0273707310_JACKET-NEW.indd 30/11/05 10:37:00 WKMR_A01.QXD 11/24/05 12:53 PM Page i Key management ratios WKMR_A01.QXD 11/24/05 12:53 PM Page ii In an increasingly competitive world, we believe it’s quality of thinking that gives you the edge – an idea that opens new doors, a technique that solves a problem, or an insight that simply makes sense of it all The more you know, the smarter and faster you can go That’s why we work with the best minds in business and finance to bring cutting-edge thinking and best learning practice to a global market Under a range of leading imprints, including Financial Times Prentice Hall, we create world-class print publications and electronic products bringing our readers knowledge, skills and understanding, which can be applied whether studying or at work To find out more about Pearson Education publications, or tell us about the books you’d like to find, you can visit us at www.pearsoned.co.uk WKMR_A01.QXD 11/24/05 12:53 PM Page iii Key management ratios The clearest guide to the critical numbers that drive your business fourth edition Ciaran Walsh WKMR_A01.QXD 11/24/05 12:53 PM Page iv PEARSON EDUCATION LIMITED Edinburgh Gate Harlow CM20 2JE Tel: +44 (0)1279 623623 Fax: +44 (0)1279 431059 Website: www.pearsoned.co.uk First published 1996 Second edition 1998 Third edition 2003 Fouth edition published in Great Britain 2006 © Ciaran Walsh 2006 The right of Ciaran Walsh to be identified as author of this work has been asserted by him in accordance with the Copyright, Designs and Patents Act 1988 ISBN-13: 978-0-273-70731-8 ISBN-10: 0-273-70731-0 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging-in-Publication Data Walsh, Ciaran Key management ratios : the clearest guide to the critical numbers that drive your business / Ciaran Walsh. 4th ed p cm Includes index ISBN-13: 978-0-273-70731-8 (alk paper) ISBN-10: 0-273-70731-0 (alk paper) Ratio analysis Management Statistical methods Statistical decision I Title HF5681.R25W347 2006 658.4’033 dc22 2005054680 All rights reserved No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without either the prior written permission of the Publishers or a licence permitting restricted copying in the United Kingdom issued by the Copyright Licensing Agency Ltd, 90 Tottenham Court Road, London W1T 4LP This book may not be lent, resold, hired out or otherwise disposed of by way of trade in any form of binding or cover other than that in which it is published, without the prior consent of the Publishers 10 09 08 07 06 05 Typeset in Century Schoolbook by 30 Printed and bound by Bell & Bain Limited, Glasgow The Publishers’ policy is to use paper manufactured from sustainable forests WKMR_A01.QXD 11/24/05 12:53 PM Page v About the author Ciaran Walsh is Senior Finance Specialist at the Irish Management Institute, Dublin He is trained both as an economist and an accountant (BSc (Econ) London, CIMA) and had 15 years’ industrial experience before joining the academic world His work with senior managers over many years has enabled him to develop his own unique approach to training in corporate finance As a consequence, he has lectured in most European countries, the Middle East and Eastern Europe His main research interest is to identify and computerize the links that tie corporate growth and capital structure into stockmarket valuation He lives in Dublin and is married with six children He can be contacted at ciaranwalsh@eircom.net About the author v WKMR_A01.QXD 11/24/05 12:53 PM Page vi To our grandchildren Rebecca Isobel Benjamin Eleanor Sophie Eve Hanna Holly Grace Aaron Alice Zoe Imogen Kate Lei Xiao Shun WKMR_A01.QXD 11/24/05 12:53 PM Page vii Contents Acknowledgments xii Foreword xiii Key for symbols xiv PART I FOUNDATIONS 1 Background Why you need this book? The form and logic Method The philosophy Excitement Data that makes sense Financial statements Introduction 11 The balance sheet 14 Balance sheet structure – fixed assets 18 Balance sheet structure – liabilities 20 Summary 24 Balance sheet terms 25 Introduction 26 The terms used 26 Profit and loss account 35 Introduction 36 Working data 42 Contents vii WKMR_A01.QXD 11/24/05 12:53 PM Page viii PART II OPERATING PERFORMANCE 47 Measures of performance 49 Relationships between the balance sheet and profit and loss account 50 The ratios ‘return on total assets’ and ‘return on equity’ 52 Balance sheet layouts 54 Operating performance 59 Return on investment (ROI) 61 Return on equity (ROE) 62 Return on total assets (ROTA) 64 Standards of operating performance 66 Performance drivers 81 Operating performance 82 Operating profit model 88 PART III CORPORATE LIQUIDITY 95 Cash flow cycle 97 Corporate liquidity 99 The cash cycle 100 Measures of liquidity – long and short analysis 110 Liquidity 113 Short-term liquidity measures 115 Current ratio 116 Quick ratio 118 Working capital to sales ratio 120 Working capital days 122 10 Financial strength 125 Interest cover 126 ‘Debt to equity’ ratio (D/E) 128 Leverage 134 Summary 136 viii Contents WKMR_A01.QXD 11/24/05 12:53 PM Page ix 11 Cash flow 137 The cash flow statement 139 Sources and uses of funds – method 140 Opening and closing cash reconciliation 144 Long and short analysis 146 Financial reporting standards 150 PART IV DETERMINANTS OF