Chapter 4 Learning Objectives 1 Calculate and interpret the market value and market value added of a public corporation. 2 Calculate and interpret key measures of financial performance, including economic value added (EVA) and rates of return on capital, assets, and equity. 3 Calculate and interpret key measures of operating efficiency, leverage, and liquidity. 4 Show how profitability depends on the efficient use of assets and on profits as a fraction of sales. 5 Understand how a company’s sustainable growth depends on both its payout policy and its return to equity. 6 Compare a company’s financial standing with its competitors and its own position in previous years.

Corporate Performance Calculations: Financial Ratios Underlying Data: Corporate Financials & Market Values Chapter 4 Outline Corporate Performance Measured Market Value Added Economic Value Added Book Rates of Return: Return on Capital, Return on Assets, Return on Equity Financial Ratios Assessing the Investment Decisions: Measuring Efficiency, Measuring Profitability Assessing the Financing Decisions: Measuring Leverage, Measuring Liquidity The Du Pont System Calculating Sustainable Growth The Role of Financial Ratios and Transparency Basic idea of this chapter: The financials (balance sheet, income statement) and market values act as the foundation. Financial ratios are the building block that help diagnose corporate performance. 2 2 2 3 2 2

Corporate Performance Measured Market Value Add Book Rates of Return Economic Value Add Three Primary Ways to Measure Corporate Performance: Market Value Add: Market capitalization minus book value of equity. Economic Value Add: Operating income minus a charge for the cost of capital employed. Also called residual income. Book Rates of Return: Measure the firm’s profits per dollar of assets. Also known as accounting rates of return because they are based on accounting information (specifically company financials). Three common measures are the return on capital (ROC), the return on equity (ROE), and the return on assets (ROA).

Market Value Added What is it? Why is it useful? Defined: Definitions: Market Capitalization —Total market value of equity, equal to share price times the number of shares outstanding Market Value Added —Market Capitalization – Book Value of Equity

Consider AT&T and Home Depot MVA: Discussion TABLE 4.3 Market Capitalization = Total market value of equity, equal to share price times the number of shares outstanding Market Value Added = Market Capitalization – Book Value of Equity (i.e. does the market believe the firm’s value exceeds its book value) Market-to-Book Ratio = (Market Value of Equity)/(Book Value of Equity) Limitations of MVA: 1. Market value reflects investors’ expectations about future performance, complete with the imprecisions that come with all forecasting. 2. Market value fluctuates frequently due to reasons outside of the financial managers control. 3. Privately owned corporations do not have a public market value. Consider AT&T and Home Depot Similar MVA, Different Market-to-Book Ratio Why?

Why is it called residual income? Economic Value Added What is it? Why is it important? Why is it called residual income? Economic Value Added = Operating Income minus the product of cost of capital and total capitalization Operating Income = Net Income + After-tax Interest Cost of Capital = The minimum acceptable rate of return on capital investment Total Capitalization = Total Long-term Capital = Equity + Bonds + other Long-term capital [all capital committed by debt and equity investors] Defined:

Consider Coca-Cola and Google EVA: Discussion TABLE 4.4 Economic Value Added = Operating Income minus the product of cost of capital and total capitalization Operating Income = Net Income + After-tax Interest Cost of Capital = The minimum acceptable rate of return on capital investment Total Capitalization = Total long-term capital = Equity + Bonds + Other Long-term Capital [all capital committed by debt and equity investors] Return on Capital = (Operating Income)/(Total Capitalization) Consider Coca-Cola and Google Similar EVA, Different Return on Capital Why? * Operating Income = Net Income + After-tax Interest; ROC = Return on Capital

Book Rates of Return* What do they measure? Return on Capital: Return on Assets: Book Rates of Return = Accounting Rates of Return = Measures of the firm’s profits per dollar of assets. Return on Capital = (after-tax operating income)/(total capitalization) Return on Assets = (after-tax operating income)/(average total assets) or = (after-tax operating income)/(start of year total assets) Return on Equity = (net income)/(average equity) or = (net income)/(start of year equity) Average Assets = (end of period assets + beginning of period assets)/2 Average Equity = (end of period equity + beginning of period equity)/2 Return on Equity: *Book Rates of Return are also referred to as Accounting rates of Return

Calculating Return on Capital Lowe’s Return on Capital Return on Capital = Net income plus after tax interest (this sum is known as operating income) as a percentage of long-term capital (known as total capitalization) Average Total Capitalization = The average of the beginning and end of year value of equity and long-term debt Lowe’s Balance Sheet (in $m)

Calculating Return on Assets Lowe’s Return on Assets Lowe’s Balance Sheet (in $m) Return on Assets = Net income plus after-tax interest (this sum is known as operating income) as a percentage of (average) total assets

