Evaluating Financial Performance: Chapter Two

Evaluating
Financial
Performance
CHAPTER TWO
Copyright © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Copyright © 2019 by McGraw-Hill Education. All rights reserved.

The Levers of Financial
Performance
A pilot uses levers to control a the flight of an aircraft.
Operating decisions are the levers by which managers
control financial performance.
In this chapter, we study how financial statements help us to
analyze the performance of the firm.
Our primary tool is ratio analysis.
HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 2

Return on Equity
Return on Equity: The most popular measure of
financial performance
Why does this

definition
make sense?
= 29.6%

The 3 Determinants of ROE

How is this
a measure of
leverage?

TABLE 2.1 ROE and Levers of Performance for 10 Diverse
Companies, 2016

Questions about Table 2.1
Differences in ROE across firms is less than
differences in components. Why?
What is the role of competition in ROE differences?
Is there any reason why profit margin and asset
turnover should be negatively related?

You try it.
Calculate ROE and the levers of performance.
Selected financial data

($ millions)
Nordstrom Walmart
Sales 14,757 485,873
Net income 354 13,643
Total assets 7,858 198,825
Shareholders' equity 870 77,798
Profit margin 2.4% 2.8%
Asset turnover 1.9 2.4
Leverage 9.0 2.6
ROE 40.7% 17.5%

Profitability Ratios
Profit
margin: The fraction of each sales dollar
realized as profits
Return on assets: The combined effect of profit

margin and asset turnover
Gross margin: The contribution to fixed costs and

profits Are COGS
fixed or
variable?

Hasbro’s Profitability Ratios

Breakeven Sales
Use gross margin to calculate Hasbro’s breakeven
sales volume
◦ Assume COGS are variable and operating expenses
are fixed.
◦ Hasbro’s 2016 operating costs were $1,968 million.
◦ Since 56% of sales goes to cover operating costs,
breakeven sales volume = $1,968/0.56 = $3,514
million.

You try it.
Calculate breakeven sales volume for Apple Inc. for 2016.

Turnover-Control Ratios
Asset
turnover: Sales generated per dollar of assets
Inventory turnover: Number of times inventory

turns over per year
Collection period: Average number of days to

collect receivables
What if you
don’t know
credit sales?

More Turnover-Control Ratios
Days’
sales in cash: Availability of cash relative to
sales
Payables period: Average number of days to pay

accounts payable What if you don’t
know credit
purchases?
Fixed-asset turnover: Sales generated per dollar of
fixed assets

Fixed Assets vs. Current
Assets
Which is likely to be more sensitive to external
events, current assets or fixed assets?
What is a self-liquidating loan?
◦ Loan to support current assets
◦ What happens to AR and inventory when sales go up?
◦ What happens to AR and inventory when sales go down?

Hasbro’s Turnover-Control Ratios
Does a higher fixed-asset

turnover indicate higher or
lower capital intensity?

The Cash Conversion Cycle (CCC)
The average length of time between when cash goes out the
door and when it comes back in
CCC= Days inventory outstanding + Collection period –
Payables period

You try it.
Calculate the cash conversion cycle for Hyundai Motor.
Hyundai Motor
Selected financial data
2016 (₩ billions)
Sales 93,649
Cost of goods sold 75,960
Accounts receivable 8,030
Inventory 10,524
Accounts payable 6,986

Financial Leverage
What does increased financial leverage do to ROE?
Is increased leverage a good thing?
◦ Southern Co. vs. Alphabet
◦ JPMorgan Chase
Have another look at Table 2.1, and describe what

you see, along with an explanation.

TABLE 2.1 ROE and Levers of Performance for 10
Diverse Companies, 2016

Leverage and Liquidity Ratios
1
Balance Sheet Ratios
Debt-to-assets
ratio: Percent of assets paid for by
creditors
Debt-to-equity ratio: Financing supplied by creditors

for every dollar from shareholders

2
Coverage Ratios
Times
interest earned: Income available in relation
to interest payments
Times burden covered: Income available in relation

to all debt service
Which coverage ratio

is more important?
Why?

3
Market Value Leverage Ratios
Market
debt-to-equity ratio: Today’s value of financial
burdens compared to shareholders’ expected value
Market debt-to-assets ratio: Today’s value of financial

burdens compared to value of expected future income
What if you don’t know
the market value of debt?


