Lecture 4: Measuring
Corporate Performance
4-1
Corporate Performance
Corporate
Performance
Calculations:
Financial Ratios
Underlying Data:
Corporate Financials & Market Values
4-2
Corporate Performance Measured
Market
Value
Add
Corporate
Performance
Economic
Value
Add
•Market Value Add: Market capitalization
minus book value of equity.
•Economic Value Add: Operating income
minus a charge for the cost of capital
employed. Also called residual income.
•Book Rates of Return: Measure the
firm’s profits per dollar of assets. Also
known as accounting rates of return because
they are based on accounting information
(specifically company financials). Three
common measures are the return on capital
(ROC), the return on equity (ROE), and the
return on assets (ROA).
Book
Rates of
Return
4-3
Market Value Added
What is it?
Why is it useful?
Defined:
Market Value Added  [Share Price  Shares Outstanding] - EquityBook Value
•Market Capitalization —Total market value of equity, equal to share price times the number of shares outstanding
•Market Value Added —Market Capitalization – Book Value of Equity
4-4
MVA: Discussion
Market Value Added  [Share Price  Shares Outstanding] - EquityBook Value
TABLE 4.3
Consider AT&T and Home Depot
Similar MVA, Different Market-to-Book Ratio
 Limitations of MVA:
1. Market value reflects investors’ expectations about future performance, complete with the imprecisions that come with all
forecasting.
2. Market value fluctuates frequently due to reasons outside of the financial managers control.
3. Privately owned corporations do not have a public market value.
4-5
Economic Value Added
Economic Value Added = Operating Income minus the product of
cost of capital and total capitalization
Operating Income = Net Income + After-tax Interest
Cost of Capital = The minimum acceptable rate of return on capital
investment
Total Capitalization = Total Long-term Capital = Equity + Bonds +
other Long-term capital [all capital committed by debt and equity
investors]
Defined:
Economic Value Added  Operating Income* - [Cost of Capital  Total Capitalization]
4-6
EVA: Discussion
Economic Value Added  Operating Income - [Cost of Capital  Total Capitalization]
TABLE 4.4
Consider Coca-Cola and Google
Similar EVA, Different Return on Capital
Why?
* Operating Income = Net Income + After-tax Interest; ROC = Return on Capital
4-7
Book Rates of Return*
• Book Rates of Return = Accounting Rates of Return = Measures of the firm’s profits per dollar of
assets.
• Return on Capital = (after-tax operating income)/(total capitalization)
• Return on Assets = (after-tax operating income)/(average total assets)
or = (after-tax operating income)/(start of year total assets)
• Return on Equity = (net income)/(average equity)
or = (net income)/(start of year equity)
• Average Assets = (end of period assets + beginning of period assets)/2
• Average Equity = (end of period equity + beginning of period equity)/2
*Book Rates of Return are also referred to as Accounting rates of Return
4-8
Calculating Return on Capital
Assets
Lowe’s Return on Capital
After Tax Operating Income = Net Income + After-Tax Interest
= 1,783 + 181 = 1,964
Average Total Capitalization = Average Long-Term Debt + Equity
(23,579  23, 094)

