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Net income + Interest expense + Tax expense
Interest coverage (earnings basis) = --------------------------------------------------------------------------------------------------------------------
Interest expense
Interest coverage (cash flow basis) =
Cash flow from operations + Interest expense + Taxes paid
----------------------------------------------------------------------------------------------------------------------------------------------------
-
Interest expense
One can also calculate coverage ratios that measure a ¬rm™s ability to measure all
¬xed ¬nancial obligations, such as interest payment, lease payments and debt repay-
ments, by appropriately rede¬ning the numerator in the above ratios. In doing so, it is
important to remember that while some ¬xed charge payments, such as interest and lease
rentals, are paid with pretax dollars, others payments, such as debt repayments, are made
with after-tax dollars.
The earnings-based coverage ratio indicates the dollars of earnings available for each
dollar of required interest payment; the cash-¬‚ow-based coverage ratio indicates the dol-
lars of cash generated by operations for each dollar of required interest payment. In both
these ratios, the denominator is the interest expense. In the numerator, we add taxes back
because taxes are computed only after interest expense is deducted. A coverage ratio of
one implies that the ¬rm is barely covering its interest expense through its operating ac-
tivities, which is a very risky situation. The larger the coverage ratio, the greater the
cushion the ¬rm has to meet interest obligations.
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Key Analysis Questions
Some of the business questions to ask when the analyst is examining a ¬rm™s debt
policies are:
• Does the company have enough debt? Is it exploiting the potential benefits of
debt”interest tax shields, management discipline, and easier communica-
tion?
• Does the company have too much debt given its business risk? What type of
debt covenant restrictions does the firm face? Is it bearing the costs of too
much debt, risking potential financial distress and reduced business flexi-
bility?
• What is the company doing with the borrowed funds? Investing in working
capital? Investing in fixed assets? Are these investments profitable?
• Is the company borrowing money to pay dividends? If so, what is the justifi-
cation?


We show debt and coverage ratios for Nordstrom and TJX in Table 9-8. While Nord-
strom recorded an increase in its liabilities-to-equity and debt-to-equity ratios, its net ¬-
nancial leverage after taking into account its increased cash balance in 1998 shows little
increase. The company™s interest coverage also remained at comfortable levels. All these
ratios suggest that Nordstrom has been following a fairly conservative debt policy.

Table 9-8 Debt and Coverage Ratios

Nordstrom Nordstrom TJX
Ratio 1998 1997 1998
.........................................................................................................................
Liabilities to equity 1.37 0.95 1.25
Debt to equity 0.72 0.46 0.18
Net debt to equity 0.54 0.48 (0.20)
Debt to capital 0.42 0.38 0.15
Net debt to net capital 0.35 0.31 (0.25)
Net debt to equity, including operating
lease obligations Not available Not available 1.19
Interest coverage (earnings based) 8.2 9.6 410
Interest coverage (cash ¬‚ow based) 16.4 13.4 541.2
Fixed charges coverage, including lease
payments (earnings based) 4.6 4.8 3.17
Fixed charges coverage, including lease
payments (cash ¬‚ow based) 8.7 6.2 3.87
.........................................................................................................................
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TJX™s debt ratios con¬rm that it is primarily relying on non-interest-bearing liabilities
such as accounts payable and accrued expenses to ¬nance its operations. Given its large
cash balance, its net debt is in fact negative. Its interest coverage ratios are extraordinar-
ily high. However, this picture changes when one considers the fact that TJX relies
heavily on operating leases for its stores. If the present value of minimum lease rental
obligations is added to TJX™s net debt, its net-debt-to-equity ratio increases dramatically.
Similarly, when one includes minimum rental payments in the ¬xed charge coverage ra-
tio, TJX™s coverage drops dramatically. This illustrates the importance of considering
off-balance-sheet obligations in analyzing a company™s ¬nancial management.

RATIOS OF DISAGGREGATED DATA. So far we have discussed how to compute
ratios using information in the ¬nancial statements. Often, analysts probe the above
ratios further by using disaggregated ¬nancial and physical data. For example, for a
multibusiness company, one could analyze the information by individual business seg-
ments. Such an analysis can reveal potential differences in the performance of each busi-
ness unit, allowing the analyst to pinpoint areas where a company™s strategy is working
and where it is not. It is also possible to probe ¬nancial ratios further by computing ratios
of physical data pertaining to a company™s operations. The appropriate physical data to
look at varies from industry to industry. As an example in retailing, one could compute
productivity statistics such as sales per store, sales per square foot, customer transactions
per store, and amount of sale per customer transactions; in the hotel industry, room oc-
cupancy rates provide important information; in the cellular telephone industry, acqui-
sition cost per new subscriber and subscriber retention rate are important. These
disaggregated ratios are particularly useful for young ¬rms and young industries (for
example, the Internet ¬rms) where accounting data may not fully capture the business
economics due to conservative accounting rules.


