McGraw-Hill/Irwin

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Corporate Performance
Corporate Performance

Calculations:
Financial Ratios

Underlying Data:
Corporate Financials & Market Values

4-2

Corporate Performance Measured

Market Value Add

Corporate Performance

Economic Value Add

Book Rates of Return

4-3

Market Value Added

What is it?

Why is it useful? Defined:

Market Value Added [Share Price Shares Outstanding] - EquityBook Value

4-4

MVA: Discussion
Market Value Added [Share Price Shares Outstanding] - EquityBook Value
TABLE 4.3

Consider AT&T and Home Depot Similar MVA, Different Market-to-Book Ratio Why?
4-5

Economic Value Added

What is it?
Why is it important? Why is it called residual income?

Defined:
Economic Value Added Operating Income* - [Cost of Capital Total Capitalization]

4-6

EVA: Discussion
Economic Value Added Operating Income - [Cost of Capital Total Capitalization]
TABLE 4.4

Consider Coca-Cola and Google Similar EVA, Different Return on Capital Why?
* Operating Income = Net Income + After-tax Interest; ROC = Return on Capital

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Book Rates of Return*

What do they measure?
Return on Capital: Return on Assets: Return on Equity:

*Book Rates of Return are also referred to as Accounting rates of Return

4-8

Calculating Return on Capital

Assets 2009 $ 632 425 8,249 208 218 9,732 22,499 277 497 33,005 2009 $ 552 4,287 577 683 1,256 7,355 4,528 598 1,455 13,936 729 6 18,307 27 19,069 $ 33,005 2008 245 416 8,209 105 215 9,190 22,722 253 460 32,625 2008 987 34 4,109 434 674 1,322 7,560 5,039 599 1,372 14,570 735 277 17,049 (6) 18,055 32,625

Lowes Return on Capital

After Tax Operating Income = Net Income + After-Tax Interest = 1,783 + 181 = 1,964
Average Total Capitalization = Average Long-Term Debt + Equity (23,579 23, 094) 23,336.5 2

Current assets: Cash and cash equivalents Short-term investments Merchandise inventory - net Deferred income taxes - net Other current assets Total current assets Property less acc. depreciation Long-term investments Other assets Total assets Liabilities and Shareholders' Equity Current liabilities: Short-term borrowings Current maturities of long-term debt Accounts payable Accrued comp./employee benefits Deferred revenue Other current liabilities Total current liabilities Long-term debt, excl. current maturities Deferred income taxes - net Other liabilities Total liabilities

ROC

After-Tax Operating Income 1,964 8.4% Average Total Capitalization 23,336.5

2009 47,220 30,757 16,463 11,688 49 1,614 287 13,638 2,825 1,042 1,783

Lowe's Income Statement Net sales Cost of sales Gross margin Expenses: Selling, general and administrative Store opening costs Depreciation Interest - net Total expenses Pre-tax earnings Income tax provision Net earnings

Shareholders' equity: Common stock - $.50 par value Capital in excess of par value Retained earnings Acc. other comprehensive income Total shareholders' equity

Lowes Balance Sheet (in $m)

Total liabilities and shareholders' equity

4-9

Calculating Return on Assets

Lowes Return on Assets
After Tax Operating Income = Net Income + After-Tax Interest = 1,783 + 181 = 1,964
Average Total Assets = (33, 005 32, 625) 2 32,815
Lowes Balance Sheet (in $m)
Assets Current assets: Cash and cash equivalents Short-term investments Merchandise inventory - net Deferred income taxes - net Other current assets Total current assets Property less acc. depreciation Long-term investments Other assets Total assets Liabilities and Shareholders' Equity Current liabilities: Short-term borrowings Current maturities of long-term debt Accounts payable Accrued comp./employee benefits Deferred revenue Other current liabilities Total current liabilities $ $ 2009 632 425 8,249 208 218 9,732 22,499 277 497 33,005 2009 552 4,287 577 683 1,256 7,355 4,528 598 1,455 13,936 729 6 18,307 27 19,069 $ 33,005 2008 245 416 8,209 105 215 9,190 22,722 253 460 32,625 2008 987 34 4,109 434 674 1,322 7,560 5,039 599 1,372 14,570 735 277 17,049 (6) 18,055 32,625

