FINANCIAL ANALYSIS: TOOLS AND TECHNIQUES CHAPTER 4 pps

CHAPTER 4 ASSESSMENT OF BUSINESS PERFORMANCE When we wish to assess the performance of a business, we’re looking for ways to measure the financial and economic consequences of past management deci- sions that shaped investments, operations, and financing over time. The important questions to be answered are whether all resources were used effectively, whether the profitability of the business met or even exceeded expectations, and whether financing choices were made prudently. Shareholder value creation ultimately re- quires positive results in all these areas—which will bring about favorable cash flow patterns exceeding the company’s cost of capital. As we’ll see, there is a wide range of choices among many individual ratios and measures, some purely financial and some economic. No one ratio or measure can be considered predominant. In this chapter, we’ll demonstrate primarily the analysis of business performance based on published financial statements. These represent the most common data source available for the purpose, even though they are not designed to reflect economic results and conditions. We’ll also dis- cuss the more important measures that help assess economic performance aspects. Our focus will be on key relationships and indicators that allow the analyst to as- sess past performance and also to project assumed future results (as discussed in Chapter 5). We’ll point out their meaning as well as the limitations inherent in them. In the final chapters we’ll discuss the larger context of valuing a company or its parts in economic terms, a process that is based on an intense assessment of performance drivers and strategic positioning, and that requires developing ex- pected cash flow results for which past performance is only a starting point. Ratio Analysis and Performance Because there are so many tools for doing performance assessment, we must re- member that different techniques address measurement in very specific and often 95 hel78340_ch04.qxd 9/27/01 11:07 AM Page 95 Copyright 2001 The McGraw-Hill Companies, Inc. Click Here for Terms of Use. 96 Financial Analysis: Tools and Techniques narrowly defined ways. One can be tempted to “run all the numbers,” particularly given the speed and ease of computer spreadsheets. Yet normally, only a few se- lected relationships will yield information the analyst really needs for useful in- sights and decision support. By definition, a ratio can relate any magnitude to any other—the choices are limited only by the imagination. To be useful, both the meaning and the limitations of the ratio chosen have to be understood. Before be- ginning any task, therefore, the analyst must define the following elements: • The viewpoint taken. • The objectives of the analysis. • The potential standards of comparison. Any particular ratio or measure is useful only in relation to the viewpoint taken and the specific objectives of the analysis. When there is such a match, the measure can become a standard for comparison. Moreover, ratios are not absolute criteria: They serve best when used in selected combinations to point out changes in financial conditions or operating performance over several periods and as com- pared to similar businesses. Ratios help illustrate the trends and patterns of such changes, which, in turn, might indicate to the analyst the risks and opportunities for the business under review. A further caution: Performance assessment via financial statement analysis is based on past data and conditions from which it might be difficult to extrapo- late future expectations. Yet, any decisions to be made as a result of such perfor- mance assessment can affect only the future—the past is gone, or sunk, as an economist would call it. No attempt to assess business performance can provide firm answers. Any insights gained will be relative, because business and operating conditions vary so much from company to company and industry to industry. Comparisons and stan- dards based on past performance are especially difficult to interpret in large, multibusiness companies and conglomerates, where specific information by indi- vidual lines of business is normally limited. Accounting adjustments of various types present further complications. To deal with all these aspects in detail is far beyond the scope of this book, although we’ll point out the key items. The reader should strive to become aware of these issues and always be cautious in using fi- nancial data. To provide a coherent structure for the many ratios and measures involved, the discussion will be built around three major viewpoints of financial perfor- mance analysis. While there are many different individuals and groups