its cash ´¬‚ow from operations facilitates this exercise. Some of the questions an an-
alyst can probe in this respect are:
ÔÇó Are there signi´¬ücant differences between a ´¬ürmÔÇ™s net income and its operat-
ing cash ´¬‚ow? Is it possible to clearly identify the sources of this difference?
Which accounting policies contribute to this difference? Are there any one-
time events contributing to this difference?
ÔÇó Is the relationship between cash ´¬‚ow and net income changing over time?
Why? Is it because of changes in business conditions or because of changes
in the ´¬ürmÔÇ™s accounting policies and estimates?
ÔÇó What is the time lag between the recognition of revenues and expenses and
the receipt and disbursement of cash ´¬‚ows? What type of uncertainties need
to be resolved in between?
ÔÇó Are the changes in receivables, inventories, and payables normal? If not, is
there adequate explanation for the changes?
Finally, as we will discuss in Chapter 12, free cash ´¬‚ow available to debt and equity
and free cash ´¬‚ow available to equity are critical inputs into the cash-´¬‚ow-based valua-
tion of ´¬ürmsÔÇ™ assets and equity, respectively.
Analysis of NordstromÔÇ™s Cash Flow
Nordstrom and TJX reported their cash ´¬‚ows using the indirect cash ´¬‚ow statement. Ta-
ble 9-11 recasts these statements so that we can analyze the two companiesÔÇ™ cash ´¬‚ow
dynamics, as discussed above.
Cash ´¬‚ow analysis presented in Table 9-11 shows Nordstrom had an operating cash
´¬‚ow before working capital investments of $424 million in 1998, a substantial improve-
ment from $365.4 million in 1997. The difference between earnings and these cash ´¬‚ows
is primarily attributable to the depreciation and amortization charge included in the com-
344 Financial Analysis
panyÔÇ™s income statement. In 1998 Nordstrom managed to squeeze an additional $199
million from its operating working capital, primarily by reducing its investment in ac-
counts receivable and inventory. This contrasts with a net operating working capital in-
vestment of $45 million in 1997. As a result of this, the company had an operating cash
´¬‚ow before long-term investments to the tune of $623 million in 1998, more than ade-
quate to meet its total investment in long-term assets. Nordstrom thus had $363.8 million
of free cash ´¬‚ow available to debt and equity holders in 1998, compared to a total of only
$62.7 million in 1997. Both in 1997 and 1998, the company was a net borrower. As a
result, there was considerable free cash ´¬‚ow available to equity holders in both years.
The company utilized this free cash ´¬‚ow to pay its regular dividends and also buy back
stock in both the years. The difference between the two years, however, is that in 1998
the company had adequate internal cash ´¬‚ow to pay dividends and buy back stock, while
in 1997 the company could not have made these payments to equity holders either with-
out borrowing or without cutting its long-term investments. Clearly, NordstromÔÇ™s cash
´¬‚ow improved signi´¬ücantly in 1998.
TJX also had a very strong cash ´¬‚ow situation in 1998. It had $567 million in operat-
ing cash ´¬‚ow before working capital investments. TJX was also able to reduce its invest-
ments in operating working capital. There is, however, a signi´¬ücant difference between
the way investments in working capital appear to have been managed by TJX and Nord-
strom. While Nordstrom reduced its investments in inventory and accounts receivable,
TJX stretched its payables and accrued expenses. Similar to Nordstrom, TJX was able to
fund all its long-term investments in operating assets from its own operating cash ´¬‚ow.
As a result, TJX had $442 million in free cash ´¬‚ow available to debt and equity holders.
From this, the company paid out approximately $25 million in interest and principal to
its debt holders and $360.7 million in dividends and stock repurchases to its equity hold-
ers, leaving a cash increase of about $57 million.
This chapter presents two key tools of ´¬ünancial analysis: ratio analysis and cash ´¬‚ow
analysis. Both these tools allow the analyst to examine a ´¬ürmÔÇ™s performance and its ´¬ü-
nancial condition, given its strategy and goals. Ratio analysis involves assessing the
´¬ürmÔÇ™s income statement and balance sheet data. Cash ´¬‚ow analysis relies on the ´¬ürmÔÇ™s
cash ´¬‚ow statement.
The starting point for ratio analysis is the companyÔÇ™s ROE. The next step is to evaluate
the three drivers of ROE, which are net pro´¬üt margin, asset turnover, and ´¬ünancial lever-
age. Net pro´¬üt margin re´¬‚ects a ´¬ürmÔÇ™s operating management, asset turnover re´¬‚ects its
investment management, and ´¬ünancial leverage re´¬‚ects its liability management. Each
of these areas can be further probed by examining a number of ratios. For example, com-
mon-sized income statement analysis allows a detailed examination of a ´¬ürmÔÇ™s net mar-
gins. Similarly, turnover of key working capital accounts like accounts receivable,
inventory, and accounts payable, and turnover of the ´¬ürmÔÇ™s ´¬üxed assets allow further
9-29 Part 2 Business Analysis and Valuation Tools
examination of a ´¬ürmÔÇ™s asset turnover. Finally, short-term liquidity ratios, debt policy ra-
tios, and coverage ratios provide a means of examining a ´¬ürmÔÇ™s ´¬ünancial leverage.