ROA

After-Tax Operating Income 1, 964 6.0% Average Total Assets 32,815 After-Tax Operating Income 1, 964 6.0% Total AssetsYear Beginning 32, 625
2009 47,220 30,757 16,463 11,688 49 1,614 287 13,638 2,825 1,042 1,783

or ROA =

Lowe's Income Statement Net sales Cost of sales Gross margin Expenses: Selling, general and administrative Store opening costs Depreciation Interest - net Total expenses Pre-tax earnings Income tax provision Net earnings

Long-term debt, excl. current maturities Deferred income taxes - net Other liabilities Total liabilities Shareholders' equity: Common stock - $.50 par value Capital in excess of par value Retained earnings Acc. other comprehensive income Total shareholders' equity Total liabilities and shareholders' equity

4-10

Calculating Return on Equity

Lowes Return on Equity
Average Total Equity = (19, 069 18, 055) 2 18,562
Lowes Balance Sheet (in $m)
Assets Current assets: Cash and cash equivalents Short-term investments Merchandise inventory - net Deferred income taxes - net Other current assets Total current assets Property less acc. depreciation Long-term investments Other assets Total assets Liabilities and Shareholders' Equity $ 2009 632 425 8,249 208 218 9,732 22,499 277 497 33,005 2009 $ 552 4,287 577 683 1,256 7,355 4,528 598 1,455 13,936 729 6 18,307 27 19,069 $ 33,005 2008 245 416 8,209 105 215 9,190 22,722 253 460 32,625 2008 987 34 4,109 434 674 1,322 7,560 5,039 599 1,372 14,570 735 277 17,049 (6) 18,055 32,625

ROE

Net Income 1, 783 9.6% Average Total Equity 18,562 Net Income 1, 783 9.9% EquityYear Beginning 18, 055
2009 47,220 30,757 16,463 11,688 49 1,614 287 13,638 2,825 1,042 1,783

or ROE =

Current liabilities: Short-term borrowings Current maturities of long-term debt Accounts payable Accrued comp./employee benefits Deferred revenue Other current liabilities Total current liabilities Long-term debt, excl. current maturities Deferred income taxes - net Other liabilities Total liabilities Shareholders' equity: Common stock - $.50 par value Capital in excess of par value Retained earnings Acc. other comprehensive income Total shareholders' equity Total liabilities and shareholders' equity

Lowe's Income Statement Net sales Cost of sales Gross margin Expenses: Selling, general and administrative Store opening costs Depreciation Interest - net Total expenses Pre-tax earnings Income tax provision Net earnings

4-11

Financial Ratios and Shareholder Value

Shareholder Value Investment Decisions Efficiency Ratios Profitability Ratios Financing Decisions Leverage Ratios Liquidity Ratios

Shareholder value depends on good investment and financing decisions.

Financial Ratios help measure the success and soundness of these decisions.

4-12

Efficiency Ratios
Asset turnover ratio = Sales Total AssetsYear Beginning

OR*

Sales Average Total Assets

How does this ratio measure efficiency?

Receivables Turnover=

Sales ReceivablesYear Beginning

How does this ratio measure efficiency?

* Either equation is a legitimate way to calculate the asset turnover ratio

4-13

Efficiency Ratios
Cost of Goods Sold Inventory Turnover Ratio= InventoryYear Beginning
How does this ratio measure efficiency?

Average Days in Inventory=

InventoryYear Beginning (Cost of Goods Sold/365)

How does this ratio measure efficiency?

Average Collection Period=

ReceivablesYear Beginning (Sales/365)

How does this ratio measure efficiency?

4-14

Calculating an Efficiency Ratio

Lowes Balance Sheet (in $m)
Current assets: Cash and cash equivalents Short-term investments Merchandise inventory - net Deferred income taxes - net Other current assets Total current assets Property less acc. depreciation Long-term investments Other assets Total assets Liabilities and Shareholders' Equity Current liabilities: Short-term borrowings Current maturities of long-term debt Accounts payable Accrued comp./employee benefits Deferred revenue Other current liabilities Total current liabilities Long-term debt, excl. current maturities Deferred income taxes - net Other liabilities Total liabilities $ Assets $ 2009 632 425 8,249 208 218 9,732 22,499 277 497 33,005 2009 552 4,287 577 683 1,256 7,355 4,528 598 1,455 13,936 729 6 18,307 27 19,069 $ 33,005 2008 245 416 8,209 105 215 9,190 22,722 253 460 32,625 2008 987 34 4,109 434 674 1,322 7,560 5,039 599 1,372 14,570 735 277 17,049 (6) 18,055 32,625

