Financial Analysis
Using Ratios
1
Agenda
 Ratio
analysis and EVA
 Briggs case
 Cash flow statement analysis
 Free cash flow
2
Four Analysis Categories

Evaluate performance relative to a peer
group, and period-over-period, to identify
strengths and weaknesses in four areas
 Profitability
 Asset
management
 Solvency risk
 Economic Value-added
3
Key Uses of Ratio Analysis

Consider impact of financial performance
on cash flow and stock price
 Measure
value-added
Set targets for projected performance to
improve valuation
 Assist in formulating a cash flow planning
forecast

4
I. Profitability
Traditional DuPont Model
 Adjusted DuPont Model
 Margin analysis

5
Which outperformed? Operating performance?
Unlevered
Assets
Levered
$10,000
$10,000
$0
$5,000
$10,000
$5,000
# Shares
400
200
Tax Rate
40%
40%
Debt
Equity
Interest rate
Unlevered
Poor
EBIT
Expected
Levered
Strong
Poor
Expect
Strong
$-500
$1,000
$1,500
$-500
$1,000
$1,500
$0
$0
$0
$250
$250
$250
Taxes
$-200
$400
$600
$-300
$300
$500
Net Income
$-300
$600
$900
$-450
$450
$750
ROA
-3.0%
6.0%
9.0%
-4.5%
4.5%
7.5%
ROE
-3.0%
6.0%
9.0%
-9.0%
9.0%
15.0%
EPS
$-0.75
$1.50
$2.25
$-2.25
$2.25
$3.75
5%
Interest
6
Traditional DuPont Model
Margins
On Sales
x
Return on
Assets
x
Financial
Leverage
=
Return on
Equity
Asset
Utilization
7
Profitability summary using the Dupont Model
NI
NI
Sales
Avg Assets



Avg Equity
Sales Avg Assets Avg Equity
ROE
NPM
TAT
LR
ROE = Return on Equity: rate of return to stockholders
NPM = Net Profit Margin: efficiency in expense control (income statement)
TAT = Total Asset turnover: asset management (balance sheet)
LR
= Leverage Ratio (‘financial leverage’; tradeoff is insolvency risk)
8
Return on Assets
NI
NI
Sales
Avg Assets



Avg Equity
Sales Avg Assets Avg Equity
NI

Avg Equity
ROE
NI
Avg Assets

Avg Assets Avg Equity
ROA
LR
ROA = Return on Assets: summarizes income statement and balance
sheet efficiency, before incorporating financial leverage
9
10
DuPont mixes operating and
financial decisions
A
problem with this approach is that because net
income is biased by financing choice, the
equation provides a poor summary of operating
performance (e.g. success in product positioning,
production efficiency, distribution, overhead
control, etc.)
Companies
with high debt have low net profit
margin, low ROA, but higher ROE, all else equal
11
Traditional Balance Sheet
Current Assets
Current Liabilities
PP&E
Long-term Debt
Stockhoders Equity
= Total Assets
= Total Liab + Equity

Our objective as financial managers is to enhance the value of the debt
and equity capital that we’ve raised in the market, on which the investors
require a rate of return.

Let’s show a balance sheet that isolates this investor capital.
Managerial Balance Sheet
+ Current Assets
-
Oper. Current Liab.
Net Working Capital
+ PP&E
+ Debt (L.T. + S.T.)
+ Equity
= Invested Capital
= Invested Capital
Invested Capital can be calculated both inside and outside the box
Net Working Capital (NWC)

NWC = Current Assets minus Operating Current
Liabilities
 Operating Current Liabilities
 grow spontaneously with the firm’s assets
 not motivated by a return on investment (non-interest)
 include Accts Payable, Accrued Expenses, Tax Payable
 exclude short-term interest-bearing debt that is part of
current liabilities on the traditional balance sheet

This S.T. debt is now outside the box as a part of the Debt Capital
Invested Capital (IC)

IC is raised to acquire assets inside the box

IC = NWC + PP&E inside the box

IC also = Debt + Equity outside the box

The overall rate of return required by investors on the
Invested Capital is known as the
Weighted Average Cost of Capital
Net Operating Profit After Taxes
This is the after-tax income earned on the
Invested Capital
+ Earnings Before Interest and Taxes
X (1 – cash tax rate)
= NOPAT