interested in the success or failure of a given business, the most important are: • Managers. • Owners (investors). • Lenders and creditors. Closest to the business on a day-to-day basis, but also responsible for its long-range performance, is the management of the organization, whether its hel78340_ch04.qxd 9/27/01 11:07 AM Page 96 TEAMFLY Team-Fly ® CHAPTER 4 Assessment of Business Performance 97 members are professional managers or owner/managers. Managers are responsi- ble and accountable for operating efficiency, the effective deployment of capital, useful human effort, appropriate use of other resources, and current and long-term results—all within the context of sound business strategies. Next are the various owners of the business, who are especially interested in the current and long-term returns on their equity investment. They usually expect growing earnings, cash flows, and dividends, which in combination will bring about growth in the economic value of their “stake.” They are affected by the way a company’s earnings are used and distributed, and by the relative value of their shares within the general movement of the security markets. Finally, there are the providers of “other people’s money,” lenders and cred- itors who extend funds to the business for various lengths of time. They are mainly concerned about the company’s liquidity and cash flows that affect its abil- ity to make the interest payments due them and eventually to repay the principal. They’ll also be concerned about the degree of financial leverage employed, and the availability of specific residual asset values that will give them a margin of protection against their risk. Other groups such as employees, government, and society have, of course, specific objectives of their own—the business’ ability to pay wages, the stability of employment, the reliability of tax payments, and the financial wherewithal to meet various social and environmental obligations. Financial performance indica- tors are useful to these groups in combination with a variety of other data. The principal financial performance areas of interest to management, own- ers, and lenders are shown in Figure 4–1, along with the most common ratios and measures relevant to these areas. We’ll follow the sequence shown in the figure and discuss each subgrouping within the three broad viewpoints. Later, we’ll re- late the key measures to each other in a systems context. Management’s Point of View Management has a dual interest in the analysis of financial performance: • To assess the efficiency and profitability of operations. • To judge how effectively the resources of the business are being used. Judging a company’s operations is largely done with an analysis of the in- come statement, while resource effectiveness is usually measured by reviewing both the balance sheet and the income statement. In order to make economic judg- ments, however, it’s often necessary to modify the available financial data to re- flect current economic values and conditions. For purposes of illustration, we’ll again use information from the sample statements of TRW Inc. for 1997 and 1996, which were reproduced in Chapter 2. The same statements are shown here in Figures 4–2 and 4–3. We’ll use this infor- mation for the remainder of this chapter. For added convenience, we’ve also ex- pressed the various items on the income statement as a percent of sales, a common hel78340_ch04.qxd 9/27/01 11:07 AM Page 97 98 Financial Analysis: Tools and Techniques way of highlighting the relative magnitude of the various categories in relation to the base of sales. In addition, Addendum 4–1 at the end of this chapter contains major se- lections from the “Notes to Financial Statements,” as published in TRW’s 1997 annual report. They are provided as explanatory background for the company’s key accounting policies, recent restructuring and acquisitions, income tax provi- sions, deferred income taxes, post-retirement benefits accounting change, debt, and industry segments. Because these items affect the development of many of the ratios in this chapter, the notes will help in understanding some of the choices an analyst must make in using financial statement information. Operational Analysis An initial assessment of the operational effectiveness for the business as a whole or any of its subdivisions is generally performed through a “common numbers” or percentage analysis of the income statement. Individual costs and expense items FIGURE 4–1 Performance Measures by Area and Viewpoint Management Owners Lenders Operational Analysis Investment Return Liquidity Gross margin Return on total net worth Current ratio Profit margin Return on common equity Acid test EBIT; EBITDA Earnings per share Quick