Evaluating
Financial
Performance
CHAPTER TWO
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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.
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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%
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 3
The 3 Determinants of ROE
How is this
a measure of
leverage?
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 4
TABLE 2.1 ROE and Levers of Performance for 10 Diverse
Companies, 2016
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 5
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?
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 6
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%
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 7
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?
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 8
Hasbro’s Profitability Ratios
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 9
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.
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 10
You try it.
Calculate breakeven sales volume for Apple Inc. for 2016.
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 11
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?
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 12
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
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 13
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?
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 14
Hasbro’s Turnover-Control Ratios
Does a higher fixed-asset
turnover indicate higher or
lower capital intensity?
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 15
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
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 16
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
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 17
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.
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 18
TABLE 2.1 ROE and Levers of Performance for 10
Diverse Companies, 2016
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 19
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
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 20
Leverage and Liquidity Ratios
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?
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 21
Leverage and Liquidity Ratios
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?
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 22
Leverage and Liquidity Ratios
4
Liquidity Ratios
Current
ratio: Liquid assets compared to imminent
debts
Acid test (Quick ratio): Very liquid assets compared to
imminent debts
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 23
ROE: The Timing Problem
Is ROE forward-looking?
Does ROE have a long-term perspective?
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 24
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%
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 25
ROIC Is Not Distorted by Company Financing
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 26
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?
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 27
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.
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 28
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?
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 29
FIGURE 2.1 M/B vs. ROE for 20 Toy/Gaming/Leisure Firms
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 30
FIGURE 2.2 M/B vs. ROE for 82 Large Corporations
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 31
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.
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 32
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
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 33
FIGURE 2.3 The Levers of Performance Suggest One Road Map for Ratio
Analysis
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 34
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?
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 35
TABLE 2.2 Ratio Analysis of Hasbro
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 36
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
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 37
TABLE 2.3 Hasbro Common-Size Balance Sheets
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 38
TABLE 2.3 Hasbro Common-Size Income Statements
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 39
TABLE 2.4 Definitions of Principal Ratios Appearing in Chapter
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 40
TABLE 2.4 Definitions of Principal Ratios Appearing in
Chapter (cont.)
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HIGGINS, ANALYSIS FOR FINANCIAL MANAGEMENT, 12E Ch. 2 41
