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Lecture 4: Measuring Corporate Performance

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Corporate Performance

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Corporate Performance Measured•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).

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Market Value Added

Book ValueMarket Value Added [Share Price Shares Outstanding] - Equity

What is it?

Why is it useful?

Defined:

•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

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MVA: Discussion

Consider AT&T and Home Depot

Similar MVA, Different Market-to-Book Ratio 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.

Book ValueMarket Value Added [Share Price Shares Outstanding] - Equity

TABLE 4.3

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Economic Value AddedEconomic 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:Economic Value Added Operating Income* - [Cost of Capital Total Capitalization]

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EVA: Discussion

Consider Coca-Cola and Google

Similar EVA, Different Return on Capital

Why?

Economic Value Added Operating Income - [Cost of Capital Total Capitalization]

TABLE 4.4

* Operating Income = Net Income + After-tax Interest; ROC = Return on Capital

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Book Rates of Return*

*Book Rates of Return are also referred to as Accounting rates of Return

• 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

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Calculating Return on CapitalAssets 2009 2008

Current assets: Cash and cash equivalents $ 632 245 Short-term investments 425 416 Merchandise inventory - net 8,249 8,209 Deferred income taxes - net 208 105 Other current assets 218 215

Total current assets 9,732 9,190

Property less acc. depreciation 22,499 22,722 Long-term investments 277 253 Other assets 497 460 Total assets $ 33,005 32,625

Liabilities and Shareholders' Equity 2009 2008

Current liabilities: Short-term borrowings $ - 987 Current maturities of long-term debt 552 34 Accounts payable 4,287 4,109 Accrued comp./employee benefits 577 434 Deferred revenue 683 674 Other current liabilities 1,256 1,322

Total current liabilities 7,355 7,560

Long-term debt, excl. current maturities 4,528 5,039 Deferred income taxes - net 598 599 Other liabilities 1,455 1,372

Total liabilities 13,936 14,570

Shareholders' equity: - - Common stock - $.50 par value 729 735 Capital in excess of par value 6 277 Retained earnings 18,307 17,049 Acc. other comprehensive income 27 (6)

Total shareholders' equity 19,069 18,055

Total liabilities and shareholders' equity $ 33,005 32,625 Lowe’s Balance Sheet (in $m)

Lowe’s Return on Capital

After-Tax Operating Income 1,964ROC 8.4%

Average Total Capitalization 23,336.5

Lowe's Income Statement 2009Net sales 47,220 Cost of sales 30,757 Gross margin 16,463 Expenses:Selling, general and administrative 11,688 Store opening costs 49 Depreciation 1,614 Interest - net 287 Total expenses 13,638 Pre-tax earnings 2,825 Income tax provision 1,042 Net earnings 1,783

After Tax Operating Income = Net Income + After-Tax Interest

= 1,783 + 181 = 1,964

Average Total Capitalization = Average Long-Term Debt + Equity

(23,579 23,094)23,336.5

2

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Calculating Return on Assets

Assets 2009 2008

Current assets: Cash and cash equivalents $ 632 245 Short-term investments 425 416 Merchandise inventory - net 8,249 8,209 Deferred income taxes - net 208 105 Other current assets 218 215

Total current assets 9,732 9,190

Property less acc. depreciation 22,499 22,722 Long-term investments 277 253 Other assets 497 460 Total assets $ 33,005 32,625

Liabilities and Shareholders' Equity 2009 2008

Current liabilities: Short-term borrowings $ - 987 Current maturities of long-term debt 552 34 Accounts payable 4,287 4,109 Accrued comp./employee benefits 577 434 Deferred revenue 683 674 Other current liabilities 1,256 1,322

Total current liabilities 7,355 7,560

Long-term debt, excl. current maturities 4,528 5,039 Deferred income taxes - net 598 599 Other liabilities 1,455 1,372

Total liabilities 13,936 14,570

Shareholders' equity: - - Common stock - $.50 par value 729 735 Capital in excess of par value 6 277 Retained earnings 18,307 17,049 Acc. other comprehensive income 27 (6)

