financial analysis

1. Evaluating Financial Performance
Finance
Jaime F. Zender
Note: Because I have found no better presentation of this material, this closely
follows the discussion in the Higgins book.

2. Financial Performance
• One of the most fundamental facts about
businesses is that the operating performance of
the firm shapes its financial structure.
• It is also true that the financial situation of the
firm can also determine its operating
performance.
• The financial statements are therefore important
diagnostic tools for the informed manager.
– To keep the discussion grounded, we will use the
1997-98 financial statement for the Timberland
Company as illustrations.

3. The Timberland Company, Balance Sheets ($ millions)
12/31/1997 12/31/1998 Change
Assets
Cash and marketable securities 98.8 151.9 53.1
Accounts receivable 75.8 79.0 3.2
Inventories 142.6 131.2 (11.4)
Prepaid expenses and other current assets 24.9 25.4 0.5
Total current assets 342.1 387.5
Property, plant, and equipment 116.5 131.2 14.7
Less accumulated depreciation and amortization (63.6) (74.3) (10.7)
Net property, plant, and equipment 52.9 56.9 4.0
Intangible assets 20.9 19.2 (1.7)
Other assets 4.2 5.8 1.6
Total assets $420.1 $469.4
Liabilities and Shareholders' Equity
Accounts Payable 20.4 25.9 5.5
Wages payable 28.2 22.1 (6.1)
Income taxes payable 17.7 18.2 0.5
Other accrued expenses 32.8 29.5 (3.3)
Total current liabilities 99.1 95.7
Long-term debt 100.0 100.0 --
Deferred income taxes 6.0 7.5 1.5
Total liabilities 205.1 203.2
Common stock 0.1 0.1
Additional paid-in capital 68.6 74.7
Retained earnings 146.3 207.7
Less treasury stock (0.1) (16.3)
Total shareholders' equity 214.9 266.2 51.3
Total liabilities and shareholders' equity $420.1 469.4

4. The Timberland Company, Income Statements ($ millions)
12/31/1997 12/31/1998
Net sales 796.5 862.2
Cost of sales 464.2 501.1
Gross profit 332.3 361.1
Selling expenses 174.7 195.7
General and administrative expenses 51.7 50.9
Depreciation and amortization 20.3 18.2
Amortization of goodwill 1.7 1.7
Total operating expenses 248.4 266.5
Operating income 83.9 94.6
Interest expense 14.8 9.5
Other expense (income) 1.4 (1.9)
Total nonoperating expenses 16.2 7.6
Income before income taxes 67.7 87.0
Provision for income taxes 20.3 27.8
Net income $47.4 $59.2

5. The Timberland Company, Statement of Cash Flow, 1998 ($ millions)
Cash Flows from Operating Activities
Net income 59.2
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation and amortization 18.2
Loss on disposal of property, plant, and equipment 1.3
Changes in current assets and liabilities
Increase in accounts receivable -2.8
Decrease in inventories 11.6
Decrease in prepaid expenses 1.1
Increase in accounts payable 5.1
Increase in accrued expenses -10
Increase in accrued income taxes 0.5
Net cash provided by operating activities 84.2
Cash Flows from Investing Activities
Proceeds from sale of property, plant, and equipment 0.1
Additions to property, plant, and equipment -20.7
Other -1.2
Net cash provided by investing activities -21.8
Cash Flows from Financing Activities
Common stock repurchases -16.2
Issuance of common stock, including tax benefit 6.1
Net cash provided by financing activities -10.1
Effect of exchange rate changes on cash 0.9
Net increase in cash 53.2
Cash at beginning of year 98.8
Cash at end of year $152.0

6. Return On Equity
• The most popular measure of financial
performance (for many audiences) is ROE.
• ROE measures accounting earnings for a period
per dollar of shareholders’ equity invested.
• For Timberland 1998 ROE was:
Equity
rs
Shareholde
Income
Net
ROE
'

