Chapter 2

Evaluating Financial
Performance

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 2-2
TABLE 2-1 ROEs and Levers of Performance
for 10 Diverse Companies, 1998

Return on Profit Asset turnover Financial

Equity Margin Turnover Leverage
(ROE) (P) (A) (T)
(%) = (%) x (times) x (times)
BankAmerica Corporation 11.2 = 10.8 x 0.1 x 13.5
Carolina Power and Light 13.5 = 12.8 x 0.4 x 2.8
Exxon Corporation 14.6 = 6.3 x 1.1 x 2.1
Food Lion Inc. 17.0 = 2.7 x 2.8 x 2.3
Harley-Davidson Inc. 20.7 = 9.9 x 1.1 x 1.9
Intel Corporation 26.0 = 23.1 x 0.8 x 1.3
Nike 12.3 = 4.2 x 1.8 x 1.7
Southwest Airlines 18.1 = 10.4 x 0.9 x 2.0
Tiffany & Company 17.4 = 7.7 x 1.1 x 2.0
The Timberland Company 22.2 = 6.9 x 1.8 x 1.8

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 2-3
ROIC Is Not Distorted by Company Financing

Company
A B
Debt @ 10% Interest $ 900 $ 0
Equity 100 1,000
Total assets $ 1,000 $ 1,000

EBIT $ 120 $ 120

- Interest expense 90 0
Earnings before tax 30 120
- Tax @ 40% 12 48
Earnings after tax $ 18 $ 72

ROE 18.0% 7.2%

ROA 1.8% 7.2%
ROIC 7.2% 7.2%

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 Market Value to Book Value of Equity Ratio versus 2-4
Return on Equity for 24 Shoe Companies

4
Market/book value of equity

Nike

Kenneth Cole
3
FIGURE 2-1

2
Timberland

Deckers Outdoor
0
0 5 10 15 20 25
Weighted average return on equity (%)

Continued
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 2-5

FIGURE 2-1 (Concluded) Footnote

The regression equation is MV/BV=0.65+0.08 ROE,

where MV/BV is the market value of equity relative to
the book value of equity and ROE is a weighted average
of return on equity in 1998 and the prior two years.
Companies with negative values of either variable were
2
omitted. Adjusted R = 0.39

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 FIGURE 2-2 Market Value of Equity Ratio versus 2-6

Return on Equity for 84 Large Corporations

18
16 Microsoft
Lucent Technologies
Market/book value of equity

14
Cisco Systems Merck
12 Colgate

10
8
6
Monsanto
4
DuPont
2
0
0 5 10 15 20 25 30 35 40
Weighted average return on equity (%)

Continued
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 2-7

FIGURE 2-2 (Concluded) Footnote

Companies are members of the Standard and Poor's 100

Index of the largest U.S. corporations. Those with negative
values and outliers with ROEs above 40 percent were
eliminated. The regression equation is MV/BV = 0.27+
0.26*ROE, where MV/BV is the market value of equity
relative to book value at the end of 1998 and ROE is a
weighted average of return on equity for 1998 and the prior
2
two years. Adjusted R = 0.44

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 2-8
TABLE 2-2 Ratio Analysis of Timberland
Company 1994-1998, and Industry Medians, 1998
Industry
1994 1995 1996 1997 1998 Median*
Profitability ratios:
Return on equity (%) 11.9 (8.2) 12.3 22.1 22.2 12.3
Return on assets (%) 3.8 (2.8) 4.5 11.3 12.6 7.4
Return on invested captial (%) 7.1 0.7 9.6 18.3 17.9 9.7
Profit margin (%) 2.8 (1.8) 3.0 5.9 6.9 4.2
Gross margin (%) 35.0 33.7 39.4 41.7 41.9 38.4
Price to earnings ratio (x) 13.5 NA 20.7 13.9 8.5 15.0