Calculating Return on Equity Lowe’s Return on Equity Lowe’s Balance Sheet (in $m) Return on Equity = Net income as a percentage of average total equity

Financial Ratios and Shareholder Value Investment Decisions Efficiency Ratios Profitability Ratios Financing Decisions Leverage Ratios Liquidity Ratios Shareholder value depends on good investment and financing decisions. Financial Ratios help measure the success and soundness of these decisions. Investment Decision – The allocation of limited resources among competing opportunities (projects) through the capital budgeting process. Financing Decision — The form and amount of financing of a firm’s investments. 2 2 2 3 2 2

Efficiency Ratios OR* How does this ratio measure efficiency? Efficiency Ratios – Ratios which measure how efficiently a firm uses its assets. How does this ratio measure efficiency? * Either equation is a legitimate way to calculate the asset turnover ratio 7

Efficiency Ratios How does this ratio measure efficiency? Efficiency Ratios – Ratios which measure how efficiently a firm uses its assets. How does this ratio measure efficiency? 7

Calculating an Efficiency Ratio Lowe’s Balance Sheet (in $m) Lowe’s Asset Turnover Ratio

Profitability Ratios How does this ratio measure the firm’s profitability? Profitability Ratio — Measures the profits generated from sales. Note: ROC, ROA, ROA and EVA are also typically considered profitability ratios. When is this ratio potentially more useful than just profit margin? Note: ROC, ROA, ROE and EVA are also typically considered profitability ratios. 3

Calculating a Profitability Ratio Lowe’s Balance Sheet (in $m) Lowe’s Operating Profit Margin

Leverage Ratios How does this ratio measure leverage? Leverage Ratios – Measures the extent to which a firm is funded by debt How does this ratio measure leverage? 3

Measuring Leverage How does this ratio measure leverage? 4

Calculating a Leverage Ratio Lowe’s Balance Sheet (in $m) Lowe’s Times Interest Earned Ratio Note: COGS stands for Cost of Goods Sold. Expenses include selling, general and administrative costs (and “store operating costs” in this example).

Measuring Liquidity How does this ratio measure liquidity? Liquidity Ratios– Ratios which measure the extent to which the firm has sufficient liquidity in the coming year. Net Working Capital = Current Assets – Current Liabilities How does this ratio measure liquidity? 5

Liquidity Ratios How does this ratio differ form the current ratio? Why might a financial manager prefer it? The Quick Ratio is sometimes referred to as the Acid-Test Ratio How does this ratio differ from the current ratio? Why might a financial manager prefer it? 6

Calculating a Liquidity Ratio Lowe’s Balance Sheet (in $m) Lowe’s NWC to Total Assets Ratio

The DuPont System What is it, and what is it used for? DuPont System: A breakdown of ROE and ROA into component ratios 13

The DuPont System: ROA Asset Turnover Operating Profit Margin 15

ROA Decomposition by Industry Discussion: For a given level of ROA, which firms have returns driven by turnover? By margin?

The DuPont System: ROE Leverage Ratio Debt Operating Burden Profit The last ratio in the DuPont breakdown of ROE is a measure of the firm’s debt burden. The denominator represents free cash flow (Cash available for distribution to investors after the company has paid for any new capital investment or additions to working capital.). If the ratio is close to zero, the firm has a heavy debt burden—much of its free cash flow goes to interest payments. Operating Profit Margin Asset Turnover 17

Sustainable Growth Definitions: Growth in Equity from Plowback = Sustainable Growth = Growth that relies only on internal financing, keeping the long-term debt ratio constant. Plowback Ratio + Payout Ratio = 1 (always) Payout Ratio– The percent of each dollar earned that is paid to shareholders. Plowback Ratio– The percent of each dollar earned that is retained by the corporation. 10

The Role of Financial Ratios Table 4.8 Comparability Discussion: after we have made all of these calculations, how do we know if the results are good or bad? Financial ratios can be used for: 1. Self comparison (or trend analysis)-- is the company improving over its past performance? 2. Peer group comparison -- how is the company doing compared to peer companies? (in this case, Home Depot vs. Lowe’s) 3. Best practice -- how does the company compare to "best of breed" companies regardless of industry? The most important role that ratio analysis plays is diagnostic. Ratio analysis points out areas of strengths and weaknesses in corporate performance. When an organization has an intense understanding of the operating processes that contribute to financial statement numbers, corrective action can be identified and hopefully implemented in a fairly short time frame. This is much like the medical doctor interpreting the results from a series of lab reports and recommending a course of action to correct the medical problem. Notes: Discrepancies between calculations here and in previous slides are from rounding. Some measures can be calculated using average values or year beginning values.

The Role of Financial Ratios TRANSPARENCY

Appendix A: Average Ratios, by Industry Table 4.7

Appendix B: Financial Ratios and Default Risk Table 4.9