sale value NOPAT Cash flow per share Operating expense analysis Share price appreciation Contribution analysis Total shareholder return Operating leverage Comparative analysis Resource Management Disposition of Earnings Financial Leverage Asset turnover Dividends per share Debt to assets Working capital management Dividend yield Debt to capitalization • Inventory turnover Payout/retention of earnings Debt to equity • Accounts receivable patterns Dividend coverage • Accounts payable patterns Dividends to assets Human resource effectiveness Profitability Market Performance Debt Service Return on assets (after taxes) Price/earnings ratio Interest coverage Return before interest and taxes Cash flow multiples Burden coverage Return on current value basis Market to book value Fixed changes coverage EVA and economic profit Relative price movements Cash flow analysis Cash flow return on investment Value drivers Free cash flow Value of the firm hel78340_ch04.qxd 9/27/01 11:07 AM Page 98 CHAPTER 4 Assessment of Business Performance 99 FIGURE 4–2 TRW INC. AND SUBSIDIARIES Consolidated Balance Sheets at December 31 ($ millions) 1997 1996 Assets Current assets: Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . $ 70 $ 386 Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,617 1,378 Inventories. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 573 524 Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79 69 Deferred income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96 424 Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,435 2,781 Property, plant, and equipment at cost . . . . . . . . . . . . . . . . . . 6,074 5,880 Less: Allowances for depreciation and amortization . . . . . . 3,453 3,400 Total property, plant & equipment—net . . . . . . . . . . . . . . 2,621 2,480 Intangible assets Intangibles arising from acquisitions . . . . . . . . . . . . . . . . . . 673 258 Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 232 31 Total intangible assets. . . . . . . . . . . . . . . . . . . . . . . . . . . 905 289 Less: Accumulated amortization . . . . . . . . . . . . . . . . . . . 94 78 Total intangible assets—net . . . . . . . . . . . . . . . . . . . . . . 811 211 Investments in affiliated companies . . . . . . . . . . . . . . . . . . . . 139 51 Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 404 376 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6,410 $5,899 Liabilities and Shareholders’ Investment Current liabilities: Short-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 411 $ 52 Accrued compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 338 386 Trade accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . 859 781 Other accruals. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 846 775 Dividends payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38 39 Income taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99 52 Current portion of long-term debt . . . . . . . . . . . . . . . . . . . . 128 72 Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,719 2,157 Long-term liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 788 767 Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,117 458 Deferred income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57 272 Minority interests in subsidiaries . . . . . . . . . . . . . . . . . . . . . . . 105 56 Shareholders’ investment: Serial preference stock II. . . . . . . . . . . . . . . . . . . . . . . . . . . 1 1 Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78 80 Other capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 462 437 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,776 1,978 Cumulative translation adjustments . . . . . . . . . . . . . . . . . . (130) 47 Treasury shares Ϫ cost in excess of par value . . . . . . . . . . (563) (354) Total shareholders’ investment . . . . . . . . . . . . . . . . . . . . 1,624 2,189 Total liabilities and shareholders’ investment . . . . . . . . . . . . . $6,410 $5,899 Source: Adapted from 1997 TRW Inc. annual report. hel78340_ch04.qxd 9/27/01 11:07 AM Page 99 100 Financial Analysis: Tools and Techniques FIGURE 4–3 TRW INC. AND SUBSIDIARIES Statements of Earnings For the Years Ended December 31, 1997 and 1996 ($ millions) Percent Percent 1997 of Sales 1996 of Sales Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,831 100.0% $9,857 100.0% Cost of sales. . . . . . . . . . . . . . . . . . . . . . . . . . . 8,826 81.5 8,376 85.0 Gross profit. . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,005 18.5% 1,481 15.0% Administrative and selling expenses . . . . . . . . 684 6.3 613 6.2 Research and development expenses. . . . . . . 461 4.2 412 4.2 Purchased in-process research and development 548 5.1 —— Interest expense. . . . . . . . . . . . . . . . . . . . . . . . 