Presentation on theme: "Evaluating Financial Performance"— Presentation transcript:
1 Evaluating Financial Performance FinanceJaime F. ZenderNote: Because I have found no better presentation of this material, this closelyfollows the discussion in the Higgins book.
2 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 financial statement for the Timberland Company as illustrations.
6 Return On EquityThe most popular measure of financial performance (for many audiences) is ROE.ROE measures accounting earnings for a period per dollar of shareholders’ equity invested.For Timberland 1998 ROE was:
7 Dissecting ROEROE 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/SalesAsset Turnover = Sales/AssetsFinancial Leverage = Assets/Shareholders’ equityROE comes from the joint inputs of these three pieces % = 6.9% × 1.8 × 1.8
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.
10 ROE Across CompaniesGenerally 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.
11 Profit MarginThis 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/SalesGross 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.
12 Asset TurnoverThis 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 timesAnalyzing the turnover of each type of asset on a company’s balance sheet gives rise to what are known as control ratios.
13 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 timesTimberland generates $15.20 in sales for each dollar of plant, property, and equipment they invest in.
14 Control Ratios – Inventory Turnover Inventory turnover = COGS/Ending Inventory = $501.1/$131.2 = 3.8 timesOne 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.
15 Control Ratios – Collection Period Collection period highlights a company’s management of its accounts receivable.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?
16 Control Ratios – Days’ Sales in Cash 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.
17 Control Ratios – Payables Period This is a control ratio for a liability.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.
18 Financial LeverageTimberland 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%
19 Coverage RatiosOften 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.
20 Liquidity RatiosA 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”).
21 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.
22 The Timing ProblemAs 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?
23 The Risk ProblemWe 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.
24 The Value ProblemROE 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.
25 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.
26 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 statementAsset turnover:Control ratios (inventory turnover, fixed asset turnover, collection period, days sales in cash, payables period), normalized balance sheetFinancial leverage:Leverage ratios, coverage ratios, liquidity ratios
28 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.
29 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.
30 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.
33 SummaryWhat 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.