Evaluating Financial Performance CHAPTER 2 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All right...
Introduction <ul><li>Analogy to flight cockpit. </li></ul><ul><li>Indicators and levers. </li></ul>
Levers of Financial Performance <ul><li>ROE is Net Income divided by Shareholders’ equity. </li></ul><ul><li>Why is this a...
TABLE 2-1 ROEs and Levers of Performance for 10 Diverse Companies, 2007*
Comparisons <ul><li>Differences in ROE across firms is less than differences in components. </li></ul><ul><li>Why? </li></...
ROA <ul><li>How defined? </li></ul><ul><li>Net income / Assets </li></ul><ul><li>What does this measure? </li></ul><ul><li...
Gross Margin <ul><li>Gross Profit / Sales </li></ul><ul><li>Gross profit = ? </li></ul><ul><li>Are COGS variable or fixed?...
Asset Turnover <ul><li>Take another look at Table 2-1. </li></ul><ul><li>Which companies have high asset turnovers? </li><...
TABLE 2-1 ROEs and Levers of Performance for 10 Diverse Companies, 2007
<ul><li>What is a self-liquidating loan?  </li></ul><ul><ul><li>What happens to AR and inventory when sales go up? </li></...
Inventory Turns <ul><li>COGS / Ending inventory </li></ul><ul><li>What are the turns? </li></ul>
Days’ Sales in Cash <ul><li>Cash + Securities / Sales per day </li></ul><ul><li>What does this ratio measure? </li></ul><u...
Payables Period <ul><li>AP / Credit purchases per day </li></ul><ul><li>COGS as a proxy for Credit purchases. </li></ul><u...
Fixed Asset Turnover <ul><li>Sales / Net PP&E </li></ul><ul><li>Capital intensity? </li></ul><ul><li>What’s the wheel anal...
Financial Leverage <ul><li>What does increased financial leverage do to ROE? </li></ul><ul><li>Is increased leverage a goo...
TABLE 2-1 ROEs and Levers of Performance for 10 Diverse Companies, 2007
Balance Sheet Ratios <ul><li>Debt-to-assets = Total liabilities / Total assets </li></ul><ul><li>Debt-to-equity = Total li...
Coverage Ratios <ul><li>TIE = EBIT / Interest expense </li></ul><ul><li>Times burden covered = EBIT divided by the sum of ...
<ul><li>Which coverage ratio is more important? </li></ul><ul><li>How much coverage is enough? </li></ul><ul><li>Cash, bor...
Market Value Leverage Ratios <ul><li>D/E and D/A </li></ul><ul><li>What do they represent? </li></ul><ul><li>Coverage rati...
Liquidity Ratios <ul><li>Current ratio = Current Assets / Current Liabilities </li></ul><ul><li>Acid test removes inventor...
Is ROE a Reliable Yardstick? <ul><li>Timing </li></ul><ul><ul><li>Forward looking and long-term perspective? </li></ul></u...
ROIC Is Not Distorted by Company Financing
ROE or Market Price? <ul><li>Which is the better way to measure financial performance? </li></ul><ul><ul><li>Value creatio...
Scatter Plots <ul><li>Price-to-book vs. ROE (weighted average) </li></ul><ul><li>Figures 2-1 and 2-2 coming up. </li></ul>...
FIGURE 2-1 Market Value to Book Value of Equity versus Return on Equity for 37 Household Products and Related Companies
FIGURE 2-2 Market to Book Value of Equity versus Return on Equity for 87 Large Corporations
Using Ratios Effectively <ul><li>Ratio values need to be understood in context. </li></ul><ul><li>Usually, no “correct” va...
Figure 2-3 The Levers of Performance Suggest One Road Map for Ratio Analysis
Scotts Miracle-Gro <ul><li>Time series of Scotts ROE? </li></ul><ul><ul><li>Recap in 2007? Quality? </li></ul></ul><ul><li...
Asset Turnover <ul><li>Asset turnover. </li></ul><ul><ul><li>Low or high? </li></ul></ul><ul><ul><li>Good or bad? </li></u...
Leverage and Liquidity Ratios? <ul><li>Impact of recap? </li></ul><ul><li>TIE or TBurdenCovered? </li></ul><ul><li>Compare...
