Good financial managers plan for the future. They check that they will have enough cash to pay the upcoming tax bill or dividend payment. They think about how much investment the firm will need to make and about how they might finance that investment. They reflect on whether they are well placed to ride out an unexpected downturn in demand or an increase in the cost of materials.
In Chapter 29, we will describe how financial managers develop both short- and long-term financial plans. But knowing where you stand today is a necessary prelude to contemplating where you might be in the future. Therefore, in this chapter we show how the firm’s financial statements help you to understand the firm’s overall performance and how some key financial ratios may alert senior management to potential problem areas.
You have probably heard stories of whizzes who can take a company’s accounts apart in minutes, calculate some financial ratios, and divine the company’s future. Such people are like abominable snowmen: often spoken of but never truly seen. Financial ratios are no substitute for a crystal ball. They are just a convenient way to summarize large quantities of financial data and to compare firms’ performance. The ratios help you to ask the right questions; they seldom answer them.
28-1Financial Ratios
Financial ratios are usually easy to calculate. That’s the good news. The bad news is that there are so many of them. To make it worse, the ratios are often presented in long lists that seem to require memorization rather than understanding.
We can mitigate the bad news by taking a moment to preview what the ratios are measuring and how they connect to the ultimate objective of value added for shareholders.
Shareholder value depends on good investment decisions. The financial manager evaluates investment decisions by asking several questions, including these: How profitable are the investments relative to the cost of capital? How should profitability be measured? What does profitability depend on? (We will see that it depends on efficient use of assets and on the profits on each dollar of sales.)
Shareholder value also depends on good financing decisions. Again, there are obvious questions: Is the available financing sufficient? The firm cannot grow unless financing is available. Is the financing strategy prudent? The financial manager should not put the firm’s assets and operations at risk by operating at a dangerously high debt ratio. Does the firm have sufficient liquidity (a cushion of cash or assets that can be readily sold for cash)? The firm has to be able to pay its bills and respond to unexpected setbacks.
Figure 28.1 summarizes these questions in more detail. The boxes on the left are for investment, those on the right for financing. In each box, we have posed a question and given examples of financial ratios or other measures that can help to answer it. For example, the bottom box on the far left asks about efficient use of assets. Three ratios that measure asset efficiency are turnover ratios for assets, inventory, and accounts receivable. The two bottom boxes on the right ask whether financial leverage is prudent and whether the firm has sufficient liquidity for the coming year. The ratios for tracking financial leverage include various debt ratios; the ratios for liquidity are the current, quick, and cash ratios.
FIGURE 28.1 An organization chart for financial ratios, showing how common financial ratios and other measures relate to shareholder value.
Figure 28.1 serves as a road map for this chapter. We will show how to calculate these and other common financial ratios and explain how they relate to the objective of shareholder value.
28-2Financial Statements
Public companies have a variety of stakeholders, such as shareholders, bondholders, bankers, suppliers, employees, and management. All these stakeholders need to monitor the firm and to ensure that their interests are being served. They rely on the company’s financial statements to provide the necessary information. Public companies in the United States report to their shareholders quarterly and annually. The annual financial statements are filed with the SEC on form 10-K and the quarterly statements are filed on form 10-Q. Therefore you often hear financial analysts refer loosely to the company’s “10-K” or its “10-Q.”
When reviewing a company’s financial statements, it is important to remember that accountants still have a fair degree of leeway in reporting earnings and book values. For example, they have discretion in the choice of depreciation method and the speed at which the firm’s assets are written off.
FINANCE IN PRACTICE
The Rise and Stall of Convergence in Accounting Standards
The International Financial Reporting Standards (IFRS), which are set by the London-based International Accounting Standards Board (IASB), aim to harmonize financial reporting around the world. They are the basis for reporting by listed firms throughout the European Union. In addition, some 100 other countries, such as Australia, Canada, Brazil, and India have adopted them or plan to do so, while China has modified its accounting standards to be largely in line with IFRS.
For some years, the SEC has worked to bring U.S. accounting standards more in line with international rules. For example, until 2007, foreign companies that traded on U.S. stock exchanges were required to show how their accounts differed from U.S. GAAP. This was a very expensive exercise that cost some companies millions of dollars annually and caused many to delist their stocks. These companies can now simply report results using international accounting standards. Subsequently, in August 2008, the SEC released its plans to allow some large U.S. multinationals, representing approximately $2.5 trillion in market capitalization, to eventually use IFRS for financial statements.
This shift from GAAP to IFRS would involve a major change in the way that accountants in the United States approach their task. IFRS tend to be “principles based,” which means that there are no hard-and-fast codes to follow. Instead, companies must be ready to defend their accounting practices in light of the general principles laid out in the IFRS. By contrast, in the United States, GAAP are accompanied by thousands of pages of prescriptive regulatory guidance and interpretations from auditors and accounting groups. For example, more than 160 pieces of authoritative literature relate to how and when companies record revenue. This leaves less room for judgment, but detailed rules rapidly become out of date, and unscrupulous companies have been able to structure transactions so that they keep to the letter but not the spirit of the rules.
By 2014, it had become clear that the SEC’s plan to move to IFRS was effectively dead and that, while the SEC and IASB would continue to collaborate on accounting rules, there was little prospect of any agreement over a single global standard that included the United States.
Although accountants around the world are working toward common practices, there are still considerable variations in the accounting rules of different countries. For investors and multinational companies these variations in accounting rules can be irksome. Accounting bodies have therefore been getting together to see whether they can iron out some of the differences. It is not a simple task, as the nearby box illustrates.
28-3Home Depot’s Financial Statements
Your task is to assess the financial standing of Home Depot, the home improvement company. Perhaps you are a mutual fund manager trying to decide whether to allocate $25 million of new money to Home Depot stock. You could be an investment banker seeking business from the company or a bondholder concerned with its credit standing. You could be the financial manager of Home Depot or of one of its competitors.
In each case, your first step is to assess the company’s current condition. You have before you the latest balance sheet and income statement.
The Balance Sheet
Table 28.1 sets out a simplified balance sheet for Home Depot for fiscal years 2017 and 2016. It provides a snapshot of the company’s assets at the end of the year and the sources of the money that was used to buy those assets.
TABLE 28.1 Balance sheet of Home Depot, fiscal 2017 and 2016 (figures in $ millions)
#Year ending January 28, 2018
*Year ending January 29, 2017
The assets are listed in declining order of liquidity. For example, the accountant lists first those assets that are most likely to be turned into cash in the near future. They include cash itself, marketable securities and receivables (that is, bills to be paid by the firm’s customers), and inventories of raw materials, work in process, and finished goods. These assets are all known as current assets.
