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17.1 Financial Ratios rll ~ I St J.,
Leverage Ratios r~' I nc I
LIquidity Ratios
Efficiency Ratios alysis
Profitability Ratios
17.2 The Du Pont System
Other FinafClclal Ratios
17.3 Using Financial Ratios
Accounting Principles
and Financial Ratios
Choosing a Benchmark
17.4 Measuring Company
Performance
17.5 The Role of Financial Ratios U) ~

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TIH5 Gujo~ te for people wili) ICtne emerjence readm.;l nn~ncja~ s~alemenl3- or annufilleporls_ Thls gUide IS bfokel1 up into the foHov/,ng secllons

THIS GUIDE IS NEITHER AN OFf ER TO SELL. NOR A SOLICITATION of AN OFfER TO 9UY. NW SECURITIES OF INTERNATIONAL BUSINESS MACHINES CORPORATION OR ANV OTHER COMPNW

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www.annUQ!reporh::.c:ofTI Useful links to financlal statements. www.prors.com Another site with

links to firionclol statements. www.corporotelntorrnctlon.com Includes links to financial statements of overseas companies. www.joxworks.com Calculates financial ratios.

finance.yalloo.com Contains financial ratio comparisons for companies and industries.

.;:.ogQfscon.pwcglobal.com Very nice software for comparing financial ratios. Click on Benchmarking Assistant.

www.sl~ITlstewarLcom Articles and data on economic value added.

www.ibm.com/investor/n I

A guided tour through on annUa

report.

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We have all heard stories of whizzes who can take a company's accounts apart in minutes, calculate a few financial ratios, and discover the company's innermost secrets. The truth, however, is that 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. Ratios help you to ask the right questions: They seldom answer them.

We will describe and calculate four types of financial ratios:

Leverage ratios show how heavily the company is in debt.

• Liquidity ratios measure how easily the firm can lay its hands on cash.

• Efficiency or turnover ratios measure how productively the firm is using its assets.

• Profitability ratios are used to measure the firm's return on its investments.

We introduced you to PepsiCo's financial statements in Chapter 3. Now let's analyze them. For convenience, Tables 17-1 and 17-3 present again Pepsi's income statement and balance sheet.

The income statement summarizes the firm's revenues and expenses and the difference between the two, which is the firm's profit. You can see in Table 17-1 that after deducting the cost of goods sold and other expenses, Pepsi had earnings before interest and taxes (EBIT) of $5,713 million. Of this sum, $167 million was used to pay debt interest (remember interest is paid out of pretax income), and $1,334 was set aside for taxes. The net income belonged to the common stockholders. However, only a part of this income was paid out as dividends, and the remaining $2,883 million was plowed back into the business. I

The income statement in Table 17-1 shows the number of dollars that Pepsi earned in 2004. When making comparisons between firms, analysts sometimes calculate a common-size income statement. In this case all items in the income statement are expressed as a percentage of revenues. Table 17-2 is Pepsi's common-size income statement. You can see, for example, that the cost of goods sold consumes 41.5 percent of revenues and that selling, general, and administrative expenses absorb a further 34.7 percent.

Whereas the income statement summarizes activity during a period, the balance sheet presents a "snapshot" of the firm at a given moment. For example, the balance sheet in Table 17-3 is a snapshot of Pepsi's assets and liabilities at the end of 2004.

456 Part Six Financial Analysis and Planning

1 7. 1 Financial Ratios

income statement Financial statement that shows the revenues, expenses, and net income of a firm over a period of time.

common-size income statement

Income statement that presents items as a percentage of revenues.

ootcnce sheet

Financial statement that shows the value of the firm's assets and liabilities at a particular time.

TABLE 17-1

12,142 10,142 1,264 5,713

167 5,546 1,334 4,212

.,;cdNsodDAtEb:INGoM~stATEMENT .. FOR PEPSICO; iNC., 2004: ,

··/.······,::,{',.:':;,I·~;:;:),~~{.::·;·"{f!~~t~~:i.~i.ffi1.llidfi~:9(d(J·II~f.~);j/ .. :\>.\.,,··';.'; .. "~·:·.·"':/

Net sales $29,261

Cost of goods sold

Selling, general, & administrative expenses De preci ation

Earnings before interest and income taxes I nterest expense

Taxable income

Taxes

Net income

Allocation of net income Dividends

Addition to retained earnings

1,329 2,883

Source: PepsiCo Annual Report, 2004.

I This is in addition to $[,264 million of cash flow earmarked for depreciation.

458

c ornmcn SiltS: bnh:-in\~~8 SPE,GI

Balance sheet that presents Items as a percentage of total assets,

TABLE 17-4

Part Six Financial Analysis and Planning

assets such as buildings, land, machinery, and equipment. Remember that the balance sheet does not show the market value of each asset, Instead, the accountant records the amount that the asset originally cost and then, in the case of plant and equipment, deducts an annual charge for depreciation. Pepsi also owns many valuable assets, such as its brand name, that are not shown on the balance sheet.