CORPORATE VALUE 153 12 Corporate valuation 155 Introduction 156 Share values 158 13 Financial leverage and corporate valuation 175 Introduction 176 Financial leverage 176 V chart 178 Market to book ratio 182 14 Growth 189 Growth 190 Analysis 194 Growth equilibrium 196 Application to acquisitions 202 PART V MANAGEMENT DECISION-MAKING 205 15 Cost, volume and price relationships 207 Introduction 209 Costing illustration 210 Contribution 214 Break-even (B/E) 220 Contribution to sales percentage (CPS) 226 Summary 240 Contents ix WKMR_Z05.QXD 11/24/05 12:51 PM Page 388 EBITDA Earnings before interest, tax, depreciation and amortization (see appendix for explanation) Employee ratios To measure the productivity of labor, three major variables – sales, profits and assets – are related back to the number of employees and their remuneration The principal ratios used are: ■ remuneration to employee ■ sales to employee ■ sales to remuneration ■ profit to employee ■ profit to remuneration ■ fixed assets to employee ■ working capital to employee Equity gearing Common funds plus preference shares expressed as percentage of long-term loan plus current liabilities Eurodollar Deposits denominated in US dollars in a bank outside the US owned by a non-resident of the US Extraordinary item A significant transaction outside the normal activities of the business and likely to be non-recurring An example would be the sale of the corporate head office at a large profit There is a strong argument that such a transaction should not be allowed to distort the trading results and that it should be isolated from the reported earnings However, the contrary argument that all such gains and losses should be included in the profit and loss account now prevails Factoring A method of raising funds by the selling of trade debtors Fixed assets Land and buildings, plant and equipment and other long-term physical assets on which the operations of the company depend Fixed cost A type of cost where the total expenditure does not vary with the level of activity or output Floating rate note (FRN) Loan on which the interest rate varies with prevailing short-term market rates Forward cover The purchase or sale of foreign currency for delivery at a fixed future time It is used to cover against the risk of an adverse exchange rate movement Forward exchange rate A rate fixed to govern the exchange of currencies at a fixed future date Free borrowing percentage The percentage of non-equity funds that is made up of ‘free’ debt, that is accounts payable, accruals and deferred tax Futures contract A contract in an organized exchange to trade in a fixed quantity of a security at a fixed price at a future date Gearing A relationship between different types of funds in a company, such as loans and equity The higher the amount of loan funds the higher the amount of fixed interest charge in the profit and loss account Where interest charges are high, a small change in operating profit will have a much increased result in return to the equity for shareholders Gilts The term ‘gilt-edged’ refers to government longer term borrowing instruments They are described as ‘short’ where the maturity is up to five years, ‘medium’ for periods of five to 15 years and ‘long’ for over 15 years to infinity Hedging A technique for reducing the risk of an exposed position by taking a compensating position in another security 388 Key management ratios WKMR_Z05.QXD 11/24/05 12:51 PM Page 389 Hurdle rate The rate of return decided on by a company as the minimum acceptable for capital investment It will be governed by the firms’ cost of capital and it may allow for different levels of risk Intangible assets Long-term non-physical assets in the balance sheet such as goodwill and brand values Interest cover A liquidity ratio that expresses the number of times the interest charged in the profit and loss account is covered by profit before interest and tax Internal rate of return (IRR) The rate of discount that brings the present value of all the cash flows associated with a capital investment to zero It measures the effective yield on the investment If this yield is greater than the ‘hurdle rate’ the investment is deemed to be financially desirable and vice versa Inventory days The inventory value in the balance sheet is expressed in terms of days The divisor is usually the average daily cost of sales Separate calculations are made for raw materials, work in progress and finished goods Investments Investments in subsidiary and associated companies and other long-term financial assets Junk bonds High-interest-bearing bonds with little security of assets issued by a company with good cash flow LIBOR London InterBank Offered Rate – the rate at which major banks in the short-term money market lend to each other It is a benchmark for many international loans and floating-rate issues to corporations Lease – finance A lease under which the lessee assumes all the risks and rewards of ownership It extends over the estimated economic life of the assets and cannot easily be canceled Under current accounting rules, such a lease is treated as a loan Leverage See gearing Leveraged buy-out The acquisition of a firm by using large amounts of debt Liquidity The ability to provide cash to meet