The remaining assets on the balance sheet consist of long-term, usually illiquid, assets such as warehouses, stores, fixtures, and vehicles. The balance sheet does not show up-to-date market values of these long-term assets. Instead, the accountant records the amount that each asset originally cost and deducts a fixed annual amount for depreciation of buildings, plant, and equipment. The balance sheet does not include all the company’s assets. Some of the most valuable ones are intangible, such as reputation, skilled management, and a well-trained labor force. Accountants are generally reluctant to record these assets in the balance sheet unless they can be readily identified and reasonably valued.1
Now look at the right-hand portion of Home Depot’s balance sheet, which shows where the money to buy the assets came from. The accountant starts by looking at the liabilities, that is, the money owed by the company. First come those liabilities that need to be paid off in the near future. These current liabilities include debts that are due to be repaid within the next year and payables (that is, amounts owed by the company to its suppliers).
The difference between the current assets and current liabilities is known as the net current assets or net working capital. It roughly measures the company’s potential reservoir of cash. For Home Depot in 2017,
The bottom portion of the balance sheet shows the sources of the cash that was used to acquire the net working capital and fixed assets. Some of the cash has come from the issue of bonds and leases that will not be repaid for many years. After all these long-term liabilities have been paid off, the remaining assets belong to the common stockholders. The company’s equity is simply the total value of the net working capital and fixed assets less the long-term liabilities. Part of this equity has come from the sale of shares to investors, and the remainder has come from earnings that the company has retained and invested on behalf of the shareholders.
The Income Statement
If Home Depot’s balance sheet resembles a snapshot of the firm at a particular point in time, its income statement is like a video. It shows how profitable the firm has been over the past year.
Look at the summary income statement in Table 28.2. You can see that during 2017, Home Depot sold goods worth $100,978 million.2 The total cost of purchasing and selling these goods was $66,548 + $17,864 = $84,412 million. In addition to these out-of-pocket expenses, Home Depot also deducted depreciation of $1,811 million for the value of the fixed assets used up in producing the goods. Thus Home Depot’s earnings before interest and taxes (EBIT) were
Of this sum, $1,057 million went to pay the interest on the short- and long-term debt (remember debt interest is paid out of pretax income) and a further $5,068 million went to the government in the form of taxes. The $8,630 million that was left over belonged to the shareholders. Home Depot paid out $4,212 million as dividends and reinvested the remainder in the business.
|
$ millions |
|
|
Net sales |
$100,978 |
|
Cost of goods sold |
66,548 |
|
Selling, general, and administrative expenses |
17,864 |
|
Depreciation |
1,811 |
|
Earnings before interest and income taxes (EBIT) |
$ 14,755 |
|
Interest expense |
1,057 |
|
Taxable income |
$ 13,698 |
|
Taxes |
5,068 |
|
Net income |
$ 8,630 |
|
Allocation of net income |
|
|
Dividends |
4,212 |
|
Addition to retained earnings |
4,418 |
TABLE 28.2 Income Statement of Home Depot, fiscal 2017 (figures in $ millions)
28-4Measuring Home Depot’s Performance
You want to use Home Depot’s financial statements to assess its financial performance and current standing. Where do you start?
At the close of fiscal 2017, Home Depot’s common stock was priced at $204.92 per share. There were 1,170 million shares outstanding, so total market capitalization was 1,170 × $204.92 = $239,756 million. This is a big number, of course, but Home Depot is a sizable company. Its shareholders have, over the years, invested billions in the company. Therefore, you decide to compare Home Depot’s market capitalization with the book value of its equity. The book value measures shareholders’ cumulative investment in the company.
At the end of fiscal 2017, the book value of Home Depot’s equity was $1,454 million. Therefore, the market value added, the difference between the market value of the firm’s shares and the amount of money that shareholders have invested in the firm, was $239,756 − $1,454 = $238,302 million.3 In other words, Home Depot’s shareholders have contributed just over $1 billion and ended up with shares worth about $240 billion. They have accumulated nearly $239 billion in market value added.
The consultancy firm, EVA Dimensions, calculates market value added for a large sample of U.S. companies. Table 28.3 shows a few of the firms from EVA Dimensions’ list. Apple is top of the class. It has created nearly $800 billion of wealth for its shareholders. Bank of America languishes near the bottom; the market value of its shares is $66 billion less than the amount that shareholders have invested in the firm.
TABLE 28.3 Stock market measures of company performance, September 2017 (dollar values in millions). Companies are ranked by market value added.
Source: EVA Dimensions.
These two firms are large. Their managers have lots of assets to work with. A small firm could not hope to create so much extra value as firms like Johnson & Johnson or Walmart or to lose as much as Bank of America. Therefore, financial managers and analysts also like to calculate how much value has been added for each dollar that shareholders have invested. To do this, they compute the ratio of market value to book value. For example, Home Depot’s market-to-book ratio is4
In other words, Home Depot has multiplied the value of its shareholders’ investment 164.9 times. This is a very large number, but Home Depot has been buying back its stock and, as a result, the book value of the equity has been reduced by the cost of the repurchases. A very active repurchase program can reduce the book equity to zero.5 This makes it very difficult to interpret ratios that include book equity in the denominator.
Table 28.3 also shows market-to-book ratios for our sample of U.S. companies. Notice that Coca-Cola has a much higher market-to-book ratio than Johnson & Johnson. But Johnson & Johnson’s market value added is higher because of its larger scale.
The market value performance measures in Table 28.3 have three drawbacks. First, the market value of the company’s shares reflects investors’ expectations about future performance. Investors pay attention to current profits and investment, of course, but market-value measures can, nevertheless, be noisy measures of current performance.
Second, measures of market performance are only a first step toward understanding the reasons for the performance. Are the measures an indication of the manager‘s competence? Are they a reflection of events that are outside the manager’s control, or do they just suggest fluctuations in investor sentiment?
Third, you can’t look up the market value of privately owned companies whose shares are not traded. Nor can you observe the market value of divisions or plants that are parts of larger companies. You may use market values to satisfy yourself that Home Depot as a whole has performed well, but you can’t use them to drill down to look at the performance of, say, its overseas stores or particular U.S. stores. To do this, you need accounting measures of profitability. We start with economic value added (EVA).
Economic Value Added
When accountants draw up an income statement, they start with revenues and then deduct operating and other costs. But one important cost is not included: the cost of the capital that the company has raised from investors. Therefore, to see whether the firm has truly created value, we need to measure whether it has earned a profit after deducting all costs, including its cost of capital.
The cost of capital is the minimum acceptable rate of return on capital investment. It is an opportunity cost of capital, because it equals the expected rate of return on investment opportunities open to investors in financial markets. The firm creates value for investors only if it can earn more than its cost of capital, that is, more than its investors can earn by investing on their own.
The profit after deducting all costs, including the cost of capital, is called the company’s economic value added or EVA. We encountered EVA in Chapter 12, where we looked at how firms often link executive compensation to accounting measures of performance. Let’s calculate EVA for Home Depot.
