SRT510 Business Case Studies Evaluating Financial Performance: Ratios

Evaluating Financial Performance Return on Equity  3 levers of performance Quick and Current Ratios Problems  Timing, Risk, Value

Return on Equity Measure of how efficiently a company uses owner’s capital % return to owners on their investment “bang per buck” Net income / Shareholder’s Equity

Three Determinants of ROE ROE = (net income/sales) * (sales/assets) * (assets/SE) profit margin * asset turnover * financial leverage

Three Determinants of ROE Profit margin: earnings squeezed out of each $ of sale Asset turnover: sales generated from each $ of assets employed Financial leverage: the amount of equity used to finance the assets

ROE and Performance Unusually high ROE from company A attracts rivals anxious to emulate the good performance which drives A’s ROE back toward the average Unusually low ROE from company B repels potential competitors, drives B (and others?) out of business so that survivor ROEs rise toward the average.

TABLE 2-1 ROEs and Levers of Performance for 10 Diverse Companies, 2004

Profit Margin (net income/sales) Reflects company’s pricing strategy and ability to control costs. Varies greatly from industry to industry Companies with high (low) profit margins tend to have low (high) asset turns  Why? Companies with low profit margins and low asset turns are….bankrupt!

Asset Turnover (sales/assets) Measures the sales generated per dollar of assets Assets are simply a means to an end…they are used up to generate income Asset turnover is dependent on business type  Why?

Asset Turnover (sales/assets) Reflects control over assets—often the margin between success and failure  E.g. DELL (from 1.6 to 2.1 from 1991 to 2004) Control over current assets is especially critical (e.g. A/R, inventory)  Even modest changes can affect finances Change in each asset tells a story

Financial Leverage (assets/SE) Increases when  proportion of debt relative to equity used to finance the business increases “more is not necessarily better”  need to strike a balance between the benefits and costs of debt financing  Highly stable & predictable operating cash flows can undertake more financial leverage

Current Ratio Current ratio = current assets/current liabilities Compares the assets that will turn into cash within the year to the liabilities that must be paid within the year. Low current ratio => don’t have enough liquidity in assets to pay off upcoming debts

Quick Ratio (=acid test) Quick ratio = (current assets-inventory)/current liabilities Identical to current ratio without inventory because inventory is often not liquid.

TABLE 2-2 Ratio Analysis of Harley-Davidson, Inc , and Industry Medians, 2004

TABLE 2-2 (Continued)

TABLE 2-4 Selected Ratios for Representative Industries, 2003 (upper-quartile, median and lower-quartile values)

TABLE 2-4 (Continued)

TABLE 2-4 (Concluded)

Problems With ROE Timing  Backward looking  1 year  Decrease does not necessarily indicate a problem

Problems With ROE Risk  “eat well, sleep well”  ROE looks only at return while ignoring risk; therefore it is not always an accurate measure of performance

Problems With ROE Value  ROE uses book value, not market value It may not be synonymous with a high return on investment to shareholders

Using Ratios Trend analysis—calculate ratios over several years and see how they change. User ROE and its three components; narrow your focus to more specific ratios as required.