Transcript Evaluating Financial Performance Finance Jaime F. Zender Note: Because I have found no better presentation of this material, this closely follows the discussion in.

Evaluating Financial Performance
Finance
Jaime F. Zender
Note: Because I have found no better presentation of this material, this closely
follows the discussion in the Higgins book.
Financial Performance
• One of the most fundamental facts about
•
•
businesses is that the operating performance of
the firm shapes its financial structure.
It is also true that the financial situation of the
firm can also determine its operating
performance.
The financial statements are therefore important
diagnostic tools for the informed manager.
– To keep the discussion grounded, we will use the
1997-98 financial statement for the Timberland
Company as illustrations.
The Timberland Company, Balance Sheets ($ millions)
12/31/1997
Assets
Cash and marketable securities
98.8
Accounts receivable
75.8
Inventories
142.6
Prepaid expenses and other current assets
24.9
Total current assets
342.1
Property, plant, and equipment
116.5
Less accumulated depreciation and amortization
(63.6)
Net property, plant, and equipment
52.9
Intangible assets
20.9
Other assets
4.2
Total assets
$420.1
Liabilities and Shareholders' Equity
Accounts Payable
Wages payable
Income taxes payable
Other accrued expenses
Total current liabilities
Long-term debt
Deferred income taxes
Total liabilities
Common stock
Additional paid-in capital
Retained earnings
Less treasury stock
Total shareholders' equity
Total liabilities and shareholders' equity
20.4
28.2
17.7
32.8
99.1
100.0
6.0
205.1
0.1
68.6
146.3
(0.1)
214.9
$420.1
12/31/1998
Change
151.9
79.0
131.2
25.4
387.5
131.2
(74.3)
56.9
19.2
5.8
$469.4
53.1
3.2
(11.4)
0.5
25.9
22.1
18.2
29.5
95.7
100.0
7.5
203.2
0.1
74.7
207.7
(16.3)
266.2
469.4
5.5
(6.1)
0.5
(3.3)
14.7
(10.7)
4.0
(1.7)
1.6
-1.5
51.3
The Timberland Company, Income Statements ($ millions)
12/31/1997
12/31/1998
Net sales
Cost of sales
Gross profit
Selling expenses
General and administrative expenses
Depreciation and amortization
Amortization of goodwill
Total operating expenses
Operating income
Interest expense
Other expense (income)
Total nonoperating expenses
Income before income taxes
Provision for income taxes
Net income
796.5
464.2
332.3
174.7
51.7
20.3
1.7
248.4
83.9
14.8
1.4
16.2
67.7
20.3
$47.4
862.2
501.1
361.1
195.7
50.9
18.2
1.7
266.5
94.6
9.5
(1.9)
7.6
87.0
27.8
$59.2
The Timberland Company, Statement of Cash Flow, 1998 ($ millions)
Cash Flows from Operating Activities
Net income
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation and amortization
Loss on disposal of property, plant, and equipment
Changes in current assets and liabilities
Increase in accounts receivable
Decrease in inventories
Decrease in prepaid expenses
Increase in accounts payable
Increase in accrued expenses
Increase in accrued income taxes
Net cash provided by operating activities
59.2
18.2
1.3
-2.8
11.6
1.1
5.1
-10
0.5
84.2
Cash Flows from Investing Activities
Proceeds from sale of property, plant, and equipment
Additions to property, plant, and equipment
Other
Net cash provided by investing activities
0.1
-20.7
-1.2
-21.8
Cash Flows from Financing Activities
Common stock repurchases
Issuance of common stock, including tax benefit
Net cash provided by financing activities
-16.2
6.1
-10.1
Effect of exchange rate changes on cash
Net increase in cash
Cash at beginning of year
Cash at end of year
0.9
53.2
98.8
$152.0
Return On Equity
• The most popular measure of financial
•
performance (for many audiences) is ROE.
ROE measures accounting earnings for a period
per dollar of shareholders’ equity invested.
Net Incom e
ROE 
Shareholders ' Equity
• For Timberland 1998 ROE was:
$59.2
ROE 
 22.2%
$266.2
Dissecting ROE
• ROE is so popular because it is, in a sense, a
•
summary of the information on the income
statement and both sides of the balance sheet.
It provides an “accounting” measure of the
“returns” to shareholders’ investment.
The three determinants of ROE:
– Profit Margin = Net Income/Sales
– Asset Turnover = Sales/Assets
– Financial Leverage = Assets/Shareholders’ equity
• ROE comes from the joint inputs of these three
pieces. 22.2% = 6.9% × 1.8 × 1.8
Return on Assets (ROA)
• When we multiply the profit margin times the
•
•
asset turnover we arrive at return on assets.
ROA doesn’t distinguish between capital raised
from shareholders and that raised from
creditors. (ROE considers only equity capital.)
As such ROA measures the “return” on each
dollar invested in assets.
Net income $59.2
Return on Assets 

