Chapter 4

Measuring
Corporate
Performance

Prepared by
Humayun Qadri © 2020 McGraw-Hill Education Limited
MacEwan University
Learning Objectives
After studying this chapter you should be able to:
 LO1 Calculate and interpret market value and market

value added for a public corporation.

 LO2 Calculate and interpret some key measures of firm

performance, including economic value added (EVA), and

rates of return on capital, assets, and equity.
 LO3 Calculate and interpret measure of a firm’s

operating efficiency, leverage and liquidity.

 LO4 Show how overall profitability depends on the

efficient use of assets and on profit margin on sales.

 LO5 Compare the company’s financial standing with that

of its main competitors and with its own position in

earlier years.

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4.1 How Financial Ratios Relate to Shareholder
Value
 Shareholder value depends on good investment and good
financing decisions.

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4.2 Measuring Market Value and Market
Value Added
 Market Capitalization: market value of equity, equal to share
price times number of shares outstanding.

 Book value of equity: Net worth of the firm according to the

balance sheet. The book value measures shareholders’
cumulative investment in the company. 

 Market Value Added (MVA): market capitalization minus book

value of equity.

 Market to book ratio: Ratio of market value to book value of

equity.

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4.3 Economic Value Added and Accounting
Rates of Return
 Economic Value Added (EVA or Residual Income): measures the
profit of a firm after deducting all costs including the cost of the
capital.
 EVA or residual income is a better measure of company
performance than accounting profits.
 EVA recognizes a firm creates value only if it can earn more than its
cost of capital.
 EVA = Net income + after tax net finance expense – (cost of capital x
total capitalization)

 Net Operating Profit after Taxes (NOPAT): The sum of net income
and after tax net finance (or interest) expense. It is what the
company would earn if it had no debt.

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Accounting Rates of Return
 Return on Capital (ROC)
NOPAT
Total capitalization

 Return on Assets (ROA)

NOPAT
Total assets

 Return on Equity (ROE)

Net income
equity

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Problems with EVA and Accounting Rates of
Return
 Based on book values for assets, debt, and equity not market
values

 Not all assets appear on the balance sheet

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4.4 Measuring Efficiency
 Efficiency ratios measure how efficiently a company uses its
many types of assets.

 Asset Turnover
total revenues or total sales
total assets at start of year
 Inventory Turnover

cost of sales
average inventories
 Average days in Inventories

average inventories
cost of sales / 365
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4.4 Measuring Efficiency
 Efficiency ratios measure how efficiently a company uses its
many types of assets.

 Receivables Turnover
revenues
average trade receivables

 Average Collection Period

average trade receivables
average daily revenues

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4.5 Analyzing the Return on Assets: The Du
Pont System
 The success of a company depends not only on the volume of
sales but on how much profit is generated from those sales.

 Profit Margin
net income or earnings
revenues

 Operating Profit Margin

NOPAT
revenues

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The Du Pont System
 Some profitability or efficiency ratios can be linked in useful
ways. A breakdown of ROA into the product of turnover and
margin is often called the DuPont Formula

 Return on Assets (ROA)

ROA = NOPAT = Sales NOPAT

total assets total assets x Sales

asset operating
ROA = turnover
x
profit margin

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4.6 Measuring Financial Leverage
 Leverage ratios measure how much financial leverage (fixed
obligations) the firm has taken on.
 Long-term Debt Ratio

long-term debt or non-current liabilities

total assets

 Long-term Debt-to-Equity Ratio

long-term debt
total equity

 Total Debt Ratio

total debt
total assets
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Measuring Financial Leverage
 Times Interest Earned (TIE)
EBIT or operating income
interest expense

 Cash Coverage Ratio

EBIT + depreciation and amortization
interest expense

 EBITDA
= EBIT plus depreciation and amortization

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Leverage and the Return on Equity
An extended version of the Du Pont formula
breaks down the Return on Equity (ROE) into 4
parts: Net Income
ROE =
Equity

Assets Sales NOPAT Net Income

=   
Equity Total Sales NOPAT
Assets

Operating
Leverage Asset Turnover Debt Burden
Profit Margin

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4.7 Measuring Liquidity
 Liquidity – access to cash or assets that can be turned into
cash on short notice.

 Net Working Capital

= current assets – current liabilities

 Current Ratio
current assets
current liabilities

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Measuring Liquidity
 Quick (Acid-Test) Ratio

quick assets
current liabilities

 Cash Ratio
cash and cash equivalents
current liabilities

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4.8 Interpreting Financial Ratios
 Compare to a natural benchmark
 ie. Does the firm have a return on capital less than the cost
of capital?
 Compare to industry ratios and averages

 Compare to principal competitors

 Compare over time – trend

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Interpreting Financial Ratios

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4.9 The Role of Financial Ratios – and a
Final Note on Transparency
 Financial ratios provide a bird’s-eye view of the performance
of a firm
 Financial ratios do not tell the whole story

 Other factors to take into account are macroeconomic and

industry conditions, labour relations, and company strategy.

 Transparency

 Dishonest managers can manipulate numbers

 Lessons from Enron
 Cost of Sarbanes-Oxley (SOX)

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Summary
 The difference between market capitalization and the
book value of equity measures the market value added
by the firms investments and operations.

 Return on Capital (ROC) and Return on Assets (ROA)

are better measures of operating performance as they
use net operating profit after taxes (NOPAT)

 Profitability ratios measure return on investment.

 Leverage ratios measure amount of debt and ability to
service interest.
 Efficiency ratios measure how efficiently assets are
used.
 Liquidity ratios measure how easily a firm can obtain
cash.

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Summary
 Du Pont System links financial ratios together
to explain ROA and ROE.

 FinancialRatios don’t give the whole picture

but should prompt the right questions.
Comparisons should be made to previous
years to assess trends and to competitors.

 Transparency

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