day-to-day needs as they arise Long-term loans (LTL) Bank and other loans of more than one year Market capitalization The notional total market value of a company calculated from the latest quoted market price of the share multiplied by the number of shares The quoted price may not give an accurate value for the total shares, it may refer to only one small block of shares Market to book ratio The relationship between the balance sheet value of the ordinary shares and their market value The expression ‘price to book’ is also used Market value weights In cost of capital calculations, the weighted cost can be derived using either the book value or market value weights to determine the overall weighted cost Matching principle A rule that a firm should match short-term uses of funds with short-term sources and long-term uses with long-term sources Minority interests The book value of shares in a subsidiary that are owned by members who are not shareholders of the parent company Miscellaneous current assets Sundry receivables and pre-payments due for realization within one year Miscellaneous long-term funds A composite entry in the balance sheet that may include deferred tax, unamortized government grants, provision for pensions and so on Money market A term applied to the trading in short-term financial instruments in London Glossary 389 WKMR_Z05.QXD 11/24/05 12:51 PM Page 390 Mutually exclusive projects In an investment appraisal exercise these are projects that compete with one another so that the acceptance of one means the exclusion of the others Net working capital See working capital Net worth (NW) The sum of common ordinary shares plus all reserves plus preference shares less intangible assets Net present value (NPV) A positive or negative value arrived at by discounting the cash flow from a capital project by the desired rate of return If the value is positive, it means that the project is financially desirable and vice versa NOPAT Net operating profit after tax (see chapter 17 for explanation) Off-balance sheet A term that refers to borrowing that does not appear on the balance sheet Sometimes achieved by a finance lease that gives the lessee all the risks and rewards, but not the legal status, of ownership Opportunity cost The alternative advantage foregone as a result of the commitment of resources to one particular end Optimal capital structure The point at which the cost of capital to a company is reduced to the minimum by the best mix of debt and equity Option A financial instrument that gives the holder the right, but not the obligation, to purchase or sell a specified asset at a specified price on or before a set date See put option; call option Over the counter (OTC) Refers to the market where shares and financial instruments are traded outside the formal exchanges Overtrading A company is in an overtrading situation when there is not sufficient liquidity to meet comfortably the day-to-day cash needs of the existing level of business There is constant danger of bankruptcy, even though the company may be trading profitably Such a situation can come about because of past trading losses, excessive expansion and so on, but can be cured by the injection of long-term funds or, maybe, the sale of fixed assets Owners’ funds (OF) The sum of the issued shares, capital reserves and revenue reserves The total represents the assets remaining to the shareholders after all prior claims have been satisfied Paid borrowing percentage The percentage of non-equity funds consisting of interest-bearing debt Par value A notional value assigned to a share largely for accounting purposes Payback period A term used in investment appraisal It refers to the time required for the non-discounted cash in-flow to accumulate to the initial cash out-flow in the investment Payout ratio The percentage of earnings available for distribution that is paid out in dividends This ratio is the reciprocal of dividend cover Preference capital Shares that have preferential rights over common shares These rights normally relate to distribution of dividends and repayment of capital The shares usually carry a fixed dividend but also carry very little voting power Preferred creditors Creditors who, in an insolvency, have a statutory right to be paid in full before any other claims Employees who have pay due to them would normally be in this category Present value (PV) A sum calculated by discounting the stream of future cash flow from a project using an interest rate equal to the desired rate of return It differs from net present value in that the amount of the investment is not included in the cash flows 390 Key management ratios WKMR_Z05.QXD 11/24/05 12:51 PM Page 391 Price to earnings multiple (PE) The value derived by dividing the current share price by the earnings per share Latest reported earnings or prospective earnings for the coming year may be used in the calculation Prime rate The rate at which banks lend to corporations with the highest credit ratings Profit after tax (PAT) Profit available for the shareholders after interest and tax has been deducted Profit before interest and tax (PBIT) Operating profit plus other income Profit before interest, tax and depreciation (PBITD) This value corresponds very closely to cash flow