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LONG-TERM ASSETS MANAGEMENT. Another area of investment management
concerns the utilization of a ¬rm™s long-term assets. It is useful to de¬ne a ¬rm™s invest-
ment in long-term assets as follows:
Net long-term assets =
(Total long-term assets ’ Non-interest-bearing long-term liabilities)
Long-term assets generally consist of net property, plant, and equipment (PP&E), intan-
gible assets such as goodwill, and other assets. Non-interest-bearing long-term liabilities
include such items as deferred taxes. We de¬ne net long-term assets and net working
capital in such a way that their sum, net operating assets, is equal to the sum of net debt
Financial Analysis

9-13 Part 2 Business Analysis and Valuation Tools

and equity, or net capital. This is consistent with the way we de¬ned operating ROA ear-
lier in the chapter.
The ef¬ciency with which a ¬rm uses its net long-term assets is measured by the fol-
lowing two ratios: net long-term assets as a percent of sales and net long-term asset turn-
over. Net long-term asset turnover is de¬ned as:
Net long-term asset turnover = ------------------------------------------------
Net long-term assets
Property plant and equipment (PP&E) is the most important long-term asset in a
¬rm™s balance sheet. The ef¬ciency with which a ¬rm™s PP&E is used is measured by the
ratio of PP&E to sales, or by the PP&E turnover ratio:
PP&E turnover = -----------------------------------------------------------------------------------
Net property, plant, and equipment
The ratios listed above allow the analyst to explore a number of business questions in
four general areas: (1) How well does the company manage its inventory? Does the com-
pany use modern manufacturing techniques? Does it have good vendor and logistics
management systems? If inventory ratios are changing, what is the underlying business
reason? Are new products being planned? Is there a mismatch between the demand fore-
casts and actual sales? (2) How well does the company manage its credit policies? Are
these policies consistent with its marketing strategy? Is the company arti¬cially increas-
ing sales by loading the distribution channels? (3) Is the company taking advantage of
trade credit? Is it relying too much on trade credit? If so, what are the implicit costs? (4)
Are the company™s investment in plant and equipment consistent with its competitive
strategy? Does the company have a sound policy of acquisitions and divestitures?
Table 9-6 shows the asset turnover ratios for Nordstrom and TJX. Nordstrom achieved
an improvement in its working capital management between 1997 and 1998, as can be
seen from a reduction of operating working capital as a percent of sales and an increase
in operating working capital turnover. This improvement is attributable to a reduction in
accounts receivable and better inventory management. There was also a marginal im-
provement in its accounts payable days as well. In contrast, Nordstrom™s long-term asset
utilization did not improve in 1998: its net long-term asset turnover and PP&E turnover
show marginal declines. In its annual report, Nordstrom acknowledges that the sales from
stores that it operated for more than a year (also called same-store sales) showed a small
decline in 1998 because management was focusing on controlling inventory to cut costs.
TJX achieved dramatically better asset utilization ratios in 1998 relative to Nord-
strom. TJX was able to invest a negligible amount of money in its operating working
capital by taking full advantage of trade credit from its vendors and by delaying payment
of some of its operating expenses. Also, because TJX has no credit card operations of its
own, it is able to collect its receivables in 3 days, in contrast to Nordstrom™s 43 receiv-
able days. TJX is also managing its inventory more ef¬ciently, perhaps because of its
more focused merchandising strategy. Finally, because TJX uses operating leases to rent
its stores, it has signi¬cantly lower capital tied up in its stores. As a result, its PP&E turn-
330 Financial Analysis

Financial Analysis

Table 9-6 Asset Management Ratios

Nordstrom Nordstrom TJX
Ratio 1998 1997 1998
Operating working capital/Sales 16.2% 20.8% (0.3)%
Net long-term assets/Sales 24.0% 23.2% 12.6%
PP&E/Sales 27.1% 25.8% 9.5%
Operating working capital turnover 6.17 4.81 Not meaningful
Net long-term assets turnover 4.17 4.31 7.94
PP&E turnover 3.69 3.88 10.52
Accounts receivable turnover 8.56 7.30 117.9
Inventory turnover 4.46 3.99 5.0
Accounts payable turnover 9.85 10.26 9.6
Days™ accounts receivable 42.6 50 3.1
Days™ inventory 81.8 91.5 73
Days™ accounts payable 37.1 35.6 38

over is almost three times as much as Nordstrom™s. One should, however, be cautious in
interpreting this difference between the two companies, because, as TJX discloses in its
footnotes, it owes a substantial amount of money in the coming years on noncancelable
operating leases. TJX™s ¬nancial statements do not fully recognize its potential invest-
ment in its stores through these noncancelable leases, potentially in¬‚ating its operating
asset turns.

