Corporate Performance Measurement: Financial Statements and Ratios

Measuring Corporate Performance

This week's session focuses on understanding and measuring corporate performance through various financial metrics and ratios. We will delve into market-based valuations, the key financial statements, and a range of accounting and efficiency ratios, along with their significance and limitations.

Topics Covered

• Market Value and Market Value Added (MVA).

• Market-to-Book value, Price-Earnings ratio, and growth opportunities.

• Performance evaluation and accounting rates of return.

• Operating efficiency, leverage, and liquidity.

• The role and limitations of financial ratios.

Market Value and Market Value Added

Market Capitalization

• Definition: The total market value of a company's outstanding equity.

• Calculation: It is determined by multiplying the share price by the total number of shares outstanding.

• Formula: \text{Market Capitalization} = (\text{# shares}) \times (\text{price per share})

Market Value Added (MVA)

• Definition: Represents the difference between a company's Market Capitalization and its book value of equity.

• Book Value of Equity: Measures shareholders' cumulative investment in the firm based on accounting records.

• Formula: \text{MVA} = \text{Market Capitalization} - \text{Book Value of Equity}

Example: Home Depot (End of 2017 Fiscal Year)

• Market Capitalization:

  • Share price: 190.21

  • Shares outstanding: 1,170 million

  • Calculation: 190.21 \times 1,170 \text{ m} = \$222,546 \text{ m}

• Market Value Added (MVA):

  • Book value of equity: \$1,454 \text{ m} (at the same point in time)

  • Calculation: \$222,546 \text{ m} - \$1,454 \text{ m} = \$221,092 \text{ million}

Income Statement

Purpose

• Core Financial Statement: One of the three primary financial statements of a company.

• Profit and Loss: Shows a company's financial performance (profit and loss) over a specific period of time (e.g., a quarter or a year).

• Usage: Crucial for corporate finance (including financial modeling) and accounting.

Components of an Income Statement

• Revenue/Sales: Total income generated from sales of goods or services.

• Cost of Goods Sold (COGS): Direct costs attributable to the production of goods sold by a company.

• Gross Profit: Revenue minus COGS.

• Marketing, Advertising, and Promotion Expenses: Costs associated with promoting and selling products/services.

• General and Administrative (G&A) Expenses: Operating expenses not directly related to production or sales, such as rent, utilities, and office supplies.

• EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization): A measure of a company's overall financial performance, often used as an alternative to simple earnings or net income.

• Depreciation & Amortization Expense: Non-cash expenses that systematically allocate the cost of a tangible (depreciation) or intangible (amortization) asset over its useful life.

• Operating Income (or EBIT - Earnings Before Interest and Taxes): Gross profit minus operating expenses (including G&A, marketing, and D&A). It represents the profit generated from a company's core operations.

• Interest Expense: Cost of borrowing money.

• Other Expenses: Various non-operating expenses.

• EBT (Pre-Tax Income): Operating income minus interest expense and other expenses.

• Income Taxes: Amount of tax owed on earnings.

• Net Income: The final profit after all expenses, including taxes, have been deducted from revenue.

• Allocation of Net Income: Typically divided into Dividends (paid to shareholders) and Addition to Retained Earnings (reinvested in the business).

Home Depot Income Statement Example (2017, in Million and % of Sales)

The Statement of Financial Position/Balance Sheet

Purpose and Structure

• Snapshot: Presents a company's assets, liabilities, and equity at a specific point in time.

• Two Sides: Shows the assets of the business on one side and the claims against those assets on the other.

• Claims Types:

  • Equity: Represents the claim of the owners (shareholders).

  • Liabilities: Represent the claims of others (e.g., creditors).

• Accounting Equation: The fundamental principle reflected by the balance sheet:
  \text{Assets} = \text{Equity} + \text{Liabilities}

Components of a Balance Sheet

Current Assets

• Definition: Assets expected to be converted into cash or used up within one year or one operating cycle.

• Examples:

  • Cash and Equivalents

  • Accounts Receivable (money owed to the company)

  • Inventory (goods available for sale)

Non-Current Assets (Fixed Assets)

• Definition: Assets not expected to be converted into cash or used up within one year.

• Examples:

  • Plant, Property, and Equipment (PP&E): Tangible assets like land, buildings, machinery.

  • Intangible Assets: Non-physical assets such as patents, trademarks, goodwill.

