1. Financial Analysis Using Ratios

2. Agenda Ratio analysis and EVA Briggs case Cash flow statement analysis
Free cash flow

3. Four Analysis Categories
Evaluate performance relative to a peer group, and period-over-period, to identify strengths and weaknesses in four areas
Profitability
Asset management
Solvency risk
Economic Value-added

4. Key Uses of Ratio Analysis
Consider impact of financial performance on cash flow and stock price
Measure value-added
Set targets for projected performance to improve valuation
Assist in formulating a cash flow planning forecast

5. I. Profitability Traditional DuPont Model Adjusted DuPont Model
Margin analysis

6. Which outperformed? Operating performance?
Unlevered
Levered
Assets
$10,000
Debt $0
$5,000
Equity
# Shares
400
200
Tax Rate
40%
Interest rate 5%
Unlevered
Levered
Poor
Expected
Strong
Expect
EBIT
$-500
$1,000
$1,500
Interest $0
$250
Taxes
$-200
$400
$600
$-300
$300
$500
Net Income
$900
$-450
$450
$750
ROA
-3.0%
6.0%
9.0%
-4.5%
4.5%
7.5%
ROE
-9.0%
15.0%
EPS
$-0.75
$1.50
$2.25
$-2.25
$3.75

7. Traditional DuPont Model
Margins
On Sales
Return on
Assets
Financial
Leverage
Return on
Equity x x =
Asset
Utilization

8. Profitability summary using the Dupont Model
ROE
NPM
TAT LR
ROE = Return on Equity: rate of return to stockholders
NPM = Net Profit Margin: efficiency in expense control (income statement)
TAT = Total Asset turnover: asset management (balance sheet)
LR = Leverage Ratio (‘financial leverage’; tradeoff is insolvency risk)

9. Return on Assets ROE ROA LR
ROA = Return on Assets: summarizes income statement and balance sheet efficiency, before incorporating financial leverage

11. DuPont mixes operating and financial decisions
A problem with this approach is that because net income is biased by financing choice, the equation provides a poor summary of operating performance (e.g. success in product positioning, production efficiency, distribution, overhead control, etc.)
Companies with high debt have low net profit margin, low ROA, but higher ROE, all else equal

12. Traditional Balance Sheet
Current Assets Current Liabilities
PP&E Long-term Debt
Stockhoders Equity
= Total Assets = Total Liab + Equity
Our objective as financial managers is to enhance the value of the debt and equity capital that we’ve raised in the market, on which the investors require a rate of return.
Let’s show a balance sheet that isolates this investor capital.

13. Managerial Balance Sheet
+ Current Assets Oper. Current Liab.
+ PP&E Debt (L.T. + S.T.)
+ Equity
= Invested Capital
Net Working Capital
= Invested Capital
Invested Capital can be calculated both inside and outside the box

14. Net Working Capital (NWC)
NWC = Current Assets minus Operating Current Liabilities
Operating Current Liabilities
grow spontaneously with the firm’s assets
not motivated by a return on investment (non-interest)
include Accts Payable, Accrued Expenses, Tax Payable
exclude short-term interest-bearing debt that is part of current liabilities on the traditional balance sheet
This S.T. debt is now outside the box as a part of the Debt Capital

15. Invested Capital (IC) IC is raised to acquire assets inside the box
IC = NWC + PP&E inside the box
IC also = Debt + Equity outside the box
The overall rate of return required by investors on the Invested Capital is known as the Weighted Average Cost of Capital

16. Net Operating Profit After Taxes
This is the after-tax income earned on the Invested Capital +
Earnings Before Interest and Taxes X
(1 – cash tax rate) =
NOPAT
By using earnings before Interest to calculate NOPAT, we exclude the influence of debt funding on earnings
NOPAT is the net income that would be earned if there were no debt

17. Return on Invested Capital
ROIC is a weighted return on Invested Capital:
ROIC = ; rd=interest rate on debt
Multiply both sides by:

18. Return on Invested Capital (ROIC)
NOPAT x
Sales IC
Net Oper. Margin x
Capital Turnover
ROIC intersects efficiency on the income statement with the productivity of assets on the balance sheet
ROIC provides a summary measure of operating performance
A financial performance analysis begins with ROIC, and drills down from there

19. Adjusted Dupont Model (isolates operating and financial leverage effects on ROE)
rd = interest rate on debt
Pure leverage effect
The second term isolates the increase in ROE resulting solely from leverage differences
This term also captures the tax break on interest (1-t) that we ignored when we calculated NOPAT

20. Which company performed better?
Unlevered
Levered
Assets
$10,000
Debt $0
$5,000
Equity
# Shares
400
200
Tax Rate
40%
Interest rate 5%
Unlevered
Levered
Poor
Expected
Strong
Expect
EBIT
$-500
$1,000
$1,500
Interest $0
$250
Taxes
$-200
$400
$600
$-300
$300
$500
Net Income
$900
$-450
$450
$750
ROA
-3.0%
6.0%
9.0%
-4.5%
4.5%
7.5%
ROE
-9.0%
15.0%
EPS
$-0.75
$1.50
$2.25
$-2.25
$3.75

