Chapter 4: Measuring Corporate Performance
Chapter 4: Measuring Corporate Performance FINE 2000 Measuring Market Value and Market Value Added
Market capitalization: Total market value of equity, equal to share price times number of shares outstanding The book value of equity is the sum of the funds invested by shareholders when they purchase shares plus earnings reinvested by the company on behalf of the shareholders. Market value added: market capitalization minus book value of equity o The difference between the market value of the firm’s shares, and the amount of money that shareholders have invested in the firm Market to book ratio: ratio of market value to book value of equity o How much value has been added for each dollar that shareholders have invested Drawbacks of market value added and Market to Book Ratio: o Market value of the company’s shares reflects investor’s expectations about future performance o Market values fluctuate because of many risks and events that are outside the financial manager’s control o You can’t look up the market value of privately owned companies whose shares are not publicly traded
Economic Value Added and Accounting Rates of Return
to see whether the firm has truly created value, need to measure whether it has earned a profit after deducting all costs, including the cost of capital cost of capital: minimum acceptable rate of return on capital investment 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 only if it can earn more than its cost of capital (more than its investors can earn by investing on their own) economic value added: operating profit minus charges for the cost of capital employed (residual income) o take into account all of the capital contributed by investors in the corporation o total capitalization: sum of the firm’s debt and shareholder’s equity o deferred tax liabilities are not actual taxes payable but are from income tax expenses on the SCI, they reduce equity but aren’t payable (quasi equity) EVA: Net Income + after tax net finance expense – (cost of capital x total capitalization) o EVA = NOPAT – (Cost of Capital x total capitalization) Net operating profit after tax (NOPAT) The after tax profits from operations, as if the firm had no debt. Equals net income (or net earnings or profit) plus after tax net finance (or interest) expense o NOPAT is what the company would earn if it were all equity financed Variation in cost of capital is due to differences in business risk Relatively safe companies have low cost of capital, riskier companies have high costs of capital EVA makes the cost of capital visible to managers Evaluating performance by EVA pushes managers to flush out and dispose of underutilized assets
Accounting Rates of Return
Measures the firm’s profits per dollar of assets ROC, ROE, ROA book rates of return Return on Capital
Chapter 4: Measuring Corporate Performance FINE 2000
The return that shareholders are giving up by keeping their money in the company is the cost of equity If the company earns more that the cost of capital, it makes its shareholders better off; it is earning a higher return than they could obtain for themselves If it earns less than the cost of capital, it makes its investors worse off they could earn a higher return simply by investing on their own in financial markets Shareholders want the company to invest in projects for which the return on capital is at least as great as the cost of capital
Return on Assets
Measures the income available to debt and equity investors per dollar of the firm’s total assets ROA: net operating profit after taxes (NOPAT) as a percentage of total assets Some financial analysts take no account for interest payments and measure ROA as net income for shareholders divided by total assets – however this calculation ignores entirely the income the firm’s assets generates for debt investors
Return on Equity
Income to shareholders per dollar that they have invested ROE: Net Income as a percentage of shareholder’s equity Can be calculated using: o Shareholder’s income can be: “profit” (net income) Total comprehensive income (sum of profit and other comprehensive income) The inclusion of other comprehensive income slightly increases ROE
Problems with EVS and Accounting Rates of Return
Rates 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 all the other things that move stock prices Also, they can be calculated for an entire company or for a particular plant or division or subsidiary Drawbacks: o Both EVA and accounting rates of return are based on book values for assets, debt and equity o Accountants do not show every asset on the SFP o It is impossible to include the value of all assets or to judge how rapidly they depreciate o SFP doesn’t show the current market value of all of the firm’s assets o Older assets may be grossly undervalued in today’s market conditions
Chapter 4: Measuring Corporate Performance FINE 2000 o
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
Measuring Efficiency
Factors that contribute to the firm’s overall profitability Asset Turnover Ratio
o o o
Shows how much sales are generated by each dollar of total assets, and therefore it measures how hard the firm’s assets are working Like some profitability ratios, the sales to assets ratio compares a flow measure (sales over the entire year) to a snapshot measure (assets on one day) The asset turnover ratio measures how efficiently the business is using its entire asset base