Total long-term capital, sometimes called total capitalization, is the sum of long-term debt and shareholders’ equity. Home Depot entered fiscal 2017 with a total capitalization of $26,682 million, which was made up of $22,349 million of long-term debt and $4,333 million of shareholders’ equity. This was the cumulative amount that had been invested in the past by the debt- and equityholders. Home Depot’s weighted-average cost of capital was about 8.2%. Therefore, investors who provided the $26,682 million required the company to earn at least .082 × 26,682 = $2,188 million for its debt- and equityholders.
In 2017, Home Depot’s after-tax interest and net income totaled (1 − .35) × 1,057 + 8,630 = $9,317 million (the tax rate in 2017 was 35%). If you deduct the total cost of the company’s capital from this figure, you can see that it earned $9,317 − 2,188 = $7,129 million more than investors required. This was Home Depot’s residual income, or EVA:
Sometimes it is helpful to re-express EVA as follows:
The return on capital or ROC is equal to the total profits that the company has earned for its debt- and equityholders, divided by the amount of money that they have contributed. If the company earns a higher return on its capital than investors require, EVA is positive.
In the case of Home Depot, with a 35% tax rate the return on capital was
Home Depot’s cost of capital was about 8.2%. So,
The first four columns of Table 28.4 show measures of EVA for our sample of large companies. Apple again heads the list. It earned $37.6 billion more than was needed to satisfy investors. By contrast, Bank of America was a laggard. Although it earned an accounting profit of $18.4 billion, this figure was calculated before deducting the cost of the capital that was employed. After deducting the cost of the capital, Bank of America made an EVA loss of $2.4 billion.
TABLE 28.4 Accounting measures of company performance, September 2017 (dollar values in millions). Companies are ranked by economic value added (EVA).
Note: EVAs do not compute exactly because of rounding in column 2.
Source: EVA Dimensions.
Accounting Rates of Return
EVA measures how many dollars a business is earning after deducting the cost of capital. Other things equal, the more assets the manager has to work with, the greater the opportunity to generate a large EVA. The manager of a small division may be highly competent, but if that division has few assets, she is unlikely to rank high in the EVA stakes. Therefore, when comparing managers, it can also be helpful to measure the firm’s return per dollar of investment.
Three common return measures are the return on capital (ROC), the return on equity (ROE), and the return on assets (ROA). All are based on accounting information and are therefore known as book rates of return.
Return on Capital6 We have already calculated Home Depot’s return on capital in 2017:
The company’s cost of capital (WACC) was about 8.2%. So we can say that the company earned nearly 27% more than shareholders demanded.
Notice that, when we calculated Home Depot’s return on capital, we summed the company’s after-tax interest and net income.7 The reason that we subtracted the tax shield on debt interest was that we wished to calculate the income that the company would have earned with all-equity financing. The tax advantages of debt financing are picked up when we compare the company’s return on capital with its weighted-average cost of capital (WACC).8 WACC already includes an adjustment for the interest tax shield.9 More often than not, financial analysts ignore this refinement and use the gross interest payment to calculate ROC. It is only approximately correct to compare this measure with the weighted-average cost of capital.
The last column in Table 28.4 shows the return on capital for our sample of well-known companies. Notice that Microsoft’s return on capital was 33.5%, more than 26 percentage points higher than its cost of capital. Although Microsoft had a higher return than Apple, it had a slightly lower EVA. This was because it had far fewer dollars invested than Apple.
Return on Equity We measure the return on equity (ROE) as the income to shareholders per dollar invested. Home Depot had net income of $8,630 million in 2017 and stockholders’ equity of $4,333 million at the start of the year. So its return on equity was
Has the company provided an adequate return for shareholders? To answer that question, we need to compare it with the company’s cost of equity. Home Depot’s cost of equity capital in 2017 was about 9.0%, so its return on equity was dramatically higher than its cost of equity, but remember once again our earlier warning about the effect of repurchases on the book value of Home Depot’s equity.
Return on Assets Return on assets (ROA) measures the income available to debt and equity investors per dollar of the firm’s total assets. Total assets (which equal total liabilities plus shareholders’ equity) are greater than total capital because total capital does not include current liabilities.10 With a 35% tax rate the return on Home Depot’s assets was
When we subtract the tax shield on Home Depot’s interest payments, we are asking how much the company would have earned if all-equity-financed. This adjustment is helpful when comparing the profitability of firms with very different capital structures. Again, this refinement is ignored more often than not, and ROA is calculated using the gross interest payment. Sometimes analysts take no account of interest payments and measure ROA as the income for equityholders divided by total assets. This measure ignores entirely the income that the assets have generated for debtholders.
We will see shortly how Home Depot’s return on assets is determined by the sales that these assets generate and the profit margin that the company earns on its sales.
Problems with EVA and Accounting Rates of Return
Rate of return and economic value added have some obvious attractions as measures of performance. Unlike market-value-based measures, they show current performance and are not affected by the expectations about future events that are reflected in today’s stock market prices. Rate of return and economic value added can also be calculated for an entire company or for a particular plant or division. However, remember that both measures are based on book (balance sheet) values for assets. Debt and equity are also book values. Accountants do not show every asset on the balance sheet, yet our calculations take accounting data at face value. For example, we ignored the fact that Home Depot has invested large sums in marketing to establish its brand name. This brand name is an important asset, but its value is not shown on the balance sheet. If it were shown, the book values of assets, capital, and equity would increase, and Home Depot would not appear to earn such high returns.
EVA Dimensions, which produced the data in Tables 28.3 and 28.4, does make a number of adjustments to the accounting data. However, it is impossible to include the value of all assets or to judge how rapidly they depreciate. For example, did Microsoft really earn a return of 33% and add $16 billion of economic value? It’s difficult to say, because its investment over the years in Windows and other software is not shown on the balance sheet and cannot be measured exactly.
Remember also that the balance sheet does not show the current market values of the firm’s assets. The assets in a company’s books are valued at their original cost less any depreciation. Older assets may be grossly undervalued in today’s market conditions and prices. So a high return on assets indicates that the business has performed well by making profitable investments in the past, but it does not necessarily mean that you could buy the same assets today at their reported book values. Conversely, a low return suggests some poor decisions in the past, but it does not always mean that today the assets could be employed better elsewhere.
28-5Measuring Efficiency
We began our analysis of Home Depot by calculating how much value the company has added for its shareholders and how much profit it is earning after deducting the cost of the capital that it employs. We examined the company’s rates of return on capital, equity, and total assets and found that its return has been higher than the cost of capital. Our next task is to probe a little deeper to understand the reasons for the company’s success. What factors contribute to a firm’s overall profitability? One factor clearly must be the efficiency with which it uses its various assets.