Lowes Asset Turnover Ratio

Average Total Assets = (33, 005 32, 625) 2 32,815

Sales 44, 270 Asset Turnover Ratio 1.4 Average Total Assets 32,815
Lowe's Income Statement Net sales Cost of sales Gross margin Expenses: Selling, general and administrative Store opening costs Depreciation Interest - net Total expenses Pre-tax earnings Income tax provision Net earnings 2009 47,220 30,757 16,463 11,688 49 1,614 287 13,638 2,825 1,042 1,783

Shareholders' equity: Common stock - $.50 par value Capital in excess of par value Retained earnings Acc. other comprehensive income Total shareholders' equity Total liabilities and shareholders' equity

4-15

Profitability Ratios
Net Income Profit Margin= Sales
How does this ratio measure the firms profitability?

Operating Profit Margin=

Net Income After-Tax Interest Sales

When is this ratio potentially more useful than just profit margin?

Note: ROC, ROA, ROE and EVA are also typically considered profitability ratios.
4-16

Calculating a Profitability Ratio

Lowes Balance Sheet (in $m)
Current assets: Cash and cash equivalents Short-term investments Merchandise inventory - net Deferred income taxes - net Other current assets Total current assets Property less acc. depreciation Long-term investments Other assets Total assets Liabilities and Shareholders' Equity Assets $ 2009 632 425 8,249 208 218 9,732 22,499 277 497 33,005 2009 $ 552 4,287 577 683 1,256 7,355 4,528 598 1,455 13,936 729 6 18,307 27 19,069 $ 33,005 2008 245 416 8,209 105 215 9,190 22,722 253 460 32,625 2008 987 34 4,109 434 674 1,322 7,560 5,039 599 1,372 14,570 735 277 17,049 (6) 18,055 32,625

Lowes Operating Profit Margin

Net Income + After-Tax Interest 1, 783 181 4.2% Sales 47, 220

OPM

Current liabilities: Short-term borrowings Current maturities of long-term debt Accounts payable Accrued comp./employee benefits Deferred revenue Other current liabilities Total current liabilities Long-term debt, excl. current maturities Deferred income taxes - net Other liabilities Total liabilities

Lowe's Income Statement Net sales Cost of sales Gross margin Expenses: Selling, general and administrative Store opening costs Depreciation Interest - net Total expenses Pre-tax earnings Income tax provision Net earnings

2009 47,220 30,757 16,463 11,688 49 1,614 287 13,638 2,825 1,042 1,783

Shareholders' equity: Common stock - $.50 par value Capital in excess of par value Retained earnings Acc. other comprehensive income Total shareholders' equity Total liabilities and shareholders' equity

4-17

Leverage Ratios
Long Term Debt Long term debt ratio= Long Term Debt+Equity
How does this ratio measure leverage?

Long-term Debt Equity Ratio=

How does this ratio measure leverage?

Long-Term Debt Equity

4-18

Measuring Leverage
Total Liabilities Total Assets How does this ratio measure leverage? Total Debt Ratio=

Times Interest Earned=

EBIT Interest Payments

How does this ratio measure leverage?

EBIT+Depreciation Cash Coverage Ratio= Interest Payments

How does this ratio measure leverage?

4-19

Calculating a Leverage Ratio

Lowes Balance Sheet (in $m)

Lowes Times Interest Earned Ratio

EBIT = Sales - COGS - Expenses - Depreciation 47, 220 30, 757 11, 737 1, 614 3,112

Assets Current assets: Cash and cash equivalents Short-term investments Merchandise inventory - net Deferred income taxes - net Other current assets Total current assets Property less acc. depreciation Long-term investments Other assets Total assets Liabilities and Shareholders' Equity $

2009 632 425 8,249 208 218 9,732 22,499 277 497 33,005 2009 $ 552 4,287 577 683 1,256 7,355 4,528 598 1,455 13,936 729 6 18,307 27 19,069 $ 33,005