Evaluating Financial Management: Financial Leverage
Financial leverage enables a ¬rm to have an asset base larger than its equity. The ¬rm
can augment its equity through borrowing and the creation of other liabilities like
accounts payable, accrued liabilities, and deferred taxes. Financial leverage increases a
¬rm™s ROE as long as the cost of the liabilities is less than the return from investing these
funds. In this respect, it is important to distinguish between interest-bearing liabilities
such as notes payable, other forms of short-term debt and long-term debt, which carry
an explicit interest charge, and other forms of liabilities. Some of these other forms of
liability, such as accounts payable or deferred taxes, do not carry any interest charge at
all. Other liabilities, such as capital lease obligations or pension obligations, carry an im-
plicit interest charge. Finally, some ¬rms carry large cash balances or investments in
marketable securities. These balances reduce a ¬rm™s net debt because conceptually the
¬rm can pay down its debt using its cash and short-term investments.
Financial Analysis

9-15 Part 2 Business Analysis and Valuation Tools

While a ¬rm™s shareholders can potentially bene¬t from ¬nancial leverage, it can also
increase their risk. Unlike equity, liabilities have prede¬ned payment terms, and the ¬rm
faces risk of ¬nancial distress if it fails to meet these commitments. There are a number
of ratios to evaluate the degree of risk arising from a ¬rm™s ¬nancial leverage.

The following ratios are
useful in evaluating the risk related to a ¬rm™s current liabilities:
Current assets
Current ratio = -----------------------------------------
Current liabilities
Cash + Short-term investments + Accounts receivable
Quick ratio = ----------------------------------------------------------------------------------------------------------------------------------------
Current liabilities
Cash + Marketable securities
Cash ratio = ------------------------------------------------------------------------
Current liabilities
Cash flow from operations
Operating cash flow ratio = ---------------------------------------------------------------
Current liabilities
All the above ratios attempt to measure the ¬rm™s ability to repay its current liabili-
ties. The ¬rst three compare a ¬rm™s current liabilities with its short-term assets that can
be used to repay the current liabilities. The fourth ratio focuses on the ability of the ¬rm™s
operations to generate the resources needed to repay its current liabilities.
Since both current assets and current liabilities have comparable duration, the current
ratio is a key index of a ¬rm™s short-term liquidity. Analysts view a current ratio of more
than one to be an indication that the ¬rm can cover its current liabilities from the cash
realized from its current assets. However, the ¬rm can face a short-term liquidity prob-
lem even with a current ratio exceeding one when some of its current assets are not easy
to liquidate. Quick ratio and cash ratio capture the ¬rm™s ability to cover its current lia-
bilities from liquid assets. Quick ratio assumes that the ¬rm™s accounts receivable are
liquid. This is true in industries where the credit-worthiness of the customers is beyond
dispute, or when receivables are collected in a very short period. However, when these
conditions do not prevail, cash ratio, which considers only cash and marketable securi-
ties, is a better indication of a ¬rm™s ability to cover its current liabilities in an emer-
gency. Operating cash ¬‚ow is another measure of the ¬rm™s ability to cover its current
liabilities from cash generated from operations of the ¬rm.
The liquidity ratios for Nordstrom and TJX are shown in Table 9-7. Nordstrom™s li-
quidity situation in 1998 was comfortable when measured in terms of current ratio or
quick ratio. Both these ratios improved in 1998. Because Nordstrom accumulated a large
cash balance and improved its cash ¬‚ow from operations through better inventory man-
agement in 1998, its cash ratio and operating cash ¬‚ow ratio also show dramatic im-
provement in 1998. All this is good news for Nordstrom™s short-term creditors. TJX also
has a comfortable liquidity position, thanks to its large cash balance and a sound oper-
ating cash ¬‚ow. Because of its tight management of operating working capital, however,
332 Financial Analysis

Financial Analysis

Table 9-7 Liquidity Ratios
Nordstrom Nordstrom TJX
Ratio 1998 1997 1998
Current ratio 2.19 1.71 1.33
Quick ratio 1.08 0.73 0.40
Cash ratio 0.31 0.03 0.35
Operating cash ¬‚ow ratio 0.78 0.32 0.49

TJX™s current and quick ratios are smaller than Nordstrom™s. If TXJ were to pay out its
cash balance, its liquidity ratios would show a signi¬cant decline.