Inventory Turnover
o o
Efficient firms don’t tie up more capital than they need In raw materials and finished goods Another way to express this is to look at how many days of output are represented by inventories
Receivables Turnover o o
o o
Sales that have been recorded on the income statement but have not yet been paid are reported on the balance sheet as trade receivables The receivables turnover ratio measures the firm’s sales as a multiple of its trade receivables
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
Chapter 4: Measuring Corporate Performance FINE 2000 Analyzing the Return on Assets
How profitable sales are
Profit Margin
o o o o o
The profit margin measures the proportion of sales that finds its way into profits When companies are partly financed by debt, a portion of the revenue produced by sales must be paid as interest to the firm’s lenders So profits from the form’s operations are divided between the debt holders and the shareholders 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 income as interest Alternative measure of profit margin:
Du Pont System o
Du Pont Formula: ROA equals the product of the asset turnover and operating profit margin
o o
ROA = Asset Turnover x Operating Profit Margin You would naturally prefer both high operating profit margin and high asset turnover, a high price and high margin strategy will typically result in lower sales per dollar of assets Du Pont formula helps to identify the constraints that firms face
o
Measuring Financial Leverage
Because debt increases return to shareholders in good times and reduces them in bad times, it is said to create financial leverage Leverage ratios measure how much the financial leverage the firm has taken on
Debt Ratio o
Financial leverage is usually measured by the ratio of long term debt to total long term capital
o
For every dollar of long term capital, x% is in the form of debt
o o
The debt to equity ratio climbs dramatically for highly leveraged companies Firms acquired in leveraged buyouts (LBO) usually issue large amounts of debt
Chapter 4: Measuring Corporate Performance FINE 2000 o o o o
Debt ratios make use of book (accounting) values rather than market values In principle, lenders should be more interested in the market value of the company, which reflects the actual value of the company’s assets and the actual cash flows those assets will produce If the market value of the company covers its debts, lenders should get their money back These measures of leverage ignore short term debt, such as bank borrowing
o
Another measure of leverage includes all liabilities
Time Interest Earned Ratio o o
The extent to which interest obligations are covered by earnings or operating profits Banks prefer to lend to firms with earnings that cover interest payments with room to spare
o
The regular interest payments is a hurdle that the companies must keep jumping if they are to avoid default
Cash Coverage Ratio o
Add back depreciation to EBIT in order to calculate operating cash flow
o o
EBITDA = earnings before interest, depreciation and amortization Many companies use “EBITDA” as a measure of true operating performance removing any effect of depreciation and amortization based on accounting methods and assumptions rather than actual performance
EBITDA
Leverage and Return on Equity
when the firm raises cash by borrowing, it must make interest payments to its lenders this reduces net profits if the firm borrows instead of issuing equity, it has fewer equity holders to share remaining profits extended version of Du Pont:
o
the product of the two middle terms, is the return on assets which depends on the firm’s production and marketing skills and is unaffected by the firm’s financial mix
Chapter 4: Measuring Corporate Performance FINE 2000 o o o o o o
the first and fourth terms do depend on the debt-equity mix the first term assets/equity which is called the leverage ratio, can be expressed as (equity + liabilities)/equity which equals to 1+total debt to equity ratio the last term which is called the debt burden measures the proportion by which interest expense reduces profits suppose that the firm is entire financed 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 profits is absorbed by interest) thus leverage can either increase or reduce return on equity
Measuring 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 liquid assets can be converted into cash quickly and cheaply companies own assets with different degrees of liquidity managers have another reason to focus on liquid assets: their book (SFP) values are usually reliable liquidity ratios have less desirable characteristics: o current assets and liabilities are easily changed, measures of liquidity can rapidly become outdated o assets that seem liquid sometimes have a nasty habit of becoming illiquid o more liquidity is not always a good thing: indicate sloppy use of capital Net Working Capital to Total Assets Ratio o
the difference between the current assets and current liabilities is known as net working capital and it roughly measures the company’s potential net reservoir of cash
Current Ratio o o
ratio of current assets to current liabilities changes in current ratio can be misleading o a company borrows a large sum from the bank and invests in marketable securities – current liabilities rise but so do current assets. If nothing else changes, net working capital is unaffected but the current ratio changes o therefore, it is preferable to net short term investments against short term debt