Current Liabilities

• Definition: Obligations due to be settled within one year or one operating cycle.

• Examples:

  • Accounts Payable (money owed by the company for goods/services received)

  • Current Debt/Notes Payable

  • Current Portion of Long-Term Debt (part of long-term debt due within a year)

Non-Current Liabilities (Long-Term Liabilities)

• Definition: Obligations due to be settled in more than one year.

• Examples:

  • Bonds Payable

  • Long-Term Debt

Shareholders' Equity

• Definition: The residual claim on assets after liabilities are settled.

• Components:

  • Share Capital: Funds raised by issuing shares.

  • Retained Earnings: Cumulative net income that has not been distributed as dividends.

Home Depot Balance Sheet Example (End of Fiscal Year 2017 & 2016, in Million)

Importance of the Balance Sheet

• Provides data for calculating key financial performance metrics, including:

  • Liquidity: Ability to meet short-term obligations (e.g., Current Ratio, Quick Ratio).

  • Leverage: Extent of debt financing (e.g., Debt to Equity).

  • Efficiency: How effectively assets are used to generate sales (e.g., Asset Turnover Ratio, Working Capital Cycle).

  • Rates of Return: Profitability relative to investments (e.g., Return on Equity (ROE), Return on Assets (ROA), Return on Invested Capital (ROIC)).

The Cash Flow Statement

Purpose

• Main Financial Statement: One of the three primary financial statements.

• Cash Movement: Reports the net cash generated and used by a company over a period, categorized into three main activities: operating, investing, and financing.

• Key Outcome: Provides the closing cash balance, reconciling with the balance sheet cash account.

Cash Flow from Operating Activities (Operating Cash Flow)

• Focus: Cash generated from regular business operations.

• Calculation: Starts with Net Earnings and adjusts for non-cash items and changes in working capital.

• Components:

  • Net Earnings

  • Plus: Depreciation and Amortization (D&A) (non-cash expense added back)

  • Less: Changes in working capital (e.g., increases in inventory or receivables subtract cash, increases in payables add cash)

  • Result: Cash from operations

Cash Flow from Investing Activities (Investing Cash Flow)

• Focus: Cash used for or generated from the purchase or sale of long-term assets.

• Components:

  • Investments in Property and Equipment (purchases are cash outflows)

  • Proceeds from sale of property, plant, and equipment (sales are cash inflows)

  • Investments in other businesses or securities (purchases are cash outflows, sales are cash inflows)

Cash Flow from Financing Activities (Financing Cash Flow)

• Focus: Cash flows involving debt and equity.

• Components:

  • Issuance (cash inflow) or repayment (cash outflow) of debt.

  • Issuance (cash inflow) or repayment (e.g., share repurchases - cash outflow) of equity.

  • Payment of dividends (cash outflow).

Net Increase (Decrease) in Cash and Closing Cash Balance

• The sum of cash flows from operating, investing, and financing activities.

• Opening Cash Balance: The cash balance at the beginning of the reporting period.

• Closing Cash Balance: Opening cash balance plus the net increase/decrease in cash.

Example: Ryanair Cash Flow (Year Ending 2022, in Million)

• Net Cash provided by Operating Activities: 441.485

• Net Cash provided by Investing Activities: -243.634

• Net Cash provided by Financing Activities: -84.664

• Increase in Cash and Cash Equivalents: 113.187

Ryanair's Operating Activities Detailed (2022 vs. 2021, in Million)

Ryanair's Investing Activities Detailed (2022 vs. 2021, in Million)

Ryanair's Financing Activities Detailed (2022 vs. 2021, in Million)

Ryanair's Cash Flow Summary (2022 vs. 2021, in Million)

Market-Based Ratios

Market-to-Book Ratio (M/B Ratio)

• Definition: A standardized measure showing how much value has been added for each dollar shareholders have invested.

• Formula: \text{Market-to-Book ratio} = \frac{\text{Market Value of Equity}}{\text{Book Value of Equity}} = \frac{\text{Stock Price}}{\text{Book Value per Share}}

• Home Depot Example:

  • Market Value of Equity: \$222,546 \text{ m} (Market Capitalization)

  • Book Value of Equity: \$1,454 \text{ m} (from Balance Sheet)

  • M/B Ratio: \frac{\$222,546}{\$1,454} = 153

• Interpretation: A ratio greater than 1 suggests that the company is creating value for its shareholders.