75 0.7 84 0.9 Other expenses (income) net. . . . . . . . . . . . . . (3) — 70 0.7 Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . 1,765 16.3% 1,179 12.0% Earnings (loss) from continuing operations before taxes Excluding purchased R&D; special charges (‘96) 788 7.3 687 7.0 Reported earnings (loss) before income taxes 240 2.2 302 3.1 Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . 289 2.7 120 1.2 Earnings (loss) from continuing operations Excluding purchased R&D; special charges (‘96) 499 4.6 434 4.4 Reported earnings (loss) after income taxes (49) (0.5) 182 1.8 Discontinued operations, gain on disposition, after tax —— 298 3.0 Net earnings (loss) . . . . . . . . . . . . . . . . . . . . . . $ (49) (0.5)% $ 480 4.8% Preference dividends . . . . . . . . . . . . . . . . . . . . —— 1 — Earnings (loss) applicable to common stock . . $ (49) (0.5)% $ 479 4.8% Per share of common stock: Average number of shares outstanding (millions) Diluted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123.7 132.8 Basic. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123.7 128.7 Diluted net earnings (loss) per share From continuing operations Excluding purchased R&D; special charges $4.03 $ 3.27 Reported. . . . . . . . . . . . . . . . . . . . . . . . . . (0.40) 1.37 From discontinued operations . . . . . . . . . . . — 2.25 Diluted net earnings (loss) per share $ (0.40) $ 3.62 Basic net earnings (loss) per share From continuing operations Excluding purchased R&D; special charges $4.03 $ 3.29 Reported. . . . . . . . . . . . . . . . . . . . . . . . . . (0.40) 1.41 From discontinued operations . . . . . . . . . . . — 2.31 Basic net earnings (loss) per share . . . . . . . . . $ (0.40) $ 3.72 Cash dividends paid. . . . . . . . . . . . . . . . . . . . . 1.24 1.135 Book value per share (year-end) . . . . . . . . . . . 13.19 17.29 Tangible book value per share (year-end) . . . . 6.58 15.62 Other data ($ millions): Depreciation of property, plant, and equipment $ 480 $ 442 Amortization of intangibles, other assets . . . . . 10 10 Capital expenditures. . . . . . . . . . . . . . . . . . . . . 549 500 Dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . 154 148 Source: Adapted from 1997 TRW Inc. annual report. hel78340_ch04.qxd 9/27/01 11:07 AM Page 100 CHAPTER 4 Assessment of Business Performance 101 are normally related to sales, that is, gross sales revenues adjusted for any returns and allowances. The common base of sales permits a ready comparison of the key costs and expenses from period to period, over longer stretches of time, and against competitor and industry databases. Expense-to-sales ratios are used both to judge the relative magnitude of selected key elements and to determine any trends toward improving or declining performance. However, we must keep in mind the type of industry involved and its particular characteristics, as well as the individual trends and special conditions of the company being studied. For example, the gross margin of a jewelry store with slow turnover of merchandise and high markups will be far greater (50 per- cent is not uncommon) than that of a supermarket, which depends on low margins and high volume for its success (gross margins of 10 to 15 percent are typical). In fact, comparing a particular company’s ratios to those of similar companies in its industry over a number of time periods will usually provide the best clues as to whether the company’s performance is improving or declining. Many published annual overviews of company and industry performance use ranking approaches, such as the annual Fortune 500 listings. Individual com- panies usually develop their own comparisons with the performance of compara- ble units within the organization or with relevant competitors on the outside. It’s also often useful to graphically depict a series of performance data over time, a process now easily achieved with the ubiquitous availability of computer spread- sheets and online financial databases and services. Gross-Margin and Cost-of-Goods-Sold Analysis One of the most common ratios in operational analysis is the calculation of cost of goods sold (cost of sales) as a percentage of sales. This ratio indicates the mag- nitude of the cost of goods purchased or manufactured, or the cost of services provided, in relation to the gross margin (gross profit) left over for operating expenses and profit. The ratios calculated from our TRW sample statements appear as follows: Cost of goods sold ϭϭ81.5% (1996: 85.0%) Gross margin ϭϭ18.5% (1994: 15.0%) The cost of goods sold (81.5 percent) and the gross margin (18.5 percent) indicate the margin of “raw profit” from operations. Remember that gross margin reflects the relationship of