Quick (Acid Test) Ratio o
managers often exclude inventories and other less liquid components of current assets when comparing current assets to current liabilities
Chapter 4: Measuring Corporate Performance FINE 2000
Cash Ratio o
a low cash ratio might not matter is the firm can borrow on short notice
Calculating Sustainable Growth Rate o o
financial managers and analysts are interested in knowing how fast the firm can grow if it relies only on internal financing, keeping the long term debt ratio constant the earnings paid out as dividends:
o
the remaining earnings are reinvested and “plowed back into” the business and added to the firm’s equity capital
o
sustainable growth rate: the firm’s growth rate if it plows back a constant fraction of earnings, maintains constant return on equity, and keeps its debt ratio constant
o o
assumes that the firm’s long term debt ratio is held constant over time firms selling products at an early stage of their life tend to have high sustainable growth rates o competition in these new markets is scarce, return on equity Is high, and with ample opportunity for profitable investment o as ROE and plowback both decline, growth must also slow
Interpreting Financial Ratios
large variations between industries I.e. high debt ratios of capital goods manufacturers Some businesses are able to generate a high level of sales from relatively few assets Competition ensures that retailers earn a correspondingly lower margin on sales although they have high asset turn over ratios When looking for benchmarks to evaluation performance, it usually makes sense to limit the comparison to the firm’s major competition In addition, it can also be helpful to look at ratios over time
Chapter 4: Measuring Corporate Performance FINE 2000
When looking at ratio history, it is important to look for major changes such as acquisitions or restructuring
The Role of Financial Ratios & Transparency Transparency
When the assumptions that accountants are following IFRS and not endorsing misleading numbers are correct, we say that the firm is “transparent” One big difference between IFRS and US GAAP and former Canadian GAAP is that IFRS requires more detailed disclosure of all changes in asset and liabilities Enron demonstrated the importance of transparency – if it had been more transparent – it’s problems would’ve shown up right away A major goal of the Sarbanes-Oxley Act Is to increase transparency and ensure that companies and their accountants provide directors, lenders and shareholders with the information they need to monitor progress
Market capitalization: Total market value of equity, equal to share price times number of shares outstanding The book value of equity is the sum of the funds invested by shareholders when they purchase shares plus earnings reinvested by the company on behalf of the shareholders. Market value added: market capitalization minus book value of equity o The difference between the market value of the firm’s shares, and the amount of money that shareholders have invested in the firm Market to book ratio: ratio of market value to book value of equity o How much value has been added for each dollar that shareholders have invested Drawbacks of market value added and Market to Book Ratio: o Market value of the company’s shares reflects investor’s expectations about future performance o Market values fluctuate because of many risks and events that are outside the financial manager’s control o You can’t look up the market value of privately owned companies whose shares are not publicly traded
Economic Value Added and Accounting Rates of Return
to see whether the firm has truly created value, need to measure whether it has earned a profit after deducting all costs, including the cost of capital cost of capital: minimum acceptable rate of return on capital investment 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 only if it can earn more than its cost of capital (more than its investors can earn by investing on their own) economic value added: operating profit minus charges for the cost of capital employed (residual income) o take into account all of the capital contributed by investors in the corporation o total capitalization: sum of the firm’s debt and shareholder’s equity o deferred tax liabilities are not actual taxes payable but are from income tax expenses on the SCI, they reduce equity but aren’t payable (quasi equity) EVA: Net Income + after tax net finance expense – (cost of capital x total capitalization) o EVA = NOPAT – (Cost of Capital x total capitalization) Net operating profit after tax (NOPAT) The after tax profits from operations, as if the firm had no debt. Equals net income (or net earnings or profit) plus after tax net finance (or interest) expense o NOPAT is what the company would earn if it were all equity financed Variation in cost of capital is due to differences in business risk Relatively safe companies have low cost of capital, riskier companies have high costs of capital EVA makes the cost of capital visible to managers Evaluating performance by EVA pushes managers to flush out and dispose of underutilized assets
Accounting Rates of Return