Market Value Added & M/B Ratio Comparison

• Observation: Microsoft's MVA is higher than Johnson & Johnson and Coca-Cola, despite a lower M/B ratio, largely due to its larger absolute scale (Market Capitalization).

Price/Earnings Ratio (P/E Ratio)

• Definition: Measures how much investors are willing to pay for 1 dollar of reported earnings.

• Formula: \text{Price/Earnings ratio} = \frac{\text{Market Price per Share}}{\text{Earnings per Share}}

• Significance: P/E and M/B ratios are commonly used by analysts and investors as important indicators of growth opportunities.

  • Growth opportunities add value to the firm only when the return on investments is higher than the cost of capital.

• Home Depot Example:

  • Market Price per Share: 190.21

  • Net Income: 8,630 million

  • Shares outstanding: 1,170 million

  • Earnings per Share (EPS): 8,630 \text{ m} / 1,170 \text{ m} = 7.376

  • P/E Ratio: \frac{190.21}{(8,630/1,170)} = 25.8

Limitations of Market-Value Performance Measures

• Future Expectations: Stock prices reflect investors’ expectations about future performance, which can be speculative.

• External Factors: Market values can fluctuate due to factors or events outside the firm management’s control (e.g., economic downturns, industry-wide issues).

• Applicability: Cannot be used to measure the performance of privately held firms, subsidiaries, or divisions, as they do not have publicly traded shares.

Financial Analysis Using Ratios

Purpose and Methodology

• Standardization: A popular way to analyze financial statements by standardizing measures, making comparisons easier.

• Performance Evaluation: Helps evaluate firm performance and identify areas that need corrective action.

• Comparison and Projection: Useful for comparing the financial performance of different divisions within a company and preparing financial projections.

• Benchmarking: Ratios should be compared to:

  • Those from previous years for trend analysis.

  • Those of other firms in the same industry to provide an appropriate benchmark.

Users of Financial Ratios (Outside the Firm)

• Lenders: Use ratios to decide whether or not to lend to a company and to assess repayment capacity.

• Credit-Rating Agencies: Employ ratios in determining a firm’s creditworthiness and assigning credit ratings.

• Investors (shareholders, bondholders): Use ratios to decide whether or not to invest in a company and to evaluate its potential returns and risks.

• Major Suppliers: Utilize ratios to decide whether or not to extend credit to a company and to design specific credit terms.

Operating Performance Ratios

Return on Assets (ROA)

• Definition: Measures how profitably a company uses its assets to generate income.

• Formula: \text{Return on Assets} = \frac{\text{After-tax Operating Income}}{\text{Total Assets}}

• After-tax Operating Income Calculation: Net Income + After-tax Interest.

  • After-tax Interest: \text{Interest Expense} \times (1 - \text{Tax Rate}) (Assuming tax rate = 0.35)

  • Home Depot Interest Expense: \$1,057 \text{ m} (from Income Statement)

  • After-tax Interest = 1,057 \times (1 - 0.35) = \$687 \text{ m}

  • After-tax Operating Income = 8,630 \text{ m} + 687 \text{ m} = \$9,317 \text{ m}

• Home Depot Example:

  • Total Assets: \$44,529 \text{ m} (from Balance Sheet)

  • ROA: \frac{9,317}{44,529} = 0.209 = 20.9\%

• Significance:

  • Shows how profitable the company would have been if it were entirely equity-financed.

  • Useful for comparing the profitability of firms with different capital structures, as it removes the effect of financing decisions.

Return on Equity (ROE)

• Definition: Measures the income generated for shareholders per dollar they have invested in the firm.

• Formula: \text{Return on Equity} = \frac{\text{Net Income}}{\text{Book Value of Equity}}

• Home Depot Example:

  • Net Income: \$8,630 \text{ m} (from Income Statement)

  • Book Value of Equity: \$1,454 \text{ m} (from Balance Sheet)

  • ROE: \frac{8,630}{1,454} = 5.935 = 593.5\%

• Interpretation: The unusually high ROE for Home Depot is attributed to its sustained program of share repurchases, which has significantly reduced the book value of shareholders’ equity to very low levels.

Profit Margin

• Definition: Measures the proportion of sales that translates into net income.

• Significance: Indicates how effective the company is in managing its cost of goods sold and operating expenses.