from trading Profit before tax (PBT) Operating profit plus other income less total interest charged Profitability index A measure for assessing the relative merit of an investment by expressing the present value of the future cash flows as a percentage of the investment amount Pro forma statements Projected financial statements Proxy vote Vote cast by an authorized person on behalf of another Put option An option to sell See also option Quick ratio (acid test) A short-term liquidity ratio calculated by dividing current assets less inventories by current liabilities Repurchase agreement (REPO) A technique for providing short-term cash to a borrower who agrees to sell a security at one price and buy it back at a slightly higher price in the future The price difference is the effective interest payment to the lender Retained earnings (RE) The final figure from the profit and loss account that is transferred to reserves in the balance sheet Return on capital This is profit before tax but after interest as a percentage of capital employed Revenue reserves Increases in shareholders’ funds that have arisen from retained profits and are available for distribution as dividends Rights issue A new issue of shares made by a company to its existing shareholders at a price below the current market value Risk-free rate of interest The yield available on government gilts Return on assets (ROA) Profit before interest and tax as percentage of total assets The corresponding term used in this book is return on total assets Return on capital employed (ROCE) Capital employed includes all the longterm funds in the balance sheet, that is shareholders’ funds plus long-term loan plus miscellaneous long-term funds Profit before tax is often expressed as a percentage of this to give return on capital employed However, as the denominator includes long-term loan, the corresponding interest on these loans should be added back into the numerator Return on equity (ROE) A measure of the percentage return generated by a company for the equity shareholders It is calculated by expressing profit after tax as a percentage of shareholders’ funds (Where preference shares exist, they should first be deducted from shareholders’ funds and the preference dividends also be deducted from the profit figure.) Return on invested capital (ROIC) See chapter 17 for explanation Return on investment (ROI) A term that is very widely used in connection with the performance of a company or project It is calculated in many different ways Usually a pre-tax profit figure is expressed as a percentage of either the long-term funds or the total funds in the balance sheet Glossary 391 WKMR_Z05.QXD 11/24/05 12:51 PM Page 392 Return on total assets (ROTA) Profit before interest and tax expressed as a percentage of total assets Sales and leaseback agreement A method of raising finance whereby a firm sells property to the funding agency and simultaneously signs a long-term lease agreement The company receives an immediate lump sum in exchange for a series of lease payments in the future Sales to fixed assets (times) An activity and performance ratio, calculated by dividing the net fixed assets value in the balance sheet into the sales turnover figure Senior debt Debt that ranks ahead of junior, or, subordinated debt in the event of a liquidation See subordinated debt Sensitivity analysis Analysis of the change in the output values of an equation from small changes in input values It is used to assess the risk in an investment project Share premium The difference between a share’s nominal value and its sale price Shareholders’ funds Issued ordinary shares plus reserves plus preference shares Short-term loans (STL) The bank overdraft, current portion of long-term debt and other interest-bearing liabilities due within one year Spontaneous financing Short-term financing that automatically results from the normal operations of the business Creditors/accounts payable and certain accruals are the main sources Subordinated debt Debt that ranks for repayment after senior debt Subsidiaries A company is a subsidiary of another if the other owns more than 50 per cent of the equity or effectively controls the company by means of voting shares or composition of the board of directors Sundry accruals An entry in the current liabilities section of the balance sheet that includes sundry accounts payable plus accrued dividends, interest, tax plus other accruals SWAP The exchange of debt and/or currency obligations between parties to their mutual benefit The benefit can arise from their differing needs for currency and/or fixed/floating interest charges Tangible assets The total of all assets in the balance sheet less intangibles, such as goodwill Tax rate The apparent rate of tax on profit found by expressing tax charged in the accounts as a percentage of profit before tax Term loan Usually a medium-term loan (three to seven years) repaid in fixed, periodic instalments that cover both interest and principal over the life of the loan Terminal value A notional cash in-flow attributed to a capital project to allow for value remaining in the project at the final year of the assessment Total assets The sum of fixed assets plus intangibles plus investments plus current assets Treasury