A ´¬ürmÔÇ™s sustainable growth rateÔÇ”the rate at which it can grow without altering its
operating, investment, and ´¬ünancing policiesÔÇ”is determined by its ROE and its dividend
policy. Therefore, the concept of sustainable growth provides a way to integrate the ratio
analysis and to evaluate whether or not a ´¬ürmÔÇ™s growth strategy is sustainable. If a ´¬ürmÔÇ™s
plans call for growing at a rate above its current sustainable rate, then the analyst can
examine which of the ´¬ürmÔÇ™s ratios is likely to change in the future.
Cash ´¬‚ow analysis supplements ratio analysis in examining a ´¬ürmÔÇ™s operating activ-
ities, investment management, and ´¬ünancial risks. Firms in the U.S. are currently re-
quired to report a cash ´¬‚ow statement summarizing their operating, investment, and
´¬ünancing cash ´¬‚ows. Firms in other countries typically report working capital ´¬‚ows, but
it is possible to use this information to create a cash ´¬‚ow statement.
Since there are wide variations across ´¬ürms in the way cash ´¬‚ow data are reported,
analysts often use a standard format to recast cash ´¬‚ow data. We discussed in this chapter
one such cash ´¬‚ow model. This model allows the analyst to assess whether a ´¬ürmÔÇ™s op-
erations generate cash ´¬‚ow before investments in operating working capital, and how
much cash is being invested in the ´¬ürmÔÇ™s working capital. It also enables the analyst to
calculate the ´¬ürmÔÇ™s free cash ´¬‚ow after making long-term investments, which is an indi-
cation of the ´¬ürmÔÇ™s ability to meet its debt and dividend payments. Finally, the cash ´¬‚ow
analysis shows how the ´¬ürm is ´¬ünancing itself, and whether or not its ´¬ünancing patterns
are too risky.
The insights gained from analyzing a ´¬ürmÔÇ™s ´¬ünancial ratios and its cash ´¬‚ows are
valuable in forecasts of the ´¬ürmÔÇ™s future prospects, a topic we address in the chapter.
1. Which of the following types of firms do you expect to have particularly high or
low asset turnover? Explain why.
ÔÇó a supermarket
ÔÇó a pharmaceutical company
ÔÇó a jewelry retailer
ÔÇó a steel company
2. Which of the following types of firms do you expect to have high or low sales mar-
ÔÇó a supermarket
ÔÇó a pharmaceutical company
ÔÇó a jewelry retailer
ÔÇó a software company
3. James Broker, an analyst with an established brokerage firm, comments: ÔÇťThe crit-
ical number I look at for any company is operating cash flow. If cash flows are less
than earnings, I consider a company to be a poor performer and a poor investment
prospect.ÔÇŁ Do you agree with this assessment? Why or why not?
346 Financial Analysis
4. In 1995 Chrysler has a return on equity of 20 percent, whereas FordÔÇ™s return is only
8 percent. Use the decomposed ROE framework to provide possible reasons for this
5. Joe Investor claims: ÔÇťA company cannot grow faster than its sustainable growth
rate.ÔÇŁ True or false? Explain why.
6. What are the reasons for a firm having lower cash from operations than working
capital from operations? What are the possible interpretations of these reasons?
7. ABC Company recognizes revenue at the point of shipment. Management decides
to increase sales for the current quarter by filling all customer orders. Explain what
impact this decision will have on:
ÔÇó Days receivable for the current quarter
ÔÇó Days receivable for the next quarter
ÔÇó Sales growth for the current quarter
ÔÇó Sales growth for the next quarter
ÔÇó Return on sales for the current quarter
ÔÇó Return on sales for the next quarter
8. What ratios would you use to evaluate operating leverage for a firm?
9. What are the potential benchmarks that you could use to compare a companyÔÇ™s
financial ratios? What are the pros and cons of these alternatives?
10. In a period of rising prices, how would the following ratios be affected by the
accounting decision to select LIFO, rather than FIFO, for inventory valuation?
ÔÇó Gross margin
ÔÇó Current ratio
ÔÇó Asset turnover
ÔÇó Debt-to-equity ratio
ÔÇó Average tax rate
1. We will call the fiscal year ending January 1999 as the year 1998, and the fiscal year ending
January 1998 as the year 1997.
2. In computing ROE, one can either use the beginning equity, ending equity, or an average of
the two. Conceptually, the average equity is appropriate, particularly for rapidly growing compa-
nies. However, for most companies, this computational choice makes little difference as long as
the analyst is consistent. Therefore, in practice, most analysts use ending balances for simplicity.