• Formula: \text{Profit Margin} = \frac{\text{Net Income}}{\text{Sales}}

• Home Depot Example:

  • Net Income: \$8,630 \text{ m} (from Income Statement)

  • Sales (Net Sales): \$100,904 \text{ m} (from Income Statement)

  • Profit Margin: \frac{8,630}{100,904} = 0.086 = 8.6\%

Operating Profit Margin

• Definition: Measures after-tax operating income relative to sales, excluding the impact of financing costs.

• Significance: Similar to ROA, it helps compare companies that employ different capital structures.

  • A firm's profit margin might appear lower simply because it uses more debt financing and pays higher interest, which operating profit margin addresses.

• Formula: \text{Operating Profit Margin} = \frac{\text{After-tax Operating Income}}{\text{Sales}} \text{ or } \frac{\text{Net Income} + (1 - \text{Tax Rate}) \times \text{Interest Expense}}{\text{Sales}}

• Home Depot Example:

  • After-tax Operating Income: \$9,317 \text{ m} (calculated for ROA)

  • Sales: \$100,904 \text{ m}

  • Operating Profit Margin: \frac{8,630 + (1 - 0.35) \times 1,057}{100,904} = \frac{9,317}{100,904} = 0.0923 = 9.23\%

Efficiency Ratios

Asset Turnover Ratio

• Definition: Measures how efficiently a firm is using its entire asset base to generate sales.

• Formula: \text{Asset Turnover Ratio} = \frac{\text{Sales}}{\text{Total Assets}}

• Home Depot Example:

  • Sales: \$100,904 \text{ m} (from Income Statement)

  • Total Assets: \$44,529 \text{ m} (from Balance Sheet)

  • Asset Turnover Ratio: \frac{100,904}{44,529} = 2.27

• Interpretation: Home Depot generates 2.27 in sales for every dollar invested in assets.

Inventory Turnover

• Definition: Indicates how many times a firm's inventories are sold and replaced during the year.

• Formula: \text{Inventory Turnover Ratio} = \frac{\text{Cost of Goods Sold}}{\text{Inventory}}

• Home Depot Example:

  • Cost of Goods Sold: \$66,548 \text{ m} (from Income Statement)

  • Inventory: \$12,748 \text{ m} (from Balance Sheet)

  • Inventory Turnover Ratio: \frac{66,548}{12,748} = 5.22

Average Days in Inventory

• Definition: Measures how long inventory is held before being sold (or for how many days the inventory lasts).

• Formula: \text{Average days in Inventory} = \frac{\text{Inventory}}{\text{Cost of Goods Sold}/365}

• Home Depot Example:

  • Average Days in Inventory: \frac{12,748}{66,548/365} = 70 \text{ days}

Receivables Turnover

• Definition: Measures how efficiently a company collects its receivables.

• Significance: A high ratio often indicates an efficient credit department that actively follows up on late payers.

• Formula: \text{Receivables Turnover} = \frac{\text{Sales}}{\text{Receivables}}

• Home Depot Example:

  • Sales: \$100,904 \text{ m} (from Income Statement)

  • Receivables: \$1,952 \text{ m} (from Balance Sheet - Accounts Receivable)

  • Receivables Turnover: \frac{100,904}{1,952} = 51.7

Average Collection Period

• Definition: Calculates the average number of days it takes for customers to pay their bills.

• Formula: \text{Average collection period} = \frac{\text{Receivables}}{\text{Sales}/365}

• Home Depot Example:

  • Average Collection Period: \frac{1,952}{100,904/365} = 7.1 \text{ days}

• Interpretation: On average, Home Depot’s customers pay their bills in about 7.1 days.

Leverage Ratios

Total Debt Ratio

• Definition: Indicates the percentage of the firm’s assets that are financed by debt.

  • The remaining balance is financed by equity.

• Significance: Debt increases returns to shareholders in good times but amplifies losses in bad times, creating financial leverage.

• Formula: \text{Total Debt Ratio} = \frac{\text{Total Debt}}{\text{Total Assets}}

• Home Depot Example:

  • Total Debt (Total Liabilities): \$43,075 \text{ m} (from Balance Sheet)

  • Total Assets: \$44,529 \text{ m} (from Balance Sheet)

  • Total Debt Ratio: \frac{43,075}{44,529} = 0.97 = 97\%

• Interpretation: Home Depot finances 97\% of its assets by debt and 3\% by equity.