TABLE 2-2 Ratio Analysis of Scotts Miracle-Gro Co.,  2003-2007, and Industry Averages, 2007
Common Size Financial Statements <ul><li>Collection period, inventory turnover vs. ratios of AR and inventory to assets? <...
TABLE 2-3 Scotts Miracle-Gro Co., Common-Size Financial Statements, 2003 –2007 and Industry Averages for 2007
TABLE 2-3 Scotts Miracle-Gro Co., Common-Size Financial Statements, 2003 –2007 and Industry Averages for 2007 ( continued )
Opportunities for Cash? <ul><li>A challenge? </li></ul><ul><li>Examine statement of cash flows, contrasting cash flows fro...
TABLE 2-4 Selected Ratios for Representative Industries, 2006 (upper-quartile, median and lower-quartile values)
TABLE 2-4 Selected Ratios for Representative Industries, 2006 (upper-quartile, median and lower-quartile values)  ( contin...
TABLE 2-5 Definitions of Principal Ratios Appearing in Chapter
TABLE 2-5 Definitions of Principal Ratios Appearing in Chapter ( continued )
Appendix International Differences <ul><li>In the upcoming table, look at the UK, Germany and Japan. </li></ul><ul><li>Ass...
Public Companies <ul><li>Indebtedness in Latin America vs. U.S., Europe, and Japan? </li></ul><ul><li>Indebtedness in Kore...
TABLE 2A-1 Ratio Analysis of Companies in Various Countries  and Regions, 2007, Median Values
TABLE 2A-1 ( Continued )
Figure 2A.1  Average Interest Coverage Ratio, 1996
IFAS <ul><li>International Financial Accounting Standards. </li></ul><ul><li>2005, Europe adopts IFAS. </li></ul><ul><li>P...
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Chap002

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Chap002

  1. 1. Evaluating Financial Performance CHAPTER 2 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
  2. 2. Introduction <ul><li>Analogy to flight cockpit. </li></ul><ul><li>Indicators and levers. </li></ul>
  3. 3. Levers of Financial Performance <ul><li>ROE is Net Income divided by Shareholders’ equity. </li></ul><ul><li>Why is this a sensible definition? </li></ul><ul><li>3 determinants of ROE are </li></ul><ul><ul><li>Profit margin -- Net income / Sales </li></ul></ul><ul><ul><li>Asset turnover -- Sales / Assets </li></ul></ul><ul><ul><li>Financial leverage -- Assets / Shareholders’ equity </li></ul></ul><ul><li>Compare different companies on these. </li></ul>
  4. 4. TABLE 2-1 ROEs and Levers of Performance for 10 Diverse Companies, 2007*
  5. 5. Comparisons <ul><li>Differences in ROE across firms is less than differences in components. </li></ul><ul><li>Why? </li></ul><ul><li>Role of competition? </li></ul><ul><li>Is there any reason why profit margin and asset returns are negatively related? </li></ul>
  6. 6. ROA <ul><li>How defined? </li></ul><ul><li>Net income / Assets </li></ul><ul><li>What does this measure? </li></ul><ul><li>Net income + interest / Assets? </li></ul>
  7. 7. Gross Margin <ul><li>Gross Profit / Sales </li></ul><ul><li>Gross profit = ? </li></ul><ul><li>Are COGS variable or fixed? </li></ul><ul><li>Why is it important to distinguish between variable and fixed costs? </li></ul>
  8. 8. Asset Turnover <ul><li>Take another look at Table 2-1. </li></ul><ul><li>Which companies have high asset turnovers? </li></ul><ul><li>Which is likely to be more sensitive to external events, current assets or fixed assets? </li></ul>
  9. 9. TABLE 2-1 ROEs and Levers of Performance for 10 Diverse Companies, 2007
  10. 10. <ul><li>What is a self-liquidating loan? </li></ul><ul><ul><li>What happens to AR and inventory when sales go up? </li></ul></ul><ul><ul><li>What happens to AR and inventory when sales go down? </li></ul></ul><ul><li>What does a ratio like AR/Sales tell us? </li></ul><ul><li>Collection period (DSO)? </li></ul>