%
2
.
22
2
.
266
$
2
.
59
$


ROE

7. Dissecting ROE
• ROE is so popular because it is, in a sense, a
summary of the information on the income
statement and both sides of the balance sheet.
It provides an “accounting” measure of the
“returns” to shareholders’ investment.
• The three determinants of ROE:
– Profit Margin = Net Income/Sales
– Asset Turnover = Sales/Assets
– Financial Leverage = Assets/Shareholders’ equity
• ROE comes from the joint inputs of these three
pieces. 22.2% = 6.9% × 1.8 × 1.8

8. Return on Assets (ROA)
• When we multiply the profit margin times the
asset turnover we arrive at return on assets.
• ROA doesn’t distinguish between capital raised
from shareholders and that raised from
creditors. (ROE considers only equity capital.)
• As such ROA measures the “return” on each
dollar invested in assets.
%
6
.
12
4
.
469
$
2
.
59
$
Assets
income
Net
Assets
on
Return 



9. ROEs and "Levers" of Performance for 10 Diverse Companies, 1998
Return on
Equity
(%) =
Profit
Margin
(%) ×
Asset
Turnover
(times) ×
Financial
Leverage
(times)
BankAmerica Corp 14.6 10.8 0.1 13.5
Carolina Power and Light 14.3 12.8 0.4 2.8
Exxon Corporation 14.6 6.3 1.1 2.1
Food Lion, Inc. 17 2.7 2.8 2.3
Harley-Davidson, Inc. 20.7 9.9 1.1 1.9
Intel Corporation 24 23.1 0.8 1.3
Nike, Inc. 12.9 4.2 1.8 1.7
Southwest Airlines Co. 18.1 10.4 0.9 2
Tiffany & Company 16.9 7.7 1.1 2
The Timberland Company 22.2 6.9 1.8 1.8

10. ROE Across Companies
• Generally speaking ROE is reasonably similar
across companies. Why?
• One would like to have a company with a high
profit margin and a high asset turnover.
Typically one of these will be relatively high and
one relatively low. Why?
• What determines the firm’s choice of financial
leverage?
• Now let’s look at each component in isolation.

11. Profit Margin
• This ratio measures the fraction of each dollar of
sales that makes it through to net income.
– It is of primary importance to an operating officer as
it reflects the company’s pricing strategy and its
ability to control costs.
– Timberland’s profit margin = Net Income/Sales =
$59.2/862.2 = 6.9%
• The “gross margin” measures profitability
relative to variable costs = Gross Profits/Sales
– Gross profit is sales less cost of goods sold.
Timberland’s gross margin is = $361.1/$862.2 =
41.9% indicating that about 42% of each dollar in
sales is available to cover fixed costs and profits.

12. Asset Turnover
• This ratio measures the sales generated per dollar of
assets employed.
– Measures capital intensity with a low asset turnover indicating a
capital intensive business.
– Nice illustration that more assets is not always better.
– Control of a company’s assets is critical and control of current
assets is especially critical to success.
– Asset turnover = sales/assets = $862.2/$469.4 = 1.8 times
• Analyzing the turnover of each type of asset on a
company’s balance sheet gives rise to what are known
as control ratios.

13. Control Ratios – Fixed-Asset Turnover
• Fixed-Asset Turnover is perhaps a “purer”
reflection of the capital intensity of a firm.
• Fixed-Asset Turnover = Sales/Net PP&E
= $862.2/$56.9 = 15.2 times
• Timberland generates $15.20 in sales for each
dollar of plant, property, and equipment they
invest in.

14. Control Ratios – Inventory Turnover
• Inventory turnover = COGS/Ending Inventory
= $501.1/$131.2 = 3.8 times
– One might also use average inventory rather than
ending inventory.
• This indicates that items in Timberland’s
inventory turn over 3.8 times per year on
average.
• Alternatively, 12 months/3.8 times=3.15 months
indicating that the typical item sits in inventory
for just over 3 months.