By using earnings before Interest to calculate NOPAT, we exclude the
influence of debt funding on earnings
NOPAT is the net income that would be earned if there were no debt
16
Return on Invested Capital
ROIC is a weighted return on Invested Capital:
ROIC =
ROIC 
NOPAT
Capital ; rd=interest rate on debt
D
E
x rd (1  T ) 
x ROE
DE
DE
DE
Multiply both sides by:
E
DE D
 x rd (1  T )  ROE
E
E
D  D
ROIC x  1  x rd (1  T )  ROE
E  E
D
ROIC  xROIC  rd (1  T )  ROE
E
ROICx
17
Return on Invested Capital (ROIC)
ROIC =
NOPAT
x
Sales
Net Oper. Margin x
Sales
IC
Capital
Turnover
ROIC
intersects efficiency on the income statement with the productivity of
assets on the balance sheet
ROIC
provides a summary measure of operating performance
A financial
performance analysis begins with ROIC, and drills down from
there
18
Adjusted Dupont Model (isolates operating and
financial leverage effects on ROE)
rd = interest rate on debt
ROE  ROIC 
Debt
xROIC  rd (1  T )
Equity
Pure leverage effect
The
second term isolates the increase in ROE resulting solely from
leverage differences
This
term also captures the tax break on interest (1-t) that we ignored when
we calculated NOPAT
19
Which company performed better?
Unlevered
Assets
Levered
$10,000
$10,000
$0
$5,000
$10,000
$5,000
# Shares
400
200
Tax Rate
40%
40%
Debt
Equity
Interest rate
Unlevered
Poor
EBIT
Expected
Levered
Strong
Poor
Expect
Strong
$-500
$1,000
$1,500
$-500
$1,000
$1,500
$0
$0
$0
$250
$250
$250
Taxes
$-200
$400
$600
$-300
$300
$500
Net Income
$-300
$600
$900
$-450
$450
$750
ROA
-3.0%
6.0%
9.0%
-4.5%
4.5%
7.5%
ROE
-3.0%
6.0%
9.0%
-9.0%
9.0%
15.0%
EPS
$-0.75
$1.50
$2.25
$-2.25
$2.25
$3.75
5%
Interest
20
Adjusted Dupont Model
ROE  ROIC 
600
10,000
9% = 6%
+
Debt
xROIC  rd (1  T )
Equity
5,000
5,000
x
+ 1.0 x
[
[ 6%
600
10,000
-
5% (1-.40)
-
3%
]
]
 From an operating perspective the companies are
identical, earning a 6% ROIC
 The levered company adds another 3% to its ROE as a
result of its debt usage
 Ultimately the answer to which is better depends largely
on which debt mix is appropriate given the industry’s
operating risk (variability in EBIT)
21
22
Increasing Leverage and ROE
ROE  ROIC 

Debt
xROIC  rd (1  T )
Equity
Note that the hurdle rate for increasing ROE
(same for EPS) by increasing leverage is very
low:
 ROIC
> Int (1-T)
 Returns to capital > after-tax cost of debt only
 To increase value need ROIC >
weighted average cost of debt and equity


Cost of both debt and equity are rising as debt
increases
Goal should not be max ROE
23
Margin analysis

Gross Margin: ability to mark-up
product and control production
expenses

Net Operating Margin: control of overhead
NOPAT
expenses (SG&A) as well
Sales
Gross profit
Sales
24
Profits Summary

Start with ROIC as a summary measure of
operating performance

Explain ROIC results using
 Margins
on income statement
 Capital turnovers from balance sheet

Explain ROE result using ROIC and Leverage

Also consider growth’s impact on value
25
Value Drivers
The three keys to value are 1) ROIC; 2)
growth in NOPAT; 3) Risk
Implied Value/NOPAT Multiples for ROIC and Growth
ROIC
Growth

10.0
8%
10%
12%
14%
16%
2%
9.4
10.0
10.4
10.7
10.9
4%
8.3
10.0
11.1
11.9
12.5
6%
6.3
10.0
12.5
14.3
15.6
8%
0.0
10.0
16.7
21.4
25.0
26
II. Asset Management (turnovers)
 Measure the efficiency with which the company invests in its assets
(e.g. efficiency in collecting receivables, turning inventory, and
utilizing PP&E capacity)
Capital Turnover
 Accts. Receivable Days
 Inventory Holding Period
 Working Capital Turnover
 PP&E Turnover

Sales
Avg Invested Capital
Avg Accounts receivable
Sales / 365
Avg Inventory
COGS / 365
Sales
Avg NWC
Sales
Avg Net PP & E
27
28
III. Solvency risk
 Measure whether the company has an appropriate level of debt in its
capital mix, or the risk of becoming insolvent