 23,336.5
2
ROC 
After-Tax Operating Income
1,964

 8.4%
Average Total Capitalization 23,336.5
Lowe's Income Statement
Net sales
Cost of sales
Gross margin
Expenses:
Selling, general and administrative
Store opening costs
Depreciation
Interest - net
Total expenses
Pre-tax earnings
Income tax provision
Net earnings
2009
47,220
30,757
16,463
Current assets:
Cash and cash equivalents
Short-term investments
Merchandise inventory - net
Deferred income taxes - net
Other current assets
Total current assets
Property less acc. depreciation
Long-term investments
Other assets
Total assets
2009
$
$
Liabilities and Shareholders' Equity
Current liabilities:
Short-term borrowings
Current maturities of long-term debt
Accounts payable
Accrued comp./employee benefits
Deferred revenue
Other current liabilities
22,499
277
497
33,005
22,722
253
460
32,625
2008
987
34
4,109
434
674
1,322
Total current liabilities
7,355
7,560
Long-term debt, excl. current maturities
Deferred income taxes - net
Other liabilities
4,528
598
1,455
5,039
599
1,372
13,936
14,570
729
6
18,307
27
735
277
17,049
(6)
19,069
18,055
33,005
32,625
Shareholders' equity:
Common stock - $.50 par value
Capital in excess of par value
Retained earnings
Acc. other comprehensive income
Total shareholders' equity
Lowe’s Balance Sheet (in $m)
245
416
8,209
105
215
9,190
552
4,287
577
683
1,256
Total liabilities
11,688
49
1,614
287
13,638
2,825
1,042
1,783
632
425
8,249
208
218
9,732
2009
$
2008
Total liabilities and shareholders' equity
$
4-9
Calculating Return on Assets
Lowe’s Return on Assets
After Tax Operating Income = Net Income + After-Tax Interest
= 1,783 + 181 = 1,964
(33, 005  32, 625)
2
 32,815
Average Total Assets =
ROA 
After-Tax Operating Income 1,964

 6.0%
Average Total Assets
32,815
or ROA =
After-Tax Operating Income 1,964

 6.0%
Total AssetsYear Beginning
32, 625
Lowe's Income Statement
Net sales
Cost of sales
Gross margin
Expenses:
Selling, general and administrative
Store opening costs
Depreciation
Interest - net
Total expenses
Pre-tax earnings
Income tax provision
Net earnings
2009
47,220
30,757
16,463
Lowe’s Balance Sheet (in $m)
Assets
Current assets:
Cash and cash equivalents
Short-term investments
Merchandise inventory - net
Deferred income taxes - net
Other current assets
Total current assets
Property less acc. depreciation
Long-term investments
Other assets
Total assets
2009
$
$
Liabilities and Shareholders' Equity
Current liabilities:
Short-term borrowings
Current maturities of long-term debt
Accounts payable
Accrued comp./employee benefits
Deferred revenue
Other current liabilities
245
416
8,209
105
215
9,190
22,499
277
497
33,005
22,722
253
460
32,625
2008
552
4,287
577
683
1,256
987
34
4,109
434
674
1,322
Total current liabilities
7,355
7,560
Long-term debt, excl. current maturities
Deferred income taxes - net
Other liabilities
4,528
598
1,455
5,039
599
1,372
13,936
14,570
729
6
18,307
27
735
277
17,049
(6)
19,069
18,055
33,005
32,625
Total liabilities
11,688
49
1,614
287
13,638
2,825
1,042
1,783
632
425
8,249
208
218
9,732
2009
$
2008
Shareholders' equity:
Common stock - $.50 par value
Capital in excess of par value
Retained earnings
Acc. other comprehensive income
Total shareholders' equity
Total liabilities and shareholders' equity
$
4-10
Calculating Return on Equity
Lowe’s Return on Equity
Lowe’s Balance Sheet (in $m)
Assets
(19, 069  18, 055)
2
 18,562
Average Total Equity =
ROE 
Net Income
1, 783

 9.6%
Average Total Equity 18,562
Current assets:
Cash and cash equivalents
Short-term investments
Merchandise inventory - net
Deferred income taxes - net
Other current assets
Total current assets
Property less acc. depreciation
Long-term investments
Other assets
Total assets
2009
$
$
Liabilities and Shareholders' Equity
or ROE =
Net Income
1, 783