stock Ordinary or common shares that have been repurchased by the company Ultra vires ‘Beyond authorized powers’ An act is deemed to be ultra vires if carried out by an agent or director of a company in excess of their authority The person who so acts may incur personal liability Underwriting Banks or other financial institutions guarantee to take up an issue of shares at a specific price in order to ensure the success of the issue This process in called underwriting 392 Key management ratios WKMR_Z05.QXD 11/24/05 12:51 PM Page 393 Variable costs A type of cost where the total expenditure varies in proportion to activity or output Warrant Sometimes attached to loan stock as a sweetener at the time of issue, warrants give an option to the holder to purchase a stated amount of equities at a fixed price for a defined period Weighted average cost of capital (WACC) See cost of capital Window dressing The alteration of financial statements at the time of publication to give an artificially improved appearance to the company situation For instance the temporary sale of inventories to a bank with agreement to repurchase could give an enhanced view of company liquidity Working capital The excess of current assets over current liabilities Working capital days The length of the working capital cycle is often calculated as inventories plus accounts receivable less accounts payable days Working capital to sales A liquidity ratio that is calculated by expressing working capital as a percentage of sales Z-growth factor A value that gives an indication of the self-funding growth rate of a company It is calculated by expressing retained earnings before extraordinary items as a percentage of opening owners’ funds It is assumed for this calculation that all assets are linearly related to sales, likewise all items in the profit and loss account It also assumes that existing debt to equity ratios will be maintained Zero coupon bond A bond that pays no interest but is issued at a discount on its face value The redemption of the bond at par ensures the desired yield to the purchaser Glossary 393 WKMR_Z06.QXD 24/11/05 1:36 pm Page 394 Index absolute values, acquisition analysis 312–15 accelerated capital allowances 345 accounting policies 323, 327 accounting standards 150–1 accounting statements see financial statements; integrity of accounting statements accounts payable 100, 146, 264, 333 accounts receivable 16–17, 86, 100, 90–1, 264, 331 accounts receivable days 327, 363 accruals, undervalued 332–3 acid test ratios see quick ratios acquisition analysis 291–3 earnings per share 298–309 financial profiles 294–7 first offers 298–309 revised offers 310–11 shareholder effects 302–9 shareholder value added 312–19 values, relative versus absolute 312–15 acquisitions 202, 340–3 administration costs 84–5, 212–3 amortization 328–9, 351–2 annuities tables 376–7, 380–1 annuity approach, terminal values calculations 352–3 appropriation of profits 40–1 APS (assets per share) 304–9, 311 assets backing 158–9 on balance sheets 14–15, 16–20 current see current assets fixed see fixed assets intangible 18–19, 340 long-term 32 non-operating 274 operating 264–5 overvalued 331–2 394 Index recognition 329 sales to total assets see sales sector parameters 79 per share (APS) 304–9, 311 total see return on total assets; total assets turn 72–3, 185–6 values 158–9 associated companies, sales to 326 average returns to total equity market 280–1 backdating revenues 324 background 2–7 bad debt reserves 330 balance sheets assets see assets function 12, 13 horizontal format 55 integrity 331–5 layouts 54–7 liabilities see liabilities profit and loss accounts, relationship with 50–2 shareholder value added 264, 272 structure 16–24 terms 25–34 vertical formats 54–7 bankruptcy 99, 120 banks 128, 146 beta values 280–1 big bath 330–1 bill and hold 325 bogus sales 327 bonus issues 348–9 book values 21, 158–9 break-even 218, 220–5 capital employed 28–9, 56–7 return on (ROCE) 52 WKMR_Z06.QXD 24/11/05 1:37 pm Page 395 equity, cost of 278–9 expenditure 106–7 invested see invested capital weighted average cost of 276–7, 314 working see working capital capital allowances, accelerated 345 capital asset pricing model (CAPM) 280–1 capital investment, future 261 see also project appraisals capital leases 334 capital reserves 23–4 capitalization 156, 159, 329–30 CAPM (capital asset pricing model) 280–1 cash 16, 99 asset purchases, spent on 38 availability, liquidity as indicator of 32 closing reconciliations 144–5 cycle 100–110 importance 100 opening reconciliations 144–5 shareholder value added 264 cash flow cycles capital expenditure 106–7 cash 99 company profiles 110–111 current ratios 116–17 dividends 106–7 interest 106–7 liquidity measures, long and short analysis 110–111 loan repayments 106–7 new equity capital 108–9 new long-term loans 108–9 non-operating cash in-flows 108–9 non-operating cash out-flows 106–7 cash flow statements construction of 142 function 12, 13, 139 hidden movements 142 indirect method 142 integrity 335–8 profit and loss accounts compared 139 sources and uses of funds 140–3, 150 cash flows contribution and 214 cycles see cash flow cycles depreciation and 102–5, 268–70 financial reporting standards 150–1 fixed outflows, debt servicing 132 