 12.6%
Assets
$469.4
ROEs and "Levers" of Performance for 10 Diverse Companies, 1998
Return on
Profit
Asset
Equity
Margin
Turnover
(%)
=
(%)
×
(times)
×
BankAmerica Corp
14.6
10.8
0.1
Carolina Power and Light
14.3
12.8
0.4
Exxon Corporation
14.6
6.3
1.1
Food Lion, Inc.
17
2.7
2.8
Harley-Davidson, Inc.
20.7
9.9
1.1
Intel Corporation
24
23.1
0.8
Nike, Inc.
12.9
4.2
1.8
Southwest Airlines Co.
18.1
10.4
0.9
Tiffany & Company
16.9
7.7
1.1
The Timberland Company
22.2
6.9
1.8
Financial
Leverage
(times)
13.5
2.8
2.1
2.3
1.9
1.3
1.7
2
2
1.8
ROE Across Companies
• Generally speaking ROE is reasonably similar
•
•
•
across companies. Why?
One would like to have a company with a high
profit margin and a high asset turnover.
Typically one of these will be relatively high and
one relatively low. Why?
What determines the firm’s choice of financial
leverage?
Now let’s look at each component in isolation.
Profit Margin
• This ratio measures the fraction of each dollar of
sales that makes it through to net income.
– It is of primary importance to an operating officer as
it reflects the company’s pricing strategy and its
ability to control costs.
– Timberland’s profit margin = Net Income/Sales =
$59.2/862.2 = 6.9%
• The “gross margin” measures profitability
relative to variable costs = Gross Profits/Sales
– Gross profit is sales less cost of goods sold.
Timberland’s gross margin is = $361.1/$862.2 =
41.9% indicating that about 42% of each dollar in
sales is available to cover fixed costs and profits.
Asset Turnover
• This ratio measures the sales generated per dollar of
assets employed.
– Measures capital intensity with a low asset turnover indicating a
capital intensive business.
– Nice illustration that more assets is not always better.
– Control of a company’s assets is critical and control of current
assets is especially critical to success.
– Asset turnover = sales/assets = $862.2/$469.4 = 1.8 times
• Analyzing the turnover of each type of asset on a
company’s balance sheet gives rise to what are known
as control ratios.
Control Ratios – Fixed-Asset Turnover
• Fixed-Asset Turnover is perhaps a “purer”
•
•
reflection of the capital intensity of a firm.
Fixed-Asset Turnover = Sales/Net PP&E
= $862.2/$56.9 = 15.2 times
Timberland generates $15.20 in sales for each
dollar of plant, property, and equipment they
invest in.
Control Ratios – Inventory Turnover
• Inventory turnover = COGS/Ending Inventory
= $501.1/$131.2 = 3.8 times
– One might also use average inventory rather than
ending inventory.
• This indicates that items in Timberland’s
•
inventory turn over 3.8 times per year on
average.
Alternatively, 12 months/3.8 times=3.15 months
indicating that the typical item sits in inventory
for just over 3 months.
Control Ratios – Collection Period
• Collection period highlights a company’s
management of its accounts receivable.
Collection Period 
AccountsReceivable
$79.0