 9.9%
EquityYear Beginning 18, 055
Lowe's Income Statement
Net sales
Cost of sales
Gross margin
Expenses:
Selling, general and administrative
Store opening costs
Depreciation
Interest - net
Total expenses
Pre-tax earnings
Income tax provision
Net earnings
2009
47,220
30,757
16,463
11,688
49
1,614
287
13,638
2,825
1,042
1,783
Current liabilities:
Short-term borrowings
Current maturities of long-term debt
Accounts payable
Accrued comp./employee benefits
Deferred revenue
Other current liabilities
632
425
8,249
208
218
9,732
245
416
8,209
105
215
9,190
22,499
277
497
33,005
22,722
253
460
32,625
2009
$
2008
2008
552
4,287
577
683
1,256
987
34
4,109
434
674
1,322
Total current liabilities
7,355
7,560
Long-term debt, excl. current maturities
Deferred income taxes - net
Other liabilities
4,528
598
1,455
5,039
599
1,372
13,936
14,570
729
6
18,307
27
735
277
17,049
(6)
19,069
18,055
33,005
32,625
Total liabilities
Shareholders' equity:
Common stock - $.50 par value
Capital in excess of par value
Retained earnings
Acc. other comprehensive income
Total shareholders' equity
Total liabilities and shareholders' equity
$
4-11
Financial Ratios and Shareholder Value
Shareholder
Value
Investment
Decisions
Efficiency
Ratios
Profitability
Ratios
Financing
Decisions
Leverage
Ratios
Liquidity
Ratios
Shareholder value depends on good investment and financing decisions.
Financial Ratios help measure the success and soundness of these decisions.
4-12
Efficiency Ratios
• Efficiency Ratios – Ratios which measure how efficiently
a firm uses its assets.
Asset turnover ratio =
Sales
Total AssetsYear Beginning
OR*
=
Sales
Average Total Assets
How does this ratio measure efficiency?
Receivables Turnover=
Sales
ReceivablesYear Beginning
How does this ratio measure efficiency?
* Either equation is a legitimate way to calculate the asset turnover ratio
4-13
Efficiency Ratios
Cost of Goods Sold
Inventory Turnover Ratio=
InventoryYear Beginning
How does this ratio measure efficiency?
Average Days in Inventory=
InventoryYear Beginning
(Cost of Goods Sold/365)
How does this ratio measure efficiency?
Average Collection Period=
ReceivablesYear Beginning
(Sales/365)
How does this ratio measure efficiency?
4-14
Calculating an Efficiency Ratio
Lowe’s Balance Sheet (in $m)
Assets
Lowe’s Asset Turnover Ratio
(33, 005  32, 625)
2
 32,815
Average Total Assets =
Sales
44, 270
Asset Turnover Ratio 

 1.4
Average Total Assets 32,815
Lowe's Income Statement
Net sales
Cost of sales
Gross margin
Expenses:
Selling, general and administrative
Store opening costs
Depreciation
Interest - net
Total expenses
Pre-tax earnings
Income tax provision
Net earnings
2009
47,220
30,757
16,463
Current assets:
Cash and cash equivalents
Short-term investments
Merchandise inventory - net
Deferred income taxes - net
Other current assets
Total current assets
Property less acc. depreciation
Long-term investments
Other assets
Total assets
2009
$
$
Liabilities and Shareholders' Equity
Current liabilities:
Short-term borrowings
Current maturities of long-term debt
Accounts payable
Accrued comp./employee benefits
Deferred revenue
Other current liabilities
245
416
8,209
105
215
9,190
22,499
277
497
33,005
22,722
253
460
32,625
2008
552
4,287
577
683
1,256
987
34
4,109
434
674
1,322
Total current liabilities
7,355
7,560
Long-term debt, excl. current maturities
Deferred income taxes - net
Other liabilities
4,528
598
1,455
5,039
599
1,372
13,936
14,570
729
6
18,307
27
735
277
17,049
(6)
19,069
18,055
33,005
32,625
Total liabilities
11,688
49
1,614
287
13,638
2,825
1,042
1,783
632
425
8,249
208
218
9,732
2009
$
2008
Shareholders' equity:
Common stock - $.50 par value
Capital in excess of par value
Retained earnings
Acc. other comprehensive income
Total shareholders' equity
Total liabilities and shareholders' equity
$
4-15
Profitability Ratios
Net Income
Profit Margin=
Sales
How does this ratio measure the firm’s profitability?
Net Income  After-Tax Interest
Operating Profit Margin=
Sales
When is this ratio potentially more useful than just profit margin?
Note: ROC, ROA, ROE and EVA are also typically considered profitability ratios.
4-16
Calculating a Profitability Ratio
Lowe’s Balance Sheet (in $m)
Assets
Lowe’s Operating Profit Margin
Current assets:
Cash and cash equivalents
Short-term investments
Merchandise inventory - net
Deferred income taxes - net
Other current assets
Total current assets
Property less acc. depreciation
Long-term investments
Other assets
Total assets
2009
$
$
Liabilities and Shareholders' Equity
OPM 
Net Income + After-Tax Interest 1, 783  181