  11. 11. Inventory Turns <ul><li>COGS / Ending inventory </li></ul><ul><li>What are the turns? </li></ul>
  12. 12. Days’ Sales in Cash <ul><li>Cash + Securities / Sales per day </li></ul><ul><li>What does this ratio measure? </li></ul><ul><li>Cash as a substitute? </li></ul>
  13. 13. Payables Period <ul><li>AP / Credit purchases per day </li></ul><ul><li>COGS as a proxy for Credit purchases. </li></ul><ul><li>Inventory changes do what? </li></ul><ul><li>Labor costs do what? </li></ul>
  14. 14. Fixed Asset Turnover <ul><li>Sales / Net PP&E </li></ul><ul><li>Capital intensity? </li></ul><ul><li>What’s the wheel analogy? </li></ul>
  15. 15. Financial Leverage <ul><li>What does increased financial leverage do to ROE? </li></ul><ul><li>Is increased leverage a good thing? </li></ul><ul><li>Florida Power vs. Netflix and Genentech in Table 2-1? </li></ul><ul><li>JPMorgan Chase? </li></ul><ul><li>Have a look, and describe what you see, along with an explanation. </li></ul>
  16. 16. TABLE 2-1 ROEs and Levers of Performance for 10 Diverse Companies, 2007
  17. 17. Balance Sheet Ratios <ul><li>Debt-to-assets = Total liabilities / Total assets </li></ul><ul><li>Debt-to-equity = Total liabilities / Shareholders’ equity </li></ul><ul><li>What do these ratios measure? </li></ul>
  18. 18. Coverage Ratios <ul><li>TIE = EBIT / Interest expense </li></ul><ul><li>Times burden covered = EBIT divided by the sum of interest and principal repayment/1- tax rate. </li></ul><ul><ul><li>Includes repayment of principal </li></ul></ul><ul><ul><li>Adjusts for differential impact of what in respect to tax? </li></ul></ul>
  19. 19. <ul><li>Which coverage ratio is more important? </li></ul><ul><li>How much coverage is enough? </li></ul><ul><li>Cash, borrowing capacity, salable assets, business risk </li></ul>
  20. 20. Market Value Leverage Ratios <ul><li>D/E and D/A </li></ul><ul><li>What do they represent? </li></ul><ul><li>Coverage ratios? </li></ul><ul><li>Growth prospects and future coverage potential? </li></ul><ul><li>Rollover risk? </li></ul>
  21. 21. Liquidity Ratios <ul><li>Current ratio = Current Assets / Current Liabilities </li></ul><ul><li>Acid test removes inventory from current assets to yield the quick ratio. </li></ul>
  22. 22. Is ROE a Reliable Yardstick? <ul><li>Timing </li></ul><ul><ul><li>Forward looking and long-term perspective? </li></ul></ul><ul><li>Risk </li></ul><ul><ul><li>Impact of leverage </li></ul></ul><ul><ul><li>ROIC = EBIT(1-Tax rate) / Interest Bearing Debt + Equity </li></ul></ul><ul><ul><li>AP excluded </li></ul></ul><ul><li>Value </li></ul><ul><ul><li>Book value vs. market value </li></ul></ul><ul><ul><li>Earnings yield, inverse of P/E </li></ul></ul><ul><li>Back to ROIC. </li></ul>
  23. 23. ROIC Is Not Distorted by Company Financing
  24. 24. ROE or Market Price? <ul><li>Which is the better way to measure financial performance? </li></ul><ul><ul><li>Value creation for investors involves market values. </li></ul></ul><ul><ul><li>Line of sight? </li></ul></ul><ul><ul><li>Asymmetric information? </li></ul></ul><ul><ul><li>External effects, economy, other stocks, etc.? </li></ul></ul>
  25. 25. Scatter Plots <ul><li>Price-to-book vs. ROE (weighted average) </li></ul><ul><li>Figures 2-1 and 2-2 coming up. </li></ul><ul><li>Slope and dispersion (R-squared)? </li></ul>
  26. 26. FIGURE 2-1 Market Value to Book Value of Equity versus Return on Equity for 37 Household Products and Related Companies
  27. 27. FIGURE 2-2 Market to Book Value of Equity versus Return on Equity for 87 Large Corporations