Pepsi's liabilities show the claims on the firm's assets. These also are classified as current versus long-term. Current liabilities are bi11s that the company expects to pay in the near future. They include debts that are due to be repaid within the next year and payables (that is, amounts the company owes to its suppliers). In addition to these short-term debts, Pepsi has borrowed money that will not be repaid for several years. These are shown as long-term liabilities,

After taking account of all the firm's liabilities, the remaining assets belong to the common stockholders, The shareholders' equity is simply the total value of the assets less the current and long-term liabilities, It is also equal to the amount that the firm has raised from stockholders ($648 million) plus the earnings that have been retained and reinvested on their behalf ($12,924 million).

Just as it is sometimes useful to provide a common-size income statement, so We can also calculate a common-size balance sheet. In this case all items are reexpressed as a percentage of total assets. Table 17-4 is Pepsi's common-size balance sheet. The table shows, for example, that in 2004 cash and marketable securities rose from 3.2 percent of total assets to 4,6 percent.

COMMQN"sIZEEl.A.l,Ar'IcEsH~gl"FbRPEPSICO;II\!C;;AS()FD~CEM13ER 31· .. ,.~; ':;/ ·.·!~il.it~m·~~~~t~~:i~~~·~'~~~6~J1t#~~·brWt~l~s~~t$)·',i '>.J

4,6 3.2
10.7 11.2
5.5 5,6
10.1 7.4
~~
30,9 27.4 Current liabilities
Debt due for repayment 3.8 2.3
Accounts payable 16.4 20.6
Other current liabilities 3.9 2.4
Total current liabilities 24.1 25,3
Long-term debt 8,6 6,7
Deferred income taxes 4.3 5,0
Other lonq-term liabilities 14,5 16,1
Total liabilities 51.5 53,1
Shareholders' equity
Common stock and other paid-in capital 2,3 7,2
Retained earnings 46,2 39,6
Total shareholders' equity 48,5 46.9
Total liabilities and shareholders' equity 100,0 100.0 Current assets

Cash and marketable securities

Receivables Inventories

Other current assets Total current assets

Fixed assets

Tangible fixed assets Property, plant,

and equipment

Less accumulated depreciation

Net tangible fixed assets

Intangible fixed assets Goodwill

Other intangible assets Total intangible fixed assets

Total fixed assets Other assets

Total assets

Note: Column sums subject to rounding error. Source: PepsiCo Annual Report, 2004,

56.9 58.3
27,8 27,4
29,1 30.9
14,0 15.0
5.5 6,3
19.4 21.3
48.6 52.2
20.6 20,5
100,0 100.0 460

Part Six Financial Analysis and Planning

the value of these assets may disappear altogether. Thus when banks demand that a borrower keep within a maximum debt ratio, they are usually content to define this debt ratio in terms of book values and to ignore the intangible assets that are not shown in the balance sheet.

Notice also that these measures of leverage take account only of long-term debt.

Managers sometimes also define debt to include all liabilities:

'T' 1 d b ti total liabilities 14,415 52

lata e t ra 10 "" "" -- := .

total assets 27,987

Therefore, Pepsi is financed 52 percent with debt, both long-term and short-term, and 48 percent with equity. We could also say that its ratio of total debt to equity is 14,415113,572 = 1.06.

Managers sometimes refer loosely to a company's debt ratio, but we have just seen that the debt ratio may be measured in several different ways. For example. Pepsi could be said to have a debt ratio of .15 (the long-term debt ratio) or .52 (the total debt ratio). There is a general point here. There are a variety of ways to define most financial ratios, and there is no law stating how they should be defined. So be warned: Don't accept a ratio at face value without understanding how it has been calculated.

Times Interest Earned Ratto Another measure of financial leverage is the extent to which interest obligations are covered by earnings. Banks prefer to lend to firms whose earnings are far in excess of interest payments. Therefore, analysts often calculate the ratio of earnings before interest and taxes (EBIT) to interest payments. For Pepsi,

T·· d EBlT 5.713 342

lmes interest earne = = _" _ = .

interest payments 167

Pepsi's profits would need to fall dramatically before they were insufficient to cover the interest payment.

The regular interest payment is a hurdle that companies must keep jumping if they are to avoid default. The times interest earned ratio (also called the interest cover ratio) measures how much clear air there is between hurdle and hurdler. However, it tells only part of the story. For example, it doesn't tell us whether Pepsi is generating enough cash to repay its debt as it becomes due.

