2
FUNDAMENTALS OF FINANCE
CHAPTER INTRODUCTION
The traditional and most fundamental aspect of financial planning and analysis is the ability to understand and evaluate financial statements and financial performance. This chapter presents a brief introduction (or refresher) to financial statements and financial ratios. Many finance professionals will use these financial ratios as overall measures of a company's performance or as overall measures of performance on a particular driver of value.
BASICS OF ACCOUNTING AND FINANCIAL STATEMENTS
The three primary financial statements are the Income Statement, the Balance Sheet, and the Statement of Cash Flows. We need all three statements to properly understand and evaluate financial performance. However, the financial statements provide only limited insight into a company's performance and must be combined with key financial ratios and ultimately an understanding of the company's market, competitive position, and strategy, before evaluating a company's current performance and value. A significant limitation of financial statements is that they present historical results – that is, the past. Other measures and mechanisms must be utilized to see what is happening in the present and to predict and manage future outcomes.
Financial statements are based on generally accepted accounting principles (GAAP). A key objective of financial statements prepared under GAAP is to match revenues and expenses. Two significant conventions arise from this objective: the accrual method of accounting and depreciation. These two conventions are significant in our intended use of financial statements for economic evaluation and business valuation purposes, since they result in differences between accounting income and cash flow.
Accrual Accounting
Financial statements record income when earned and expenses when incurred. For example, the accrual basis of accounting will record sales when the terms of the contract are fulfilled, usually prior to collection of cash. Similarly, expenses are recorded when service is performed rather than when paid.
Depreciation
GAAP requires that expenditures for such things as property, plant, and equipment with long useful lives be recorded as assets and depreciated over the expected useful life of the asset. As a result, when a firm spends cash to purchase equipment, it records it as an asset on the balance sheet and depreciates the cost of that asset each year on the income statement.
Income Statement (aka Profit and Loss)
The income statement, or what is frequently referred to as the profit and loss (P&L) statement, is a summary of all income and expense transactions completed during the period (year, quarter, etc.). Typical captions and math logic for a basic income statement include these examples:
| Sales | + $1,000 |
| Cost of Goods Sold | – 500 |
| Gross Margin | = 500 |
| Operating Expenses | – 200 |
| Operating Income | = 300 |
| Income Tax Expense | – 100 |
| Net Income | = 200 |
Many different measures, terms, and acronyms are used in practice to describe various elements of the P&L. Table 2.1 illustrates how some of these common measures are determined as well as how they relate to one another.
TABLE 2.1 Comparison of Common P&L Measures
| Abbreviation | P& L | EBIT | EBIAT | EBITDA | EP | ||
| Sales | $100,000 | $100,000 | $100,000 | $100,000 | $100,000 | ||
| Cost of Sales | COGS | 50,000 | 50,000 | 50,000 | 50,000 | 50,000 | |
| Gross Margin | GM | 50,000 | 50,000 | 50,000 | 50,000 | 50,000 | |
| % of Sales | 50.0% | 50.0% | 50.0% | 50.0% | 50.0% | ||
| R&D | 5,000 | 5,000 | 5,000 | 5,000 | 5,000 | ||
| SG&A | SG&A | 15,000 | 15,000 | 15,000 | 15,000 | 15,000 | |
| Depreciation & Amortization (D&A) | 10,000 | 10,000 | 10,000 | – | 10,000 | ||
| Operating Profit | OP | 20,000 | 20,000 | 20,000 | 30,000 | 20,000 | |
| % of Sales | 20.0% | 20.0% | 20.0% | 30.0% | 20.0% | ||
| Interest Expense | 3,000 | ||||||
| Profit before Tax | PBT | 17,000 | |||||
| Income Tax | 35.0% | 5,950 | 7,000 | 7,000 | |||
| Net Income | PAT | 11,050 | |||||
| % | 11.1% | ||||||
| Earnings before | EBIT | 20,000 | |||||
| Interest and Taxes | |||||||
| Earnings before | EBIAT | 13,000 | 13,000 | ||||
| Interest after Taxes | |||||||
| Earnings before | EBITDA | 30,000 | |||||
| Interest, Taxes, D&A | |||||||
| Capital Charge | 10,000 | ||||||
| Economic Profit | EP | 3,000 | |||||
Following are definitions of key terms used in Table 2.1:
- Net Income: Residual of income over expense; sometimes referred to as profit after tax (PAT).
- EBIT: Earnings before interest and taxes. This measure reflects the income generated by operating activities (generally equals or approximates operating income) before subtracting financing costs (interest) and income tax expense.
- EBIAT: Earnings before interest and after taxes, aka net operating profit after taxes (NOPAT) or operating profit after tax (OPAT). This measure estimates the after‐tax operating earnings. It excludes financing costs but does reflect income tax expense. It is useful in comparing and evaluating the operational performance of firms, excluding the impact of financing costs.