forecasts 268–9 future, values determined by 262 growth and 190 long and short analysis 146–9 negative 192 net 268–9, 318 from operations (CFFO) 337–8 profits and 38, 102–3 project appraisals 244, 246, 248–9 revenue recognition manipulation and 328 statements see cash flow statements CFFO (cash flows from operations) 337–8 closing and opening cash reconciliations 144–5 collection periods 90–1, 94 common stock, issued 21–2, 158 company profiles 110–111 compounding tables 374–81 conditional sales 326 consignment sales 325 contra agreements 326 contribution 214 calculation of 219 cash flows and 214 maximization 216, 236 percentage of sales (CPS) 226–37 product mix 234–5 profits and 216–7 total 216–8, 228–9f per unit (CPU) 216–7, 226, 230 per unit of capacity 236, 238–9 per unit of the limiting factor 236, 238 corporate liquidity cash flow cycles 96–111 cash flows 137–51 financial strength 125–6 liquidity 113–23 corporate tax 366 corporate value determinants corporate valuation 155–74, 186–7 financial leverage 175–87 growth 189–203 share values see shares: values costs administration 84–5, 212–3 alternative costing approaches 215 Index 395 WKMR_Z06.QXD 24/11/05 1:37 pm Page 396 costs (continued) break-even see break-even capitalized 329–30 classification 212–3 costing illustration 210–11 debt 132 equity 276 factory overheads 84–5 fixed 212–3, 216–7, 220–4 labor 84–5, 212–3 materials 84–5, 212–3 operating 84–5, 328–31 operating leverage 224–5 ratios 84–5 selling 84–5, 212–3 timing adjustments 39 total incurred 36 total operating 84–5 variable 212–3, 220–4 weighted average cost of capital (WACC) see weighted average cost of capital CPS (contribution percentage of sales) 226–37 CPU (contribution per unit) 216–7, 226, 230 creditors 56 current assets 16–17, 110, 146, 148, 192, 264 current assets to sales 194–201 current liabilities 20–21, 28, 110, 128–9, 146, 148, 192, 264 current ratios 116–17, 146, 148, 190, 294–7, 364 DCF (discounted cash flow) 256–7, 312 debt 128–9, 132 debt to equity ratios 128–34, 136, 148, 333–5, 342 debt to total assets ratios 146, 190, 368 debtor days 90–1, 94 debtors 16 decision-making see management decision-making deferred tax 130, 330, 345, 350 depreciation 38, 102–5, 268–70, 328–9, 335–6, 345, 351–2 determinants of corporate value see corporate value determinants discount factors 246, 248–9, 276–85 discounted cash flow (DCF) 256–7, 312 396 Index discounting tables 374–81 distribution of profits 40–1 dividends cash flows and 106–7 cover 164–7, 369 per share (DPS) 162–3, 304–9, 311 yield 168–70, 371 DPS see dividends: per share earnings cash flows from operations and 337–8 growth 170 retained earnings to sales 194–201 earnings after tax 40–1, 53, 160 earnings before interest and tax (EBIT) 40–1, 52–3, 64, 335–6 earnings before interest, tax, depreciation and amortization (EBITDA) 335–6, 351–2 earnings before tax 40–1, 53 earnings per share (EPS) 160–2, 298–311 earnings yield ratios 168–70, 182, 185, 186, 370 EBIT see earnings before interest and tax EBITDA (earnings before interest, tax, depreciation and amortization) 335–6, 351–2 economic value added (EVA) 261 Enron 335 EPS see earnings per share equity capital 108–9, 278–9 costs 276 debt to equity ratios see debt to equity ratios return on see return on equity values 274–5 EVA (economic value added) 261 Example Co plc 42–3 excessive capitalization 329 exchange rates 344 extraordinary items 38 factory overheads 84–5 fair values 340 fictitious revenues 324, 326–7 fictitious sales 326–7 finance leases 345 WKMR_Z06.QXD 24/11/05 1:37 pm Page 397 financial engineering 176 financial leverage 126, 176–78, 180–1, 187 financial profiles 294–7 financial reporting standards 150–1 financial statements 9–11 assets see assets balance sheets see balance sheets cash flow statements see cash flow statements integrity see integrity of accounting statements liabilities see liabilities profit and loss accounts see profit and loss accounts financial strength 125–6 finished goods 100 fixed assets 18–19, 86, 110, 157 acquisition analysis 318 depreciation and 329 integrity 328 revaluation of 346–7 sales to 91 shareholder value added 264, 266–8 fixed assets to sales 313–5 fixed costs see costs foreign currencies 344 funds long-term 28, 32, 350 non-equity 274, 314, 319 owners 21–3, 110, 156–7 self-funding 202–3 sources 15–16, 140–3, 150 uses 140–3, 143 future capital investment 261 future values tables 378–81 gearing see leverage geographical data 42, 44 charts 357–73 debt 132–4 dividend yield 168–9 dividends cover 166–7 growth 202–3 market to book ratios 173–4 price to earnings ratios 170–1 return on equity 68–9 return on total assets 76–7 glossary 382–91 goods invoiced but not shipped 325 goods shipped but not ordered 325 goodwill 340–3, 351–2 grants 350 gross margins 333 gross profit to sales 332 growth 189–90 acquisition analysis 294–7 acquisitions, application to 202 analysis 194–5 earnings 170 earnings per share 162 equilibrium 196–204 example 190–3 long-term 352–3 profits 162 rates 194–201 sales see sales self-funding 202–3 share prices 162 value and 283–5 hidden movements, cash flows 142 historic values 261 horizontal format balance sheets 55 impairment, goodwill 342 income statements see profit and loss accounts instalment sales 325 intangible