Cast1Coverage Ratio We have pointed out that depreciation is deducted when we are calculating the firm's earnings, even though no cash goes out the door. Thus, rather than asking whether earnings are sufficient to cover interest payments, it might be more interesting to calculate the extent to which interest is covered by the cash flow from operations. This is measured by the cash coverage ratio. For Pepsi,

C 1 . EBIT + depreciation 5,713 + 1.264 41 8

as 1 coverage ratio = =. = .

~ interest payments 167

A firm repays $10 million face value of outstanding debt and issues $10 million of new debt with a lower rate of interest. What happens to its lonq-term debt ratio? What happens to its times interest earned and cash coverage ratios?

liquidity

Ability to sell an asset for cash at short notice.

Liquidity Ratios

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 it will be able to 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.

462

Part Six Financial Analysis and Planning

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:

Q ick ' cash + marketable securities + receivables 1,280 + 2,999 63

mc ratio "" = . = ,

current liabilities 6,752

a. A firm has $1.2 million in current assets and $1.0 million in current liabilities. If it uses $,5 million of cash to payoff some of its accounts payable, what will happen to the current ratio? What happens to net working capital?

b. A firm uses cash on hand to pay for additional inventories. What will happen to the current ratio? To 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:

C h ' cash + marketable securities 1,280 19

as ratto = = -- =,

current liabilities 6,752

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 that lets it borrow whenever it chooses? None of the standard liquidity measures takes the firm's "reserve borrowing power" into account.

Efficiency Ratios

Firms want to use their assets efficiently, and financial analysts want to measure that efficiency, Of course, defining a single measure of "efficiency" for firms that use many inputs and technologies can entail complex and subtle issues, so in practice analysts are usually content to use turnover ratios that measure how much the firm produces for every dollar of assets employed, For example, we may look at the sales generated per dollar of assets or at the level of inventory per dollar of goods sold,

Asset Turnover Ratio The asset turnover, or sales-to-assets. ratio shows how hard the firm's assets are being put to use, For Pepsi, each dollar of assets produced $1.1 0 of sales:

Sales

29,261 = 1.10

(27.987 + 25,327)/2

----~--=

Average total assets

A high ratio compared with other firms in the same industry could indicate that the firm is working close to capacity. It may prove difficult to generate further business without additional investment.

Notice that since the assets are likely to change over the year. we use the average of the assets at the beginning and end of the year, Averages are often used when a flow figure (in this case annual sales) is compared with a snapshot figure (total assets),

Instead of looking at the ratio of sales to total assets, managers sometimes look at how hard particular types of capital are being put to use. For example, they might look at the value of sales per dollar invested in fixed assets. Or they might look at the ratio of sales to net working capital,

Thus for Pepsi each dollar of fixed assets generated $2,18 of sales:

SaJes 29,261

=: =2.18

Average fixed assets (13,589 + 13,211)/2

Average Collection Period The average collection period measures how quickly customers pay their bills, It expresses accounts receivable in terms of daily sales:

464

Part Slx Financial Analysis and Planning

margin, which also has wide acceptance and which we will call the operating profit margin:

. . net income + interest

Operating profit margin» = ------~~-

sales

4,212+ [67 29.26[

.150. or l5.00/c

Holding everything constant, a firm would naturally prefer a high profit margin. But all else cannot be held constant. A high-price and high-margin strategy typically will result in lower sales. So while Bloomingdales might have a higher margin than JCPenney, it will not necessarily enjoy higher profits. A low-margin but high-volume strategy can be quite successful. We return to this issue later.

Return on Assets (ROA) Managers often measure the performance of a firm by the ratio of net income to total assets. However, because net income measures profits net of interest expense. tbis practice makes the apparent profitability of the firm a function of its capital structure. It is better to use net income plus interest because we are measuring the return on all the firm's assets, not just the equity investment."

R net income + interest 4,212 + 167 164 164(;1

eturn on assets > = = . . or .-if

average total assets (27,987 + 25.327)/2

The assets in a company's books are valued on the basis of their original cost (less any depreciation). A high return on assets does not always mean that you could buy the same assets today and get a high return. Nor does a low return imply that the assets could be employed better elsewhere. But it does suggest that you should ask some searching questions.

In a competitive industry firms can expect to earn only their cost of capital. Therefore, a high return on assets is sometimes cited as an indication that the firm is taking advantage of a monopoly position to charge excessive prices. For example, when a public utility commission tries to determine whether a utility is charging a fair price, much of the argument will center on a comparison between the cost of capital and the return that the utility is earning (its ROA).