- EBITDA: Earnings before interest, taxes, depreciation, and amortization. EBITDA adjusts EBIT (operating income) by adding back noncash charges for depreciation and amortization. This measure is used in valuation and financing decisions since it approximates cash generated by the operation. It does not include capital requirements such as working capital and expenditures for property and equipment.
- Economic Profit: Economic profit measures subtract a capital charge from the earnings to arrive at an economic profit. The capital charge is computed based on the level of capital employed in the business.
Balance Sheet
The balance sheet is a critical financial report and frequently does not get the attention it deserves in evaluating the performance of an entity. It is a summary of the company's assets, liabilities, and owners' equity, and, importantly, it represents a snapshot of all open transactions as of the reporting date. For example, the inventory balance represents all materials delivered to the company, work in process, and finished goods not yet shipped to customers. Accounts payable represents open invoices due to vendors that have not been paid as of the balance sheet date. As a result, the balance sheet can be a good indicator of the efficiency of an operation. A firm with a very efficient manufacturing process will have lower inventory levels than a similar firm with less effective practices.
The balance sheet is constructed as shown in Table 2.2.
TABLE 2.2 Assets = Liabilities + Shareholders' Equity
| Assets | Liabilities and Equity | ||
| Cash | 150 | Accounts Payable | 100 |
| Receivables | 200 | Accrued Liabilities | 100 |
| Inventories | 200 | Debt | 200 |
| Fixed Assets, net | 50 | Total Liabilities | 400 |
| Shareholders' Equity | 200 | ||
| Total Assets | 600 | Total Liabilities and Equity | 600 |
Another way to look at the balance sheet is to reorder the traditional format (Table 2.2) to identify the net operating assets and the sources of capital provided to the organization. This presentation, as illustrated in Table 2.3, is more useful in understanding the dynamics of the balance sheet. The net operating assets are those assets that are required to operate and support the business. The net operating assets must be funded (or provided to the firm) by investors, either bondholders or shareholders.
TABLE 2.3 Net Operating Assets/Invested Capital Illustration
| Net Assets | Sources of Capital | ||
| Cash | 150 | ||
| Receivables | 200 | ||
| Inventories | 200 | ||
| Fixed Assets, net | 50 | ||
| Debt | 200 | ||
| Total Assets | 600 | ||
| Less Operating Liabilities | Shareholders' Equity | 200 | |
| Accounts Payable | −100 | ||
| Accrued Liabilities | −100 | ||
| Net Assets | 400 | Total “Invested Capital” | 400 |
Statement of Cash Flows (SCF)
The statement of cash flows (SCF) summarizes the cash generated and utilized by the enterprise during a specific period (year, quarter, etc.). Since cash flow will be a focus of our economic valuation and is an important business measure, we will pay particular interest to cash flow drivers and measures. The statement of cash flows starts with the net income generated by the company over the period, as reported on the income statement.
Since net income is based on various accounting conventions, such as the matching principle, the SCF identifies various adjustments to net income to arrive at cash flow. In addition, we also need to factor in various cash flow items that are not reflected in net income, such as working capital requirements, dividends, and purchases of equipment.
A simplified format for a statement of cash flow is shown in Table 2.4.
TABLE 2.4 Cash Flow Statement
| Net Income | $ 200 |
| Depreciation and Amortization | 10 |
| (Increase) Decrease in Working Capital | −25 |
| Purchases of Property and Equipment | −25 |
| Operating Cash Flow | 160 |
| Dividends | 0 |
| Debt Repayments | −60 |
| Cash Flow | $ 100 |
Since the cash flow statement starts with net income but then is adjusted by multiple different factors to arrive at the final cash flow amount, many nonfinancial folks (okay, some finance folks, too) find this cumbersome and not intuitive. Rest assured that the “cash flow” amount reported here will be the same result of all checks written and deposits recorded in the enterprise's checking account.
The three primary financial statements just discussed are interrelated. Understanding these relationships is critical to evaluating business performance and valuation and is presented in Figure 2.1. For example, net income (or PAT) flows from the income statement to increase shareholders' equity in the balance sheet. Net income for the period is also the starting point for the statement of cash flows. Other elements on the statement of cash flows are the result of year‐to‐year changes in various balance sheet accounts, including capital expenditures, changes in working capital, and reductions or increases in borrowings. Finally, financial ratios look at the relationship of various line items both within each financial statement and across all financial statements (e.g. return on assets).
FIGURE 2.1 Financial Statement Interrelationships
FINANCIAL RATIOS AND INDICATORS
The basic financial statements are simply raw financial results and are of limited value. Financial ratios can be very useful tools in measuring and evaluating business performance as presented in the basic financial statements. Ratios can be used as tools in understanding profitability, asset utilization, liquidity, and key business trends and in evaluating overall management performance and effectiveness.
