Corporate Performance & Financial Ratios

CORPORATE PERFORMANCE & FINANCIAL RATIOS

Profitability

  • Market Capitalization (Market cap)
    • Formula: extMarketcap=extPrice/shareimesextNumberofsharesoutstandingext{Market cap} = ext{Price/share} imes ext{Number of shares outstanding}
  • Market Value Added (MVA)
    • Formula: extMVA=extMarketcap−extBookvalueofEquityext{MVA} = ext{Market cap} - ext{Book value of Equity}
    • Measures:
    • How much value has been added for each dollar shareholders have invested.
    • Downsides:

    • a. A product of speculation.

    • b. MVA might fluctuate for external reasons.

    • c. Inaccessible for privately owned companies.
    • Broad, unprecise metric.
  • Cost of Capital
    • Definition: The minimum acceptable rate of return on capital investments.

Economic Value Added (EVA)

  • EVA Formula:
    • extEVA=extNetincome+extAfter−taxinterest−(extCostofcapitalimesextTotalcapitalization)ext{EVA} = ext{Net income} + ext{After-tax interest} - ( ext{Cost of capital} imes ext{Total capitalization})
    • Alternatively: extEVA=extNOPAT−(extCostofcapitalimesextTotalcapitalization)ext{EVA} = ext{NOPAT} - ( ext{Cost of capital} imes ext{Total capitalization})
    • Definition: Profit that excludes the cost of capital.
    • Characteristics:
    • Recognizes that companies need to cover their opportunity costs before they add value.
    • Makes the Cost of Capital visible.
    • More assets lead to more possibilities for EVA.
    • Downsides:
    • Inability to compare the performance of companies of differing sizes.
  • Net Operating Profit After Taxes (NOPAT)
    • Definition: extNOPAT=extNetincome+extAfter−taxinterestext{NOPAT} = ext{Net income} + ext{After-tax interest}
    • Importance: Reflects profit as if the company were all-equity financed, ensuring that all operating income is directed to shareholders.
    • More useful than net income because it removes the effect of interest tax deductions.
  • Comparison Metrics of Company Profits:
    1. Return On Capital (ROC)
    • Formula: extROC=extNOPATextTotalcapitalizationext{ROC} = \frac{ ext{NOPAT}}{ ext{Total capitalization}}
    • Total capitalization defined as: extTotalcapitalization=extDebt+extShareholderEquityext{Total capitalization} = ext{Debt} + ext{Shareholder Equity}
    • Indicates the extra percentage of profit made on the cost of capital; must be greater than the Cost of Capital.
    1. Return On Assets (ROA)
    • Formula: extROA=extNOPATextTotalassetsext{ROA} = \frac{ ext{NOPAT}}{ ext{Total assets}}
    • Indicates income available per asset; reflects the company's profitability if it were all-equity financed.
    • Particularly useful for comparing companies with different capital structures.
    1. Return On Equity (ROE)
    • Formula: extROE=extNetincomeextEquityext{ROE} = \frac{ ext{Net income}}{ ext{Equity}}
    • Indicates income per dollar invested by shareholders.

Overall Problems with Ratios

  1. Usage of book values that do not utilize current market values.
  2. Older assets may be undervalued; hence, performance may not accurately reflect current market conditions.
  3. Only showcases past good decisions without predictive capability.

Efficiency Ratios

  • Asset Turnover Ratio
    • Formula: extAssetTurnoverRatio=extTotalrevenue(orsales)extTotalassetsatthestartoftheyearext{Asset Turnover Ratio} = \frac{ ext{Total revenue (or sales)}}{ ext{Total assets at the start of the year}}
    • Significance: Indicates the number of sales generated per dollar of assets; assesses how efficiently assets are used.
    • Generally utilizes average total assets for calculation.
  • Inventory Turnover Ratio
    • Formula: extInventoryTurnover=extCostofsalesextAverageinventories(overtheyear)ext{Inventory Turnover} = \frac{ ext{Cost of sales}}{ ext{Average inventories (over the year)}}
    • Indicates how many times the entire inventory was sold and replaced over a period.
    • Alternative:
    • Average Days in Inventory: extAverageDaysinInventory=extAverageinventoriesextCostofsales/365ext{Average Days in Inventory} = \frac{ ext{Average inventories}}{ ext{Cost of sales} / 365}
      • Represents the number of days that inventory is held before it is sold.
  • Receivables Turnover Ratio
    • Formula: extReceivablesTurnover=extRevenuesextAverageaccountreceivablesext{Receivables Turnover} = \frac{ ext{Revenues}}{ ext{Average account receivables}}
    • Indicates the speed at which customers pay; a higher value is generally better.
    • Alternative:
    • Average Collection Period: extAverageCollectionPeriod=extAverageaccountreceivablesextAveragedailyrevenuesext{Average Collection Period} = \frac{ ext{Average account receivables}}{ ext{Average daily revenues}}
      • Indicates the number of days it takes for a company to collect payment from its customers.