  28. 28. Using Ratios Effectively <ul><li>Ratio values need to be understood in context. </li></ul><ul><li>Usually, no “correct” values for ratios. </li></ul><ul><li>Rely on rule of thumb assessment techniques, such as comps and own time series changes. </li></ul>
  29. 29. Figure 2-3 The Levers of Performance Suggest One Road Map for Ratio Analysis
  30. 30. Scotts Miracle-Gro <ul><li>Time series of Scotts ROE? </li></ul><ul><ul><li>Recap in 2007? Quality? </li></ul></ul><ul><li>ROIC? </li></ul><ul><li>Profit margin? </li></ul><ul><ul><li>Puzzle? </li></ul></ul><ul><li>Gross margin? </li></ul><ul><ul><li>How strong a brand? </li></ul></ul>
  31. 31. Asset Turnover <ul><li>Asset turnover. </li></ul><ul><ul><li>Low or high? </li></ul></ul><ul><ul><li>Good or bad? </li></ul></ul><ul><li>Fixed asset turnover? </li></ul><ul><li>Inventory turnover? </li></ul><ul><li>Collection period? </li></ul><ul><li>Days’ sales in cash? </li></ul>
  32. 32. Leverage and Liquidity Ratios? <ul><li>Impact of recap? </li></ul><ul><li>TIE or TBurdenCovered? </li></ul><ul><li>Compare Scotts to industry averages: see next slide. </li></ul>
  33. 33. TABLE 2-2 Ratio Analysis of Scotts Miracle-Gro Co., 2003-2007, and Industry Averages, 2007
  34. 34. Common Size Financial Statements <ul><li>Collection period, inventory turnover vs. ratios of AR and inventory to assets? </li></ul><ul><ul><li>Sales/assets? </li></ul></ul><ul><li>Working capital? </li></ul><ul><ul><li>Fraction of assets that are short-term? </li></ul></ul><ul><li>COGS </li></ul><ul><ul><li>Small %s can be large relative to net income. </li></ul></ul>
  35. 35. TABLE 2-3 Scotts Miracle-Gro Co., Common-Size Financial Statements, 2003 –2007 and Industry Averages for 2007
  36. 36. TABLE 2-3 Scotts Miracle-Gro Co., Common-Size Financial Statements, 2003 –2007 and Industry Averages for 2007 ( continued )
  37. 37. Opportunities for Cash? <ul><li>A challenge? </li></ul><ul><li>Examine statement of cash flows, contrasting cash flows from operations to cash flows from investment. </li></ul><ul><li>Excess cash? </li></ul><ul><li>Recap + distribution to shareholders? </li></ul>
  38. 38. TABLE 2-4 Selected Ratios for Representative Industries, 2006 (upper-quartile, median and lower-quartile values)
  39. 39. TABLE 2-4 Selected Ratios for Representative Industries, 2006 (upper-quartile, median and lower-quartile values) ( continued )
  40. 40. TABLE 2-5 Definitions of Principal Ratios Appearing in Chapter
  41. 41. TABLE 2-5 Definitions of Principal Ratios Appearing in Chapter ( continued )
  42. 42. Appendix International Differences <ul><li>In the upcoming table, look at the UK, Germany and Japan. </li></ul><ul><li>Asset turns and profit margins in Asia and Latin America? </li></ul><ul><li>Japanese collection periods, payables periods, and keiretsu . </li></ul><ul><li>Leverage and liquidity across the globe? </li></ul>
  43. 43. Public Companies <ul><li>Indebtedness in Latin America vs. U.S., Europe, and Japan? </li></ul><ul><li>Indebtedness in Korea, Thailand, Indonesia? </li></ul><ul><ul><li>Controlling families, state-owned banks, and the state </li></ul></ul><ul><ul><li>Use of banks to foster top-down directed development </li></ul></ul>
  44. 44. TABLE 2A-1 Ratio Analysis of Companies in Various Countries and Regions, 2007, Median Values
  45. 45. TABLE 2A-1 ( Continued )
  46. 46. Figure 2A.1 Average Interest Coverage Ratio, 1996
  47. 47. IFAS <ul><li>International Financial Accounting Standards. </li></ul><ul><li>2005, Europe adopts IFAS. </li></ul><ul><li>Post Enron and WorldCom, U.S. will adopt IFAS. </li></ul><ul><li>Consolidated balance sheets vs. those of parent, expensing R&D, fair value accounting. </li></ul><ul><li>Principles vs. rules. </li></ul>

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