BEYOND THE PAGE
Is it better to use average or start-of-year assets?
mhhe.com/brealey13e
Asset Turnover Ratio The asset turnover, or sales-to-assets, ratio shows how much sales volume is generated by each dollar of total assets, and therefore it measures how hard the firm’s assets are working. For Home Depot, each dollar of assets produced $2.35 of sales:
Technical note: Like a number of other financial ratios, the sales-to-assets ratio compares a flow measure (sales over the entire year) with a snapshot measure (assets at a point in time). But which point in time should you use? We calculated the ratio of Home Depot’s sales to assets at the start of the year, but frequently analysts use the average of the firm’s assets at the start and end of the year. The idea is that this better measures the assets that the firm had to work with assets during the year.11 In the case of Home Depot, the two ratios are effectively identical:
There is no obvious best measure. If assets are turned over very slowly, it may be better to use the value at the start of the year; if they are turned over fast, as is often the case, it may be preferable to use the average measure. However, it’s probably not worth getting too steamed up over the matter. After all, both measures rest on the doubtful assumption that the asset levels at the close of each financial year are typical of the rest of the year. But, like many retailers, Home Depot ends its financial year in January/February just after the busy holiday season, when inventories and receivables are unusually low.
The asset turnover ratio measures how efficiently the business is using its entire asset base. But you also might be interested in how hard particular types of assets are being put to use. Here are a couple of examples.
Inventory Turnover Efficient firms don’t tie up more capital than they need in raw materials and finished goods. They hold only a relatively small level of inventories, and they turn over those inventories rapidly. The balance sheet shows the cost of inventories rather than the amount that the finished goods will eventually sell for. So it is usual to compare the level of inventories with the cost of goods sold rather than with sales. In Home Depot’s case,
Another way to express this measure is to look at how many days of output are represented by inventories. This is equal to the level of inventories divided by the daily cost of goods sold:
Receivables Turnover Receivables are sales for which the company has not yet been paid. The receivables turnover ratio measures the firm’s sales as a proportion of its receivables. For Home Depot,
If customers are quick to pay, unpaid bills will be a relatively small proportion of sales and the receivables turnover will be high. Therefore, a comparatively high ratio often indicates an efficient credit department that is quick to follow up on late payers. Sometimes, however, a high ratio indicates that the firm has an unduly restrictive credit policy and offers credit only to customers who can be relied on to pay promptly.12
Another way to measure the efficiency of the credit operation is by calculating the average length of time for customers to pay their bills. The faster the firm turns over its receivables, the shorter the collection period. Home Depot’s customers pay their bills in about 7.3 days:
The receivables turnover ratio and the inventory turnover ratio may help to highlight particular areas of inefficiency, but they are not the only possible indicators. For example, Home Depot might compare its sales per square foot with those of its competitors,13 a steel producer might calculate the cost per ton of steel produced, an airline might look at revenues per passenger-mile, and a law firm might look at revenues per partner. A little thought and common sense should suggest which measures are likely to produce the most helpful insights into your company’s efficiency.
28-6Analyzing the Return on Assets: The Du Pont System
We have seen that every dollar of Home Depot’s assets generates $2.35 of sales. But a company’s success depends not only on the volume of its sales but also on how profitable those sales are. This is measured by the profit margin.
Profit Margin The profit margin measures the proportion of sales that finds its way into profits. It is sometimes defined as
This definition can be misleading. When companies are partly financed by debt, a portion of the profits from the sales must be paid as interest to the firm’s lenders. We would not want to say that a firm is less profitable than its rivals simply because it employs debt finance and pays out part of its profits as interest. Therefore, when we are calculating the profit margin, it is useful to add back the after-tax debt interest to net income. This gives an alternative measure of profit margin, which is called the operating profit margin:
The Du Pont System
We calculated earlier that Home Depot has earned a return of 21.7% on its assets. The following equation shows that this return depends on two factors—the sales that the company generates from its assets (asset turnover) and the profit that it earns on each dollar of sales (operating profit margin):
This breakdown of ROA into the product of asset turnover and margin is often called the Du Pont formula, after the chemical company that popularized the formula. In Home Depot’s case, the formula gives the following breakdown of ROA:
ROA = asset turnover × operating profit margin = 2.35 × .0923 = .217
All firms would like to earn a higher return on their assets, but their ability to do so is limited by competition. The Du Pont formula helps to identify the constraints that firms face. Fast-food chains, which have high asset turnover, tend to operate on low margins. Classy hotels have relatively low turnover ratios but tend to compensate with higher margins.
Firms often seek to improve their profit margins by acquiring a supplier. The idea is to capture the supplier’s profit as well as their own. Unfortunately, unless they have some special skill in running the new business, any gain in profit margin is offset by a decline in asset turnover. Other things equal, vertical integration brings higher profit margins and lower asset turnover.
A few numbers may help to illustrate this point. Table 28.5 shows the sales, profits, and assets of Admiral Motors and its components supplier, Diana Corporation. Both earn a 10% return on assets, though Admiral has a lower operating profit margin (20% versus Diana’s 25%). Since all of Diana’s output goes to Admiral, Admiral’s management reasons that it would be better to merge the two companies. That way, the merged company would capture the profit margin on both the auto components and the assembled car.
TABLE 28.5 Merging with suppliers or customers generally increases the profit margin, but this increase is offset by a reduction in asset turnover
The bottom row of Table 28.5 shows the effect of the merger. The merged firm does indeed earn the combined profits. Total sales remain at $20 million, however, because all the components produced by Diana are used within the company. With higher profits and unchanged sales, the profit margin increases. Unfortunately, the asset turnover is reduced by the merger since the merged firm has more assets. This exactly offsets the benefit of the higher profit margin. The return on assets is unchanged.
Figure 28.2 shows evidence of the trade-off between asset turnover and operating profit margin. You can see that industries with high average turnover ratios tend to have lower average profit margins. Conversely, high margins are typically associated with low turnover. The two curved lines in the figure trace out the combinations of profit margin and turnover that result in an ROA of either 3% or 10%. Despite the enormous dispersion across industries in both margin and turnover, that variation tends to be offsetting, so for most industries, the return on assets lies between 3% and 10%. The notable exception is mining, which was suffering badly in 2017 from low commodity prices.
FIGURE 28.2 Asset turnover and operating profit margin for 45 U.S. industries in the year ending September 2017. High asset turnover tends to be associated with low profit margins.
Source: U.S. Census Bureau, Quarterly Financial Report Manufacturing, Mining, Trade, and Selected Service Industries, Third Quarter 2017.
28-7Measuring Leverage
When a firm borrows money, it promises to make a series of interest payments and then to repay the amount that it has borrowed. If profits rise, the debtholders continue to receive only the fixed interest payment, so all the gains go to the shareholders. Of course, the reverse happens if profits fall. In this case, shareholders bear the greater part of the pain. If times are sufficiently hard, a firm that has borrowed heavily may not be able to pay its debts. The firm is then bankrupt, and shareholders lose most or all of their investment.
Because debt increases the returns to shareholders in good times and reduces them in bad times, it is said to create financial leverage. Leverage ratios measure how much financial leverage the firm has taken on. CFOs keep an eye on leverage ratios to ensure that lenders are happy to continue to take on the firm’s debt.