2008 245 416 8,209 105 215 9,190 22,722 253 460 32,625 2008 987 34 4,109 434 674 1,322 7,560 5,039 599 1,372 14,570 735 277 17,049 (6) 18,055 32,625

Times Interest Earned

Lowe's Income Statement Net sales Cost of sales Gross margin Expenses: Selling, general and administrative Store opening costs Depreciation Interest - net Total expenses Pre-tax earnings Income tax provision Net earnings

EBIT 3,112 10.8 Interest 287

2009 47,220 30,757 16,463 11,688 49 1,614 287 13,638 2,825 1,042 1,783

Current liabilities: Short-term borrowings Current maturities of long-term debt Accounts payable Accrued comp./employee benefits Deferred revenue Other current liabilities Total current liabilities Long-term debt, excl. current maturities Deferred income taxes - net Other liabilities Total liabilities Shareholders' equity: Common stock - $.50 par value Capital in excess of par value Retained earnings Acc. other comprehensive income Total shareholders' equity Total liabilities and shareholders' equity

4-20

Measuring Liquidity
NWC to Total Assets Ratio = Net Working Capital Total Assets
How does this ratio measure liquidity?

Current Assets Current Ratio= Current Liabilities

How does this ratio measure liquidity?

4-21

Liquidity Ratios
Quick ratio= Cash + Marketable Securities + Receivables Current Liabilities
How does this ratio differ form the current ratio? Why might a financial manager prefer it?

Cash Ratio=

Cash + Marketable Securities Current Liabilities

How does this ratio differ from the current ratio? Why might a financial manager prefer it?

4-22

Calculating a Liquidity Ratio

Lowes Balance Sheet (in $m)
Assets Current assets: Cash and cash equivalents Short-term investments Merchandise inventory - net Deferred income taxes - net Other current assets Total current assets Property less acc. depreciation Long-term investments Other assets Total assets Liabilities and Shareholders' Equity Current liabilities: Short-term borrowings Current maturities of long-term debt Accounts payable Accrued comp./employee benefits Deferred revenue Other current liabilities Total current liabilities $ $ 2009 632 425 8,249 208 218 9,732 22,499 277 497 33,005 2009 552 4,287 577 683 1,256 7,355 4,528 598 1,455 13,936 729 6 18,307 27 19,069 $ 33,005 2008 245 416 8,209 105 215 9,190 22,722 253 460 32,625 2008 987 34 4,109 434 674 1,322 7,560 5,039 599 1,372 14,570 735 277 17,049 (6) 18,055 32,625

Lowes NWC to Total Assets Ratio

Net Working Capital = 9,732-7,355 2,377
NWC to Total Assets
Lowe's Income Statement Net sales Cost of sales Gross margin Expenses: Selling, general and administrative Store opening costs Depreciation Interest - net Total expenses Pre-tax earnings Income tax provision Net earnings

NWC 2,377 7.2% Total Assets 33, 005

2009 47,220 30,757 16,463 11,688 49 1,614 287 13,638 2,825 1,042 1,783

Long-term debt, excl. current maturities Deferred income taxes - net Other liabilities Total liabilities Shareholders' equity: Common stock - $.50 par value Capital in excess of par value Retained earnings Acc. other comprehensive income Total shareholders' equity Total liabilities and shareholders' equity

4-23

The DuPont System

What is it, and what is it used for?

4-24

The DuPont System: ROA

Net Income Interest ROA= Assets
Sales Net Income Interest ROA= x Assets Sales

Asset Turnover

Operating Profit Margin

4-25

ROA Decomposition by Industry

4-26

The DuPont System: ROE

Net Income ROE= Equity Assets Sales Net Income Interest Net Income ROE= x x x Equity Assets Sales Net Income Interest

Leverage Ratio Asset Turnover

Operating Profit Margin

Debt Burden

4-27

Sustainable Growth
Payout Ratio= Dividends Earnings
Plowback Ratio= Earnings-Dividends Earnings

Growth in equity from plowback = Plowback Ratio ROE Earnings - Dividends Earnings Earnings Equity Earnings-Dividends = Equity
4-28

The Role of Financial Ratios

Table 4.8

4-29

The Role of Financial Ratios

4-30

Appendix A: Average Ratios, by Industry

Table 4.7

4-31

Appendix B: Financial Ratios and Default Risk

Table 4.9

4-32