Return on Equity (ROE) Another measure of profitability focuses on the return on the shareholders' equity:

. net income

Return on equity = .

average equity

___ 4_,2_1_2 __ = .331, or 33.1 o/e (13.572 + 11,874)/2

(, Different analysts may measure profit mr.rgiu in different ways. For example. some may include interest payments net of the interest tax shield. and so they udjust the numcrt.tor in the profit margin to [net income + interest x II - (ax rnte i]. Others use earnings before interest and (axes (ESIT) in the numerator. while still o.hers prefer EBIT( I - tax nlte). Unfortunately. there is no uniformity on which definition is used or preferred. You simply need to be aware that there are differences in practice uud be consistent in how you calculate these measures.

J This definition of ROA is also misleading if it is used to compare firms with different capital structures. The reason is that firms that pay more interest pay less in taxes. Thus this ratio reflects differences in Iiuancial leverage us well as ill operating perfonnauce. If you want a measure of operating performance alone. we suggest adjusting for leverage by subtracting that part of totul income generated by interest tax shields (interest payments x mnrginal tax rate). This give, theincome the firm would earn if it were ulr-cqnity-financed. Thus, usinga tax rate of 35 percent for Pepsi.

net income + interest ~ interest tax shields Adjusted return 011 assets = -------------average total assets

4.212 + 167 -U5 x 167J -------- = .162. or 16.2'k [27.987 + 25.327)/2

466

ParI Six Financial Analysis and Planning

ROA :::: net income + interest = assets

net income + interest X

sales assets

t

sales

t

operating profit margin

asset turnover

All firms would like to earn a higher return on their assets, but their ability to do so is limited by competition. If the expected return on assets is fixed by competition, firms face a trade-off between the turnover ratio and the profit margin, Thus we find that fast-food chains, which have high turnover, also tend to operate on low profit margins, Classy hotels have relatively low turnover ratios but tend to compensate for this with higher margins. Table 17-5 illustrates the trade-off. Both the fast-food chain and the hotel have the same return on assets. However, their profit margins and turnover ratios are entirely different.

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, they are likely to find that any gain in profit margin is offset by a decline in the asset turnover.

A few numbers may help to illustrate this point. Table 17-6 shows the sales. profits, and assets of Admiral Motors and its components supplier Diana Corporation. Both earn a 10 percent return on assets, though Admiral has a lower operating profit margin (20 percent versus Diana's 25 percent). Since all of Diana's output goes to Admiral, Admiral's management reasons that it would be better to merge the two COI11- panics, That way the merged company would capture the profit margin on both the auto components and the assembled car.

The bottom line of Table 17-6 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 ratio is reduced by the merger since the merged firm operates with higher assets. This exactly offsets the benefit of the higher profit margin. The return on assets is unchanged.

'Ve can also break down the return on equity (ROE) into its component parts:

ROE = net income equity

Therefore,

ROE = assets X equity

r

sales X net income + interest x ~~_n_e_t_i_n_c_o_m~e~~

assets sales net income + interest

r r t

debt burden

leverage ratio

asset operating profit

turnover margin

Notice that the product of the two middle terms is the return on assets. This 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

TABLE 17-5 Fast-food chains and hotels may have a similar return on assets but different asset turnover ratios and profit margins

Fast-food chains Hotels

S~'f'f:Wf~lf;~:r~TWM~~gi& ':~etU~J1~,rr A~,~~~~:::

2.0 5% 10%

0.5 20 10

9 There is a complication here became the amount of taxes paid depends on the fi.iuncing mix. It would be better to acid back any interest tax shields when calculating the finn's operating profit margin,

468

Part Six Financial Analysis and Planning

You can probably think of a number of other ratios that could provide useful insights into a company's health. For example, a retail chain might compare its sales per square foot with those of its competitors, a steel producer might look at the cost per ton of steel produced, and an airline might look at revenues per passenger-mile flown. Internet firms have been evaluated on the basis of stock price per "hit" on the Web site.

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TABLE 17-7 Summary of financial ratios

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Leverage Ratios

, long-term debt

Long-term debt ratio = --__..'__-----

long-term debt + equity

. long-term debt

Long-term debt-equity ratio = ,

equity

total liabilities Total debt ratio = -_.:.__.:.__.:._~

total assets

EBIT Times interest earned = -----interest payments

h EBIT + depreciation

Cas coverage ratio = -----'-_.:._--

interest payments

Liquidity Ratios

NWC t ne~t~w~o~r~k~in-"g~c~a-,-p~it_al

a assets = ~

total assets

current assets current liabilities

Q lck . cash + marketable securities + receivables UIC ratio = ---------------

current liabilities

Current ratio =

h ' cash + marketable securities

Cas rat 10 = .::__.:.___:__.:.__:__---_.:._'---'--

current liabilities

Efficiency Ratios

sales

Total asset turnover = --__::..:.:;_:..:._--

average total assets

. average receivables

Average collection period = --..:::......----

average daily sales

cost of goods sold Inventory turnover = _:__:_:__----'=_.:._--~

average inventory

average inventory Days' sales in inventories = __ ___:"-- __ __:c_

cost of goods sold/365

Profitability Ratios

P fit ' net income

ro I margin =

sales

. net income + interest

Operatmg profit margin = -~:___:_----

sales

net income + interest

Retu rn on assets = _:,:_:_:_::.....::..::..:..:..:..::___:__:_:_:__:_:~

average total assets net income

Return on equity = -----

average equity

, dividends

Payout ratio = ,

earnings

Plowback ratio = 1 - payout ratio

Growth in equity from plowback = plowback ratio x ROE

~.