Debt Ratio Financial leverage is usually measured by the ratio of long-term debt to total long-term capital. (Here “long-term debt” should include not just bonds or other borrowing but also financing from long-term leases.)14 For Home Depot,
This means that 94 cents of every dollar of long-term capital is in the form of debt.
Leverage is also measured by the debt–equity ratio. For Home Depot,
Home Depot’s long-term debt ratio is very high for U.S. nonfinancial companies, but the CFO could fairly point out that the book value of the equity substantially understates its market value. Home Depot’s long-term debt is less than 2% of Home Depot’s market capitalization.
Some companies deliberately operate at very high debt levels. For example, in Chapter 32, we look at leveraged buyouts (LBOs). Firms that are acquired in a leveraged buyout usually issue large amounts of debt. When LBOs first became popular in the 1990s, these companies had average debt ratios of about 90%. Many of them flourished and paid back their debtholders in full; others were not so fortunate.
Notice that our measure of leverage ignores short-term debt. That probably makes sense if the short-term debt is temporary or is matched by similar holdings of cash, but if the company is a regular short-term borrower, it may be preferable to widen the definition of debt to include all liabilities. In this case,
Therefore, Home Depot is financed 97% with long- and short-term liabilities and 3% with equity.15 We could also say that its ratio of total debt to equity is 43,075/1,454 = 29.6.
Managers sometimes refer loosely to a company’s leverage, but we have just seen that leverage may be measured in different ways. This is not the first time we have come across several ways to define a financial ratio. There is no law stating how a ratio should be defined. So be warned: Do not use a ratio without understanding how it has been calculated.
Times-Interest-Earned Ratio Another measure of financial leverage is the extent to which interest obligations are covered by earnings. Banks prefer to lend to firms whose earnings cover interest payments with room to spare. Interest coverage is measured by the ratio of earnings before interest and taxes (EBIT) to interest payments. For Home Depot,16
The company enjoys a comfortable interest coverage or times-interest-earned ratio. Sometimes lenders are content with coverage ratios as low as 2 or 3.
The regular interest payment is a hurdle that companies must keep jumping if they are to avoid default. Times-interest-earned measures how much clear air there is between hurdle and hurdler. The ratio is only part of the story, however. For example, it doesn’t tell us whether Home Depot is generating enough cash to repay its debt as it comes due.
Cash Coverage Ratio In Chapter 26, we pointed out that depreciation is deducted when calculating the firm’s earnings, even though no cash goes out the door. Suppose we add back depreciation to EBIT to calculate operating cash flow.17 We can then calculate a cash coverage ratio. For Home Depot,
Leverage and the Return on Equity
When the firm raises cash by borrowing, it must make interest payments to its lenders. This reduces net profits. On the other hand, if a firm borrows instead of issuing equity, it has fewer equityholders to share the remaining profits. Which effect dominates? An extended version of the Du Pont formula helps us answer this question. It breaks down the return on equity (ROE) into four parts:
Notice that the product of the two middle terms is the return on assets. It depends on the firm’s production and marketing skills and is unaffected by the firm’s financing mix. However, the first and fourth terms do depend on the debt–equity mix. The first term, assets/equity, which we call the leverage ratio, can be expressed as (equity + liabilities)/equity, which equals 1 + total-debt-to-equity ratio. The last term, which we call the “debt burden,” measures the proportion by which interest expense reduces net income.
Suppose that the firm is financed entirely by equity. In this case, both the leverage ratio and the debt burden are equal to 1, and the return on equity is identical to the return on assets. If the firm borrows, however, the leverage ratio is greater than 1 (assets are greater than equity) and the debt burden is less than 1 (part of the profits is absorbed by interest). Thus, leverage can either increase or reduce return on equity. You will usually find, however, that leverage increases ROE when the firm is performing well and ROA exceeds the interest rate.
28-8Measuring Liquidity
If you are extending credit to a customer or making a short-term bank loan, you are interested in more than the company’s leverage. You want to know whether the company can lay its hands on the cash to repay you. That is why credit analysts and bankers look at several measures of liquidity. Liquid assets can be converted into cash quickly and cheaply.
Think, for example, what you would do to meet a large unexpected bill. You might have some money in the bank or some investments that are easily sold, but you would not find it so easy to turn your old sweaters into cash. Companies, likewise, own assets with different degrees of liquidity. For example, accounts receivable and inventories of finished goods are generally quite liquid. As inventories are sold off and customers pay their bills, money flows into the firm. At the other extreme, real estate may be very illiquid. It can be hard to find a buyer, negotiate a fair price, and close a deal on short notice.
Managers have another reason to focus on liquid assets: Their book (balance sheet) values are usually reliable. The book value of a catalytic cracker may be a poor guide to its true value, but at least you know what cash in the bank is worth. Liquidity ratios also have some less desirable characteristics. Because short-term assets and liabilities are easily changed, measures of liquidity can rapidly become outdated. You might not know what the catalytic cracker is worth, but you can be fairly sure that it won’t disappear overnight. Cash in the bank can disappear in seconds.
Also, assets that seem liquid sometimes have a nasty habit of becoming illiquid. This happened during the subprime mortgage crisis in 2007. Some financial institutions had set up funds known as structured investment vehicles (SIVs) that issued short-term debt backed by residential mortgages. As mortgage default rates began to climb, the market in this debt dried up and dealers became very reluctant to quote a price. Investors who were forced to sell found that the prices that they received were less than half the debt’s estimated value.
Bankers and other short-term lenders applaud firms that have plenty of liquid assets. They know that when they are due to be repaid, the firm will be able to get its hands on the cash. But more liquidity is not always a good thing. For example, efficient firms do not leave excess cash in their bank accounts. They don’t allow customers to postpone paying their bills, and they don’t leave stocks of raw materials and finished goods littering the warehouse floor. In other words, high levels of liquidity may indicate sloppy use of capital. Here, EVA can help because it penalizes managers who keep more liquid assets than they really need.
Net-Working-Capital-to-Total-Assets Ratio Current assets include cash, marketable securities, inventories, and accounts receivable. Current assets are mostly liquid. The difference between current assets and current liabilities is known as net working capital. Since current assets usually exceed current liabilities, net working capital is generally positive. For Home Depot,
Net working capital = 18,933 − 16,194 = $2,739 million
Net working capital was 6.2% of total assets:
Current Ratio The current ratio is just the ratio of current assets to current liabilities:
Home Depot has $1.17 in current assets for every dollar in current liabilities.
Changes in the current ratio can be misleading. For example, suppose that a company borrows a large sum from the bank and invests it in marketable securities. Current liabilities rise and so do current assets. If nothing else changes, net working capital is unaffected but the current ratio changes. For this reason, it is sometimes preferable to net short-term investments against short-term debt when calculating the current ratio.
