EvaluatingFinancial PerformanceChapter TwoCopyright ©

Evaluating
Financial Performance
Chapter Two
Copyright © 2019 by McGraw-Hill Education. All rights
reserved.
Copyright © 2019 McGraw-Hill Education. All rights reserved.
No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
1
The Levers of Financial Performance
A pilot uses levers to control a the flight of an aircraft.
Operating decisions are the levers by which managers control
financial performance.
In this chapter, we study how financial statements help us to
analyze the performance of the firm.
Our primary tool is ratio analysis.
Ch. 2 2
Higgins, Analysis for Financial Management, 12e

2
Return on Equity
Return on Equity: The most popular measure of financial
performance
= 29.6%
Why does this definition make sense?
Ch. 2 3
3
The 3 Determinants of ROE
How is this a measure of leverage?
Ch. 2 4

4
TABLE 2.1 ROE and Levers of Performance for 10 Diverse
Companies, 2016
Ch. 2 5
5
Questions about Table 2.1
Differences in ROE across firms is less than differences in
components. Why?
What is the role of competition in ROE differences?
Is there any reason why profit margin and asset turnover should
be negatively related?
Ch. 2 6
6

You try it.
Calculate ROE and the levers of performance.
Ch. 2 7
Nordstrom: Profit margin=354/14,757=2.4%; Asset
turnover=14,757/7,858=1.9; Leverage=7,858/870=9.0;
ROE=2.4%×1.9×9.0=40.7%
Walmart: Profit margin=13,643/485,873=2.8%; Asset
turnover=485,873/198,825=2.4; Leverage=198,825/77,798=2.6;
ROE=2.8%×2.4×2.6=17.5%
7
Profitability Ratios
Profit margin: The fraction of each sales dollar realized as
profits
Return on assets: The combined effect of profit margin and
asset turnover
Gross margin: The contribution to fixed costs and profits
Are COGS fixed or variable?
Ch. 2 8

8
Hasbro’s Profitability Ratios
Ch. 2 9
9
Breakeven Sales
Use gross margin to calculate Hasbro’s breakeven sales vol ume
Assume COGS are variable and operating expenses are fixed.
Hasbro’s 2016 operating costs were $1,968 million.
Since 56% of sales goes to cover operating costs, breakeven
sales volume = $1,968/0.56 = $3,514 million.
Ch. 2 10
10

You try it.
Calculate breakeven sales volume for Apple Inc. for 2016.
Ch. 2 11
Gross margin=84,263/215,639=39.1%.
Breakeven=24,239/0.391=$61,992.
11
Turnover-Control Ratios
Asset turnover: Sales generated per dollar of assets
Inventory turnover: Number of times inventory turns over per
year
Collection period: Average number of days to collect
receivables
What if you don’t know credit sales?
Ch. 2 12
12
More Turnover-Control Ratios

Days’ sales in cash: Availability of cash relative to sales
Payables period: Average number of days to pay accounts
payable
Fixed-asset turnover: Sales generated per dollar of fixed assets
What if you don’t know credit purchases?
Ch. 2 13
13
Fixed Assets vs. Current Assets
Which is likely to be more sensitive to external events, current
assets or fixed assets?
What is a self-liquidating loan?
Loan to support current assets
What happens to AR and inventory when sales go up?
What happens to AR and inventory when sales go down?
Ch. 2 14
14
Hasbro’s Turnover-Control Ratios

Does a higher fixed-asset turnover indicate higher or lower
capital intensity?
Ch. 2 15
15
The Cash Conversion Cycle (CCC)
The average length of time between when cash goes out the
door and when it comes back in
CCC= Days inventory outstanding + Collection period –
Payables period
Ch. 2 16
16
You try it.

Calculate the cash conversion cycle for Hyund ai Motor.
Ch. 2 17Hyundai Motor
Selected financial data
2016 (₩ billions)Sales93,649Cost of goods sold75,960Accounts
receivable8,030Inventory10,524Accounts payable6,986
DIO=10,524/(75,960/365)=51, Coll.
Pd.=8,030/(93,649/365)=31, Pay. Pd.=6,986/(75,960/365)=34,
CCC=51+31-34=48 days
17
Financial Leverage
What does increased financial leverage do to ROE?
Is increased leverage a good thing?
Southern Co. vs. Alphabet
JPMorgan Chase
Have another look at Table 2.1, and describe what you see,
along with an explanation.
Ch. 2 18
18
TABLE 2.1 ROE and Levers of Performance for 10 Diverse
Companies, 2016
Ch. 2 19

19
Leverage and Liquidity Ratios 1
Balance Sheet Ratios
Debt-to-assets ratio: Percent of assets paid for by creditors
Debt-to-equity ratio: Financing supplied by creditors for every
dollar from shareholders
Ch. 2 20
20