Usefulness
Using financial ratios can provide a great deal of insight into a company's performance, particularly when combined with an understanding of the company and its industry. In addition to providing measures of performance, ratios can be used to monitor key trends over time and compare a company's performance to that of peers or “best practice” companies.
Variations
There are a number of different financial terms and ratios, and variations of each of these in use. This leads to potential confusion when similar‐sounding measures are computed differently or used interchangeably. It is important to clearly define the specific ratio or financial measure used.
Key Financial Ratios
To illustrate key financial ratios, we will use the information in Table 2.5 for Roberts Manufacturing Company (RMC). Unless otherwise indicated, the ratios will be computed using the estimated results for 2018.
TABLE 2.5 Roberts Manufacturing Company Historical and Estimated 2018 Financials 
| 2015 | 2016 | 2017 | 2018 | ||
| P&L | |||||
| Net Sales | 79,383 | 85,734 | 92,593 | 100,000 | |
| Cost of Goods Sold | 35,722 | 38,580 | 41,667 | 45,000 | |
| Gross Margin | 43,661 | 47,154 | 50,926 | 55,000 | |
| SG&A | 25,403 | 27,435 | 29,630 | 32,000 | |
| R&D | 6,351 | 6,859 | 7,407 | 8,000 | |
| Operating Income | 11,907 | 12,860 | 13,889 | 15,000 | |
| Interest (Income) Expense | 600 | 600 | 600 | 600 | |
| Other (Income) Expense | 5 | 7 | 6 | 5 | |
| Income Before Income Taxes | 11,302 | 12,253 | 13,283 | 14,395 | |
| Federal Income Taxes | 3,843 | 4,166 | 4,516 | 4,894 | |
| Net Income | 7,460 | 8,087 | 8,767 | 9,501 | |
| Balance Sheet | |||||
| Cash | 25 | 2,404 | 4,400 | 7,944 | |
| Receivables | 15,877 | 17,147 | 18,545 | 20,000 | |
| Inventories | 14,289 | 15,432 | 16,667 | 18,000 | |
| Other | 200 | 800 | 975 | 900 | |
| Current Assets | 30,391 | 35,783 | 40,587 | 46,844 | |
| Net Fixed Assets | 15,877 | 17,147 | 18,750 | 20,000 | |
| Net Goodwill and Intangibles | 14,000 | 13,000 | 12,000 | 11,000 | |
| Other Long‐Term Assets | 200 | 210 | 428 | 205 | |
| Total Assets | 60,467 | 66,140 | 71,765 | 78,049 | |
| Accounts Payable | 3,572 | 3,858 | 4,167 | 4,500 | |
| Notes Payable, Bank | – | – | – | – | |
| Accrued Expenses & Taxes | 4,000 | 4,500 | 4,750 | 5,000 | |
| Current Liabilities | 7,572 | 8,358 | 8,917 | 9,500 | |
| Long‐Term Debt | 10,000 | 10,000 | 10,000 | 10,000 | |
| Other | 3,000 | 3,100 | 2,900 | 3,300 | |
| Stockholders Equity | 39,895 | 44,682 | 49,949 | 55,249 | |
| Total Liabilities and Equity | 60,467 | 66,140 | 71,765 | 78,049 | |
| Other Information: | |||||
| Stock Price | 9.22 | 9.78 | 10.00 | 10.59 | |
| Shares Outstanding (in millions) | 16.7 | 16.8 | 16.9 | 17.0 | |
| Market Value of Equity | 153,974 | 164,304 | 169,000 | 180,030 | |
| Interest rate | 6% | ||||
| Income Tax Rate | 34% | ||||
| Dividends | 3,000 | 3,300 | 3,500 | 4,200 | |
| Capital Expenditures | 3,000 | 4,200 | 4,800 | 5,000 | |
| D&A | 2,800 | 2,930 | 3,197 | 3,750 | |
| Employees | 411 | 450 | 460 | 490 | |
| Other Information: | |||||
| Comparable Companies are trading in the following ranges (trailing 12 months): | |||||
| LOW | HIGH | ||||
| Sales | 1.3 | 2.0 | |||
| Earnings (P/E) | 16.0 | 20.0 | |||
| EBITDA | 8.0 | 10.0 | |||
| PEG | 1.3 | 2.0 | |||
| Cost of Capital (WACC) | 12% | ||||
Operating Measures
Operating measures will include ratios that provide insight into the operating performance of the company. These measures will typically utilize the information presented in the income statement.
Sales Growth
Sales growth is an important determiner of financial performance. Based only on information in the income statement, we are limited to measuring the sales growth rate over the periods reported. Two key sales growth measures are year‐over‐year growth and compound annual growth rate (CAGR):
- Year‐over‐Year Growth: Roberts Manufacturing Company's sales are expected to grow from $92,593 in 2017 to $100,000 in 2018. This represents a growth of 8% in 2018:
- Compound Annual Growth Rate: This measure looks at the growth rate over time (n years). The CAGR from 2015 to 2018 is computed as follows:
Revenue growth contributed by acquisitions has significantly different economic characteristics than that contributed by the existing business. As a result, total revenue growth is frequently split between “acquired” and “organic” growth.