assets 18–19, 340 integrity of accounting statements 321–3 balance sheets 326–35 cash flow statements 335–8 operating costs 328–31 operating revenue enhancement 323–8 interest cash flows and 106–7 cover 126–7, 294–7, 367 interest bearing debt 128 internal rate of return (IRR) 254–5, 256 inventories 16–17, 86, 157 accounts payable links 264 integrity 328 obsolescence reserves 330 overvalued 331–2 sales to 90–91 inventory days 92–3, 332, 362 invested capital 264 return on (ROIC) 282–6 investment funds 168 Index 397 WKMR_Z06.QXD 24/11/05 1:37 pm Page 398 investments 18–19 profiles 244–5 project appraisal see project appraisal ratios 241–57 return on 61–2, 244 involuntary takeovers 99 IRR (internal rate of return) 254–5, 256 issued common stock 21–2, 158 labor costs 84–5, 212–3 leases 334, 345 legal claims, debt and 132 leverage 134–5 acquisition analysis 294–7 effects of 70 financial see financial leverage operating 224–5 liabilities 157 on balance sheets 14–15, 20–4 current see current liabilities long-term loans see long-term loans short-term 28 undervalued 332–3 limiting factor, contribution per unit of 236, 238 liquidity acquisition analysis 294–7 corporate see corporate liquidity current ratios 116–17 long and short analysis 110–111 measures of 110–111 quick ratios 118–19 ratios 190 short-term measures 115–21 working capital as measure of 32 working capital days 122–3 working capital to sales ratios 120–1 loans long-term see long-term loans repayments 38, 106–7 short-term 128–9 long and short analysis 110–111, 146–9 long-term accounts receivable 327 long-term assets 32 long-term contracts, revenues 325 long-term funds 28, 32, 350 long-term growth approach, terminal values calculations 352–3 long-term loans 20–1, 108–9, 110, 128–9, 192 398 Index machine hours 238 management decision-making acquisition analysis 291–319 cost, volume and price relationships 207–40 integrity of accounting statements 321–38 investment ratios 241–57 shareholder value added 259–89 management performance 272–3 manipulation of accounts see integrity of accounting statements margins 72–7, 82–5, 184–5, 266, 313–5, 359 market capitalization 156, 159 market premiums 280–1 market to book ratios 172–4, 182–7, 294–7, 300, 373 market values 22, 160 matching principle 148, 329 materials 84–5, 100, 212–3 minority interests 350 MVA (market value added) 261 negative cash flows 192 net cash flows 268–9, 318 net fixed assets 18–19 net operating profit after tax (NOPAT) 270, 318, 352–3 net present values (NPV) 250, 252–3, 256 net working capital 264, 266–8 net worth 30–1 nominal values 21, 158 non-equity funds 274, 314, 319 non-operating assets 274 non-operating cash in-flows 108–9 non-operating cash out-flows 106–7 NOPAT see net operating profit after tax notes to accounts 323, 329 NPV see net present values offers, acquisition analysis 298–311 opening and closing cash reconciliations 144–5 operating assets 264–5 operating costs 84–5, 328–31 operating leases 334 operating leverage 224–5 operating performance WKMR_Z06.QXD 24/11/05 1:37 pm Page 399 drivers 81–94 margins on sales 82–5 measures of performance 48–57 operating profit model 88–91 return on capital employed 52 return on equity see return on equity return on investment 61–2 return on total assets see return on total assets standards of 66–79 operating profits 40, 88–91, 270, 318 operating revenue enhancement 323–8 operations, cash flows from (CFFO) 337–8 overdrafts 146 overtrading 120 overvalued assets 331–2 owners’ funds 21–3, 110, 156–7 ownership, risks and rights of 334 par values 158 pay-back 243 payments and receipts cash statements 142 pay-out ratios 164–5 PE ratios see price earnings ratios pensions 344 performance drivers 81–94 managerial 272–4 margins on sales 82–5 measures of 49–57 operating see operating performance terms, multiplicity of 50 PPS (price per share) 303–9, 311 preference shares 350 premature revenues 324–5 prepayments, overvalued 332 present values (PV) 246, 248, 250–3, 270, 271–4, 319, 374–7 price earnings (PE) ratios 170–1, 294–7, 308, 310, 372 price per share (PPS) 303–9, 311 product mix 234–5 profit and loss accounts balance sheets, relationship with 50–2 cash flow statements compared 139 function 12, 13 general observations 38–9 integrity 323–31 place in accounts 36–7 terms 40–1, 51 profitability 50, 294–7 profits 99 appropriation 40–1 cash flows and, distinction between 38 contribution and 216–7 definitions 40 distribution 40–1 growth 162 loss of 99 operating see operating profits trading 40 project appraisals 262 cash flow, effects of time on 248–9 discount factors 246, 248–9 discounted cash flow 256–7 investment profiles 244–5 internal rate of return 254–5, 256 net present values 250, 252–3, 256 present values 246, 248, 250–3 solutions, steps to 246–9 summary 256–7 provisions 350 purchasers unlikely to pay 326 PV see present values quick ratios 118–19, 365 raw materials 100 receipts and payments cash statements 142 recognition assets 329 revenues 324–8 reconciliations, opening and closing cash 144–5 reconstruction 99 relative values 312–15 repayment of loans see loans: repayments reserves 23–4, 330–1 restructuring reserves 331 retained earnings 40–1 retained earnings to sales 194–201 return on capital employed (ROCE) 52 return on equity (ROE) 52–3, 62–3, 67–9, 176–85, 190, 294–7, 357 return on invested capital (ROIC) 282–6 Index 399 WKMR_Z06.QXD 24/11/05 1:37 pm Page 400 return on investment (ROI) 61–2, 244 return on total assets (ROTA) 52–3, 64–5, 70–9, 176–7, 294–7, 358 revaluation of fixed assets 346–7 revenue reserves 23–4 revenues 36, 39, 220–4, 323–8 reverse yield gap 170 rights of ownership 334 risk measurement 261 risk-free rates 280–1 risks of ownership 334 ROCE (return on capital employed) 52 ROE see return on equity ROI see return on investment ROIC (return on invested capital) 282–6 ROTA see return on total assets sales to accounts receivable 90–1, 94 accounts receivable links 264 acquisition analysis 318 to associated companies 326 bogus 327 capacity 327 conditional 326 consignment 325 current assets to sales 194–201 fictitious 326–7 to fixed assets 92, 361 growth 314 assumptions 266–7 instalment 325 to inventories 90–91 margins 76–7, 82–5, 266, 313–4, 359 retained earnings to sales 194–201 to total assets 76–7, 82, 86–91, 360 working capital to 120–1 scrip issues 348–9 sectoral data 42, 44 charts 357–73 debt 132–4 dividends cover 166–7 return on equity 68–9 return on total assets 78–9 self-funding growth 202–3 selling costs 84–5, 212–3 SFA (sales to fixed assets) 92, 361 shareholder value added (SVA) 259–61 acquisition analysis 316–9 capital asset pricing model (CAPM) 280–1 400 Index creation of 282–3 depreciation and cash flow 268–70 description 262–5 discount factors 276–85 equity, cost of 278–9 forecast assumptions 266–7 growth and 283–45 net cash flow, forecasting 268–9 non-equity funds 274 non-operating assets 274 operating assets 264–5 present values 271–4 terminal values 270–2, 286–7, 352–3 total appraisal 288–9 total present values 259 valuation, approach to 266–74 weighted average cost of capital (WACC) 276–7 shareholders acquisition analysis, effects 302–9 equity, value for, 274–6 stakes 30 value added see shareholder value added shares bonus issues 348–9 number of 319 preference 350 prices 162, 166 scrip issues 348–9 values asset backing 158–9 asset values 158–9 book values 158–9 dividend yield ratios 168–70 dividends cover 164–7 dividends per share 162–3 earnings per share 160–2 earnings yield ratios 168–70, 185 market capitalization 159 market to book ratios 172–4, 182–7 market values 160 nominal 158 pay-out ratios 164–5 price earnings ratios see price earnings ratios short and long analysis 110–111, 146–9 short-term borrowings 192 short-term liabilities 28 WKMR_Z06.QXD 24/11/05 1:37 pm Page 401 short-term liquidity measures 115–21 short-term loans in debt to equity ratios 128–9 side letters 326 sources and uses of funds see funds special items 338–43 special purpose entities (SPE) 334–5 STA see sales: to total assets stock, common, issued 21–2 stock in trade see inventories stuffed revenues 324 SVA see shareholder value added takeover, involuntary 99 tax charts 366 deferred see deferred tax rates, shareholder value added 266, 270, 313–5 terminal values 270–2, 286–7, 352–3, 319 timing adjustments 39 timing differences 345 total assets 26–7 debt to total assets ratios 146, 190, 368 return on see return on total assets sales to see sales total contribution 216–8, 228–9 total costs incurred 36 total investment 318 total operating costs 84–5 total revenue earned 36 trade debtors 16–17 trading profits 40 true and fair view 338 underfunding 120 undervalued liabilities 332–3 US Consolidated Company Inc 42, 44–5 uses of funds 140–3, 150 V charts 178–81 valuation approach to 266–74 charts 178–81 corporate 155–74, 186–7 values absolute, acquisition analysis 312–15 assets 158–9 drivers 272, 314 economic value added 261 equity 274–5 future cash flows, determined by 262 future values tables 378–81 growth and 283-5 historic 261 market value added 261 of operations, acquisition analysis 319 present see net present values; present values relative, acquisition analysis 312–15 per share, acquisition analysis 319 shareholder value added see shareholder value added shares see shares terminal 270–2, 286–7 see also corporate value determinants variable costs 212–3, 220–4 vendors funding sales 326 vertical format balance sheets 54–7 warranty costs 332 weighted average cost of capital (WACC) 276–7, 314, 319, 352–3 weighted contribution percentage of sales 232–3 work in progress 100 working capital 32–3 acquisition analysis 318 balance sheets 56–7 days 122–3 net, shareholder value added 264, 266–8 to sales 120–1, 313–5 working data Example Co plc 42–3 geographical data 42, 44 sectoral data 42, 44 US Consolidated Company Inc 42, 44–5 wrongly classified revenues 324 Index 401 WKMR_Z06.QXD 24/11/05 1:37 pm Page 402 Read on … Key Management Models The management tools and Practices that will improve your business Steven Ten Have ISBN: 0273662015 The most influential management models in the world from activity-based costing to value chain analysis: what they mean and when to use them Management models – love them or hate them, they're at the heart of management thinking and practice They have 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Business ratios are the guiding stars for the management of enterprises; they provide their targets and standards They are helpful to managers in directing them towards the most beneficial