 4.2%
Sales
47, 220
Lowe's Income Statement
Net sales
Cost of sales
Gross margin
Expenses:
Selling, general and administrative
Store opening costs
Depreciation
Interest - net
Total expenses
Pre-tax earnings
Income tax provision
Net earnings
2009
47,220
30,757
16,463
Current liabilities:
Short-term borrowings
Current maturities of long-term debt
Accounts payable
Accrued comp./employee benefits
Deferred revenue
Other current liabilities
245
416
8,209
105
215
9,190
22,499
277
497
33,005
22,722
253
460
32,625
2008
552
4,287
577
683
1,256
987
34
4,109
434
674
1,322
Total current liabilities
7,355
7,560
Long-term debt, excl. current maturities
Deferred income taxes - net
Other liabilities
4,528
598
1,455
5,039
599
1,372
13,936
14,570
729
6
18,307
27
735
277
17,049
(6)
19,069
18,055
33,005
32,625
Total liabilities
11,688
49
1,614
287
13,638
2,825
1,042
1,783
632
425
8,249
208
218
9,732
2009
$
2008
Shareholders' equity:
Common stock - $.50 par value
Capital in excess of par value
Retained earnings
Acc. other comprehensive income
Total shareholders' equity
Total liabilities and shareholders' equity
$
4-17
Leverage Ratios
Long Term Debt
Long term debt ratio=
Long Term Debt+Equity
How does this ratio measure leverage?
Long-Term Debt
Long-term Debt Equity Ratio=
Equity
How does this ratio measure leverage?
4-18
Measuring Leverage
Total Liabilities
Total Assets
How does this ratio measure leverage?
Total Debt Ratio=
Times Interest Earned=
EBIT
Interest Payments
How does this ratio measure leverage?
EBIT+Depreciation
Cash Coverage Ratio=
Interest Payments
How does this ratio measure leverage?
4-19
Calculating a Leverage Ratio
Lowe’s Balance Sheet (in $m)
Assets
Lowe’s Times Interest Earned
Ratio
EBIT = Sales - COGS - Expenses - Depreciation
 47, 220  30, 757  11, 737  1, 614  3,112
Current assets:
Cash and cash equivalents
Short-term investments
Merchandise inventory - net
Deferred income taxes - net
Other current assets
Total current assets
Property less acc. depreciation
Long-term investments
Other assets
Total assets
2009
$
$
Liabilities and Shareholders' Equity
Times Interest Earned 
Lowe's Income Statement
Net sales
Cost of sales
Gross margin
Expenses:
Selling, general and administrative
Store opening costs
Depreciation
Interest - net
Total expenses
Pre-tax earnings
Income tax provision
Net earnings
EBIT
3,112