15. Control Ratios – Collection Period
• Collection period highlights a company’s
management of its accounts receivable.
• Note that what is desired here is credit sales.
Outsiders rarely know this so commonly all sales
are assumed to be for credit.
• Timberland’s customers are taking just over a
month to pay their bills. Good or bad?
days
4
.
33
days
365
/
2
.
862
$
0
.
79
$
day
per
sales
Credit
Receivable
Accounts



Period
Collection

16. Control Ratios – Days’ Sales in Cash
• Timberland currently has 64.3 days’ worth of
sales in cash and securities.
• Too much or too little?
• Question really is how much liquidity does the
firm require for efficient operations. While more
might always seem better, think about the return
the asset “cash” generates for you.
days
3
.
64
days
365
/
2
.
862
$
9
.
151
$
day
per
Sales
securities
and
Cash
' 


Cash
in
Sales
Days

17. Control Ratios – Payables Period
• This is a control ratio for a liability.
• The proper calculation uses credit purchases which,
again, an outsider rarely knows. Usually COGS is used
as a substitute. COGS differs from credit sales because:
– Firm may be adding or depleting inventory; purchasing at a
different rate than it is selling.
– COGS includes a mark-up for depreciation and labor making
COGS larger than credit purchases so this ratio is, on average,
artificially small.
– Thus it is difficult to compare the 18.9 days to its credit terms.
It is, however, reasonable to compare this to last year’s ratio.
days
9
.
18
days
365
/
1
.
501
$
9
.
25
$
day
per
purchases
Credit
payable
Accounts



Period
Payables

18. Financial Leverage
• Timberland has $1.80 in assets for every dollar
that shareholders have invested.
• This is a relatively modest amount of leverage
for a manufacturing company.
• Other leverage ratios tell us the same thing:
– Debt to assets – 43.3%
– Debt to equity – 76.3%
8
.
1
2
.
266
$
4
.
469
$
equity
rs'
Shareholde
Assets



Leverage
Financial

19. Coverage Ratios
• Often more informative than the leverage ratios
are “coverage ratios.”
• These ratios tell us what the firm is earning each
year relative to the burden the debt imposes.
times
2
.
10
5
.
9
$
5
.
96
$
Expense
Interest
EBIT
earned
interest
Times 


times
2
.
10
)
0
.
87
/
8
.
27
1
/(
0
.
0
$
5
.
9
$
5
.
96
$
rate
Tax
1
repayment
Princial
Interest
EBIT
covered
burden
Times 













20. Liquidity Ratios
• A further determinant of a firm’s debt capacity is
the liquidity of its assets relative to its liabilities.
• The two common ratios used to measure
liquidity are the current ratio and the quick ratio
(also called the “acid test”).
times
0
.
4
7
.
95
$
5
.
387
$
s
liabilitie
Current
assets
Current
ratio
Current 


times
7
.
2
7
.
95
$
2
.
131
$
5
.
387
$
s
liabilitie
Current
Inventory
-
assets
Current
ratio
Quick 




21. Limitations of Ratio Analysis
• We have been talking as if management always
wants to increase ROE or as if a high ROE is
always better.
– If company A has a higher ROE than company B is
company A necessarily better?
– If a company increases its ROE is it necessarily
evidence of improved performance?
• There are three critical problems with ROE.
– Often called the timing problem, the value problem,
and the risk problem.

22. The Timing Problem
• As a decision-maker in a business environment
you are often encouraged to focus your
attention on the past and particularly on one
period in the past – correct?
• Sounds silly, but this is exactly what ROE does.
• Clearly last year’s ROE must be taken in context.
– If not it is virtually meaningless.
– If company ROE was lower last year than it was two
years ago the company must be doing worse –
correct?

23. The Risk Problem
• We talked a lot about how risk and return go
together. ROE is a “return” like measure so
where is the risk dimension?
• This problem alone makes ROE an inaccurate
and possibly misleading indicator of financial
performance.
• One has to realize that the risk dimension is
missing and so be particularly wary of making
comparisons across companies using ROE alone.