 33.4 days
Credit sales per day $862.2 / 365days
• Note that what is desired here is credit sales.
•
Outsiders rarely know this so commonly all sales
are assumed to be for credit.
Timberland’s customers are taking just over a
month to pay their bills. Good or bad?
Control Ratios – Days’ Sales in Cash
Days' Sales in Cash 
Cash and securities
$151.9

 64.3 days
Sales per day
$862.2 / 365days
• Timberland currently has 64.3 days’ worth of
•
•
sales in cash and securities.
Too much or too little?
Question really is how much liquidity does the
firm require for efficient operations. While more
might always seem better, think about the return
the asset “cash” generates for you.
Control Ratios – Payables Period
• This is a control ratio for a liability.
PayablesPeriod 
Accountspayable
$25.9

 18.9 days
Credit purchasesper day $501.1 / 365days
• The proper calculation uses credit purchases which,
again, an outsider rarely knows. Usually COGS is used
as a substitute. COGS differs from credit sales because:
– Firm may be adding or depleting inventory; purchasing at a
different rate than it is selling.
– COGS includes a mark-up for depreciation and labor making
COGS larger than credit purchases so this ratio is, on average,
artificially small.
– Thus it is difficult to compare the 18.9 days to its credit terms.
It is, however, reasonable to compare this to last year’s ratio.
Financial Leverage
Assets
$469.4
FinancialLeverage

 1.8
Shareholders' equity $266.2
• Timberland has $1.80 in assets for every dollar
•
•
that shareholders have invested.
This is a relatively modest amount of leverage
for a manufacturing company.
Other leverage ratios tell us the same thing:
– Debt to assets – 43.3%
– Debt to equity – 76.3%
Coverage Ratios
• Often more informative than the leverage ratios
•
are “coverage ratios.”
These ratios tell us what the firm is earning each
year relative to the burden the debt imposes.
EBIT
$96.5
T imesinterestearned

 10.2 times
InterestExpense $9.5
T imesburden covered
EBIT
$96.5

 10.2 times
 Princialrepayment $9.5  $0.0 /(1  27.8 / 87.0)
Interest 

1  T ax rate


Liquidity Ratios
• A further determinant of a firm’s debt capacity is
•
the liquidity of its assets relative to its liabilities.
The two common ratios used to measure
liquidity are the current ratio and the quick ratio
(also called the “acid test”).
Current assets
$387.5
Current ratio

 4.0 times
Current liabilities $95.7
Quick ratio
Current assets - Inventory $387.5  $131.2