470

Part Six Financial Analysis and Planning

FIGURE 17-1 PepsiCo financial ratios

18
16
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c
~ 14
i:
~
c.
~
'E- 10
III
E
.... 8
t;:
e
c. 6
e
0
c:: 4
2
0
1996 2003

L---~L---~----~----~----~-----L----~----~O

2004

1998

1999

2001

1997

2000 Year

2002

formula that ROA = operating profit margin x asset turnover. The figure shows that for the most part, the improvement in Pepsi's ROA came from improvement in margin. Notice, for example, that after 2001 turnover began a gradual but steady decline, while the profit margin increased substantially. Perhaps Pepsi raised prices during this period (higher margins) even if doing so slowed sales (lower turnover). By and large this strategy seems to have resulted in a higher return on assets.

It is also helpful to compare Pepsi's financial position with that of other firms. How ever, you would not expect companies in different industries to have similar ratios, For example, a soft-drink manufacturer is unlikely to have the same profit margin as a jeweler or the same leverage as a finance company. It makes sense, therefore, to limit comparison to other firms in the same industry. This is where the common-size balance sheet, which reports all items as a percentage of assets, can facilitate comparisons. Table 17~8 compares the common-size balance sheets of Pepsi and Coca-Cola.

TABLE 17-8

,i;.;··<\?i,l60MT\IION~SIZE~~ALANCE:'SHEETSFbRPEPsicdAND.· c.oCA~C6LAASOJ= 'DECEMBER 31, '2004

;", ~i:'_ .•. - ._ ,.>:-. -. " '." "; _._:,-, - '_',.- .. ~:,_' " " ". ",_ ',.:,,', '.····c .. : .': :.-' _: .. >-. ' -:.', . -. _ : ",:'," - "_'.: ': : '-', :,' -", _ " ',- '_ - _' :'_ " . _._ " : .. '-. -:", -,-, ," .,- , :',/ _ '_ - -; .... ,.'. __ ',_; -, _. ,_: " . ... ' , .

... . (aO iterns~)qjressedas·p¢rc~l)tage·of. total·,asset.s),:'

.' ....•.. 7,~66ke'<~ .: : ',.: ~ ,
,~~psi
CUrrent assets Current liabilities
Cash and marketable securities 4.6 21.6 Debt due for repayment 3.8 19.2
Receivables 10.7 6.9 Accounts payable 16.4 13.7
Inventories 5.5 4.5 Other current liabilities 3.9 2.1
Other current assets 10.1 5.5 Total current liabilities 24.1 35.0
Total current assets 30.9 38.6 3.7
Long-term debt 8.6
Fixed assets Other long-term liabilities 18.8 10,4
Net tangible assets 29.1 19.4 49.1
Total liabilities 51.5
Total intangible fixed assets 19.4 12.2
Total fixed assets 48.6 31.7 Shareholders' equity
Other assets 20.6 29.7 Common stock and other paid-in capital 2.3 18.5
Retained earnings 46.2 32.3
Total assets 100.0 100.0
Total shareholders' equity 48.5 50.9
Total liabilities and shareholders' equity 100.0 100.0 472

TABLE 17-10 Benchmark financial ratios for PepsiCo

Part Six Financial Analysis and Planning

Valuation Ratios
PIE ratio (TTM) 22.35 21.66 20.66 22.06
Price to book (MRO) 6.68 6.25 7.25 4.04
Price to cash flow (TTM) i 7.17 16.85 17.19 15.93
Financial Strength
Quick ratio (MRO) 0.95 0.87 0.65 1.21
Current ratio (MRO) 1.28 1.19 1.26 1.71
LT debt to equity (MRO) 0.18 0.31 0.77 0.60
Total debt to equity (MRO) 0.26 0.54 0.97 0.76
Interest coverage (TIM) 31.49 29.74 17.14 12.59
Profitability Ratios (%)
Operating margin (TTM) 17.97 20.91 17.02 21.97
Net profit margin (TTM) 14.27 17.01 11.49 14.03
Management Effectiveness (%j
Return on assets (TTM) 15.88 14.96 11.31 7.63
Return on equity (TIM) 32.84 31.06 33.28 20.00
Efficiency
Receivable turnover (TIM) 9.37 10.08 13.39 10.26
Inventory turnover (TTM) 8.67 7.49 6.75 13.29
Asset turnover (TTM) 1.11 0.92 1.09 0.96
Source: www.investor.reuters.com, March 10, 2005.
Notes:
1. TIM = trailing 12 months.
2. MRQ = most recent quarter. Table 17-11 presents ratios for a sample of major industry groups to give you a feel for some of the differences across industries. You should note that while some ratios such as asset turnover or total debt ratio tend to be relatively stable over time, others such as return on assets or equity will be more sensitive to the state of the economy as profits ebb and flow with the business cycle.