24. The Value Problem
• ROE measures a “return” figure but it is based
on two accounting figures.
• The numerator is net income and this is not free
cash flow (the cash flow that the company could
payout to its investors).
• Secondly, even if net income is close to free cash
flow, ROE is measured relative to book value of
equity not the market value of equity.
• It is the market value investors must pay to
purchase a share of the firm’s equity and this is
generally higher than the book value.

25. Ratio Analysis For Timberland
• Given the limitations of ratio analysis the most
useful way to evaluate financial ratios is by
examining their changes over time.
• Comparing the ratios to industry averages
provides an interesting benchmark but
differences between companies in a given
industry can make the exercise misleading.
• A systematic approach will also help alleviate the
information overload that results from the
random calculation of countless ratios.

26. A Systematic Approach
• At the top tier of ratios lie ROE and ROA.
• The major levers of performance are in the next
tier, followed by more narrowly focused ratios:
– Profit margin:
• Gross margin, tax rate, normalized income statement
– Asset turnover:
• Control ratios (inventory turnover, fixed asset turnover,
collection period, days sales in cash, payables period),
normalized balance sheet
– Financial leverage:
• Leverage ratios, coverage ratios, liquidity ratios

27. Ratio Analysis of Timberland Company 1994 - 1998
1994 1995 1996 1997 1998
Industry
Median
Major Ratios
ROE 11.9 (8.2) 12.3 22.1 22.2 12.3
ROA 3.8 (2.8) 4.5 11.3 12.6 7.4
ROIC 7.1 0.7 9.6 18.3 17.9 9.7
Profitability Ratios
Profit Margin 2.8 (1.8) 3.0 5.9 6.9 4.2
Gross Margin 35.0 33.7 39.4 41.7 41.9 38.4
Price to earnings ratio 13.5 NA 20.7 13.9 8.5 15.0
Turnover and Control Ratios
Asset Turnover 1.3 1.6 1.5 1.9 1.8 1.8
Fixed-asset Turnover 9.3 12.5 14.1 15.1 15.2 9.2
Inventory Turnover 1.9 2.4 2.6 3.3 3.8 2.7
Collection Period 73.5 53.4 53.2 34.7 33.4 39.1
Days' Sales in Cash 3.7 21.4 49.4 45.3 64.3 10.8
Payables Period 32.6 21.2 18.6 16.0 18.9 36.3
Leverage and Liquidity Ratios
Assets to Equity 3.2 3.0 2.7 2.0 1.8 1.7
Debt to Assets 68.5 66.2 63.2 48.8 43.3 39.6
Debt to Equity 217.4 196.3 171.9 95.4 76.3 65.5
Times Interest Earned 2.9 0.2 2.5 5.6 10.2 9.1
Times Burden Covered 1.6 0.1 1.1 5.6 10.2 7.4
Current Ratio 3.5 4.8 3.7 3.5 4.0 3.0
Acid Test 1.5 2.3 2.1 2.0 2.7 1.5

28. Ratio Analysis of Timberland
• ROE:
– After a loss in ’95 the ROE is up to a strong 22.2% in
’98. This is strong relative to its industry and to the
median firm in the S&P500 that year which had an
ROE of 14.8%.
– The other major ratios show similar patterns.
• The rise in ROE is coming from the increase in
its profit margin and asset turnover and is
somewhat offset by the reduction in its financial
leverage.

29. Ratio Analysis of Timberland
• The increased profit margin is coming primarily
from a rising gross margin indicating that it is
some combination of more aggressive pricing
and cost control that has driven the increase.
• Improved asset turnover reflects overall
improved asset management.
– Inventory turnover and fixed asset turnover are
strongly higher.
– The only asset rising relative to sales is cash. Is this
good or bad?
• Leverage and liquidity ratios all show increasing
financial conservatism.

30. Normalized Financial Statements
• Note on the normalized balance sheet that 80%
of the firm’s assets are current assets.
– This highlights the importance of working capital
management.
– Note the reduction in inventories and accounts
receivable noted above.
• The normalized income statement is pleasant
reading.
– Profit margin and gross margin are up since ’95.
– Results would have been better except for the rise in
SG&A expenses.