DEBT AND LONG-TERM SOLVENCY. A company™s ¬nancial leverage is also in¬‚u-
enced by its debt ¬nancing policy. There are several potential bene¬ts from debt ¬nanc-
ing. First, debt is typically cheaper than equity because the ¬rm promises prede¬ned
payment terms to debt holders. Second, in most countries, interest on debt ¬nancing is
tax deductible whereas dividends to shareholders are not tax deductible. Third, debt ¬-
nancing can impose discipline on the ¬rm™s management and motivate it to reduce
wasteful expenditures. Fourth, it is often easier for management to communicate their
proprietary information on the ¬rm™s strategies and prospects to private lenders than to
public capital markets. Such communication can potentially reduce a ¬rm™s cost of cap-
ital. For all these reasons, it is optimal for ¬rms to use at least some debt in their capital
structure. Too much reliance on debt ¬nancing, however, is potentially costly to the
¬rm™s shareholders. The ¬rm will face ¬nancial distress if it defaults on the interest and
principal payments. Debt holders also impose covenants on the ¬rm, restricting the
¬rm™s operating, investment, and ¬nancing decisions.
The optimal capital structure for a ¬rm is determined primarily by its business risk.
A ¬rm™s cash ¬‚ows are highly predictable when there is little competition or there is little
threat of technological changes. Such ¬rms have low business risk, and hence they can
rely heavily on debt ¬nancing. In contrast, if a ¬rm™s operating cash ¬‚ows are highly vol-
atile and its capital expenditure needs are unpredictable, it may have to rely primarily on
equity ¬nancing. Managers™ attitude towards risk and ¬nancial ¬‚exibility also often de-
termine a ¬rm™s debt policies.
There are a number of ratios which help the analyst in this area. To evaluate the mix
of debt and equity in a ¬rm™s capital structure, the following ratios are useful:
Total liabilities
Liabilities-to-equity ratio = -------------------------------------------------
Shareholders™ equity
Short-term debt + Long-term debt
Debt-to-equity ratio = ------------------------------------------------------------------------------------
Shareholders™ equity
Short-term debt + Long-term debt “ Cash and marketable securities
Net-debt-to-equity ratio = ------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Shareholders™ equity
Financial Analysis

9-17 Part 2 Business Analysis and Valuation Tools

Short-term debt + Long-term debt
Debt-to-capital ratio = ------------------------------------------------------------------------------------------------------------------------------------------------
Short-term debt + Long-term debt + Shareholders™ equity
Net-debt-to-net-capital ratio = ""
Interest bearing liabilities “ Cash and marketable securities
"" = ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
Interest bearing liabilities “ Cash and marketable securities + Shareholders™ equity
The ¬rst ratio restates the assets-to-equity ratio (one of the three primary ratios un-
derlying ROE) by subtracting one from it. The second ratio provides an indication of how
many dollars of debt ¬nancing the ¬rm is using for each dollar invested by its sharehold-
ers. The third ratio uses net debt, which is total debt minus cash and marketable securi-
ties, as the measure of a ¬rm™s borrowings. The fourth and ¬fth ratios measure debt as a
proportion of total capital. In calculating all the above ratios, it is important to include
all interest bearing obligations, whether the interest charge is explicit or implicit. Recall
that examples of line items which carry an implicit interest charge include capital lease
obligations and pension obligations. Analysts sometimes include any potential off-bal-
ance-sheet obligations that a ¬rm may have, such as noncancelable operating leases, in
the de¬nition of a ¬rm™s debt.
The ease with which a ¬rm can meet its interest payments is an indication of the de-
gree of risk associated with its debt policy. The interest coverage ratio provides a mea-
sure of this construct:


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