This comment applies to all ratios discussed in this chapter where one of the items in the ratio is
a flow variable (items in the income statement or cash flow statement) and the other item is a stock
variable (items in the balance sheet). Throughout this chapter, we use the ending balances of the
stock variables for computational simplicity.
3. We discuss in greater detail in Chapter 12 how to estimate a companyÔÇ™s cost of equity cap-
ital. The equity beta for both Nordstrom and TJX was close to one in 1999, and the yield on long-
term treasury bonds was approximately 6 percent. If one assumes a risk premium of 6 percent, the
two firmsÔÇ™ cost of equity is 12 percent; if the risk premium is assumed to be 8 percent, then their
9-31 Part 2 Business Analysis and Valuation Tools
cost of equity is 14 percent. Lower assumed risk premium will, of course, lead to lower estimates
of equity capital.
4. Strictly speaking, part of a cash balance is needed to run the firmÔÇ™s operations, so only the
excess cash balance should be viewed as negative debt. However, firms do not provide informa-
tion on excess cash, so we subtract all cash balance in our definitions and computations below. An
alternative possibility is to subtract only short-term investments and ignore the cash balance com-
5. See ÔÇťRatio Analysis and Valuation,ÔÇŁ by Doron Nissim and Stephen Penman, unpublished
manuscript, March 1999, for a more detailed description of this approach.
6. TJX has a small amount of debt and a cash balance larger than its debt. Therefore, its weight-
ed average cost of capital is likely to be similar to its cost of equity. We will discuss in Chapter
12 how to estimate a companyÔÇ™s weighted average cost of capital.
7. See Taxes and Business Strategy, by Myron Scholes and Mark Wolfson, Englewood Cliffs,
NJ: Prentice-Hall, 1992.
8. There are a number of issues related to the calculation of these ratios in practice. First, in
calculating all the turnover ratios, the assets used in the calculations can either be year-end values
or an average of the beginning and ending balances in a year. We use the year-end values here for
simplicity. Second, strictly speaking, one should use credit sales to calculate accounts receivable
turnover and daysÔÇ™ receivables. However, since it is usually difficult to obtain data on credit sales,
total sales are used instead. Similarly, in calculating accounts payable turnover or daysÔÇ™ payables,
cost of goods sold is substituted for purchases for data availability reasons.
9. Changes in cash and marketable securities are excluded because this is the amount being ex-
plained by the cash flow statement. Changes in short-term debt and the current portion of long-
term debt are excluded because these accounts represent financing flows, not operating flows.
The Home Depot, Inc.
T he difference between a company with a concept and one without is
the difference between a stock that sells for 20 times earnings and one that sells for
10 times earnings. The Home Depot is de´¬ünitely a concept stock, and it has the mul-
Business Analysis and Valuation Tools
tiple to prove it ÔÇ“ 27-28 times likely earnings in the current ´¬üscal year ending this
month. On the face of it, The Home Depot might seem like a tough one for the con-
cept-mongers to work with. ItÔÇ™s a chain of hardware stores. But, as we noted in our
last visit to the company in the spring of ÔÇ™83, these hardware stores are huge ware-
house outlets ÔÇ“ 60,000 to 80,000 feet in space. You can ´¬üt an awful lot of saws in
these and still have plenty of room left over to knock together a very decent concept.
And in truth, the warehouse notion is the hottest thing in retailing these days. The
9 Home Depot buys in quantum quantities, which means that its suppliers are eager
to keep within its good graces and hence provide it with a lot of extra service. The
company, as it happens, is masterful in promotion and pricing. The last time we
counted, it had 22 stores, all of them located where the sun shines all the time.
Growth has been sizzling. Revenues, a mere $22 million in fiscal ÔÇ™80, shot past
the quarter billion mark three years later. As to earnings, they have climbed from
two cents in fiscal ÔÇ™80 to an estimated 60 cents in the fiscal year coming to an end
[in January 1985].
Its many boosters in the Street, moreover, anticipate more of the same as far as
the bullish eye can see. TheyÔÇ™re confidently estimating 30% growth in the new fis-
cal year as well. Could be. But while we share their esteem for the companyÔÇ™s mer-
chandising skills and imagination, weÔÇ™re as bemused now as we were the first time
we looked at The Home Depot by its rich multiple. Maybe a little more now than
The above report appeared on January 21, 1985, in ÔÇťUp & Down Wall Street,ÔÇŁ a reg-
ular column in BarronÔÇ™s ´¬ünancial weekly.
Bernard Marcus and Arthur Blank founded The Home Depot in 1978 to bring the ware-
house retailing concept to the home center industry. The company operated retail ÔÇťdo-it-
This case was prepared by Professor Krishna Palepu as the basis for class discussion rather than to illustrate either