21. Adjusted Dupont Model [ ] [ ]+ x -
5% (1-.40) [ ] 9% = 6% +
1.0 x 6% - 3%
From an operating perspective the companies are identical, earning a 6% ROIC
The levered company adds another 3% to its ROE as a result of its debt usage
Ultimately the answer to which is better depends largely on which debt mix is appropriate given the industry’s operating risk (variability in EBIT)

23. Increasing Leverage and ROE
Note that the hurdle rate for increasing ROE (same for EPS) by increasing leverage is very low:
ROIC > Int (1-T)
Returns to capital > after-tax cost of debt only
To increase value need ROIC >
weighted average cost of debt and equity
Cost of both debt and equity are rising as debt increases
Goal should not be max ROE

24. Margin analysis Gross Margin: ability to mark-up
product and control production
expenses
Net Operating Margin: control of overhead expenses (SG&A) as well

25. Profits Summary
Start with ROIC as a summary measure of operating performance
Explain ROIC results using
Margins on income statement
Capital turnovers from balance sheet
Explain ROE result using ROIC and Leverage
Also consider growth’s impact on value

26. Implied Value/NOPAT Multiples for ROIC and Growth
Value Drivers
The three keys to value are 1) ROIC; 2) growth in NOPAT; 3) Risk
Implied Value/NOPAT Multiples for ROIC and Growth
ROIC
10.0 8%
10%
12%
14%
16%
Growth 2%
9.4
10.4
10.7
10.9 4%
8.3
11.1
11.9
12.5 6%
6.3
14.3
15.6
0.0
16.7
21.4
25.0

27. II. Asset Management (turnovers)
Measure the efficiency with which the company invests in its assets (e.g. efficiency in collecting receivables, turning inventory, and utilizing PP&E capacity)
Capital Turnover
Accts. Receivable Days
Inventory Holding Period
Working Capital Turnover
PP&E Turnover

29. III. Solvency risk Debt-to-EBITDA Debt-to-Capital Interest Coverage
Measure whether the company has an appropriate level of debt in its capital mix, or the risk of becoming insolvent
Debt-to-EBITDA
Debt-to-Capital
Interest Coverage
or Times Interest Earned
Tradeoff: There are many considerations that drive this decision, but the primary tradeoff is that while higher debt increases insolvency risk and the cost of capital, it also can boost the return to stockholders (ROE).

32. III. Solvency risk: Liquidity focus
Measure ability to meet near-term financial obligations by holding sufficient assets that are expected to convert to cash within the year
Inventory is the least liquid current asset, so exclude it in the quick ratio
Current ratio
Quick ratio

34. Liquidity interactions
Tradeoff: By shrinking the current ratio companies can reduce Invested Capital requirements and thereby boost ROIC
But a lower current ratio indicates greater liquidity risk
Liquidity can also be located off the balance sheet in committed unused lines of credit
Companies that have less total debt and/or have stronger cash flow can afford to have lower liquidity

35. IV. Economic Value Added
EVA is a measure of periodic economic profit, or single period $value-added to shareholders
Unlike Net Income, EVA measures residual income after deducting a charge for all of the Invested Capital used in the business (i.e. it charges for Equity capital)
Net income fails to effectively capture the cost of an inefficient balance sheet

36. EVA’s relation to value
Market value added, the difference between a company’s market value and its book value, is the present value of the company’s future expected EVAs
EVA links profit measurement to valuation
Net Present Value (NPV) for a new capital investment is equal to the present value of the investment’s future expected EVAs
EVA links profit measurement to capital budgeting

37. Value-based management using EVA
Focus managers on controlling capital investment and beating the cost of capital
“Incredibly, most corporate groups, divisions, and departments have no idea how much capital they tie up or what it costs”— Fortune
Provide appropriate incentives for value-added growth investments, while divesting value-destroying business lines
Push accountability for capital charges down into profit centers at all levels of organization
Optimize the use of debt to minimize WACC

38. Calculating EVA
$Capital Charge
EVA deducts a Capital (financing) Charge for the Investment Capital used to generate NOPAT
WACC = Weighted Average Cost of Capital
WACC is an estimate of the % return required by investors on the firm’s Invested Capital

39. ROIC > WACC = +EVA
EVA spread %
Investments must generate an ROIC that exceeds the cost of financing
$Capital captures the firm’s ability to find profitable growth opportunities
Recall that MVA is present value of future EVA
WACC captures risk
The EVA spread can be compared across firms, but do not target max

41. Overinvestment problem of net income focus
Assume capital structure is 50%/50% D/E:
Only need to earn ROIC > Interest (1-T) x 50%, which here is 3.5%, to increase Net Income; need 12% for breakeven EVA; result is overinvestment

42. Should the investment be made?

43. EVA captures Equity cost risk effects not included in any measure of profitability, and encourages optimal capital structure
Captures differences in risk and associated financing cost side of the risk/return tradeoff via WACC
seek optimal use of debt to minimize WACC
include risk shifts in profit measurement
If use excessive debt to increase ROE, cost of Equity and Debt increase, resulting in higher WACC and capital charge in EVA calculation

44. Accounting adjustments
Adjusts capital for accounting distortions that understate capital (e.g. leases, reserves on balance sheet) or discourage investment (e.g. R&D, advertising, and training expenses)

45. Key terms
NOPAT
Invested Capital
ROIC
EVA
WACC