Debt-to-EBITDA

Debt-to-Capital

Interest Coverage

or Times Interest Earned
ST Debt  LT Debt
EBITDA
ST Debt  LT Debt
ST Debt  LT Debt  Equity
EBIT
Interest Expense
 Tradeoff: There are many considerations that drive this decision, but
the primary tradeoff is that while higher debt increases insolvency
risk and the cost of capital, it also can boost the return to
stockholders (ROE).
29
30
31
III. Solvency risk: Liquidity focus
 Measure ability to meet near-term financial obligations by holding
sufficient assets that are expected to convert to cash within the year
 Inventory is the least liquid current asset, so exclude it in the quick
ratio


Current ratio
Quick ratio
Current Assets
Current Liabilitie s
Current Assets  Inventory
Current Liabilitie s
32
33
Liquidity interactions
 Tradeoff: By shrinking the current ratio companies can
reduce Invested Capital requirements and thereby
boost ROIC
 But a lower current ratio indicates greater liquidity risk
 Liquidity can also be located off the balance sheet in
committed unused lines of credit
 Companies that have less total debt and/or have
stronger cash flow can afford to have lower liquidity
34
IV. Economic Value Added

EVA is a measure of periodic economic profit,
or single period $value-added to shareholders

Unlike Net Income, EVA measures residual
income after deducting a charge for all of the
Invested Capital used in the business (i.e. it
charges for Equity capital)
 Net
income fails to effectively capture the cost of an
inefficient balance sheet
35
EVA’s relation to value

Market value added, the difference between a
company’s market value and its book value, is the
present value of the company’s future expected EVAs


EVA links profit measurement to valuation
Net Present Value (NPV) for a new capital investment is
equal to the present value of the investment’s future
expected EVAs

EVA links profit measurement to capital budgeting
36
Value-based management using EVA

Focus managers on controlling capital investment
and beating the cost of capital
 “Incredibly,
most corporate groups, divisions, and
departments have no idea how much capital they tie up
or what it costs”— Fortune



Provide appropriate incentives for value-added
growth investments, while divesting valuedestroying business lines
Push accountability for capital charges down into
profit centers at all levels of organization
Optimize the use of debt to minimize WACC
37
Calculating EVA
$EVA  $NOPAT  WACC%  $Capital 
$Capital Charge



EVA deducts a Capital (financing) Charge for
the Investment Capital used to generate
NOPAT
WACC = Weighted Average Cost of Capital
WACC is an estimate of the % return
required by investors on the firm’s Invested
Capital
38
ROIC > WACC = +EVA
$EVA  $NOPAT  WACC%  $Capital 
 NOPAT

EVA  
 WACC   Capital
 Capital

EVA  ROIC  WACC  Capital
EVA spread %


Investments must generate an ROIC that exceeds the cost of financing
$Capital captures the firm’s ability to find profitable growth
opportunities



Recall that MVA is present value of future EVA
WACC captures risk
The EVA spread can be compared across firms, but do not target max
39
40
Overinvestment problem of
net income focus

Assume capital structure is 50%/50% D/E:
Assumptions:
Investment
EBIT
Interest rate
Tax rate
Equity Cost
WACC

$100
$12
10%
30%
17%
12%
Net Income:
EBIT
Interest Exp
EBT
Taxes
Net Income
$12.0
$5.0
$7.0
2.1
4.9
EVA:
NOPAT
Capital Charge
EVA
ROIC
$8.40
12.0
-3.6
8.4%
Only need to earn ROIC > Interest (1-T) x 50%,
which here is 3.5%, to increase Net Income; need
12% for breakeven EVA; result is overinvestment
41
Should the investment be made?
Capital
EBIT
Tax rate
NOPAT
ROIC
WACC
EVA
Before Investment:
$1,000
$340
40%
204
20.4%
10%
$104
New Investment:
$300
$60
40%
36
12.0%
10%
$6
After Investment:
$1,300
$400
40%
240
18.5%
10%
$110
42
EVA captures Equity cost risk effects not
included in any measure of profitability, and
encourages optimal capital structure

Captures differences in risk and
associated financing cost side of the
risk/return tradeoff via WACC
 seek
optimal use of debt to minimize WACC
 include risk shifts in profit measurement

If use excessive debt to increase ROE, cost of
Equity and Debt increase, resulting in higher
WACC and capital charge in EVA calculation
43
Accounting adjustments

Adjusts capital for accounting distortions
that understate capital (e.g. leases,
reserves on balance sheet) or
discourage investment (e.g. R&D,
advertising, and training expenses)
44
Key terms





NOPAT
Invested Capital
ROIC
EVA
WACC
45