Evaluating Financial Performance

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Evaluating Financial Performance

• Finance
• Jaime F. Zender

Note Because I have found no better presentation
of this material, this closely follows the
presentation in the Higgins book.
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Financial Performance

• One of the most fundamental facts about
  businesses is that the operating performance of
  the firm shapes its financial structure.
• It is also true that the financial situation of
  the firm can also determine its operating
  performance.
• The financial statements are therefore important
  diagnostic tools for the informed manager.
• Too keep the discussion grounded, we will use the
  1997-98 financial statement for the Timberland
  Company as illustrations.

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Return On Equity

• The most popular measure of financial performance
  (for many audiences) is ROE.
• ROE measures accounting earnings for a period per
  dollar of shareholders equity invested.
• For Timberland 1998 ROE was

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Dissecting ROE

• ROEs popularity stems from the fact that it is,
  in a sense, a summary of the information on the
  income statement and both sides of the balance
  sheet. Provides an accounting measure of the
  returns to shareholders investment.
• The three determinants of ROE
• Profit Margin Net Income/Sales
• Asset Turnover Sales/Assets
• Financial Leverage Assets/Shareholders equity
• ROE comes from the joint inputs of these three
  pieces. 22.2 6.9 1.8 1.8

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ROE Across Companies

• Generally speaking ROE is reasonably similar
  across companies. Why?
• One would like to have a company with a high
  profit margin and a high asset turnover.
  Typically one of these will be relatively high
  and one relatively low. Why?
• What determines the firms choice of financial
  leverage?
• Lets look at each component in isolation.

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Profit Margin

• This ratio measures the fraction of each dollar
  of sales that makes it through to net income.
• It is of primary importance to an operating
  officer as it reflects the companys pricing
  strategy and its ability to control costs.
• Timberlands profit margin Net Income/Sales
  59.2/862.2 6.9
• The gross margin measures profitability
  relative to variable costs Gross Profits/Sales
• Gross profit is sales less cost of goods sold.
  Timberlands gross margin is 361.1/862.2
  41.9 indicating that about 42 of each dollar in
  sales is available to cover fixed costs and
  profits.

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Asset Turnover

• This ratio measures the sales generated per
  dollar of assets employed.
• Measures capital intensity with a low asset
  turnover indicating a capital intensive business.
• Nice illustration that more assets is not always
  better.
• Control of a companys assets is critical and
  control of current assets is especially critical
  to success.
• Asset turnover sales/assets 862.2/469.4
  1.8 times
• Analyzing the turnover of each type of asset on a
  companys balance sheet gives rise to what are
  known as control ratios.

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Control Ratios Fixed-Asset Turnover

• Fixed-Asset Turnover is perhaps a purer
  reflection of the capital intensity of a firm.
• Fixed-Asset Turnover Sales/Net PPE
• 862.2/56.9 15.2 times
• Timberland generates 15.20 in sales for each
  dollar of plant, property, and equipment they
  invest in.

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Control Ratios Inventory Turnover

• Inventory turnover COGS/Ending Inventory
  501.1/131.2 3.8 times
• One might also use average inventory rather than
  ending inventory.
• This indicates that items in Timberlands
  inventory turn over 3.8 times per year on
  average.
• Alternatively 12 month/3.8 times 3.15 months
  indicating that the typical item sits in
  inventory for just over 3 months.

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Control Ratios Collection Period

• Collection period highlights a companys
  management of its accounts receivable.
• Note that what is desired here is credit sales.
  Outsiders rarely know this so commonly all sales
  are assumed to be for credit.
• Timberlands customers are taking just over a
  month to pay their bills. Good or bad?

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Control Ratios Days Sales in Cash

• Timberland currently has 64.3 days worth of
  sales in cash and securities.
• Too much or too little?
• Question really is how much liquidity does the
  firm require for efficient operations. While
  more might seem better think about the return the
  asset cash generates.

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Control Ratios Payables Period

• This is a control ratio for a liability.
• The proper calculation uses credit purchases
  which, again, an outsider rarely knows. Usually
  COGS is used as a substitute. COGS differs from
  credit sales because
• Firm may be adding or depleting inventory
  purchasing at a different rate than it is
  selling.
• COGS includes a mark-up for depreciation and
  labor making COGS larger than credit purchases so
  this ratio is, on average, artificially small.
• Thus it is difficult to compare the 18.9 days to
  its credit terms. It is, however, reasonable to
  compare this to last years ratio.

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Return on Assets (ROA)

• When we multiply the profit margin times the
  asset turnover we arrive at return on assets.
• ROA doesnt distinguish between capital raised
  from shareholders and that raised from creditors.
  ROE considers only equity capital.
• As such it measures the return on each dollar
  invested in assets.