prices, volume, and costs. A change in gross margin can result from a combination of changes in: • The selling price of the product. • The level of manufacturing costs for the product. • Any variations in the product mix of the business. $2,005 $10,831 $8,826 $10,831 hel78340_ch04.qxd 9/27/01 11:07 AM Page 101 102 Financial Analysis: Tools and Techniques In a trading or service organization, gross margin can be affected by a com- bination of changes in: • The price charged for the products or services provided. • The price paid for merchandise purchased on the outside. • The cost of services from internal or external sources. • Any variation in the product/service mix of the business. The volume of operations also can have a significant effect if, for example, a manufacturing company has high fixed costs (see Chapter 6 for a discussion of operating leverage), or a small trading company has less buying power and economies of scale than a large competitor. In the case of TRW, the cost of goods sold and the gross margin shown in the annual report represented a consolidation of the two major business segments. In other words, the income statement combined the automotive business and space, defense, and information systems. We note a gross margin improvement of three and one-half percentage points from the prior year, which was in part af- fected by the restructuring and acquisition activities during the two years. For a more detailed insight, we should calculate the gross margins for the individual business areas, if this information was publicly available. In its annual report, TRW provided a selective breakdown, by major prod- uct line, of sales, operating profit, identifiable assets, depreciation and amortiza- tion, and capital expenditures, which would allow the analyst to make some overall comparisons (see p. 157, “Industry Segments”). These data would have to be supplemented by additional internal information, however, to be able to per- form a detailed ratio analysis—something routinely done within the company. There are particular complications in the analysis of manufacturing com- panies. The nature of manufacturing cost accounting systems governs the specific costing of products for inventory and for current sale. Significant differences can exist in the apparent cost performance of companies when using standard full cost systems (all costs, fixed and variable, are allocated to each unit of production based on an estimate of normal cost levels) as compared to using direct costing (fixed manufacturing costs are not allocated to individual products but charged as a block against operations). The charges against a particular period of operations can be affected to some degree by the choice of accounting methods. Increasingly, however, companies are turning to various forms of activity-based accounting for internal purposes, which provides a more precise basis for judging the real eco- nomic costs of products and services. Inflation, which affects the prices of both cost inputs and goods or services sold, or currency fluctuations, in the case of international businesses, further distort the picture. We’ll take up some of these issues later in this chapter. Any major change in a company’s cost of goods sold or gross margin over a relevant period of time would call for further analysis to identify the cause. The length of the time period chosen for such trend analysis depends on the nature of the business. For example, as we demonstrated in Chapter 3, many businesses hel78340_ch04.qxd 9/27/01 11:07 AM Page 102 CHAPTER 4 Assessment of Business Performance 103 have normal seasonal fluctuations, while others are affected by longer-term busi- ness cycles. Thus, this ratio serves as a signal rather than an absolute measure, as is the case with most of the measures discussed. Profit Margin The relationship of reported net profit after taxes (net income) to sales indicates management’s ability to operate the business with sufficient success. Success in this case means not only recovering the cost of the merchandise or services, the expenses of operating the business (including depreciation), and the cost of bor- rowed funds, but also leaving a margin of reasonable compensation to the owners for putting their capital at risk. The ratio of net profit (income) to sales (total reve- nue) essentially expresses the overall cost/price effectiveness of the operation. As we’ll demonstrate later, however, a more significant ratio for this purpose is the relationship of profit to the amount of capital employed in generating it. At this point, we should note that earnings can be affected significantly by mandated changes in accounting methods issued from time to time by FASB. There might be sizable