Quick (Acid-Test) Ratio Some current assets are closer to cash than others. If trouble comes, inventory may not sell at anything above fire-sale prices. (Trouble typically comes because the firm can’t sell its inventory of finished products for more than production cost.) Thus, managers often exclude inventories and other less liquid components of current assets when comparing current assets to current liabilities. They focus instead on cash, marketable securities, and bills that customers have not yet paid. This results in the quick ratio:
Cash Ratio A company’s most liquid assets are its holdings of cash and marketable securities. That is why analysts also look at the cash ratio:
A low cash ratio may not matter if the firm can borrow on short notice. Who cares whether the firm has actually borrowed from the bank or whether it has a guaranteed line of credit so it can borrow whenever it chooses? None of the standard measures of liquidity takes the firm’s “reserve borrowing power” into account.
28-9Interpreting Financial Ratios
We have shown how to calculate some common summary measures of Home Depot’s performance and financial condition. Now you need some way to judge whether they are high or low. In some cases, there may be a natural benchmark. For example, if a firm has negative economic value added or a return on capital less than the cost of that capital, it has not created wealth for its shareholders.
But what about some of our other measures? There is no right level for, say, the asset turnover or profit margin, and if there were, it would almost certainly vary from year to year and industry to industry. Therefore, when assessing company performance, managers usually look first at how the financial ratios have changed over time, and then they look at how their measures stack up in comparison with companies in the same line of business.
We will first compare Home Depot’s position in 2017 with its performance in earlier years. For example, Figure 28.3 plots Home Depot’s return on assets since 1996. We know that ROA = asset turnover × operating profit margin. Figure 28.3 shows that beginning in 1999, there was a steady decline in the company’s ability to generate sales from its assets, though for a while this effect was largely offset by a rise in the profit margin. When the downturn in the housing market in 2008 also led to a sharp decline in the profit margin, Home Depot’s ROA fell dramatically. The turnaround came under new management in 2009, and in each of the following years, the company was able to increase both the rate of asset turnover and the profit margin.
FIGURE 28.3 Home Depot’s financial ratios, 1996–2017.
Managers also need to ask themselves how the company’s performance compares with that of its principal competitors. Table 28.6 sets out some key performance measures for Home Depot and Lowe’s.18 Home Depot has the higher asset turnover ratio and operating profit margin and these combine to produce a higher return on assets. Home Depot has higher book debt ratios, but, thanks to its greater profitability, it has the higher interest cover. Its assets also appear to be more liquid.
|
Fiscal 2017 |
|||
|
Home Depot |
Lowe’s Companies |
||
|
Performance Measures: |
|||
|
Market value added ($ millions) |
Market value of equity – book value of equity |
$238,302 |
$80,467 |
|
Market-to-book ratio |
Market value of equity/book value of equity |
164.9 |
13.5 |
|
EVA ($ millions) |
(After-tax interest + net income) – (cost of capital × capital) |
$6,366 |
$2,150 |
|
Return on capital (ROC, %) |
(After-tax interest + net income)/total capital |
34.9 |
18.5 |
|
Return on equity (ROE, %) |
Net income/equity |
199.2 |
53.6 |
|
Return on assets (ROA, %) |
(After-tax interest + net income)/total assets |
21.7 |
11.2 |
|
Efficiency Measures: |
|||
|
Asset turnover |
Sales/total assets at start of year |
2.35 |
1.99 |
|
Inventory turnover |
Cost of goods sold/inventory at start of year |
5.3 |
4.3 |
|
Days in inventory |
Inventory at start of year/daily cost of goods sold |
68.8 |
84.4 |
|
Receivables turnovera |
Sales/receivables at start of year |
49.8 |
n.a. |
|
Average collection period (days)a |
Receivables at start of year/daily sales |
7.3 |
n.a. |
|
Profit margin (%) |
Net income/sales |
8.55 |
5.03 |
|
Operating profit margin (%) |
(After-tax interest + net income)/sales |
9.23 |
5.63 |
|
Leverage Measures: |
|||
|
Long-term debt ratio |
Long-term debt/(long-term debt + equity) |
0.94 |
0.73 |
|
Total debt ratio |
Total liabilities/total assets |
0.97 |
0.83 |
|
Times-interest-earned |
EBIT/interest payments |
14.0 |
9.7 |
|
Cash coverage ratio |
(EBIT + depreciation)/interest payments |
15.7 |
12.0 |
|
Liquidity Measures: |
|||
|
Net-working-capital-to-total-assets ratio |
Net working capital/total assets |
0.06 |
0.02 |
|
Current ratio |
Current assets/current liabilities |
1.17 |
1.06 |
|
Quick ratio |
(Cash + marketable securities + receivables)/current liabilities |
0.34 |
0.05 |
|
Cash ratio |
(Cash + marketable securities)/current liabilities |
0.22 |
0.05 |
TABLE 28.6 Selected financial ratios for Home Depot and Lowe’s, 2017
a Lowe’s sells most of its receivables to a third party.
BEYOND THE PAGE
Try It! Financial ratios for U.S. companies
mhhe.com/brealey13e
Home Depot and Lowe’s are fairly close competitors, and it makes sense to compare their financial ratios. However, all financial ratios must be interpreted in the context of industry norms. For example, you would not expect a soft-drink manufacturer to have the same profit margin as a jeweler or the same leverage as a finance company. You can see this from Table 28.7, which presents some financial ratios for a sample of industry groups.
Notice the large variation across industries. Some of these differences, particularly in profitability measures, may arise from chance; for example, in 2017 the sun shone less kindly on the oil industry. But other differences may reflect more fundamental factors. For example, telecoms and utility companies tend to have high debt ratios, which persist in good years and bad. In comparison, business equipment companies tend to borrow far less. We pointed out earlier that some businesses are able to generate a high level of sales from relatively few assets. You can see that this is the case for retail companies. On the other hand, these companies earn a relatively low profit margin on these sales. By contrast, utilities turn over their assets more slowly but earn a much higher margin of profit on their sales.
TABLE 28.7 Median financial ratios for publicly traded North American companies, December 2015
Source: WRDS Financial Ratios Suite.
SUMMARY
Managers use financial statements to monitor their own company’s performance, to help understand the policies of a competitor, and to check on the financial health of customers. But there is a danger of being overwhelmed by the sheer volume of data in a company’s Annual Report.19 That is why managers use a few salient ratios to summarize the firm’s market valuation, profitability, efficiency, capital structure, and liquidity. We have described some of the more popular financial ratios.
We offer the following general advice to users of these ratios:
1. Financial ratios seldom provide answers, but they do help you to ask the right questions.
2. There is no international standard for financial ratios. A little thought and common sense are worth far more than blind application of formulas.
3. You need a benchmark for assessing a company’s financial position. It is generally useful to compare the company’s current financial ratios with the equivalent ratios in the past and with the ratios of other firms in the same business.
FURTHER READING
There are some good general texts on financial statement analysis. See, for example:
K. G. Palepu and P. M. Healy, Business Analysis and Valuation, 5th ed. (Cincinnati, OH: South-Western Publishing, 2013).
L. Revsine, D. Collins, B. Johnson, F. Mittelstaedt, and L. Soffer, Financial Reporting and Analysis, 7th ed. (New York: McGraw-Hill/Irwin, 2017).