Putting It All Together: Assessing Sustainable Growth Rate
Analysts often use the concept of sustainable growth as a way to evaluate a ¬rm™s ratios
in a comprehensive manner. A ¬rm™s sustainable growth rate is de¬ned as:
ROE — ( 1 “ Dividend payout ratio )
Sustainable growth rate =
We already discussed the analysis of ROE in the previous four sections. The dividend
payout ratio is de¬ned as:
Cash dividends paid
Dividend payout ratio = -----------------------------------------------
-
Net income
A ¬rm™s dividend payout ratio is a measure of its dividend policy. As we discuss in detail
in Chapter X, ¬rms pay dividends for several reasons. Dividends are a way for the ¬rm
to return to its shareholders any cash generated in excess of its operating and investment
needs. When there are information asymmetries between a ¬rm™s managers and its
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Financial Analysis




shareholders, dividend payments can serve as a signal to shareholders about managers™
expectation of the ¬rm™s future prospects. Firms may also pay dividends to attract a cer-
tain type of shareholder base.
Sustainable growth rate is the rate at which a ¬rm can grow while keeping its pro¬t-
ability and ¬nancial policies unchanged. A ¬rm™s return on equity and its dividend pay-
out policy determine the pool of funds available for growth. Of course, the ¬rm can grow
at a rate different from its sustainable growth rate if its pro¬tability, payout policy, or ¬-
nancial leverage changes. Therefore, the sustainable growth rate provides a benchmark
against which a ¬rm™s growth plans can be evaluated. Figure 9-2 shows how a ¬rm™s sus-
tainable growth rate can be linked to all the ratios discussed in this chapter. These link-
ages allow an analyst to examine the drivers of a ¬rm™s current sustainable growth rate.
If the ¬rm intends to grow at a higher rate than its sustainable growth rate, one could

Figure 9-2 Sustainable Growth Rate Framework for Financial Ratio Analysis


SUSTAINABLE
GROWTH RATE


Dividend Payout


ROE



Financial
Operating ROA Leverage Effect




Net Operating Operating Asset Net Financial
Spread
Pro¬t Margin Turnover Leverage



Gross pro¬t margin Operating working Net effective interest Debt/Equity
capital turnover rate
SG&A/Sales Cash and marketable
Operating long-term Interest income/Cash securities/Equity
R&D/Sales
asset turnover and marketable Interest coverage
Effective tax rate on
securities
Receivables turnover • earnings basis
operating pro¬ts
Interest expense/Total • cash basis
Inventory turnover
debt
Payables turnover
PP&E turnover
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9-21 Part 2 Business Analysis and Valuation Tools




assess which of the ratios are likely to change in the process. This analysis can lead to
asking business questions such as: Where is the change going to take place? Is manage-
ment expecting pro¬tability to increase? Or asset productivity to improve? Are these ex-
pectations realistic? Is the ¬rm planning for these changes? If the pro¬tability is not
likely to go up, will the ¬rm increase its ¬nancial leverage, or cut dividends? What is the
likely impact of these ¬nancial policy changes?
Table 9-9 shows the sustainable growth rate and its components for Nordstrom and
TJX. Nordstrom had a lower ROE and a higher dividend payout ratio relative to TJX,
leading to a signi¬cantly lower sustainable growth rate in both 1998 and 1997. However,
Nordstrom improved its sustainable growth rate because of its improved ROE and a mar-
ginal decline in its payout ratio.
Nordstrom™s actual growth rate in 1998 in sales, assets, and liabilities was lower than
its sustainable growth rate in 1997. In 1998 Nordstrom™s sales grew by 3.6 percent, net
operating assets declined by 5.3 percent, and its net debt grew by 6.9 percent. These dif-
ferences in Nordstrom™s sustainable growth rate and its actual growth rates in sales, net
assets, and net debt are reconciled by the fact that Nordstrom reduced its equity base
through signi¬cant stock repurchases. Nordstrom has the room to grow in future years
at much higher levels without altering its operating and ¬nancial policies.


Historical Patterns of Ratios for U.S. Nonfinancial Firms
To provide a benchmark for analysis, Table 9-10 reports historical values of the key ra-
tios discussed in this chapter. These ratios are calculated using ¬nancial statement data
for all non¬nancial publicly listed U.S. companies. The table shows the values of ROE,
its key components, and the sustainable growth rate for each of the years 1979 to 1998,
and the average for this twenty-year period. The data in the table show that the average
ROE during this period has been 11.2 percent, average operating ROA has been 9 percent,
and the average spread between operating ROA and net borrowing costs after tax has
been 2.7 percent. Average sustainable growth rate for U.S. companies during this period
has been 4.6 percent. Of course, an individual company™s ratios might depart from these
economy-wide averages for a number of reasons, including industry effects, company
strategies, and management effectiveness. Nonetheless, the average values in the table
serve as useful benchmarks in ¬nancial analysis.

Table 9-9 Sustainable Growth Rate

Nordstrom Nordstrom TJX
Ratio 1998 1997 1998
.........................................................................................................................
ROE 15.6% 12.6% 34.5%
Dividend payout ratio 0.21 0.22 0.09
Sustainable growth rate 12.3% 9.8% 31.4%
.........................................................................................................................
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Table 9-10 Historical Values of Key Financial Ratios

Operating Net Sustainable
NOPAT Asset Operating Financial Growth
Year ROE Margin Turnover ROA Spread Leverage Rate
.......................................................................................................................................
1979 14.7% 7.2% 1.77 11.5% 5.4% 0.57 8.8%
1980 13.9% 7.0% 1.81 11.3% 4.3% 0.58 8.0%
1981 13.5% 7.4% 1.77 11.3% 3.7% 0.59 7.5%
1982 10.5% 6.8% 1.61 9.4% 1.7% 0.60 4.2%
1983 10.5% 6.9% 1.61 9.6% 1.6% 0.53 4.2%
1984 12.4% 7.4% 1.64 10.6% 3.1% 0.56 6.1%

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