31. Common-Sized Balance Sheet for Timberland and Industry
1994 1995 1996 1997 1998
Industry
Average
Assets
Cash and marketable securities 1.3% 9.1% 20.8% 23.5% 32.4% 7.4%
Accounts receivable 27.1 22.7 22.4 18.0 16.8 22.7
Inventories 46.1 42.9 35.4 34.0 28.0 37.1
Prepaid expenses and other current assets 4.4 5.5 4.1 5.9 5.4 5.5
Total current assets 79.0 80.2 82.6 81.4 82.6 72.0
Property, plant, and equipment 23.4 22.8 23.1 27.7 28.0 31.5
Less accumulated depreciation and amortization 9.0 10.3 12.2 15.1 15.8 13.6
Net property, plant, and equipment 14.4 12.4 10.9 12.6 12.1 17.9
Intangible assets 5.5 5.8 5.0 5.0 4.1 3.2
Other assets 1.1 1.6 1.5 1.0 1.2 6.9
Total assets 100% 100% 100% 100% 100% 100%
Liabilities and Shareholders' Equity
Accounts payable 7.8% 6.0% 4.7% 4.9% 5.5% 11.2%
Notes payable 4.8 -- -- -- -- 2.0
Current portion of long-term debt 1.7 1.8 4.0 -- -- 1.0
Wages payable 1.9 0.2 2.6 4.2 3.9 --
Accrued expenses 6.4 8.5 11.3 14.5 11.0 10.0
Total current liabilities 22.6 16.5 22.7 23.6 20.4 24.2
Long-term debt 43.7 47.3 38.2 23.8 21.3 14.8
Deferred income taxes 2.2 2.4 2.4 1.4 1.6 1.0
Total liabilities 68.5 66.3 63.2 48.8 43.3 39.9
Common stock 0.0 0.0 0.0 0.0 0.0 4.6
Additional paid-in capital 12.2 14.2 13.7 16.3 15.9 10.8
Retained earnings 19.3 19.6 23.0 34.8 44.2 54.8
Less treasury stock 0.0 0.0 0.0 0.0 3.5 10.2
Total shareholders' equity 31.5 33.7 36.8 51.2 56.7 60.1
Total liabilities and shareholders' equity 100% 100% 100% 100% 100% 100%

32. Normalized Income Statement for Timberland and Industry
1994 1995 1996 1997 1998
Industry
Average
Net sales 100% 100% 100% 100% 100% 100%
Cost of sales 65.0 66.3 60.6 58.5 58.3 60.8
Gross profit 35.0 33.7 39.4 41.5 41.7 39.2
S,G,& A expenses 25.8 29.4 28.9 28.4 28.6 29.3
Depreciation and amortization 2.4 2.9 3.1 2.5 2.1 1.8
Total operating expenses 28.2 32.3 32.0 31.0 30.7 31.0
Operating income 6.8 1.4 7.4 10.5 11.0 8.2
Interest expense 2.4 3.5 3.0 1.9 1.1 0.7
Other expense (income) -- 0.2 (0.1) 0.2 (0.2) (0.2)
Extraordinary expense (income) -- 0.6 -- -- -- 0.4
Total nonoperating expenses 2.3 4.2 2.9 2.0 0.9 0.9
Income before income taxes 4.4 (2.9) 4.5 8.5 10.1 7.3
Provision for income taxes 1.6 (1.1) 1.5 2.5 3.2 2.7
Net income 2.8 (1.8) 3.0 5.9 6.9 4.6

33. Summary
• What is being reflected here is a robust recovery
from a difficult period in the firm’s history.
– In ’94 the firm experienced a 50% increase in sales
driven by “fad” demand for its product.
– In response Timberland over-expanded and lost
control of assets, particularly inventory and accounts
receivable.
– The bubble burst in ’95.
– Since then they have aggressively managed assets
and reduced debt.
– Challenge ahead is what to do with all the excess
cash being generated and a question of whether they
can rekindle growth.