 10.8
Interest
287
2009
47,220
30,757
16,463
11,688
49
1,614
287
13,638
2,825
1,042
1,783
Current liabilities:
Short-term borrowings
Current maturities of long-term debt
Accounts payable
Accrued comp./employee benefits
Deferred revenue
Other current liabilities
632
425
8,249
208
218
9,732
245
416
8,209
105
215
9,190
22,499
277
497
33,005
22,722
253
460
32,625
2009
$
2008
2008
552
4,287
577
683
1,256
987
34
4,109
434
674
1,322
Total current liabilities
7,355
7,560
Long-term debt, excl. current maturities
Deferred income taxes - net
Other liabilities
4,528
598
1,455
5,039
599
1,372
13,936
14,570
729
6
18,307
27
735
277
17,049
(6)
19,069
18,055
33,005
32,625
Total liabilities
Shareholders' equity:
Common stock - $.50 par value
Capital in excess of par value
Retained earnings
Acc. other comprehensive income
Total shareholders' equity
Total liabilities and shareholders' equity
COGS stands for Cost of Goods Sold. Expenses include selling, general and administrative costs (and “store operating costs” in this example).
$
4-20
Measuring Liquidity
NWC to Total Assets Ratio =
Net Working Capital
Total Assets
How does this ratio measure liquidity?
Current Assets
Current Ratio=
Current Liabilities
How does this ratio measure liquidity?
• Liquidity Ratios– Ratios which measure the extent to which the firm has sufficient liquidity in the coming
year.
• Net Working Capital = Current Assets – Current Liabilities
4-21
Liquidity Ratios
Quick ratio=
Cash + Marketable Securities + Receivables
Current Liabilities
How does this ratio differ form the current ratio? Why might a financial manager prefer it?
Cash Ratio=
Cash + Marketable Securities
Current Liabilities
How does this ratio differ from the current ratio? Why might a financial manager prefer it?
4-22
Calculating a Liquidity Ratio
Lowe’s Balance Sheet (in $m)
Assets
Lowe’s NWC to Total Assets Ratio
Net Working Capital = 9,732-7,355  2,377
Current assets:
Cash and cash equivalents
Short-term investments
Merchandise inventory - net
Deferred income taxes - net
Other current assets
Total current assets
Property less acc. depreciation
Long-term investments
Other assets
Total assets
2009
$
$
Liabilities and Shareholders' Equity
NWC to Total Assets 
Lowe's Income Statement
Net sales
Cost of sales
Gross margin
Expenses:
Selling, general and administrative
Store opening costs
Depreciation
Interest - net
Total expenses
Pre-tax earnings
Income tax provision
Net earnings
NWC
2,377

 7.2%
Total Assets 33, 005
2009
47,220
30,757
16,463
Current liabilities:
Short-term borrowings
Current maturities of long-term debt
Accounts payable
Accrued comp./employee benefits
Deferred revenue
Other current liabilities
245
416
8,209
105
215
9,190
22,499
277
497
33,005
22,722
253
460
32,625
2008
552
4,287
577
683
1,256
987
34
4,109
434
674
1,322
Total current liabilities
7,355
7,560
Long-term debt, excl. current maturities
Deferred income taxes - net
Other liabilities
4,528
598
1,455
5,039
599
1,372
13,936
14,570
729
6
18,307
27
735
277
17,049
(6)
19,069
18,055
33,005
32,625
Total liabilities
11,688
49
1,614
287
13,638
2,825
1,042
1,783
632
425
8,249
208
218
9,732
2009
$
2008
Shareholders' equity:
Common stock - $.50 par value
Capital in excess of par value
Retained earnings
Acc. other comprehensive income
Total shareholders' equity
Total liabilities and shareholders' equity
$
4-23
The DuPont System
•DuPont System: A breakdown of ROE and
ROA into component ratios
4-24
The DuPont System: ROA
Net Income  Interest
ROA=
Assets
Sales Net Income  Interest
ROA=
x
Assets
Sales
Asset
Turnover
Operating Profit
Margin
4-25
ROA Decomposition by Industry
4-26
The DuPont System: ROE
Net Income
ROE=
Equity
Assets Sales Net Income  Interest
Net Income
ROE=
x
x
x
Equity Assets
Sales
Net Income  Interest
Leverage
Ratio Asset
Turnover
Operating
Profit
Margin
Debt
Burden
The last ratio in the DuPont breakdown of ROE is a measure of the firm’s debt burden. The denominator
represents free cash flow (Cash available for distribution to investors after the company has paid for any new
capital investment or additions to working capital.). If the ratio is close to zero, the firm has a heavy debt
burden—much of its free cash flow goes to interest payments.
4-27
Sustainable Growth
Payout Ratio=
Dividends
Earnings
Plowback Ratio=
Earnings-Dividends
Earnings
Growth in equity from plowback = Plowback Ratio  ROE
Earnings - Dividends Earnings


Earnings
Equity
Earnings-Dividends
=
Equity
4-28
The Role of Financial Ratios
Table 4.8
4-29
The Role of Financial Ratios
4-30
Appendix A: Average Ratios, by Industry
Table 4.7
4-31
Appendix B: Financial Ratios and Default Risk
Table 4.9
4-32