adjustments, as occurred in the early 90s, when future em- ployee medical benefits had to be recognized as a liability with an offsetting charge to earnings. For purposes of ratio analysis and for period-to-period com- parisons, extraordinary adjustments should be excluded, along with any other ex- traordinary gains or losses a company might encounter in a particular period. In most cases, significant items of this kind are highlighted in the company’s financial statements, allowing the analyst to choose whether to include them in the analysis. The calculation of the net profit (net earnings) ratio is simple, as the figures from our TRW example show. We have chosen to use net profit before special charges and discontinued operations in these calculations, to permit a clearer comparison of the results of TRW’s continuing operations for the two years: Profit margin ϭ ϭ 4.6% (1996: 4.4%) Note the increase of two-tenths of a percentage point from 1996, which is the result of both record volume and aggressive cost containment. A variation of this ratio uses net profit before interest and taxes. This figure represents the operating profit before any compensation is paid to debt holders. It’s also the profit before the calculation of federal and state income taxes, which are often based on modified sets of deductible expenses and accounting write-offs. The ratio represents a purer view of operating effectiveness, undistorted by fi- nancing patterns and tax calculations. Referred to as earnings before interest and taxes (EBIT), this pretax, pre-interest income ratio for TRW appears as follows, again using the results from ongoing operations only: EBIT ϭ ϭ 8.0% (1996: 7.8%) $788 ϩ $75 $10,831 $499 $10,831 hel78340_ch04.qxd 9/27/01 11:07 AM Page 103 104 Financial Analysis: Tools and Techniques In its published data TRW reported that the pretax operating margin for its two major businesses, a measure which corresponds to EBIT, was 9.0 percent (9.4 percent for 1996) for the automotive segment (65 percent of 1997 sales), and 8.4 percent (7.3 percent for 1996) for space, defense, and information systems (35 percent of 1997 sales), providing some additional insight into their compara- tive performance. A modification frequently used by security analysts is EBIT, adjusted for depreciation and amortization, in an attempt to show the pretax earnings un- affected by taxes and the allocation of past expenditures in the form of deprecia- tion and amortization. Called EBITDA, this income measure affects the ratio as follows, using TRW’s figures from continuing operations: EBITDA ϭ ϭ 12.5% (1996: 12.4%) A sound argument can be made, however, for considering income taxes an ongoing expense of being in business. The EBIT formula can therefore be modi- fied by using profit before interest but after taxes, which requires a tax adjustment for the interest amount. Again, the intent is to focus on operating efficiency by leaving out any compensation to the various holders of capital. Using the TRW figures, this modified result appears as follows: EBIAT ϭ ϭ 5.0% (1996: 4.9%) For convenience in removing the effect of interest from aftertax profit, we usually assume that the interest paid during the period was fully tax deductible. Thus, we simply add back to the stated profit figure the after-tax cost of interest. We obtain the latter by multiplying pretax interest by a factor of “one minus the tax rate,” employing either the effective (average) tax rate paid on earnings (37.0 percent in TRW’s case) or, ideally, the marginal (highest bracket) corporate tax rate for the firm in question. The choice of tax rates depends on the complexity of the company’s taxa- tion pattern. TRW operates worldwide, and therefore is subject to a variety of taxes, which are combined in the provision for income taxes on the income state- ment. It’s most straightforward to rely on the effective overall rate paid, which for TRW approximated the marginal U.S. corporate tax rate prevailing in 1997. Chap- ter 9 contains a specific discussion of the cost of debt and the nature of the neces- sary tax adjustments to be made to interest cost. The EBIAT concept can be further refined in the form of NOPAT, the net operating profit after taxes, which excludes interest expense and income as well as any nonoperating income and expense items. The NOPAT measure has gained in importance with the shift toward shareholder value measures, which we’ll dis- cuss in more detail in Chapter 12. As an expression of the after-tax earnings power of the operations of the business, NOPAT becomes an input to such measures as $499 ϩ (1 Ϫ .37) 75 $10,831 $788 ϩ $75 ϩ $480 ϩ $10 $10,831 hel78340_ch04.qxd 9/27/01 11:07 AM Page 104 [...]