Finance
Jaime F. Zender
Note: Because I have found no better presentation of this material, this closely
follows the discussion in the Higgins book.
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
1997-98 financial statement for the Timberland
Company as illustrations.
The Timberland Company, Balance Sheets ($ millions)
12/31/1997 12/31/1998 Change
Assets
Cash and marketable securities 98.8 151.9 53.1
Accounts receivable 75.8 79.0 3.2
Inventories 142.6 131.2 (11.4)
Prepaid expenses and other current assets 24.9 25.4 0.5
Total current assets 342.1 387.5
Property, plant, and equipment 116.5 131.2 14.7
Less accumulated depreciation and amortization (63.6) (74.3) (10.7)
Net property, plant, and equipment 52.9 56.9 4.0
Intangible assets 20.9 19.2 (1.7)
Other assets 4.2 5.8 1.6
Total assets $420.1 $469.4
EBIT $96.5
Times interest earned 10.2 times
Interest Expense $9.5
EBIT $96.5
Times burden covered 10.2 times
Princial repayment $9.5 $0.0 /(1 27.8 / 87.0)
Interest
1 Tax rate
Liquidity Ratios
• A 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”).
Current assets $387.5
Current ratio 4.0 times
Current liabilities $95.7
Current assets - Inventory $387.5 $131.2
Quick ratio 2.7 times
Current liabilities $95.7
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.
The Timing Problem
• As 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?
The Risk Problem
• We 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.
The Value Problem
• ROE 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.
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.
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 statement
– Asset turnover:
• Control ratios (inventory turnover, fixed asset turnover,
collection period, days sales in cash, payables period),
normalized balance sheet
– Financial leverage:
• Leverage ratios, coverage ratios, liquidity ratios
Ratio Analysis of Timberland Company 1994 - 1998
Industry
1994 1995 1996 1997 1998 Median
Major Ratios
ROE 11.9 (8.2) 12.3 22.1 22.2 12.3
ROA 3.8 (2.8) 4.5 11.3 12.6 7.4
ROIC 7.1 0.7 9.6 18.3 17.9 9.7
Profitability Ratios
Profit Margin 2.8 (1.8) 3.0 5.9 6.9 4.2
Gross Margin 35.0 33.7 39.4 41.7 41.9 38.4
Price to earnings ratio 13.5 NA 20.7 13.9 8.5 15.0
Turnover and Control Ratios
Asset Turnover 1.3 1.6 1.5 1.9 1.8 1.8
Fixed-asset Turnover 9.3 12.5 14.1 15.1 15.2 9.2
Inventory Turnover 1.9 2.4 2.6 3.3 3.8 2.7
Collection Period 73.5 53.4 53.2 34.7 33.4 39.1
Days' Sales in Cash 3.7 21.4 49.4 45.3 64.3 10.8
Payables Period 32.6 21.2 18.6 16.0 18.9 36.3
Leverage and Liquidity Ratios
Assets to Equity 3.2 3.0 2.7 2.0 1.8 1.7
Debt to Assets 68.5 66.2 63.2 48.8 43.3 39.6
Debt to Equity 217.4 196.3 171.9 95.4 76.3 65.5
Times Interest Earned 2.9 0.2 2.5 5.6 10.2 9.1
Times Burden Covered 1.6 0.1 1.1 5.6 10.2 7.4
Current Ratio 3.5 4.8 3.7 3.5 4.0 3.0
Acid Test 1.5 2.3 2.1 2.0 2.7 1.5
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.
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.
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.
Common-Sized Balance Sheet for Timberland and Industry
Industry
1994 1995 1996 1997 1998 Average
Assets
Cash and marketable securities 1.3% 9.1% 20.8% 23.5% 32.4% 7.4%
Accounts receivable 27.1 22.7 22.4 18.0 16.8 22.7
Inventories 46.1 42.9 35.4 34.0 28.0 37.1
Prepaid expenses and other current assets 4.4 5.5 4.1 5.9 5.4 5.5
Total current assets 79.0 80.2 82.6 81.4 82.6 72.0
Property, plant, and equipment 23.4 22.8 23.1 27.7 28.0 31.5
Less accumulated depreciation and amortization 9.0 10.3 12.2 15.1 15.8 13.6
Net property, plant, and equipment 14.4 12.4 10.9 12.6 12.1 17.9
Intangible assets 5.5 5.8 5.0 5.0 4.1 3.2
Other assets 1.1 1.6 1.5 1.0 1.2 6.9
Total assets 100% 100% 100% 100% 100% 100%