Total shareholders' equity 19,069 18,055

Total liabilities and shareholders' equity $ 33,005 32,625

Lowe’s Balance Sheet (in $m)Lowe’s Return on Assets

After-Tax Operating Income 1,964ROA 6.0%

Average Total Assets 32,815

After-Tax Operating Income 1,964ROA = 6.0%

Total Assets 32,625Year Beginning

or

Lowe's Income Statement 2009Net sales 47,220 Cost of sales 30,757 Gross margin 16,463 Expenses:Selling, general and administrative 11,688 Store opening costs 49 Depreciation 1,614 Interest - net 287 Total expenses 13,638 Pre-tax earnings 2,825 Income tax provision 1,042 Net earnings 1,783

After Tax Operating Income = Net Income + After-Tax Interest

= 1,783 + 181 = 1,964

(33,005 32,625)Average Total Assets =

232,815

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Calculating Return on Equity

Assets 2009 2008

Current assets: Cash and cash equivalents $ 632 245 Short-term investments 425 416 Merchandise inventory - net 8,249 8,209 Deferred income taxes - net 208 105 Other current assets 218 215

Total current assets 9,732 9,190

Property less acc. depreciation 22,499 22,722 Long-term investments 277 253 Other assets 497 460 Total assets $ 33,005 32,625

Liabilities and Shareholders' Equity 2009 2008

Current liabilities: Short-term borrowings $ - 987 Current maturities of long-term debt 552 34 Accounts payable 4,287 4,109 Accrued comp./employee benefits 577 434 Deferred revenue 683 674 Other current liabilities 1,256 1,322

Total current liabilities 7,355 7,560

Long-term debt, excl. current maturities 4,528 5,039 Deferred income taxes - net 598 599 Other liabilities 1,455 1,372

Total liabilities 13,936 14,570

Shareholders' equity: - - Common stock - $.50 par value 729 735 Capital in excess of par value 6 277 Retained earnings 18,307 17,049 Acc. other comprehensive income 27 (6)

Total shareholders' equity 19,069 18,055

Total liabilities and shareholders' equity $ 33,005 32,625

Lowe’s Balance Sheet (in $m)Lowe’s Return on Equity

Net Income 1,783ROE 9.6%

Average Total Equity 18,562

Net Income 1,783ROE = 9.9%

Equity 18,055Year Beginning

or

Lowe's Income Statement 2009Net sales 47,220 Cost of sales 30,757 Gross margin 16,463 Expenses:Selling, general and administrative 11,688 Store opening costs 49 Depreciation 1,614 Interest - net 287 Total expenses 13,638 Pre-tax earnings 2,825 Income tax provision 1,042 Net earnings 1,783

(19,069 18,055)Average Total Equity =

218,562

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Financial Ratios and Shareholder Value

Shareholder value depends on good investment and financing decisions.

Financial Ratios help measure the success and soundness of these decisions.

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Efficiency Ratios

SalesReceivables Turnover=

ReceivablesYear Beginning

SalesAsset turnover ratio =

Total AssetsYear Beginning

Sales=

Average Total AssetsOR*

How does this ratio measure efficiency?

How does this ratio measure efficiency?

* Either equation is a legitimate way to calculate the asset turnover ratio

• Efficiency Ratios – Ratios which measure how efficiently a firm uses its assets.

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Efficiency Ratios

InventoryAverage Days in Inventory=

(Cost of Goods Sold/365)Year Beginning

How does this ratio measure efficiency?

Cost of Goods SoldInventory Turnover Ratio=

InventoryYear Beginning

How does this ratio measure efficiency?

ReceivablesAverage Collection Period=

(Sales/365)Year Beginning

How does this ratio measure efficiency?

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Calculating an Efficiency RatioAssets 2009 2008

Current assets: Cash and cash equivalents $ 632 245 Short-term investments 425 416 Merchandise inventory - net 8,249 8,209 Deferred income taxes - net 208 105 Other current assets 218 215

Total current assets 9,732 9,190

Property less acc. depreciation 22,499 22,722 Long-term investments 277 253 Other assets 497 460 Total assets $ 33,005 32,625

Liabilities and Shareholders' Equity 2009 2008

Current liabilities: Short-term borrowings $ - 987 Current maturities of long-term debt 552 34 Accounts payable 4,287 4,109 Accrued comp./employee benefits 577 434 Deferred revenue 683 674 Other current liabilities 1,256 1,322

Total current liabilities 7,355 7,560

Long-term debt, excl. current maturities 4,528 5,039 Deferred income taxes - net 598 599 Other liabilities 1,455 1,372