... interest and the after-tax effect of any nonrecurring income and expense items hel78 340 _ch 04. qxd 1 14 9/27/01 11:07 AM Page 1 14 Financial Analysis: Tools and Techniques When there is reason to believe that income taxes paid were modified for any reason and the effective tax rate does not reflect normal conditions, the marginal income tax rate should be used to calculate the net effect of interest and other... reported as $4. 03 for 1997, and hel78 340 _ch 04. qxd 9/27/01 11:07 AM Page 119 CHAPTER 4 Assessment of Business Performance 119 $3.27 for 1996 (see Figure 4 3) Earnings per share are available on both an annual and a quarterly basis, and are a matter of record whenever a company’s shares are publicly traded A recent requirement by the Financial Accounting Standards Board and the Securities and Exchange... widely published statistic Rankings of companies and industry sectors are compiled by major business magazines and rating agencies The ratio is closely watched by stock market analysts and, in turn, by management and the board of directors Since the ratio focuses only on the hel78 340 _ch 04. qxd 9/27/01 118 11:07 AM Page 118 Financial Analysis: Tools and Techniques ownership portion of the capital structure,... of outstanding shares Finally, they are concerned about the effect of business results achieved and future expectations about results—on the market value of their investment, especially in the case of publicly traded stock The key concepts related hel78 340 _ch 04. qxd 9/27/01 11:07 AM Page 116 116 Financial Analysis: Tools and Techniques to this last aspect are discussed in detail in Chapters 10 and 11;... company’s earnings performance and prospects The calculation is quite straightforward, and relates current market prices of common shares to the most recent available earnings per share on an annual basis: Earnings multiple (Price/earnings ratio): Market price per share ϭ Factor Earnings per share hel78 340 _ch 04. qxd 9/27/01 11:07 AM 1 24 Page 1 24 Financial Analysis: Tools and Techniques The result is a simple... assets: Net profit $49 9 ϭ Assets $6 ,41 0 ϭ 7.8% (1996: 7 .4% ) hel78 340 _ch 04. qxd 9/27/01 11:07 AM Page 113 CHAPTER 4 Assessment of Business Performance 113 or Return on net assets: Net profit $49 9 ϭ ϭ 13.5% (1996: 11.6%) Net assets $6 ,41 0 Ϫ $2,719 (capitalization) While either ratio is an indicator of overall profitability, the results can be seriously distorted by nonrecurring gains and losses during the... course, be restated to show that the value of hel78 340 _ch 04. qxd 9/27/01 11:07 AM Page 126 126 Financial Analysis: Tools and Techniques the company’s shares is a function of the total value of the firm less the value of its debt: VS ϭ VF Ϫ VD AM FL Y We’ll return to a more detailed discussion of valuation principles and shareholder value creation in Chapters 11 and 12 In summary, the ratios pertinent to the... detail in Chapter 12 hel78 340 _ch 04. qxd 9/27/01 11:07 AM Page 115 CHAPTER 4 Assessment of Business Performance 115 As we’ll discuss in Chapters 7 and 8, profitability also depends on the economic analysis and successful implementation of new investment projects Here it’s critical to define and develop the relevant cash flow changes brought about by the investment decision, and to judge the results through... beginning and ending amounts for the year, the calculation for TRW’s turnover ratios appears as follows: hel78 340 _ch 04. qxd 9/27/01 11:07 AM 108 Page 108 Financial Analysis: Tools and Techniques Sales $10,831 ϭ Average total assets 5($5,899 ϩ $6 ,41 0) or ϭ 1.76 times (1996: 1.70) Average total assets $6,1 54 Assets to sales: ϭ ϭ 57% (1996: 59%) Sales $10,831 Sales to assets: If net assets (total assets less current... amounts The TRW inventory turnover figures appear as follows: hel78 340 _ch 04. qxd 9/27/01 110 11:07 AM Page 110 Financial Analysis: Tools and Techniques Inventory turnover Sales $10,831 : ϭ (Sales) Average inventory $ 548 ϭ 19.8 times (1996: 18.7 times) or Inventory turnover Cost of sales $8,826 : ϭ (Cost of sales) Average inventory $ 548 ϭ 16.1 times (1996: 15.9 times) These calculations reflect the frequency . before interest and taxes (EBIT) Average assets $49 9 $6 ,41 0 Ϫ $2,719 Net profit Net assets (capitalization) hel78 340 _ch 04. qxd 9/27/01 11:07 AM Page 113 1 14 Financial Analysis: Tools and Techniques When. 1 ,48 1 15.0% Administrative and selling expenses . . . . . . . . 6 84 6.3 613 6.2 Research and development expenses. . . . . . . 46 1 4. 2 41 2 4. 2 Purchased in-process research and development 548 . report. hel78 340 _ch 04. qxd 9/27/01 11:07 AM Page 99 100 Financial Analysis: Tools and Techniques FIGURE 4 3 TRW INC. AND SUBSIDIARIES Statements of Earnings For the Years Ended December 31, 1997 and 1996 ($