Measures the firm’s profits per dollar of assets ROC, ROE, ROA book rates of return Return on Capital
Chapter 4: Measuring Corporate Performance FINE 2000
The return that shareholders are giving up by keeping their money in the company is the cost of equity If the company earns more that the cost of capital, it makes its shareholders better off; it is earning a higher return than they could obtain for themselves If it earns less than the cost of capital, it makes its investors worse off they could earn a higher return simply by investing on their own in financial markets Shareholders want the company to invest in projects for which the return on capital is at least as great as the cost of capital
Return on Assets
Measures the income available to debt and equity investors per dollar of the firm’s total assets ROA: net operating profit after taxes (NOPAT) as a percentage of total assets Some financial analysts take no account for interest payments and measure ROA as net income for shareholders divided by total assets – however this calculation ignores entirely the income the firm’s assets generates for debt investors
Return on Equity
Income to shareholders per dollar that they have invested ROE: Net Income as a percentage of shareholder’s equity Can be calculated using: o Shareholder’s income can be: “profit” (net income) Total comprehensive income (sum of profit and other comprehensive income) The inclusion of other comprehensive income slightly increases ROE
Problems with EVS and Accounting Rates of Return
Rates 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 all the other things that move stock prices Also, they can be calculated for an entire company or for a particular plant or division or subsidiary Drawbacks: o Both EVA and accounting rates of return are based on book values for assets, debt and equity o Accountants do not show every asset on the SFP o It is impossible to include the value of all assets or to judge how rapidly they depreciate o SFP doesn’t show the current market value of all of the firm’s assets o Older assets may be grossly undervalued in today’s market conditions
Chapter 4: Measuring Corporate Performance FINE 2000 o
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
Measuring Efficiency
Factors that contribute to the firm’s overall profitability Asset Turnover Ratio
o o o
Shows how much sales are generated by each dollar of total assets, and therefore it measures how hard the firm’s assets are working Like some profitability ratios, the sales to assets ratio compares a flow measure (sales over the entire year) to a snapshot measure (assets on one day) The asset turnover ratio measures how efficiently the business is using its entire asset base
Inventory Turnover
o o
Efficient firms don’t tie up more capital than they need In raw materials and finished goods Another way to express this is to look at how many days of output are represented by inventories
Receivables Turnover o o
o o
Sales that have been recorded on the income statement but have not yet been paid are reported on the balance sheet as trade receivables The receivables turnover ratio measures the firm’s sales as a multiple of its trade receivables
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
Chapter 4: Measuring Corporate Performance FINE 2000 Analyzing the Return on Assets
How profitable sales are
Profit Margin
o o o o o
The profit margin measures the proportion of sales that finds its way into profits When companies are partly financed by debt, a portion of the revenue produced by sales must be paid as interest to the firm’s lenders So profits from the form’s operations are divided between the debt holders and the shareholders 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 income as interest Alternative measure of profit margin:
Du Pont System o
Du Pont Formula: ROA equals the product of the asset turnover and operating profit margin
o o
ROA = Asset Turnover x Operating Profit Margin You would naturally prefer both high operating profit margin and high asset turnover, a high price and high margin strategy will typically result in lower sales per dollar of assets Du Pont formula helps to identify the constraints that firms face
o
Measuring Financial Leverage
Because debt increases return to shareholders in good times and reduces them in bad times, it is said to create financial leverage Leverage ratios measure how much the financial leverage the firm has taken on
Debt Ratio o
Financial leverage is usually measured by the ratio of long term debt to total long term capital
o
For every dollar of long term capital, x% is in the form of debt
o o
The debt to equity ratio climbs dramatically for highly leveraged companies Firms acquired in leveraged buyouts (LBO) usually issue large amounts of debt
Chapter 4: Measuring Corporate Performance FINE 2000 o o o o
Debt ratios make use of book (accounting) values rather than market values In principle, lenders should be more interested in the market value of the company, which reflects the actual value of the company’s assets and the actual cash flows those assets will produce If the market value of the company covers its debts, lenders should get their money back These measures of leverage ignore short term debt, such as bank borrowing
o
Another measure of leverage includes all liabilities
Time Interest Earned Ratio o o