Total liabilities 13,936 14,570

Shareholders' equity: - - Common stock - $.50 par value 729 735 Capital in excess of par value 6 277 Retained earnings 18,307 17,049 Acc. other comprehensive income 27 (6)

Total shareholders' equity 19,069 18,055

Total liabilities and shareholders' equity $ 33,005 32,625

Lowe’s Balance Sheet (in $m)

Lowe’s Asset Turnover Ratio

Sales 44,270Asset Turnover Ratio 1.4

Average Total Assets 32,815

Lowe's Income Statement 2009Net sales 47,220 Cost of sales 30,757 Gross margin 16,463 Expenses:Selling, general and administrative 11,688 Store opening costs 49 Depreciation 1,614 Interest - net 287 Total expenses 13,638 Pre-tax earnings 2,825 Income tax provision 1,042 Net earnings 1,783

(33,005 32,625)Average Total Assets =

232,815

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Profitability Ratios

How does this ratio measure the firm’s profitability?

When is this ratio potentially more useful than just profit margin?

Net Income After-Tax Interest Operating Profit Margin=

Sales

Net Income Profit Margin=

Sales

Note: ROC, ROA, ROE and EVA are also typically considered profitability ratios.

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Calculating a Profitability RatioAssets 2009 2008

Current assets: Cash and cash equivalents $ 632 245 Short-term investments 425 416 Merchandise inventory - net 8,249 8,209 Deferred income taxes - net 208 105 Other current assets 218 215

Total current assets 9,732 9,190

Property less acc. depreciation 22,499 22,722 Long-term investments 277 253 Other assets 497 460 Total assets $ 33,005 32,625

Liabilities and Shareholders' Equity 2009 2008

Current liabilities: Short-term borrowings $ - 987 Current maturities of long-term debt 552 34 Accounts payable 4,287 4,109 Accrued comp./employee benefits 577 434 Deferred revenue 683 674 Other current liabilities 1,256 1,322

Total current liabilities 7,355 7,560

Long-term debt, excl. current maturities 4,528 5,039 Deferred income taxes - net 598 599 Other liabilities 1,455 1,372

Total liabilities 13,936 14,570

Shareholders' equity: - - Common stock - $.50 par value 729 735 Capital in excess of par value 6 277 Retained earnings 18,307 17,049 Acc. other comprehensive income 27 (6)

Total shareholders' equity 19,069 18,055

Total liabilities and shareholders' equity $ 33,005 32,625

Lowe’s Balance Sheet (in $m)

Lowe’s Operating Profit Margin

Net Income + After-Tax Interest 1,783 181OPM 4.2%

Sales 47,220

Lowe's Income Statement 2009Net sales 47,220 Cost of sales 30,757 Gross margin 16,463 Expenses:Selling, general and administrative 11,688 Store opening costs 49 Depreciation 1,614 Interest - net 287 Total expenses 13,638 Pre-tax earnings 2,825 Income tax provision 1,042 Net earnings 1,783

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Leverage Ratios

Long Term DebtLong term debt ratio=

Long Term Debt+Equity

How does this ratio measure leverage?

Long-Term DebtLong-term Debt Equity Ratio=

EquityHow does this ratio measure leverage?

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Measuring LeverageTotal Liabilities

Total Debt Ratio=Total Assets

How does this ratio measure leverage?

EBITTimes Interest Earned=

Interest PaymentsHow does this ratio measure leverage?

EBIT+DepreciationCash Coverage Ratio=

Interest Payments

How does this ratio measure leverage?

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Calculating a Leverage RatioAssets 2009 2008

Current assets: Cash and cash equivalents $ 632 245 Short-term investments 425 416 Merchandise inventory - net 8,249 8,209 Deferred income taxes - net 208 105 Other current assets 218 215

Total current assets 9,732 9,190

Property less acc. depreciation 22,499 22,722 Long-term investments 277 253 Other assets 497 460 Total assets $ 33,005 32,625

Liabilities and Shareholders' Equity 2009 2008

Current liabilities: Short-term borrowings $ - 987 Current maturities of long-term debt 552 34 Accounts payable 4,287 4,109 Accrued comp./employee benefits 577 434 Deferred revenue 683 674 Other current liabilities 1,256 1,322

Total current liabilities 7,355 7,560

Long-term debt, excl. current maturities 4,528 5,039 Deferred income taxes - net 598 599 Other liabilities 1,455 1,372