Chapter 15 provides an in‐depth review of revenue drivers, measures, and analysis.
Gross Margin % of Sales
How Is It Computed? Gross margin % of sales is simply the gross margin as a percentage of total revenues.
What Does It Measure and Reflect? Gross margin % is an important financial indicator. Gross margins will vary widely across industries, ranging from razor‐thin margins of 10% to 15% (e.g. grocery retailers) to very high margins approaching 70% to 80% (technology and software companies).
The gross margin % will be impacted by a number of factors and therefore will require substantial analysis. The factors affecting gross margin include:
- Industry
- Competition and pricing
- Product mix
- Composition of fixed and variable costs
- Product costs
- Production variances
- Material and labor costs
Chapter 15 provides an in‐depth review of gross margin drivers, measures, and analysis.
R&D % Sales
How Is It Computed?
What Does It Measure and Reflect? This ratio reflects the level of investment in research and development (R&D) compared to the current‐period total sales. This ratio will vary significantly from industry to industry and from high‐growth to low‐growth companies. Some industries, for example retail, may have little or no R&D, whereas other firms, such as pharmaceuticals or technology companies, will likely have large R&D spending. Firms in high‐growth markets or those investing heavily for future growth will have very large levels of R&D % Sales, occasionally exceeding 20% of sales.
Chapter 16 provides an in‐depth review of product development drivers, measures, and analysis.
Selling, General, and Administrative (SG&A) % Sales
How Is It Computed?
What Does It Measure and Reflect? Since this measure compares the level of SG&A spending to sales, it provides a view of spending levels for selling and distributing the firm's products and in supporting the administrative aspects of the business. The measure will reflect the method of distribution, process efficiency, and administrative overhead. In addition, SG&A will often include costs associated with initiating or introducing new products.
Chapter 16 provides an in‐depth review of operating process and expense drivers, measures, and analysis.
Operating Income (EBIT) % Sales
How Is It Computed?
What Does It Measure and Reflect? This is a broad measure of operating performance. It will reflect operating effectiveness, relative pricing strength, and level of investments for future growth.
Return on Sales (Profitability)
How Is It Computed?
What Does It Measure and Reflect? This is an overall measure of performance. In addition to the factors described under operating income % of sales, this measure reflects taxes and other income and expense items.
Asset Utilization Measures
Asset utilization is a very important element in total financial performance. It is a significant driver of cash flow and return to investors. Chapter 17 provides an in‐depth review of working capital drivers, measures, and analysis.
Days Sales Outstanding (DSO)
How Is It Computed?
What Does It Measure and Reflect? DSO is a measure of the length of time it takes to collect receivables from customers. It will be impacted by the industry in which the firm participates, the creditworthiness of customers, and even the countries in which the firm does business. In addition, DSO is affected by the efficiency and effectiveness of the revenue process (billing and collection), by product quality, and even by the pattern of shipments within the quarter or the year.
Inventory Turns
How Is It Computed?
What Does It Measure and Reflect? Inventory turns measure how much inventory a firm carries compared to sales levels. Factors that will affect this measure include effectiveness of supply chain management and production processes, product quality, degree of vertical integration, and predictability of sales.
Days Sales in Inventory (DSI)
How Is It Computed?
What Does It Measure and Reflect? This measure is impacted by the same factors as inventory turns. The advantage to this measure is that it is easier for people to relate to the number of days of sales in inventory. It is easier to conceptualize the appropriateness (or potential improvement opportunity) of carrying 146 days' worth of sales in inventory than to conceptualize 2.5 inventory turns.
Operating Cash Cycle
How Is It Computed?
What Does It Measure and Reflect? Operating cash cycle measures the overall efficiency and the length of time it takes the business to convert inventory into cash. It is calculated by combining the number of days' worth of inventory on hand with the length of time it takes the firm to collect invoices from customers. The factors impacting this measure are the aggregate of those affecting DSO and inventory turns/DSI.
Operating Capital Turnover and Operating Capital % Sales
How Is It Computed?
Operating capital computation:
| Receivables | 20,000 |
| Inventory | 18,000 |
| Other Current Assets | 900 |
| Accounts Payable | −4,500 |
| Accrued Expenses | −5,000 |
| Operating Capital | 29,400 |
What Does It Measure and Reflect? These measures reflect the net cash that is tied up in supporting the operating requirements of the business. The factors impacting these measures are the aggregate of those affecting DSO and inventory turns, as well as the timing of payments to vendors, employees, and suppliers.
Capital Asset Intensity (Fixed Asset Turnover)
How Is It Computed?