Times Interest Earned Ratio (TIE)

• Definition: Shows the extent to which interest obligations are covered by earnings.

• Formula: \text{Times Interest Earned} = \frac{\text{EBIT}}{\text{Interest Payments}}

• Home Depot Example:

  • EBIT (Earnings before interest and income tax): \$14,755 \text{ m} (from Income Statement)

  • Interest Expense: \$1,057 \text{ m} (from Income Statement)

  • TIE: \frac{14,755}{1,057} = 14

• Interpretation: By this measure, Home Depot appears to be conservatively financed with interest payments covered 14 times by earnings.

• Limitation: This ratio does not indicate whether the firm is generating enough cash to repay its debt as it becomes due.

Cash Coverage Ratio

• Definition: A more robust measure of debt servicing ability, accounting for depreciation as a non-cash expense.

• Formula: \text{Cash Coverage Ratio} = \frac{\text{EBIT + Depreciation}}{\text{Interest Payments}}

• Rationale: Depreciation is added back to EBIT because it is a non-cash expense, providing a better proxy for operating cash flow available to cover interest payments.

• Home Depot Example:

  • EBIT: \$14,755 \text{ m} (from Income Statement)

  • Depreciation: \$2,062 \text{ m} (from Income Statement)

  • Interest Expense: \$1,057 \text{ m} (from Income Statement)

  • Cash Coverage Ratio: \frac{14,755 + 2,062}{1,057} = 15.9

Quick Question: Debt Repayment and Issuance Impact

• Scenario: A firm repays \text{£}10 \text{ million} face value of outstanding debt and issues \text{£}10 \text{ million} of new debt with a lower interest rate.

• Impact on Total Debt Ratio: Nothing will happen to the total debt ratio (computed using book values) as the face values of the old and new debt are equal, so total debt remains unchanged.

• Impact on Times Interest Earned and Cash Coverage Ratios: Both ratios will increase because the firm will reduce its interest expense (due to the lower interest rate on the same amount of debt), while EBIT and (EBIT+Depreciation) remain constant or improve relatively.

Liquidity Ratios

Current Ratio

• Definition: Measures a company's ability to meet its short-term obligations using its short-term assets.

• Liquid Asset: An asset that can be converted quickly and cheaply into cash at the current market price.

• Formula: \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}

• Home Depot Example:

  • Current Assets: \$18,933 \text{ m} (from Balance Sheet)

  • Current Liabilities: \$16,194 \text{ m} (from Balance Sheet)

  • Current Ratio: \frac{18,933}{16,194} = 1.17

• Net Working Capital:

  • Definition: The difference between current assets and current liabilities.

  • Formula: \text{Net Working Capital} = \text{Current Assets} - \text{Current Liabilities}

  • Home Depot Example: 18,933 - 16,194 = \$2,739 \text{ m}

Acid Test or Quick Ratio

• Definition: A more stringent measure of liquidity, excluding less liquid current assets like inventory.

• Rationale: Managers often exclude inventory and other less-liquid components of current assets because they may not be easily converted into cash, especially if the company faces financial trouble.

• Formula: \text{Quick Ratio} = \frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}}

• Home Depot Example:

  • Current Assets: \$18,933 \text{ m} (from Balance Sheet)

  • Inventory: \$12,748 \text{ m} (from Balance Sheet)

  • Current Liabilities: \$16,194 \text{ m} (from Balance Sheet)

  • Quick Ratio: \frac{18,933 - 12,748}{16,194} = 0.38

• Drawback of Liquidity Ratios: Because short-term assets and liabilities are easily changed, measures of liquidity can rapidly become outdated and may not always reflect a consistent picture of a firm's financial health.

The Limitations of Financial Ratio Analysis

• Snapshot Nature: The financial position statement (balance sheet) is a snapshot, reflecting the company's position at a specific date, which may not be representative of the entire period.

• Starting Point for Analysis: Ratio analysis should be seen as the start of the analysis, raising questions that require deeper investigation rather than providing definitive answers.

• Difficulty in Industry Comparison: It is sometimes challenging to identify appropriate industry categories or truly comparable peers, especially for diversified firms.

• Accounting Practice Differences: Accounting practices can differ widely among firms, even within the same industry, making direct comparisons difficult without adjustment.

• Inadequacy of Single Ratios: Investment decisions should never be made based on a single ratio alone; a comprehensive analysis involving multiple ratios and qualitative factors is essential.