 2.7 times
Current liabilities
$95.7
Limitations of Ratio Analysis
• We have been talking as if management always
wants to increase ROE or as if a high ROE is
always better.
– If company A has a higher ROE than company B is
company A necessarily better?
– If a company increases its ROE is it necessarily
evidence of improved performance?
• There are three critical problems with ROE.
– Often called the timing problem, the value problem,
and the risk problem.
The Timing Problem
• As a decision-maker in a business environment
•
•
you are often encouraged to focus your
attention on the past and particularly on one
period in the past – correct?
Sounds silly, but this is exactly what ROE does.
Clearly last year’s ROE must be taken in context.
– If not it is virtually meaningless.
– If company ROE was lower last year than it was two
years ago the company must be doing worse –
correct?
The Risk Problem
• We talked a lot about how risk and return go
•
•
together. ROE is a “return” like measure so
where is the risk dimension?
This problem alone makes ROE an inaccurate
and possibly misleading indicator of financial
performance.
One has to realize that the risk dimension is
missing and so be particularly wary of making
comparisons across companies using ROE alone.
The Value Problem
• ROE measures a “return” figure but it is based
•
•
•
on two accounting figures.
The numerator is net income and this is not free
cash flow (the cash flow that the company could
payout to its investors).
Secondly, even if net income is close to free cash
flow, ROE is measured relative to book value of
equity not the market value of equity.
It is the market value investors must pay to
purchase a share of the firm’s equity and this is
generally higher than the book value.
Ratio Analysis For Timberland
• Given the limitations of ratio analysis the most
•
•
useful way to evaluate financial ratios is by
examining their changes over time.
Comparing the ratios to industry averages
provides an interesting benchmark but
differences between companies in a given
industry can make the exercise misleading.
A systematic approach will also help alleviate the
information overload that results from the
random calculation of countless ratios.
A Systematic Approach
• At the top tier of ratios lie ROE and ROA.
• The major levers of performance are in the next
tier, followed by more narrowly focused ratios:
– Profit margin:
• Gross margin, tax rate, normalized income statement
– Asset turnover:
• Control ratios (inventory turnover, fixed asset turnover,
collection period, days sales in cash, payables period),
normalized balance sheet
– Financial leverage:
• Leverage ratios, coverage ratios, liquidity ratios
Ratio Analysis of Timberland Company 1994 - 1998
Major Ratios
ROE
ROA
ROIC
Profitability Ratios
Profit Margin
Gross Margin
Price to earnings ratio
Turnover and Control Ratios
Asset Turnover
Fixed-asset Turnover
Inventory Turnover
Collection Period
Days' Sales in Cash
Payables Period
Leverage and Liquidity Ratios
Assets to Equity
Debt to Assets
Debt to Equity
Times Interest Earned
Times Burden Covered
Current Ratio
Acid Test
1994
1995
1996
1997
Industry
1998 Median
11.9
3.8
7.1
(8.2)
(2.8)
0.7
12.3
4.5
9.6
22.1
11.3
18.3
22.2
12.6
17.9
12.3
7.4
9.7
2.8
35.0
13.5
(1.8)
33.7
NA
3.0
39.4
20.7
5.9
41.7
13.9
6.9
41.9
8.5
4.2
38.4
15.0
1.3
9.3
1.9
73.5
3.7
32.6
1.6
12.5
2.4
53.4
21.4
21.2
1.5
14.1
2.6
53.2
49.4
18.6
1.9
15.1
3.3
34.7
45.3
16.0
1.8
15.2
3.8
33.4
64.3
18.9
1.8
9.2
2.7
39.1
10.8
36.3
3.2
68.5
217.4
2.9
1.6
3.5
1.5
3.0
66.2
196.3
0.2
0.1
4.8
2.3
2.7
63.2
171.9
2.5
1.1
3.7
2.1
2.0
48.8
95.4
5.6
5.6
3.5
2.0
1.8
43.3
76.3
10.2
10.2
4.0
2.7
1.7
39.6
65.5
9.1
7.4
3.0
1.5
Ratio Analysis of Timberland
• ROE:
– After a loss in ’95 the ROE is up to a strong 22.2% in
’98. This is strong relative to its industry and to the
median firm in the S&P500 that year which had an