Total liabilities 13,936 14,570

Shareholders' equity: - - Common stock - $.50 par value 729 735 Capital in excess of par value 6 277 Retained earnings 18,307 17,049 Acc. other comprehensive income 27 (6)

Total shareholders' equity 19,069 18,055

Total liabilities and shareholders' equity $ 33,005 32,625

Lowe’s Balance Sheet (in $m)

Lowe’s Times Interest Earned Ratio

EBIT 3,112Times Interest Earned 10.8

Interest 287

Lowe's Income Statement 2009Net sales 47,220 Cost of sales 30,757 Gross margin 16,463 Expenses:Selling, general and administrative 11,688 Store opening costs 49 Depreciation 1,614 Interest - net 287 Total expenses 13,638 Pre-tax earnings 2,825 Income tax provision 1,042 Net earnings 1,783

EBIT = Sales - COGS - Expenses - Depreciation

47,220 30,757 11,737 1,614 3,112

COGS stands for Cost of Goods Sold. Expenses include selling, general and administrative costs (and “store operating costs” in this example).

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Measuring LiquidityNet Working Capital

NWC to Total Assets Ratio =Total Assets

Current AssetsCurrent Ratio=

Current Liabilities

How does this ratio measure 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

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Liquidity RatiosCash + Marketable Securities + Receivables

Quick ratio=Current Liabilities

How does this ratio differ form the current ratio? Why might a financial manager prefer it?

Cash + Marketable SecuritiesCash Ratio=

Current Liabilities

How does this ratio differ from the current ratio? Why might a financial manager prefer it?

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Calculating a Liquidity RatioAssets 2009 2008

Current assets: Cash and cash equivalents $ 632 245 Short-term investments 425 416 Merchandise inventory - net 8,249 8,209 Deferred income taxes - net 208 105 Other current assets 218 215

Total current assets 9,732 9,190

Property less acc. depreciation 22,499 22,722 Long-term investments 277 253 Other assets 497 460 Total assets $ 33,005 32,625

Liabilities and Shareholders' Equity 2009 2008

Current liabilities: Short-term borrowings $ - 987 Current maturities of long-term debt 552 34 Accounts payable 4,287 4,109 Accrued comp./employee benefits 577 434 Deferred revenue 683 674 Other current liabilities 1,256 1,322

Total current liabilities 7,355 7,560

Long-term debt, excl. current maturities 4,528 5,039 Deferred income taxes - net 598 599 Other liabilities 1,455 1,372

Total liabilities 13,936 14,570

Shareholders' equity: - - Common stock - $.50 par value 729 735 Capital in excess of par value 6 277 Retained earnings 18,307 17,049 Acc. other comprehensive income 27 (6)

Total shareholders' equity 19,069 18,055

Total liabilities and shareholders' equity $ 33,005 32,625

Lowe’s Balance Sheet (in $m)

Lowe’s NWC to Total Assets Ratio

Lowe's Income Statement 2009Net sales 47,220 Cost of sales 30,757 Gross margin 16,463 Expenses:Selling, general and administrative 11,688 Store opening costs 49 Depreciation 1,614 Interest - net 287 Total expenses 13,638 Pre-tax earnings 2,825 Income tax provision 1,042 Net earnings 1,783

Net Working Capital = 9,732-7,355 2,377

NWC 2,377NWC to Total Assets 7.2%

Total Assets 33,005

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The DuPont System

•DuPont System: A breakdown of ROE and ROA into component ratios

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The DuPont System: ROA

Sales Net Income InterestROA= x

Assets Sales

AssetTurnover

Operating ProfitMargin

Net Income InterestROA=

Assets

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ROA Decomposition by Industry

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The DuPont System: ROE

Assets Sales Net Income Interest Net IncomeROE= x x x

Equity Assets Sales Net Income Interest

LeverageRatio Asset

Turnover

OperatingProfit

Margin

DebtBurden

Net IncomeROE=

Equity

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.

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Sustainable Growth

Earnings-DividendsPlowback Ratio=

Earnings

DividendsPayout Ratio=

Earnings

Growth in equity from plowback = Plowback Ratio ROE

Earnings - Dividends Earnings

Earnings Equity

Earnings-Dividends =

Equity

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The Role of Financial RatiosTable 4.8

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The Role of Financial Ratios

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Appendix A: Average Ratios, by IndustryTable 4.7

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Appendix B: Financial Ratios and Default Risk

Table 4.9