What Does It Measure and Reflect? This measure reflects the level of investment in property, plant, and equipment relative to sales. Some businesses are very capital intensive (i.e. they require a substantial investment in capital), whereas others have modest requirements. For example, electric utility and transportation industries typically require high capital investments. On the other end of the spectrum, software development companies would usually require minimal levels of capital.
Asset Turnover
How Is It Computed?
What Does It Measure and Reflect? This measure reflects the level of investment in all assets (including working capital; property, plant, and equipment; and intangible assets) relative to sales. It reflects each of the individual asset utilization factors discussed previously.
Capital Structure/Liquidity Measures
Capital structure measures are indicators of the firm's source of capital (debt vs. equity), creditworthiness, ability to service existing debt, and ability to raise additional financing if needed. Liquidity measures examine the ability of the firm to convert assets to cash to satisfy short‐term obligations.
Our definition of debt includes all interest‐bearing obligations. The following measures will include notes payable, long‐term debt, and current maturities of long‐term debt (long‐term debt due within one year).
For Roberts Manufacturing Company:
| Notes Payable | $ – |
| Current Maturities of Long‐Term Debt | $ – |
| Long‐Term Debt | $10,000 |
| Total Debt | $10,000 |
How Is It Computed? What Does It Measure and Reflect? This measure of liquidity computes the ratio of current assets (that will convert to cash within one year) to current liabilities (that require cash payments within one year). As such, it compares the level of assets available to satisfy short‐term obligations. How Is It Computed? What Does It Measure and Reflect? The quick ratio is a more conservative measure of liquidity than the current ratio, since it removes inventory from other assets that are more readily converted into cash. How Is It Computed? What Does It Measure and Reflect? Debt to equity measures the proportion of total book capital supplied by bondholders (debt) versus shareholders (equity). How Is It Computed? What Does It Measure and Reflect? This measure computes the percentage of total book value (as recorded on the books and financial statements) of capital supplied by bondholders. A low debt‐to‐total‐capital percentage indicates that most of the capital to run the firm has been supplied by stockholders. A high percentage, say 70%, would indicate that most of the capital has been supplied by bondholders. The capital structure for the latter example would be considered highly leveraged. This measure is also computed using market value of debt and equity. How Is It Computed? What Does It Measure and Reflect? This measure computes the number of times the firm earns the interest expense on current borrowings. A high number reflects slack, indicating an ability to cover interest expense even if income were to be reduced significantly. Alternatively, it indicates a capacity to borrow more funds if necessary. Conversely, a low number reflects an inability to easily service existing debt levels and borrow additional funds.Current Ratio
Quick Ratio
Debt to Equity
Debt to Total Capital
Times Interest Earned (Interest Coverage)
Overall Measures of Performance
Return on Assets (ROA)
How Is It Computed?
What Does It Measure and Reflect? This measure computes the level of income generated on the assets employed by the firm. It is an important overall measure of effectiveness since it considers the level of income relative to the level of assets employed in the business.
Return on Equity (ROE)
How Is It Computed?
What Does It Measure and Reflect? This measure computes the income earned on the book value of the company's equity.
Note that ROE is greater than ROA. This is because part of the capital of the firm is furnished by bondholders and this financial leverage enhances the return to stockholders (ROE).
ROE Tree
A very useful analytical tool that can be used to understand the drivers of ROE is to break the measure down into components. This methodology, often called the Dupont model or return tree, is illustrated here:
For Roberts Manufacturing Company:
Using this formula, we can compare the performance of one company to another by examining the components of ROE. It is also useful to examine ROE performance over time and to determine how a change in each of the components would affect ROE. For example, if we improve profitability to 10.5%, ROE will improve to 19%. The individual components (profitability, asset turnover, and financial leverage) can be further broken down into a tree to highlight the contribution of individual measures (e.g. DSO or SG&A % of sales). An expanded ROE tree is illustrated in Chapter 4.
Return on Invested Capital (ROIC)
How Is It Computed?
What Does It Measure and Reflect? ROIC measures the income available to all suppliers of capital (debt and equity) compared to the total capital provided from all sources (debt and equity). Another way of looking at ROIC is that this measure indicates the amount of income a company earns for each dollar invested in the company, including both debt and equity investment.
Return on Invested Capital – Market (ROICM)
A variation to ROIC is to use the market value of capital, rather than the historical book value.
How Is It Computed?
What Does It Measure and Reflect? ROICM measures the income available to all suppliers of capital (debt and equity) compared to the total capital provided from all sources (debt and equity) at current market values. While ROIC is a good measure of management effectiveness, ROICM relates current income levels to the market value of a company. A very low ROICM may indicate that the company's market value is very high compared to current performance. This may be due to very high expectations for future growth or a potential overvaluation of the company's stock.
Cash Generation and Requirements
In addition to measures such as EBITDA, others have been developed to measure and evaluate cash flow.
Cash Effectiveness (CE%)
Some managers and analysts measure the operating cash flow relative to the income generated as a measure of cash effectiveness.