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Financial Leverage

• Timberland has 1.80 in assets for every dollar
  that shareholders have invested.
• This is a relatively modest amount of leverage
  for a manufacturing company.
• Other leverage ratios tell us the same thing
• Debt to assets 43.3
• Debt to equity 76.3

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Coverage Ratios

• Often more informative than the leverage ratios
  are coverage ratios.
• These ratios tell us what the firm is earning
  each year relative to the burden the debt
  imposes.

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Liquidity Ratios

• A further determinant of a firms debt capacity
  is the liquidity of its assets relative to its
  liabilities.
• The two common ratios used to measure liquidity
  are the current ratio and the quick ratio (also
  called the acid test).

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Limitations of Ratio Analysis

• We have been talking as if management always
  wants to increase ROE or as if a high ROE is
  always better.
• If company A has a higher ROE than company B is
  company A necessarily better?
• If a company increases its ROE is it necessarily
  evidence of improved performance?
• There are three critical problems with ROE.
• Often called the timing problem, the value
  problem, and the risk problem.

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The Timing Problem

• As a decision-maker in a business environment you
  are often encouraged to focus your attention on
  the past and particularly on one period in the
  past correct?
• Sounds silly, but this is exactly what ROE does.
• Clearly last years ROE must be taken in context.
• If not it is virtually meaningless.
• If company ROE was lower last year than it was
  two years ago the company must be doing worse
  correct?

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The Risk Problem

• We talked a lot about how risk and return go
  together. ROE is a return like measure so
  where is the risk dimension?
• This problem alone makes ROE an inaccurate and
  possibly misleading indicator of financial
  performance.
• One has to realize that the risk dimension is
  missing and so be particularly wary of making
  comparisons across companies using ROE alone.

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The Value Problem

• ROE measures a return figure but it is based on
  two accounting figures.
• The numerator is net income and this is not free
  cash flow (the cash flow that the company could
  payout to its investors).
• Secondly, even if net income is close to free
  cash flow, ROE is measured relative to book value
  of equity not the market value of equity.
• It is the market value investors must pay to
  purchase a share of the firms equity and this is
  generally higher than the book value.

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Ratio Analysis For Timberland

• Given the limitations of ratio analysis the most
  useful way to evaluate financial ratios is by
  examining their changes over time.
• Comparing the ratios to industry averages
  provides an interesting benchmark but differences
  between companies in a given industry can make
  the exercise misleading.
• A systematic approach will also help alleviate
  the information overload that results from the
  random calculation of countless ratios.

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A Systematic Approach

• At the top tier of ratios lie ROE and ROA.
• The major levers of performance are in the next
  tier, followed by more narrowly focused ratios
• Profit margin
• Gross margin, tax rate, normalized income
  statement
• Asset turnover
• Control ratios (inventory turnover, fixed asset
  turnover, collection period, days sales in cash,
  payables period), normalized balance sheet
• Financial leverage
• Leverage ratios, coverage ratios, liquidity ratios

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Ratio Analysis of Timberland

• ROE
• After a loss in 95 the ROE is up to a strong
  22.2 in 98. This is strong relative to its
  industry and to the median firm in the SP500
  that year which had an ROE of 14.8.
• The other major ratios show similar patterns.
• The rise in ROE is coming from the increase in
  its profit margin and asset turnover and is
  somewhat offset by the reduction in its financial
  leverage.

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Ratio Analysis of Timberland

• The increased profit margin is coming primarily
  from a rising gross margin indicating that it is
  some combination of more aggressive pricing and
  cost control that has driven the increase.
• The added fact that Timberlands sales have
  increased only modestly over this period suggests
  more aggressive pricing is primarily responsible
  although there are indications of cost savings.
• Improved asset turnover reflects overall improved
  asset management.
• Inventory turnover and fixed asset turnover are
  strongly higher.
• The only asset rising relative to sales is cash.
  Good or bad?
• Leverage and liquidity ratios all show increasing
  financial conservatism.

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Normalized Financial Statements

• Note on the normalized balance sheet that 80 of
  the firms assets are current assets.
• This highlights the importance of working capital
  management.
• Note the reduction in inventories and accounts
  receivable noted above.
• The normalized income statement is pleasant
  reading.
• Profit margin and gross margin are up since 95.
• Results would have been better except for the
  rise in SGA expenses.

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Summary

• What is being reflected here is a robust recovery
  from a difficult period in the firms history.
• In 94 the firm experienced a 50 increase in
  sales driven by fad demand for its product.
• In response Timberland over-expanded and lost
  control of assets, particularly inventory and
  accounts receivable.
• The bubble burst in 95.
• Since then they have aggressively managed assets
  and reduced debt.
• Challenge ahead is what to do with all the excess
  cash being generated.