Coverage Ratios
Times interest earned: Income available in relation to interest
payments
Times burden covered: Income available in relation to all debt
service
Which coverage ratio is more important? Why?
Ch. 2 21
Stryker’s tax rate is $206/$1,212 = 17%
21
Market Value Leverage Ratios
Market debt-to-equity ratio: Today’s value of financial burdens
compared to shareholders’ expected value
Market debt-to-assets ratio: Today’s value of financial burdens
compared to value of expected future income

What if you don’t know the market value of debt?
Ch. 2 22
22
Liquidity Ratios
Current ratio: Liquid assets compared to imminent debts
Acid test (Quick ratio): Very liquid assets compared to
imminent debts
Ch. 2 23
23
ROE: The Timing Problem

Is ROE forward-looking?
Does ROE have a long-term perspective?
Ch. 2 24
24
ROE: The Risk Problem
Does ROE take into account business risk?
What is the impact of leverage on ROE?
Return on invested capital: A measure of return on capital
independent of the amount of leverage
Ch. 2 25
= 17.5%
25
ROIC Is Not Distorted by Company Financing
Ch. 2 26

26
ROE: The Value Problem
Should we calculate return on book equity or market equity?
Earnings yield: ROE using market value of equity instead of
book value
Price-to-earnings ratio: Inverse of earnings yield; commonly
used measure of performance
Is this a better measure of performance than ROE?
Ch. 2 27
27
ROE or Market Price?

Which is the better way to measure financial performance?
We have just discussed problems with ROE.
What about problems with stock price?
How do operating decision affect stock price?
Managers (should) know more about the company than outside
investors.
Stock price depends on many factors outside management’s
control.
Ch. 2 28
28
Comparing ROE to Stock Price
Market-to-book vs. ROE (weighted-average)
Figures 2.1 and 2.2 coming up
Slope and dispersion (R-squared)?
Where is Hasbro relative to others in Figure 2.1?
Where are Apple and Amazon in Figure 2.2?
Ch. 2 29
29
Ch. 2 30
FIGURE 2.1 M/B vs. ROE for 20 Toy/Gaming/Leisure Firms

30
Ch. 2 31
FIGURE 2.2 M/B vs. ROE for 82 Large Corporations
31
Ratio Analysis
Ratio analysis is the systematic use of the ratios previously
defined to understand financial performance.
Caveats to keep in mind:
Ratios don’t tell the whole story; they’re more like clues that
point to issues requiring further investigation.
There are no universally “correct” values for ratios.
Ch. 2 32

32
Using Ratios Effectively
Ratio values need to be understood in context.
It is important to compare ratios to something else.
Comparable companies
Changes in a company’s ratios over time
Ch. 2 33
33
FIGURE 2.3 The Levers of Performance Suggest One Road Map
for Ratio Analysis
Ch. 2 34

34
Example of Ratio Analysis
Analyze the profitability measures
What do the various measures tell you?
What is Hasbro’s trend over time?
How does Hasbro compare to the industry?
Analyze the levers of ROE
Which levers explain the changes in ROE over time?
Analyze the control ratios
Is Hasbro managing assets efficiently?
How do they compare to prior performance and industry
performance?
Analyze the leverage ratios
What’s the trend in their use of debt?
How do they compare to the industry?
Is their amount of leverage concerning?
Ch. 2 35
35
TABLE 2.2 Ratio Analysis of Hasbro
Ch. 2 36

36
Common Size Financial Statements
Add insight in analyzing a company
Helps in recognizing trends over time
Can compare to other companies without scale effects
What do common-size figures tell you compared to typical
ratios?
For example, collection period vs. AR/Assets
For example, inventory turnover vs. Inventory/Assets
What do you learn about working capital
Fraction of assets that are short-term
What do you learn about COGS?
Small changes in percentages can be large relative to net
income
Ch. 2 37
37
TABLE 2.3 Hasbro Common-Size Balance Sheets

Ch. 2 38
38
TABLE 2.3 Hasbro Common-Size Income Statements
Ch. 2 39
39
TABLE 2.4 Definitions of Principal Ratios Appearing in
Chapter
Ch. 2 40

40
TABLE 2.4 Definitions of Principal Ratios Appearing in
Chapter (cont.)
Ch. 2 41
41
Sheet1Selected financial data($
millions)NordstromWalmartSales14,757485,873Net
income35413,643Total assets7,858198,825Shareholders'
equity87077,798Profit margin2.4%2.8%Asset
turnover1.92.4Leverage9.02.6ROE40.7%17.5%
NordstromWalmart
Sales14,757 485,873
Net income354 13,643
Total assets7,858 198,825
Shareholders' equity870 77,798
Profit margin2.4%2.8%
Asset turnover1.9 2.4

Leverage9.0 2.6
ROE40.7%17.5%
Selected financial data
($ millions)

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