ROE of 14.8%.
– The other major ratios show similar patterns.
• The rise in ROE is coming from the increase in
its profit margin and asset turnover and is
somewhat offset by the reduction in its financial
leverage.
Ratio Analysis of Timberland
• The increased profit margin is coming primarily
•
from a rising gross margin indicating that it is
some combination of more aggressive pricing
and cost control that has driven the increase.
Improved asset turnover reflects overall
improved asset management.
– Inventory turnover and fixed asset turnover are
strongly higher.
– The only asset rising relative to sales is cash. Is this
good or bad?
• Leverage and liquidity ratios all show increasing
financial conservatism.
Normalized Financial Statements
• Note on the normalized balance sheet that 80%
of the firm’s assets are current assets.
– This highlights the importance of working capital
management.
– Note the reduction in inventories and accounts
receivable noted above.
• The normalized income statement is pleasant
reading.
– Profit margin and gross margin are up since ’95.
– Results would have been better except for the rise in
SG&A expenses.
Common-Sized Balance Sheet for Timberland and Industry
Assets
Cash and marketable securities
Accounts receivable
Inventories
Prepaid expenses and other current assets
Total current assets
Property, plant, and equipment
Less accumulated depreciation and amortization
Net property, plant, and equipment
Intangible assets
Other assets
Total assets
Liabilities and Shareholders' Equity
Accounts payable
Notes payable
Current portion of long-term debt
Wages payable
Accrued expenses
Total current liabilities
Long-term debt
Deferred income taxes
Total liabilities
Common stock
Additional paid-in capital
Retained earnings
Less treasury stock
Total shareholders' equity
Total liabilities and shareholders' equity
Industry
1998 Average
1994
1995
1996
1997
1.3%
27.1
46.1
4.4
79.0
23.4
9.0
14.4
5.5
1.1
100%
9.1%
22.7
42.9
5.5
80.2
22.8
10.3
12.4
5.8
1.6
100%
20.8%
22.4
35.4
4.1
82.6
23.1
12.2
10.9
5.0
1.5
100%
23.5%
18.0
34.0
5.9
81.4
27.7
15.1
12.6
5.0
1.0
100%
32.4%
16.8
28.0
5.4
82.6
28.0
15.8
12.1
4.1
1.2
100%
7.4%
22.7
37.1
5.5
72.0
31.5
13.6
17.9
3.2
6.9
100%
7.8%
4.8
1.7
1.9
6.4
22.6
43.7
2.2
68.5
0.0
12.2
19.3
0.0
31.5
100%
6.0%
-1.8
0.2
8.5
16.5
47.3
2.4
66.3
0.0
14.2
19.6
0.0
33.7
100%
4.7%
-4.0
2.6
11.3
22.7
38.2
2.4
63.2
0.0
13.7
23.0
0.0
36.8
100%
4.9%
--4.2
14.5
23.6
23.8
1.4
48.8
0.0
16.3
34.8
0.0
51.2
100%
5.5%
--3.9
11.0
20.4
21.3
1.6
43.3
0.0
15.9
44.2
3.5
56.7
100%
11.2%
2.0
1.0
-10.0
24.2
14.8
1.0
39.9
4.6
10.8
54.8
10.2
60.1
100%
Normalized Income Statement for Timberland and Industry
Net sales
Cost of sales
Gross profit
S,G,& A expenses
Depreciation and amortization
Total operating expenses
Operating income
Interest expense
Other expense (income)
Extraordinary expense (income)
Total nonoperating expenses
Income before income taxes
Provision for income taxes
Net income
1994
100%
65.0
35.0
25.8
2.4
28.2
6.8
2.4
--2.3
4.4
1.6
2.8
1995
100%
66.3
33.7
29.4
2.9
32.3
1.4
3.5
0.2
0.6
4.2
(2.9)
(1.1)
(1.8)
1996
100%
60.6
39.4
28.9
3.1
32.0
7.4
3.0
(0.1)
-2.9
4.5
1.5
3.0
1997
100%
58.5
41.5
28.4
2.5
31.0
10.5
1.9
0.2
-2.0
8.5
2.5
5.9
1998
100%
58.3
41.7
28.6
2.1
30.7
11.0
1.1
(0.2)
-0.9
10.1
3.2
6.9
Industry
Average
100%
60.8
39.2
29.3
1.8
31.0
8.2
0.7
(0.2)
0.4
0.9
7.3
2.7
4.6
Summary
• What is being reflected here is a robust recovery
from a difficult period in the firm’s history.
– In ’94 the firm experienced a 50% increase in sales
driven by “fad” demand for its product.
– In response Timberland over-expanded and lost
control of assets, particularly inventory and accounts
receivable.
– The bubble burst in ’95.
– Since then they have aggressively managed assets
and reduced debt.
– Challenge ahead is what to do with all the excess
cash being generated and a question of whether they
can rekindle growth.