How Is It Computed?
The cash effectiveness for Roberts Manufacturing Company for 2018 is estimated to be 66% (Table 2.6).
TABLE 2.6 Cash Effectiveness for Roberts Manufacturing Company
| $ | % | |
| Operating Profit after Tax | 9900 | 100% |
| Depreciation & Amortization | 3750 | 38% |
| Capital Expenditures | −5000 | −51% |
| (Increase) Decrease in Operating Capital | −2130 | −22% |
| Operating Cash Flow | 6520 | 66% |
What Does It Measure and Reflect? The cash effectiveness ratio can be a good indicator of the relationship between reported income and cash flow. A significant decrease may signal that receivables collections are slowing or inventories are growing faster than income. Conversely, an increase in the percentage may indicate that the company is doing a better job in managing receivables, inventories, and capital investments. However, this measure is highly dependent on the rate of growth and the maturity of a business. A fast‐growing company may have very low or even negative cash effectiveness percentage, since asset levels must grow to support future sales growth. A company that is shrinking may find it easy to post CE% greater than 100% since capital investment levels will often decline faster than sales.
Self‐Financing or Internal Growth Rate (IGR)
Managers must understand if the company is generating enough cash flow from operations to meet requirements to support future growth. A company that is self‐financing will generate enough cash from operations to satisfy working capital and other requirements to support growth. Many companies test this requirement with future cash flow projections. Others use rules of thumb; for example, in order to support future growth levels of 15%, a company needs an ROIC of 20%. Ross et al. have developed a formula to estimate the self‐financing growth rate given a firm's ROA and cash retention policy.1
How Is It Computed?
where r is the percentage of net income retained in the business (i.e. not paid out as dividends to shareholders):
What Does It Measure and Reflect? The IGR measure provides a good estimate of the rate at which the firm can grow without requiring outside financing. If this company grows at a rate faster than 7%, it will need to raise additional funds. If growth is under 7%, then the firm is generating enough cash to fund the growth. If the firm desires to increase the internal growth rate, it can retain a greater percentage of earnings or increase ROA.
Limitations and Pitfalls of Financial Ratios
Since the measures are based on financial statements that are prepared after the close of the period, these ratios are referred to as “lagging” measures of performance. We will discuss leading/predictive indicators a bit later.
Some managers place too much emphasis in blindly comparing ratios from one company to another. In order to effectively compare ratios across companies, it is important to understand the strategy, market(s), and structure of each company. For example, a company that is vertically integrated will likely post significantly different financial results than one that is not. A company with a strong value‐added product in a growing market will likely have very different characteristics than a company participating in a competitive, slower‐growth market.
Financial ratios should be used as part of a broader diagnostic evaluation. These ratios will provide a great basis to identify trends, will complement other aspects of an overall assessment, and will be a great source of questions. Think of them in the same way a medical doctor uses key quantitative data about our health. Even in routine examinations, doctors will monitor key factors such as weight. But a patient's weight provides limited insight until combined with other insights, observations, and comparisons. How does the weight compare with others of the same age, height, and frame? Has the patient gained or lost weight since the last exam? If the patient has lost weight, why? This obviously could be good if intended as part of a fitness program or bad if a result of a health problem. Only through observation, discussion with the patient, and perhaps additional testing can the doctor reach conclusions. So it is with many elements of financial performance.
Another potential limitation is that there is a great variety of similar ratios employed in business. An example is return on capital, as there are a number of potential definitions for both the income measure and the capital measure in such a ratio. It is important to understand exactly what is being measured by a formula before reaching any conclusions.
Similarly, it is important to understand the period to which the measure relates. Many measures could apply to monthly, quarterly, or annual periods. Further, an annual measure could be based on a balance at the end of the period or an average of the quarterly balances.
Putting It All Together
These individual ratios and measures take on greater meaning when combined as part of an analytical summary as shown in Table 2.7.