S. Penman, Financial Statement Analysis and Security Valuation, 5th ed. (New York: McGraw-Hill/ Irwin, 2012).
PROBLEM SETS
Select problems are available in McGraw-Hill’s Connect. Please see the preface for more information.
1. Financial Statements Construct a balance sheet for Galactic Enterprises given the following data:
|
Cash balances |
$25,000 |
|
Inventories |
$30,000 |
|
Net plant and equipment |
$140,000 |
|
Accounts receivable |
$35,000 |
|
Accounts payable |
$24,000 |
|
Long-term debt |
$130,000 |
2. What is shareholders’ equity?
3. Performance measures Keller Cosmetics maintains an operating profit margin of 8% and a sales-to-assets ratio of 3. It has assets of $500,000 and equity of $300,000. Assume that interest payments are $30,000 and the tax rate is 25%.
a. What is the return on assets?
b. What is the return on equity?
4. Performance measures* Table 28.8 gives abbreviated balance sheets and income statements for Walmart. At the end of fiscal 2017, Walmart had 2,960 million shares outstanding with a share price of $106. The company’s weighted-average cost of capital was about 5%. Assume the marginal corporate tax rate was 35%. Calculate:
a. Market value added.
b. Market-to-book ratio.
c. Economic value added.
d. Return on start-of-the-year capital.
|
Fiscal 2017 |
Fiscal 2016 |
|
|
Balance Sheet |
||
|
Assets |
||
|
Current assets: |
||
|
Cash and marketable securities |
6,756 |
$ 6,867 |
|
Accounts receivable |
5,614 |
5,835 |
|
Inventories |
43,783 |
43,046 |
|
Other current assets |
3,511 |
1,941 |
|
Total current assets |
$ 59,664 |
$ 57,689 |
|
Fixed assets: |
||
|
Net fixed assets |
$114,818 |
$ 114,178 |
|
Other long-term assets |
30,040 |
26,958 |
|
Total assets |
$204,522 |
$ 198,825 |
|
Liabilities and Shareholders’ Equity |
||
|
Current liabilities: |
||
|
Accounts payable |
$ 46,092 |
$ 41,433 |
|
Other current liabilities |
32,429 |
25,495 |
|
Total current liabilities |
$ 78,521 |
$ 66,928 |
|
Long-term debt |
36,825 |
42,018 |
|
Other long-term liabilities |
11,307 |
12,081 |
|
Total liabilities |
$126,653 |
$121,027 |
|
Total shareholders’ equity |
77,869 |
77,798 |
|
Total liabilities and shareholders’ equity |
$204,522 |
$198,825 |
|
Income Statement |
||
|
Net sales |
$500,343 |
$485,873 |
|
Cost of goods sold |
373,396 |
361,256 |
|
Selling, general, and administrative expenses |
95,981 |
91,773 |
|
Depreciation |
10,529 |
10,080 |
|
Earnings before interest and tax (EBIT) |
$ 20,437 |
$ 22,764 |
|
Interest expense |
2,178 |
2,267 |
|
Taxable income |
$ 18,259 |
$ 20,497 |
|
Tax |
4,600 |
6,204 |
|
Net income |
$ 13,659 |
$ 14,293 |
e. TABLE 28.8 Balance sheets and income statement for Walmart, fiscal 2017 and 2016 (figures in $ millions)
5. Performance measures Describe some alternative measures of a firm’s overall performance. What are their advantages and disadvantages? In each case, discuss what benchmarks you might use to judge whether performance is satisfactory.
6. Financial ratios* Look again at Table 28.8, which gives abbreviated balance sheets and income statements for Walmart. Assume Walmart had a 35% marginal corporate tax rate in 2017. Calculate the following using balance-sheet figures from the start of the year:
a. Return on assets.
b. Operating profit margin.
c. Sales-to-assets ratio.
d. Inventory turnover.
e. Debt–equity ratio.
f. Current ratio.
g. Quick ratio.
7. Financial ratios There are no universally accepted definitions of financial ratios, but five of the following ratios are clearly incorrect. Substitute the correct definitions.
a. Debt–equity ratio = (long-term debt + value of leases)/(long-term debt + value of leases + equity)
b. Return on equity = (EBIT − tax)/average equity
c. Profit margin = net income/sales
d. Days in inventory = sales/(inventory/365)
e. Current ratio = current liabilities/current assets
f. Sales-to-net-working-capital = average sales/average net working capital
g. Quick ratio = (current assets − inventories)/current liabilities
h. Times-interest-earned = interest earned × long-term debt
8. Financial ratios True or false?
a. A company’s debt–equity ratio is always less than 1.
b. The quick ratio is always less than the current ratio.
c. The return on equity is always less than the return on assets.
9. Financial ratios Sara Togas sells all its output to Federal Stores. The following table shows selected 2017 financial data, in millions, for the two firms:
The company’s tax rate is 35%. Calculate the sales-to-assets ratio, the operating profit margin, and the return on assets for the two firms. Now assume that the two companies merge. If Federal continues to sell goods worth $100 million, how will the three ratios change?
10. Financial ratios* As you can see, someone has spilled ink over some of the entries in the balance sheet and income statement of Transylvania Railroad (Table 28.9). Can you use the following information to work out the missing entries? (Note: For this problem, use the following definitions: inventory turnover = COGS/average inventory; receivables collection period = average receivables/[sales/365].)
· Long-term debt ratio: .4.
· Times-interest-earned: 8.0.
TABLE 28.9 Balance sheet and income statement of Transylvania Railroad (figures in $ millions)
· Current ratio: 1.4.
· Quick ratio: 1.0.
· Cash ratio: .2.
· Inventory turnover: 5.0.
· Receivables collection period: 73 days.
· Tax rate = .4.
11. Efficiency ratios
a. If a firm’s assets of $10,000 represent 200 days’ sales, what is its annual sales?
b. What is its asset turnover ratio?
12. Efficiency ratios If Microcharge’s customers take on average 60 days to pay their bills, what is its receivables turnover?
13. Efficiency ratios Magic Flutes has total receivables of $3,000, which represent 20 days’ sales. Total assets are $75,000. The firm’s operating profit margin is 5%. Find the firm’s sales-to-assets ratio and return on assets
14. Leverage ratios A firm has a long-term debt–equity ratio of .4. Shareholders’ equity is $1 million. Current assets are $200,000, and total assets are $1.5 million. If the current ratio is 2.0, what is the ratio of debt to total long-term capital?
15. Leverage ratios Consider this simplified balance sheet for Geomorph Trading:
|
Current assets |
$100 |
$60 |
Current liabilities |
||
|
Long-term assets |
500 |
280 |
Long-term debt |
||
|
70 |
Other liabilities |
||||
|
190 |
Equity |
||||
|
$600 |
$600 |
a. Calculate the ratio of debt to equity.
b. What are Geomorph’s net working capital and total long-term capital? Calculate the ratio of debt to total long-term capital.
