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.