TABLE 2.7 Roberts Manufacturing Company Performance Assessment Summary
| 2015 | 2016 | 2017 | 2018 | 2015 | 2016 | 2017 | 2018 | CAGR | ||
| P&L | ||||||||||
| Net Sales | $79,383 | $85,734 | $92,593 | $100,000 | 100% | 100% | 100% | 100% | 8.0% | |
| Cost of Goods Sold | 35,722 | 38,580 | 41,667 | 45,000 | 45% | 45% | 45% | 45% | 8.0% | |
| Gross Margin | 43,661 | 47,154 | 50,926 | 55,000 | 55% | 55% | 55% | 55% | 8.0% | |
| SG&A | 25,403 | 27,435 | 29,630 | 32,000 | 32% | 32% | 32% | 32% | 8.0% | |
| R&D | 6,351 | 6,859 | 7,407 | 8,000 | 8% | 8% | 8% | 8% | 8.0% | |
| Operating Income | 11,907 | 12,860 | 13,889 | 15,000 | 15% | 15% | 15% | 15% | 8.0% | |
| Interest (Income) Expense | 600 | 600 | 600 | 600 | 1% | 1% | 1% | 1% | 0.0% | |
| Other (Income) Expense | 5 | 7 | 6 | 5 | 0% | 0% | 0% | 0% | 0.0% | |
| Income Before Income Taxes | 11,302 | 12,253 | 13,283 | 14,395 | 14% | 14% | 14% | 14% | 8.4% | |
| Federal Income Taxes | 3,843 | 4,166 | 4,516 | 4,894 | 5% | 5% | 5% | 5% | 8.4% | |
| Net Income | 7,460 | 8,087 | 8,767 | 9,501 | 9% | 9% | 9% | 10% | 8.4% | |
| EPS | 0.45 | 0.48 | 0.52 | 0.56 | ||||||
| EBIAT | 7,859 | 8,488 | 9,167 | 9,900 | ||||||
| Balance Sheet | ||||||||||
| Cash | 25 | 2,404 | 4,400 | 7,944 | 0% | 3% | 5% | 8% | ||
| Receivables | 15,877 | 17,147 | 18,545 | 20,000 | 20% | 20% | 20% | 20% | ||
| Inventories | 14,289 | 15,432 | 16,667 | 18,000 | 18% | 18% | 18% | 18% | ||
| Other | 200 | 800 | 975 | 900 | 0% | 1% | 1% | 1% | ||
| Current Assets | 30,391 | 35,783 | 40,587 | 46,844 | 38% | 42% | 44% | 47% | ||
| Net Fixed Assets | 15,877 | 17,147 | 18,750 | 20,000 | 20% | 20% | 20% | 20% | ||
| Net Goodwill and Intangibles | 14,000 | 13,000 | 12,000 | 11,000 | 18% | 15% | 13% | 11% | ||
| Other Long‐Term Assets | 200 | 210 | 428 | 205 | 0% | 0% | 0% | 0% | ||
| Total Assets | 60,467 | 66,140 | 71,765 | 78,049 | 76% | 77% | 78% | 78% | ||
| Accounts Payable | 3,572 | 3,858 | 4,167 | 4,500 | 5% | 5% | 5% | 5% | ||
| Notes Payable, Bank | – | – | – | – | 0% | 0% | 0% | 0% | ||
| Accrued Expenses & Taxes | 4,000 | 4,500 | 4,750 | 5,000 | 5% | 5% | 5% | 5% | ||
| Current Liabilities | 7,572 | 8,358 | 8,917 | 9,500 | 10% | 10% | 10% | 10% | ||
| Long‐Term Debt | 10,000 | 10,000 | 10,000 | 10,000 | 13% | 12% | 11% | 10% | ||
| Other | 3,000 | 3,100 | 2,900 | 3,300 | 4% | 4% | 3% | 3% | ||
| Stockholders Equity | 39,895 | 44,682 | 49,949 | 55,249 | 50% | 52% | 54% | 55% | ||
| Total Liabilities and Equity | 60,467 | 66,140 | 71,765 | 78,049 | 76% | 77% | 78% | 78% | ||
| Operating Capital | 22,793 | 25,021 | 27,270 | 29,400 | ||||||
| Invested Capital | 49,895 | 54,682 | 59,949 | 65,249 | ||||||
| Market Value of Equity | 153,974 | 164,304 | 169,000 | 180,030 | ||||||
| Cash Flow | ||||||||||
| Net Income | 7,460 | 8,087 | 8,767 | 9,501 | 9% | 9% | 9% | 10% | ||
| D&A | 2,800 | 2,930 | 3,197 | 3,750 | 4% | 3% | 3% | 4% | ||
| Capital Expenditures | −3,000 | −4,200 | −4,800 | −5,000 | −4% | −5% | −5% | −5% | ||
| (Inc) Decrease in OC | −2,228 | −2,249 | −2,130 | 0% | −3% | −2% | −2% | |||
| FCF | 7,260 | 4,589 | 4,914 | 6,121 | 9% | 5% | 5% | 6% | ||
| Employees | 411 | 450 | 460 | 490 | ||||||
| Returns/Ratios: | ||||||||||
| DSO | 73.0 | 73.0 | 73.1 | 73.0 | ||||||
| Inv Turns | 2.5 | 2.5 | 2.5 | 2.5 | ||||||
| DSI | 146.0 | 146.0 | 146.0 | 146.0 | ||||||
| FA T/o | 5.0 | 5.0 | 4.9 | 5.0 | ||||||
| Asset Turnover | 1.3 | 1.3 | 1.3 | 1.3 | ||||||
| ROA | 12.3% | 12.2% | 12.2% | 12.2% | ||||||
| ROIC | 15.8% | 15.5% | 15.3% | 15.2% | ||||||
| ROE | 18.7% | 18.1% | 17.6% | 17.2% | ||||||
| Economic Profit | 7859 | 8488 | 9167 | 9900 | ||||||
| Interest Earned | 19.8 | 21.4 | 23.1 | 25.0 | ||||||
| Debt to Total Capital (book) | 20.0% | 18.3% | 16.7% | 15.3% | ||||||
| Debt to Total Capital (market) | 8.1% | 7.8% | 7.7% | 5.3% | ||||||
| Leverage (Assets/Equity) | 1.52 | 1.48 | 1.44 | 1.41 | ||||||
| Current Ratio | 4.0 | 4.3 | 4.6 | 4.9 | ||||||
| ROE Analysis | ||||||||||
| Profitability | 9.4% | 9.4% | 9.5% | 9.5% | ||||||
| Asset Turnover | x | 1.31 | 1.30 | 1.29 | 1.28 | |||||
| Leverage | x | 1.52 | 1.48 | 1.44 | 1.41 | |||||
| ROE | = | 18.7% | 18.1% | 17.6% | 17.2% | |||||
| WACC | 12% |
Creating a set of graphs capturing selected performance measures will typically be helpful to analyze and communicate this information as shown in Figure 2.2.