16. Leverage ratios Discuss alternative measures of financial leverage. Should the market value of equity be used or the book value? Is it better to use the market value of debt or the book value? How should you treat off-balance-sheet obligations such as pension liabilities? How would you treat preferred stock?
17. Leverage ratios Suppose that a firm has both fixed-rate and floating-rate debt outstanding. What effect will a decline in interest rates have on the firm’s times-interest-earned ratio? What about the ratio of the market value of debt to that of equity? Would you judge that leverage has increased or decreased?
18. Leverage and liquidity ratios Look again at the balance sheet for Geomorph in Problem 14 . Suppose that at year-end Geomorph had $30 in cash and marketable securities. Immediately after the year-end it used a line of credit to borrow $20 for one year, which it invested in additional marketable securities. Would the company appear to be (a) more or less liquid, (b) more or less highly leveraged? Make any additional assumptions that you need.
19. Liquidity ratios Airlux Antarctica has current assets of $300 million, current liabilities of $200 million and a crash—sorry—cash ratio of .05. How much cash and marketable securities does it hold?
20. Liquidity ratios How would the following actions affect a firm’s current ratio?
a. Inventory is sold.
b. The firm takes out a bank loan to pay its suppliers.
c. The firm arranges a line of credit with a bank that allows it to borrow at any time to pay its suppliers.
d. A customer pays its overdue bills.
e. The firm uses cash to purchase additional inventories.
21. Interpreting financial ratios This question reviews some of the difficulties encountered in interpreting accounting numbers.
a. Give four examples of important assets, liabilities, or transactions that may not be shown on the company’s books.
b. How does investment in intangible assets, such as research and development, distort accounting ratios? Give at least two examples.
22. Interpreting financial ratios Here are some data for five companies in the same industry:
You have been asked to calculate a measure of times-interest-earned for the industry. Discuss the possible ways that you might calculate such a measure. Does changing the method of calculation make a significant difference to the end result?
23. Interpreting financial ratios How would rapid inflation affect the accuracy and relevance of a manufacturing company’s balance sheet and income statement? Does your answer depend on how much debt the firm has issued?
24. Interpreting financial ratios Suppose that you wish to use financial ratios to estimate the risk of a company’s stock. Which of those that we have described in this chapter are likely to be helpful? Can you think of other accounting measures of risk?
25. Interpreting financial ratios Look up some firms that have been in trouble. Plot the changes over the preceding years in the principal financial ratios. Are there any patterns?
CHALLENGE
25. Calculating EVA We noted that, when calculating EVA, you should calculate income as the sum of the after-tax interest payment and net income. Why do you need to deduct the tax shield? Would an alternative be to use a different measure of the cost of capital? Or would you get the same result if you simply deducted the cost of equity from net income (as is often done)?
26. Return on capital Sometimes analysts use the average of capital at the start and end of the year to calculate return on capital. Provide some examples to illustrate when this does and does not make sense. (Hint: Start by assuming that capital increases solely as a result of retained earnings.)
27. Leverage ratios Take another look at Geomorph Trading’s balance sheet in Problem 14 and consider the following additional information:
The “R&R reserve” covers the future costs of removal of an oil pipeline and environmental restoration of the pipeline route.
There are many ways to calculate a debt ratio for Geomorph. Suppose you are evaluating the safety of Geomorph’s debt and want a debt ratio for comparison with the ratios of other companies in the same industry. Would you calculate the ratio in terms of total liabilities or total capitalization? What would you include in debt—the bank loan, the deferred tax account, the R&R reserve, the unfunded pension liability? Explain the pros and cons of these choices.
FINANCE ON THE WEB
Use data from Yahoo! Finance (finance.yahoo.com) to answer the following questions.
1. Select two companies that are in a similar line of business and find their simplified balance sheets and income statements. Then draw up common-size statements for each company and compute the principal financial ratios. Compare and contrast the companies based on these data.
2. Look up the latest financial statements for a company of your choice and calculate the following ratios for the latest year:
a. Return on capital.
b. Return on equity.
c. Operating profit margin.
d. Days in inventory.
e. Debt ratio.
f. Times-interest-earned.
g. Current ratio.
h. Quick ratio.
3. Select five companies and, using their financial statements, compare the days in inventory and average collection period for receivables. Can you explain the differences between the companies?
1Home Depot’s balance sheet does include an entry for “goodwill.” This reflects the difference between the price paid to acquire a company and that company’s book value.
2For simplicity, we have added $74 million of investment income to net sales.
3Market value added is usually defined as the difference between the market value of the firm’s capital (debt plus equity) and the book value of the capital. In practice, since the market and book value of debt are generally not too different, market value added is usually measured as the difference in the market and book values of the equity.
4The market-to-book ratio can also be calculated by dividing stock price by book value per share.
5It can even result in a negative ratio. For example, stock repurchases by McDonald’s have led to negative book equity.
6The expression, return on capital, is commonly used when calculating the profitability of an entire firm. When measuring the profitability of an individual plant, the equivalent measure is generally called return on investment (or ROI).
7This figure is called the company’s net operating profit after tax, or NOPAT:
NOPAT = after-tax interest + net income
In the case of Home Depot:
NOPAT = (1-.35) × 1,057 + 8,630 = $9,317
8For the same reason, we used the after-tax interest payment when we calculated Home Depot’s EVA.
9Remember WACC is a weighted average of the after-tax rate of interest and the cost of equity.
10Although it is sometimes done, it is not correct to compare return on assets with WACC. Current liabilities are ignored when calculating WACC.
11Sometimes it is convenient to use a snapshot figure at the end of the year, although this is not strictly appropriate.
12Where possible, it makes sense to look only at credit sales. Otherwise, a high ratio might simply indicate that a small proportion of sales is made on credit.
13For example, Home Depot reports its sales per square foot as part of its financial statements.
14A finance lease is a long-term rental agreement that commits the firm to make regular payments. This commitment is just like the obligation to make payments on an outstanding loan. See Chapter 25.
15In this case, the debt consists of all liabilities, including current liabilities.
16The numerator of times-interest-earned can be defined in several ways. Sometimes depreciation is excluded. Sometimes it is just earnings plus interest’—that is, earnings before interest but after tax. This last definition seems nutty to us because the point of times-interest-earned is to assess the risk that the firm won’t have enough money to pay interest. If EBIT falls below interest obligations, the firm won’t have to worry about taxes. Interest is paid before the firm pays taxes.
17Earnings before interest, taxes, depreciation, and amortization are often termed EBITDA.
18We do not report a measure of receivables turnover for Lowe’s, since the company sells most of its receivables to a third party.
19HSBC’s 2007 Annual Report totaled 454 pages. The Financial Times reported that Britain’s postal service was obliged to limit the number that its postmen carried in order to prevent back injuries.