4
Liquidity Ratios
Current
ratio: Liquid assets compared to imminent
debts
Acid test (Quick ratio): Very liquid assets compared to

imminent debts

ROE: The Timing Problem
Is ROE forward-looking?
Does ROE have a long-term perspective?

ROE: The Risk Problem
Does
ROE take into account business risk?
What is the impact of leverage on ROE?
Return on invested capital: A measure of return on capital
independent of the amount of leverage
= 17.5%

ROIC Is Not Distorted by Company Financing

ROE: The Value Problem
Should
we calculate return on book equity or market
equity?
Earnings yield: ROE using market value of equity instead
of book value
Price-to-earnings ratio: Inverse of earnings Isyield;

this a better measure of
commonly used measure of performance performance than ROE?


ROE or Market Price?
Which is the better way to measure financial
performance?
We have just discussed problems with ROE.
What about problems with stock price?
◦ How do operating decision affect stock price?
◦ Managers (should) know more about the company than
outside investors.
◦ Stock price depends on many factors outside
management’s control.

Comparing ROE to Stock
Price
Market-to-book vs. ROE (weighted-average)
Figures 2.1 and 2.2 coming up
Slope and dispersion (R-squared)?
Where is Hasbro relative to others in Figure 2.1?
Where are Apple and Amazon in Figure 2.2?

FIGURE 2.1 M/B vs. ROE for 20 Toy/Gaming/Leisure Firms

FIGURE 2.2 M/B vs. ROE for 82 Large Corporations

Ratio Analysis
Ratio analysis is the systematic use of the ratios
previously defined to understand financial
performance.
Caveats to keep in mind:
◦ Ratios don’t tell the whole story; they’re more like clues
that point to issues requiring further investigation.
◦ There are no universally “correct” values for ratios.

Using Ratios Effectively
Ratio values need to be understood in context.
It is important to compare ratios to something else.
◦ Comparable companies
◦ Changes in a company’s ratios over time

FIGURE 2.3 The Levers of Performance Suggest One Road Map for Ratio
Analysis

Example of Ratio
Analysis
Analyze the profitability measures
◦ What do the various measures tell you?
◦ What is Hasbro’s trend over time?
◦ How does Hasbro compare to the industry?
Analyze the levers of ROE

◦ Which levers explain the changes in ROE over time?
Analyze the control ratios

◦ Is Hasbro managing assets efficiently?
◦ How do they compare to prior performance and industry performance?
Analyze the leverage ratios

◦ What’s the trend in their use of debt?
◦ How do they compare to the industry?
◦ Is their amount of leverage concerning?

TABLE 2.2 Ratio Analysis of Hasbro

Common Size Financial
Statements
Add insight in analyzing a company
◦ Helps in recognizing trends over time
◦ Can compare to other companies without scale effects
What do common-size figures tell you compared to typical

ratios?
◦ For example, collection period vs. AR/Assets
◦ For example, inventory turnover vs. Inventory/Assets
What do you learn about working capital

◦ Fraction of assets that are short-term
What do you learn about COGS?

◦ Small changes in percentages can be large relative to net income

TABLE 2.3 Hasbro Common-Size Balance Sheets

TABLE 2.3 Hasbro Common-Size Income Statements

TABLE 2.4 Definitions of Principal Ratios Appearing in Chapter

TABLE 2.4 Definitions of Principal Ratios Appearing in
Chapter (cont.)

Evaluating Financial Performance: Chapter Two

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Copyright © 2019 by McGraw-Hill Education. All rights reserved.

HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 2

Why does this

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Selected financial data

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Return on assets: The combined effect of profit

Gross margin: The contribution to fixed costs and

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Inventory turnover: Number of times inventory

Collection period: Average number of days to

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Payables period: Average number of days to pay

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Does a higher fixed-asset

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Have another look at Table 2.1, and describe what

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Debt-to-equity ratio: Financing supplied by creditors

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Times burden covered: Income available in relation

Which coverage ratio

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Market debt-to-assets ratio: Today’s value of financial

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Acid test (Quick ratio): Very liquid assets compared to

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Price-to-earnings ratio: Inverse of earnings Isyield;

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Analyze the levers of ROE

Analyze the control ratios

Analyze the leverage ratios

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What do common-size figures tell you compared to typical

What do you learn about working capital

What do you learn about COGS?

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