The extent to which interest obligations are covered by earnings or operating profits Banks prefer to lend to firms with earnings that cover interest payments with room to spare
o
The regular interest payments is a hurdle that the companies must keep jumping if they are to avoid default
Cash Coverage Ratio o
Add back depreciation to EBIT in order to calculate operating cash flow
o o
EBITDA = earnings before interest, depreciation and amortization Many companies use “EBITDA” as a measure of true operating performance removing any effect of depreciation and amortization based on accounting methods and assumptions rather than actual performance
EBITDA
Leverage and Return on Equity
when the firm raises cash by borrowing, it must make interest payments to its lenders this reduces net profits if the firm borrows instead of issuing equity, it has fewer equity holders to share remaining profits extended version of Du Pont:
o
the product of the two middle terms, is the return on assets which depends on the firm’s production and marketing skills and is unaffected by the firm’s financial mix
Chapter 4: Measuring Corporate Performance FINE 2000 o o o o o o
the first and fourth terms do depend on the debt-equity mix the first term assets/equity which is called the leverage ratio, can be expressed as (equity + liabilities)/equity which equals to 1+total debt to equity ratio the last term which is called the debt burden measures the proportion by which interest expense reduces profits suppose that the firm is entire financed 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 profits is absorbed by interest) thus leverage can either increase or reduce return on equity
Measuring 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 liquid assets can be converted into cash quickly and cheaply companies own assets with different degrees of liquidity managers have another reason to focus on liquid assets: their book (SFP) values are usually reliable liquidity ratios have less desirable characteristics: o current assets and liabilities are easily changed, measures of liquidity can rapidly become outdated o assets that seem liquid sometimes have a nasty habit of becoming illiquid o more liquidity is not always a good thing: indicate sloppy use of capital Net Working Capital to Total Assets Ratio o
the difference between the current assets and current liabilities is known as net working capital and it roughly measures the company’s potential net reservoir of cash
Current Ratio o o
ratio of current assets to current liabilities changes in current ratio can be misleading o a company borrows a large sum from the bank and invests in marketable securities – current liabilities rise but so do current assets. If nothing else changes, net working capital is unaffected but the current ratio changes o therefore, it is preferable to net short term investments against short term debt
Quick (Acid Test) Ratio o
managers often exclude inventories and other less liquid components of current assets when comparing current assets to current liabilities
Chapter 4: Measuring Corporate Performance FINE 2000
Cash Ratio o
a low cash ratio might not matter is the firm can borrow on short notice
Calculating Sustainable Growth Rate o o
financial managers and analysts are interested in knowing how fast the firm can grow if it relies only on internal financing, keeping the long term debt ratio constant the earnings paid out as dividends:
o
the remaining earnings are reinvested and “plowed back into” the business and added to the firm’s equity capital
o
sustainable growth rate: the firm’s growth rate if it plows back a constant fraction of earnings, maintains constant return on equity, and keeps its debt ratio constant
o o
assumes that the firm’s long term debt ratio is held constant over time firms selling products at an early stage of their life tend to have high sustainable growth rates o competition in these new markets is scarce, return on equity Is high, and with ample opportunity for profitable investment o as ROE and plowback both decline, growth must also slow
Interpreting Financial Ratios
large variations between industries I.e. high debt ratios of capital goods manufacturers Some businesses are able to generate a high level of sales from relatively few assets Competition ensures that retailers earn a correspondingly lower margin on sales although they have high asset turn over ratios When looking for benchmarks to evaluation performance, it usually makes sense to limit the comparison to the firm’s major competition In addition, it can also be helpful to look at ratios over time
Chapter 4: Measuring Corporate Performance FINE 2000
When looking at ratio history, it is important to look for major changes such as acquisitions or restructuring
The Role of Financial Ratios & Transparency Transparency
When the assumptions that accountants are following IFRS and not endorsing misleading numbers are correct, we say that the firm is “transparent” One big difference between IFRS and US GAAP and former Canadian GAAP is that IFRS requires more detailed disclosure of all changes in asset and liabilities Enron demonstrated the importance of transparency – if it had been more transparent – it’s problems would’ve shown up right away A major goal of the Sarbanes-Oxley Act Is to increase transparency and ensure that companies and their accountants provide directors, lenders and shareholders with the information they need to monitor progress
