Ch.

4 Measuring Corporate Performance

4.1. Value and Value Added

 How financial ratios help to understand value added

4.2. Measuring Market Value and Market Value Added

 Market Capitalization = total market value of equity = share price x number of shares
outstanding
 Market Value Added = Market Capitalization – book value of equity
 Market-to-book ratio = (market value of equity) / (book value of equity) – how much
value has been added for each dollar invested
 Disadvantages: reflect expectations of future performance, market values can fluctuate,
cannot be used for privately owned companies
4.3. Economic Value Added and Accounting Rates of Return

 Measuring profitability
 Economic Value Added (EVA) – after-tax operating income minus a charge for the cost of
capital employed, also called residual income; include all long-term capital provided by
investors: equity + long-term debt = total capitalization
EVA = NOPAT (net operating profit after tax) – cost of capital
EVA = after tax income – (cost of capital x total capitalization)
Better measure than accounting income, as it recognizes that companies must cover the
opportunity cost before adding value
 Accounting rates of return:
Return on Capital Employed (ROCE) = EBIT / capital employed
Return on Capital (ROC) = after tax operating income / total capitalization = after tax
operating income / average total capitalization *average capitalization = cap. at
beginning of year + cap. at end of year / 2* (measures the return to all investors)
Return on Assets (ROA) = after-tax operating income / total assets = after tax
operating income / average total assets (measures the income available to all investors
per dollar of total assets)
Return on equity (ROE) = net income / equity= net income / average equity (income to
shareholders per dollar invested)
ROC, ROA, and ROE: how profitable it would be if all equity-financed, good for
comparison between firms with different structures
 Problems with EVA and accounting rates of return: based on book values – value of
intangible assets such as brand name are ignored; some assets might be undervalued
due to depreciation
4.4. Measuring Efficiency
  Asset Turnover Ratio = sales / total assets at start of year = sales / average total
assets; sales per dollar of total assets, how hard the assets are working
 Inventory Turnover = cost of goods sold (CoGS) / inventory at start of year
 Average days in Inventory = inventory at start of year / CoGs/ 365
 Receivables turnover = sales / receivables at start of year; high ratio – efficient
payment, it is best to have a high turnover or short collection period
 Average collection period = receivables at start of year/ average daily sales
 Efficiency – small inventory and a fast turnover
 Inventory and receivables ratio identify efficiency problems, but there are many other
ratios that can do the same
4.5 Analyzing ROA: The DuPont System

 Profit margin = net income / sales

 Operating profit margin = after-tax operating income/sales
 The DuPont System:
o Breakdown of ROA into product of turnover and margin:

Trade-off between turnover and margin – one high, the other is low -> an
insight into the company’s strategy
4.6. Measuring Financial Leverage

 The ability to pay long-term debt

 Debt ratio:
Long-term Debt Ratio = long-term debt / (long-term debt + equity); high for highly
leveraged companies, ignores short-term debt
Long-term Debt Equity ratio = long-term debt / equity; higher than 1 – more debt than
equity financed
The second is higher for highly leveraged companies; book values used even though
market values are more accurate, but book values ignore assets that can’t be sold
(intangible), in this case – short-term debt is ignored, but if company often borrows in
the short-term use:
Total Debt Ratio = total liabilities / total assets
  Times Interest Earned Ratio – how many times the earnings cover interest owed, higher
– better
Times Interest Earned = EBIT / interest payments
 Cash Coverage Ratio = (EBIT + depreciation) / interest payments
 Leverage and ROE
o Financing by borrowing -> must pay interest -> decreases profit, but if
borrowing -> fewer equity holders to share dividend, which effect
dominates?

Debt burden – measures the proportion by which interest expense

decreases profits
4.7. Measuring Liquidity

 Access to cash or other assets that can quickly turn into cash; accounts receivable –
liquid, real estate – illiquid; book values of liquid – usually reliable; measures can quickly
become outdated
 Net Working Capital to Total Assets Ratio = NWC / Total Assets (where NWC=current
assets – current liabilities)
Measure of the potential net reservoir of cash
 Current ratio = current assets / current liabilities
 Quick ratio = (cash + marketable securities + receivables) / current liabilities; considers
the current assets closest to cash
 Cash ratio = (cash + marketable securities) / current liabilities; the most liquid assets,
doesn’t really matter if firms can borrow on short notice – measures don’t consider
‘reserve borrowing power’
4.8. Calculating Sustainable Growth

 How fast can the firm grow only relying on internal financing = sustainable growth rate;
mature firms grow by reinvesting and depend on retained earnings
 Payout ratio = dividends/earnings -> proportion of earnings paid out as dividends
 Plowback ratio = 1 – payout ratio -> proportion of earnings reinvested
  Sustainable growth rate = plowback ratio x ROE -> assumes the long-term debt ratio is
held constant, as ROE and plowback decrease growth slows
4.9. Interpreting Financial Ratios

 Ratio values vary across industries; some have industry averages, while others have a
natural benchmark
 When comparing – it makes sense to limit to major competitors, also good to compare
with the same company’s ratios in previous years
4.10. Role of ratios and transparency

 Not making up/covering facts

 Problems call for corrective action
 Sarbanes-Oaxley act (SOX) – regulatory demands on management, accounting and
auditing.