Leverage Ratios

  • Definition: Indicates the extent of financial leverage a firm has adopted.
  • Ratios:
    1. Long-term Debt Ratio
    • Formula: extLong−termDebtRatio=extLong−termdebtextTotalassetsext{Long-term Debt Ratio} = \frac{ ext{Long-term debt}}{ ext{Total assets}}
    • Indicates the percentage of total assets that is financed through long-term debt.
    1. Debt-to-Equity Ratio
    • Formula: extDebt−to−EquityRatio=extLong−termdebtextTotalequityext{Debt-to-Equity Ratio} = \frac{ ext{Long-term debt}}{ ext{Total equity}}
    • Reflects the amount of debt financing per dollar of equity financing.
    1. Total Debt Ratio
    • Formula: extTotalDebtRatio=extTotaldebtextTotalassetsext{Total Debt Ratio} = \frac{ ext{Total debt}}{ ext{Total assets}}
    • Unlike the long-term debt ratio, it includes current liabilities in its calculations.
    1. Time-Interest Earned Ratio
    • Formula: extTime−InterestEarnedRatio=extEBITextInterestexpensesext{Time-Interest Earned Ratio} = \frac{ ext{EBIT}}{ ext{Interest expenses}}
    • Measures how much more earnings exist compared to interest obligations.
    1. Cash Coverage Ratio
    • Formula: extCashCoverageRatio=extEBIT+extDepreciation(amortization)extInterestexpense=extEBITDAextInterestexpenseext{Cash Coverage Ratio} = \frac{ ext{EBIT} + ext{Depreciation (amortization)}}{ ext{Interest expense}} = \frac{ ext{EBITDA}}{ ext{Interest expense}}
    • Acknowledges that depreciation and amortization are deducted in earnings calculations despite cash not being expended; reflects true operating performance.
  • ROE Linkage
    • Relation: extROE=extROAimesextSalesextTotalassetsimesextTotalassetsextEquityext{ROE} = ext{ROA} imes \frac{ ext{Sales}}{ ext{Total assets}} imes \frac{ ext{Total assets}}{ ext{Equity}}
    • Conditions for Borrowing Firms:
    • Leverage ratio > 1
    • Debt burden < 1
    • Leverage ratio defined as: extLeverageratio=extTotalassetsextEquityext{Leverage ratio} = \frac{ ext{Total assets}}{ ext{Equity}}
    • Debt burden defined as: extDebtburden=extNetincomeextNOPAText{Debt burden} = \frac{ ext{Net income}}{ ext{NOPAT}}
  • Note: Equity ratios particularly utilize book values because market-added value is difficult to quantify; it often originates from intangibles that may diminish with a drop in company valuation.

Liquidity

  • Definition: Refers to the company’s ability to quickly convert assets into cash when required, particularly for repayment obligations.
  • Liquid Assets: Trade receivables and finished goods inventories which have reliable book values; contrasted with illiquid assets, like real estate.
  • Disadvantages of Liquidity Ratios:
    • Current asset and liability values can fluctuate easily.
    • Liquid assets may transition to illiquid status over time.

More on Liquidity

  • Caution with Excess Liquidity: Holding excessive cash may indicate ineffective capital deployment, where the company is not actively reinvesting or utilizing its funds efficiently.
  • Net Working Capital
    • Formula: extNetworkingcapital=extCurrentassets−extCurrentliabilitiesext{Net working capital} = ext{Current assets} - ext{Current liabilities}
    • Represents a potential reservoir of cash for operational needs.
  • Liquidity Ratios:
    1. Current Ratio
    • Formula: extCurrentRatio=extCurrentassetsextCurrentliabilitiesext{Current Ratio} = \frac{ ext{Current assets}}{ ext{Current liabilities}}
    • Indicates the amount of assets available per dollar of liabilities.
    • Note: Can be misleading; better to calculate using short-term investments alongside short-term debts.
    1. Quick (Acid Test) Ratio
    • Formula: extQuickRatio=extQuickassetsextCurrentliabilitiesext{Quick Ratio} = \frac{ ext{Quick assets}}{ ext{Current liabilities}}
    • Definition of Quick Assets: Total current assets minus inventories, prepaid expenses, and assets held for sale.
    • Represents the ‘true’ assets per dollar of liabilities.
    1. Cash Ratio
    • Formula: extCashRatio=extCashandCashEquivalentsextCurrentliabilitiesext{Cash Ratio} = \frac{ ext{Cash and Cash Equivalents}}{ ext{Current liabilities}}
    • Measures liquidity for the most liquid assets available.
  • Note: Liquidity ratios may have negligible importance if the firm can secure short-term borrowing easily.

DuPont System

  1. Profit Margin
    • Formula: extProfitMargin=extNetincomeextRevenuesext{Profit Margin} = \frac{ ext{Net income}}{ ext{Revenues}}
    • Indicates the proportion of sales that translates into profits.
    • Operating Profit Margin:
      • Formula: extOperatingProfitMargin=extNOPATextRevenuesext{Operating Profit Margin} = \frac{ ext{NOPAT}}{ ext{Revenues}}
      • After-tax debt interest is added back to reflect operational returns properly.
  2. Return on Assets (ROA)
    • Formula: extROA=extNOPATextTotalassets=extAssetTurnoverimesextOperatingProfitMarginext{ROA} = \frac{ ext{NOPAT}}{ ext{Total assets}} = ext{Asset Turnover} imes ext{Operating Profit Margin}
    • Strategies different companies can adopt:
      • High Asset Turnover, Low Profit Margin: Example – Walmart.
      • Low Asset Turnover, High Profit Margin: Example – Louis Vuitton.
    • Typical ROA values range between 3-10%.