FIGURE 2.2 Key Performance Trends for Roberts Manufacturing Company
A quick reference guide to key financial terms and measures is provided in Table 2.8.
TABLE 2.8 Key Financial Terms and Measures: Quick Reference Guide
| Measure | Description | Computed as… | Application |
| Value Creation and Overall Effectiveness | |||
| ROE | Return on equity | Net income/Shareholders' equity | Measures return to shareholders' capital (equity) |
| ROIC | Return on invested capital | EBIAT/Invested capital | Measures return to all providers of capital (equity and debt) |
| EP | Economic profit/ | EBIAT – (Cost of capital × Invested capital) | Measures return to all sources of capital (equity and debt) |
| TRS | Total return to shareholders | Stock price appreciation + Reinvested dividends | Measure of management performance (and compensation) |
| Operating Measures | |||
| COGS | Cost of goods sold | Total product cost, including labor, material, overhead, and variances | |
| Gross Margin % | Gross margin as a % of sales | Gross margin/sales | Key operating measure |
| SG&A % | SG&A expenses as a % of sales | SG&A/Sales | Key operating measure |
| Operating Income/Profit | Sales – COGS – Operating expenses | Key operating measure | |
| EBIT | Earnings before interest and taxes | Key operating measure | |
| Operating Margin % /“Profitability” | Operating Income as a % of sales | Operating Income/Sales | Key operating measure |
| EBITDA | Earnings before interest, taxes, depreciation, and amortization | EBIT + D&A | Adds back noncash expense items (D&A) |
| EBIAT/OPAT | Earnings before interest and after tax/Operating profit after tax | EBIT(1 – t) | Earnings available to all providers of capital |
| CAGR | Compound annual growth rate | CAGR = [(LY/FY)1/n] – 1 | Measures growth in a key variable over time (e.g. sales) |
| Asset Management | |||
| DSO | Days Sales Outstanding | (Accounts receivable × 365)/Sales | Measures time to collect from customers |
| Inventory Turns | Inventory turnover | Cost of goods sold/Inventory | Supply chain effectiveness |
| DSI/DIOH | Days sales of inventory/Days inventory on hand | 365/Inventory turns | A more intuitive measure of inventory levels/cycle time |
| Operating Capital Turnover | Operating capital levels relative to sales | Sales/Operating capital | Measures operating capital relative to sales |
| Operating Capital % Sales | Operating capital levels relative to sales | Operating capital/Sales | Measures operating capital relative to sales |
| Operating Capital Cycle | DSO + DSI | Measures key operating capital elements relative to sales | |
| Asset Turnover | Asset levels relative to sales | Sales/Total assets | Asset requirements and effectiveness |
| Capital Structure | |||
| TIE/C | Time interest earned/Covered | EBIT/Interest expense | Measures ability to service debt |
| Debt to total Capital | % of capital contributed by lenders | Debt/(Debt + Equity) | Measures financial risk and capital structure |
| Valuation | |||
| WACC/Cost of Capital | Weighted average cost of capital | WACC = (ke * we) + (Kd * wd) | Expected returns of equity and debt investors |
| Invested Capital | Total capital contributed by investors | Book equity + Interest‐bearing debt | Historical investment from all investors |
| Enterprise Value (EV) | Market value of debt and equity | Total value of the firm | |
| Market Value/Market Cap | Market value of equity | Shares outstanding × Share price | Equity value of the firm |
Note: Definitions and uses of ratios often vary.
SUMMARY
Understanding and interpreting financial statements is a required competency for effective management and investing. Combining this competency with an understanding of the business, industry, and strategic objectives of a firm can significantly improve management effectiveness and decision making. Historical and projected financial statements will serve as the basis for many decisions and are an important part of the foundation in building an effective performance management framework.