company™s return on equity. Since ¬rms invest
considerable resources in their assets, using them productively is critical to overall prof-
itability. A detailed analysis of asset turnover allows the analyst to evaluate the effective-
ness of a ¬rm™s investment management.
There are two primary areas of asset management: (1) working capital management
and (2) management of long-term assets. Working capital is de¬ned as the difference be-
tween a ¬rm™s current assets and current liabilities. However, this de¬nition does not dis-
tinguish between operating components (such as accounts receivable, inventory, and
accounts payable) and the ¬nancing components (such as cash, marketable securities,
and notes payable). An alternative measure that makes this distinction is operating work-
ing capital, as de¬ned in Table 9-3:
Operating working capital = (Current assets “ cash and marketable securities)
“ (Current liabilities “ Short-term and current portion of long-term debt)

WORKING CAPITAL MANAGEMENT. The components of operating working capi-
tal that analysts primarily focus on are accounts receivable, inventory, and accounts pay-
able. A certain amount of investment in working capital is necessary for the ¬rm to run
its normal operations. For example, a ¬rm™s credit policies and distribution policies
determine its optimal level of accounts receivable. The nature of the production process
and the need for buffer stocks determine the optimal level of inventory. Finally, accounts
payable is a routine source of ¬nancing for the ¬rm™s working capital, and payment prac-
tices in an industry determine the normal level of accounts payable.
328 Financial Analysis

Financial Analysis

The following ratios are useful in analyzing a ¬rm™s working capital management:
operating working capital as a percent of sales, operating working capital turnover, ac-
counts receivable turnover, inventory turnover, and accounts payable turnover. The turn-
over ratios can also be expressed in number of days of activity that the operating working
capital (and its components) can support. The de¬nitions of these ratios are given below.
Operating working capital
Operating working capital-to-sales ratio = --------------------------------------------------------------
Operating working capital turnover = --------------------------------------------------------------
Operating working capital
Accounts receivable turnover = ------------------------------------------------
Accounts receivable
Cost of goods sold
Inventory turnover = --------------------------------------------
Purchases Cost of goods sold
------------------------------------------ or --------------------------------------------
Accounts payable turnover =
Accounts payable Accounts payable
Accounts receivable
Days™ receivables = ----------------------------------------------------
Average sales per day
Days™ inventory = -----------------------------------------------------------------------------------
Average cost of goods sold per day
Accounts payable
Days™ payables = -----------------------------------------------------------------------------------------------------------------------
Average purchases (or cost of goods sold) per day
Operating working capital turnover indicates how many dollars of sales a ¬rm is able
to generate for each dollar invested in its operating working capital. Accounts receivable
turnover, inventory turnover, and accounts payable turnover allow the analyst to examine
how productively the three principal components of working capital are being used.
Days™ receivables, days™ inventory, and days™ payables are another way to evaluate the
ef¬ciency of a ¬rm™s working capital management.8


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