TABLE 17-11 Financial ratios for major Industry groups

Return on . Payoi.if Equity (%)" Ratio"';':

All manufacturing 0.19 4.13 0.07 0.91 0.93 6.88 6.37

Food products Textiles Petroleum/coal Chemicals Drugs Machinery Computers/electronic Transportation equip. Beverages/tobacco

15.76 0.31

0.28 3.65 0.09 0.81 1.37 6.20 8.50 17.80 0.36
0.23 2.92 0.20 0.92 1.47 4.35 6.39 8.39 0.23
0.15 3.64 0.04 1.00 1.34 3.31 4.45 18.14 0.25
0.19 4.27 0.00 0.72 0.59 10.37 6.13 7.31 0.33
0.25 9.44 0.02 0.76 0.87 13.53 11.72 59.14 0.29
0.19 4.64 0.13 1.02 0.89 8.04 7.19 14.82 0.17
0.11 4.52 0.14 1.31 0.66 5.30 3.52 10.06 0.20
0.17 2.22 0.01 0.72 0.94 3.94 3,69 13.12 0.30
0,28 5.25 -0.02 0.70 0.63 14.76 9.24 27.62 0.51 Source: U.S. Department of Commerce, Quarterly Financial Report for Manufacturing. Mining and Trade Corporations, December 2004.

474

Part Six Financial Analysis and Planning

TABLE 17-12 Measures of company performance, 2005. Companies are ranked by market value added.

Microsoft 7.4 204,168 32.9 11.7 31,090 6,456
Wal-Mart 2.9 169,927 13.2 6.2 86,822 5,920
Johnson & Johnson 3.4 135,584 18.1 8.2 57,833 5,682
Intel 4.0 98,189 18.6 13.7 32,394 1,645
Coca-Cola 4.8 83,080 21.3 6.4 21,166 3,116
IBM 2.2 79,894 9.0 11.2 67,369 -1,506
Merck 2.1 37,921 17.9 8.0 36,887 3,705
Dow Chemical 1.0 25,403 5.9 6.5 44,639 -299
Delta Air Lines 1.0 4,090 -1.0 -6.7 27,888 -2,155
Note: Economic value added is the rate of return on capital less the cost of capital times the amount of capital invested; e.g .. for Microsoft, EVA ~ (.329 -
.177) x $31 ,090 million.
Source: Data provided by Stern Stewart & Co. TI18 net profit of a firm or division after deducting the cost of the capital employed.

than the cost of capital makes investors worse off: They could earn a higher expected return simply by investing their cash in the capital market. Naturally, therefore, financial managers are concerned whether the firm's return on its assets exceeds or falls short of the cost of capital. Look, for example, at tbe third column of Table 17-12, which shows the return on capital I I for our sample of 12 companies. Microsoft had the highest return at 32.9 percent. Since the cost of capital for Microsoft was 11.7 percent, each dollar invested in Microsoft was earning almost three times the return that investors could have expected by investing in the capital market.

Let us work out how much this amounted to. Microsoft's total capital in 2005 was $31,090 million. With a return of 32.9 percent, it earned profits of .329 x $31,090 :::: $] 0,228 million. The total cost of capital employed by Microsoft was .117 x $31,090 :::: $3,637 million. So after deducting the cost of capital, Microsoft earned $] 0,228 - $3,637:::: $6,591 million. This is called Microsoft's economic value added, or EVA, a term coined by the consulting firm Stern Stewart, which has done much to develop and promote the concept. (The value of Microsoft's EVA given in Table 17~] 2 is off by a few percent from the value we've derived because of rounding error in the interest rates.) Another common term for economic value added is residual income.

The final column of Table 17-12 shows the economic value added for our sample of large companies. You can see that while Wal-Mart had a far lower return on capital than Intel, it was nevertheless far ahead in terms of EVA. This is partly because WalMart was less risky and investors did not require such a high return, but also because Wal-Mart had far more dollars invested than Intel. Notice that IBM is a laggard in the EVA stakes. Its positive return on capital indicates that the company earns a profit after deducting out-of-pocket costs. But this profit is calculated before deducting the cost of capital. IBM's residual income (or EVA) was negative at -$1,506 million.

Residual income, or EVA, is a better measure of a company's performance than accounting profits. Profits are calculated after deducting all costs except the cost of capital. EVA recognizes that companies need to cover their cost of capital before they add value. If a plant or division is not earning a positive EVA, its management is likely to face some pointed questions about whether the assets could be better employed elsewhere or by fresh management. Therefore, a growing number of firms now calculate EVA and tie managers' compensation to it.

This is not the first time that we have encountered EVA. In Chapter 9 we pointed out that managers often ask how far a project's sales could fall before the profits failed to cove)' the cost of capital. In other words, they define a project as breaking even when its economic value added is zero.

11 Return on capital is closely related to return Oil assets. It measure, profitability per dollar of long-term capital (long-term debt plus shareholders' equity) instead of per dollar of total assets.

476

su

rv1ARY

What are the standard measures of a firm's leverage, liquidity, efficiency, and profitability? What is the significance of each of these measures?

How does the Du Pont formula help identify the determinants of the firm '8 return on its assets and equity?

What are some potential pitfalls of ratio analysis based on accounting data?

Part Six Financial Analysis and Planning

"In some ways we're in good shape. We have very little short-term debt, and OUr current assets are three times our current liabilities. But that's not altogether good news because it also suggests that we may have more working capital than We need. I've been looking at our main competitors. They turn over their inventory 12 times a year compared with our figure of just 8 times. Also, their customers take an average of 45 days to pay their bills. Ours take 67. If we could just match their performance on these two measures, we would re1ease $300 million that could be paid OUt to shareholders."

"Perhaps we could talk more about this tomorrow," said the CEO. "In the meantime I intend to have a word with the production manager about our inventory levels and with the credit manager about our collections policy. You've also got me thinking about whether we should sell off our packaging division. I've always worried about the divisional manager there. Spends too much time practicing his backswing and not enough worrying about his return on assets."

If you are analyzing a company's financial statements, there is a danger of being overwhelmed by the sheer volume of data contained in the income statement, balance sheet, and statement of cash flow. Managers use a few salient ratios to summarize the firm's leverage, liquidity, efficiency, and profitability. They may also combine accounting data with other data to measure the esteem in which investors hold the company or the efficiency with which the firm uses its resources.

Look back at Table 17-7, which summarizes the four categories of financial ratios that we have discussed in this chapter. Remember though that financial analysts define the same ratio in different ways or use different terms to describe the same ratio.

Leverage ratios measure the indebtedness of the firm. Liquidity ratios measure how easily the firm can obtain cash. Efficiency ratios measure how intensively the firm is using its assets. Profitability ratios measure the firm's return on its investments. Be selective in your choice of these ratios. Different ratios often tell you similar things.

Financial ratios crop up repeatedly in financial discussions and arrangements. For example, banks and bondholders commonly place limits on the borrower's leverage ratios. Ratings agencies also look at leverage ratios when they decide how highly to rate the firm's bonds.

The Du Pont system provides a useful way to link ratios to explain the firm's return on assets and equity. The formula states that the return on equity is the product of the firm's leverage ratio, asset turnover, operating profit margin, and debt burden. Return on assets is the product of the finn's asset turnover and operating profit margin.

Financial ratio analysis will rarely be useful if practiced mechanically. It requires a large dose of good judgment. Financial ratios seldom provide answers, but they do help you ask the right questions. Moreover, accounting data do not necessarily reflect market values properly, and so must be used with caution. You need a benchmark for assessing a company's financial position. Therefore, we typically compare financial ratios with tlle company's ratios in earlier years and with the ratios of other firms in the same business.

478

ParI Six Financial Analysis and Planning

Calculate the following financial ratios:

a. Long-term debt ratio
b. Total debt ratio
c. Times interest earned
d. Cash coverage ratio
e. Current ratio
f. Quick ratio
g. Operating profit margin
h. Inventory turnover
i. Days in inventory
j. Average collection period
k. Return on equity
1. Return on assets m. Payout ratio

2. Gross Investment, What was Medl'hones gross investment in plant and other equipment?

3. Market-Value Ratios. The market value of lVledPhone was €22.3 billion at year end. There were 195 million shares outstanding. Calculate earnings per share and the price-earnings ratio.

4. Du Pont Analysis. Use the data for lVleclPhone to

a. Calculate MedPhone's ROE.

b. Demonstrate that ROE = leverage ratio x asset turnover ratio x operating profit margin x debt burden.

5. Du Pont Analysis. Use the data for lVledPhone to confirm that ROA = asset turnover X operating profit margin.

6. Common-Size Balance Sheet. Prepare a common-size balance sheet for MedPhone using its balance sheet from Problem l.

r·.

;::,

7. Financial Ratios. Explain the difference between leverage ratios and liquidity ratios. and also between efficiency ratios and profitability ratios. Give one or two examples of each type.

S. Defining Ratios. There are no universally accepted definitions of financial ratios. but some of the following ratios make no sense at all. Substitute correct definitions.

1 on g - term debt

a. Debt-equity ratio = ---'"-----long-term debt + equity

EBIT - tax b. Return all equity =

average equity

. net l11COllle + interest

c. Profit margin = sales

total assets

d. Inventory turnover == ----,---average inventory

current liabilities e. Current rati o e ------current assets

f II" I sales

'. Average eo ection penoe == . bl 1"6-

~ average recerva esi» j

o Q . k ". . _ cash + marketable securities + receivables

00' L1lC ratio - current liabilities

9. Current Liabilities. Suppose that at year-end Pepsi had unused lines of credit which would have allowed it to borrow a further $300 million. Suppose also that it used this line of credit [0 borrow $300 million and invested the proceeds in marketable securities, Wou.d the company have appeared to be (a) more or less liquid, (b) more or less highly leveraged? Calculate the ape propriate ratios.

10. Current Ratio. How would the following actions affect a firm's current ratio?

a. Inventory is sold at cost.

b. The firm takes out a bank loan to pay its accounts due.

480

Par! Six Financial Analysis and Planning

14. EVA. Suppose Permafrost were not a public finn. but a division of a much larger. diversified corporation, There are "pure play" public companies competing in Pennafrosts business, how_ . ever. How could the CFO of Permafrost's parent corporation go about estimating the division\ market value added and EVA? How could the CFO use these estimates? Discuss and explain.

el

25. Financial Statements. As you can see, someone has spilled ink over some of the entries in the balance sheet and income statement of Transylvania Railroad. Can you lise the following information to work out the missing entries:

Please visit us at www.mhhe.cnm/bmm5e or refer to your Student CD

Long-term debt ratio Times interest earned Current ratio

Quick ratio

Cash ratio

Return on assets

Return on equity Inventory turnover Average collection period

4
8.0
14
1.0
.2
18%
41%
5.0
71.2 days I INCOME STATEMENT

~ (figures in millions of dollars)

I ~et sales U~

I Cost of goods sold e e e

Selling, general, and administrative expenses 10

Depreciation 20

Earnings before Interest and taxes (EBIT) •••

Interest expense 00.

Income before tax e e e

Tax .~.

Net income e e e

BALANCE SHEET (figures in millions of dollars)

~~-~~----------------~-----------------------------------~

This Year

Last Year

1--.
Assets
Cash and marketable securities ••• 20
Receivables ... 34
Inventories ~ .. 26
Total current assets ••• 80
Net property, plant, and equipment ••• 25
Tot21 assets GoI'H' 105
Liabilities and shareholders equity
Accounts payable 25 20
['-Jotes payable 30 35
Total current liabilities ••• 55
Long-term debt .. ~ 20
Shareholders' equity •• & 30
Total liabilities and shareholders' equity 115 105 482

Pert Six Fincmciol Analysis and :::>Ionning

Mr. Green decided to start with the 6~year summary of HH's balance sheet and income statement (Table 17-141. Then he turned to examine ill more detail the latest position (Tables 17-15 and 17-16).

TABLE 17-14 Financial highlights for The Hobby Horse Company, Inc., year ending March 31

TABLE 17-15

What appear to be the problem areas in HH? Do the financial ratios suggest questions that Ms. Platt and Mr. Green need to address?

.... 2006 2005 .. 2004 2003 2002 2PQ1A
Net sales 3,351 3,314 2,845 2.796 2,493 2,160
EBIT -9 312 256 243 212 156
Interest 37 63 65 58 48 46
Taxes 3 60 46 43 39 34
Net profit --49 189 145 142 125 76
Earnings per share -0.15 0.55 0.44 0.42 0.37 0.25
Current assets 669 469 491 435 392 423
Net fixed assets 923 780 753 680 610 536
Total assets 1,592 1,249 1,244 1,115 1,002 959 i
Current liabilities 680 365 348 302 276 320
l.onq-term debt 236 159 297 311 319 315
Stockholders' equity 676 725 599 502 407 324
Number of stores 240 221 211 184 170 157
Employees 13,057 11,835 9,810 9,790 9,075 7,825 INCOME STATEMENT FOR

THE HOBBY HORSE COMPANY, INC., FOR YEAR END1NG MARCH 31, 2006

(all items in millions of dollars)

Net sales 3,351

Cost of goods sold 1,990

Selling, general, and administrative expenses 1,211

Depreciation expense 159

Earnings before interest and taxes (EBIT) -9

Net interest expense 37

Taxable income -46

Income taxes 3

Net income -49

Allocation of net income

Addition to retained eamings Dividends

-49 o

Note: Column sums subject to rounciing error.