Turnover-control ratios:
Asset turnover (x) 1.3 1.6 1.5 1.9 1.8 1.8
Fixed asset turnover (x) 9.3 12.5 14.1 15.1 15.2 9.2
Inventory turnover (x) 1.9 2.4 2.6 3.3 3.8 2.7
Collection period (days) 73.5 53.4 53.2 34.7 33.4 39.1
Days' sales in cash (days) 3.7 21.4 49.4 45.3 64.3 10.8
Payables period (days) 32.6 21.2 18.6 16.0 18.9 36.3

Continued
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 2-9

TABLE 2-2 (Concluded) Ratio Analysis of Timberland

Company 1994-1998, and Industry Medians, 1998
Leverage and liquidity ratios:
Assets to equity (x) 3.2 3.0 2.7 2.0 1.8 1.7
Debt to assets (%) 68.5 66.2 63.2 48.8 43.3 39.6
Debt to equity (%) 217.4 196.3 171.9 95.4 76.3 65.5
Times interest earned (x) 2.9 0.2 2.5 5.6 10.2 9.1
Times burden covered (x) 1.6 0.1 1.1 5.6 10.2 7.4
Debt to assets (market
value %) 57.5 56.0 40.2 23.7 28.7 18.1
Debt to equity (market
value %) 135.4 127.3 67.1 31.1 40.2 22.1
Current ratio (x) 3.5 4.8 3.7 3.5 4.0 3.0
Acid test (x) 1.5 2.3 2.1 2.0 2.7 1.5

* Sample consists of five representative shoe companies: Brown Group, Kenneth Cole, Nike, Stride Rite,
and Wolverine World Wide.

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 2-10

TABLE 2-3 Timberland Company Common-Size Financial

Statements, 1994- 1998 and Industry Averages, 1998

Industry
1994 1995 1996 1997 1998 Average*
Assets
Cash and marketable securities 1.3% 9.1% 20.8% 23.5% 32.4% 7.4%
Accounts receivable 27.1 22.7 22.4 18.0 16.8 22.7
Inventories 46.1 42.9 35.4 34.0 28.0 37.1
Prepaid Expenses and other current assets 4.4 5.5 4.1 5.9 5.4 5.5
Total Current Assets 79.0 80.2 82.6 81.4 82.6 72.0
Property, plant and equipment 23.4 22.8 23.1 27.7 28.0 31.5
Less accumulated depreciation and amortization 9.0 10.3 12.2 15.1 15.8 13.6
Net property, plant and equipment 14.4 12.4 10.9 12.6 12.1 17.9
Intangible assets 5.5 5.8 5.0 5.0 4.1 3.2
Other Assets 1.1 1.6 1.5 1.0 1.2 6.9
Total assets 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

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 2-11

TABLE 2-3 Timberland Company Common-Size Financial

Statements, 1994- 1998 and Industry Averages, 1998
Industry
1994 1995 1996 1997 1998 Average*
Liabilities and Shareholders' Equity
Accounts Payable 7.8% 6.0% 4.7% 4.9% 5.5% 11.2%
Notes Payable 4.8 - - - - 2.0
Long Term Debt Due In One Year 1.7 1.8 4.0 - - 1.0
Wages payable 1.9 0.2 2.6 4.2 3.9
Accrued Expenses 6.4 8.5 11.3 14.5 11.0 10.0
Total current liabilities 22.6 16.5 22.7 23.6 20.4 24.2
Long Term Debt 43.7 47.3 38.2 23.8 21.3 14.8
Deferred Taxes 2.2 2.4 2.4 1.4 1.6 1.0
Total liabilities 68.5 66.3 63.2 48.8 43.3 39.9
Common Stock 0.0 0.0 0.0 0.0 0.0 4.6
Additional paid-in capital 12.2 14.2 13.7 16.3 15.9 10.8
Retained Earnings 19.3 19.6 23.0 34.8 44.2 54.8
Less: Treasury Stock 0.0 0.0 0.0 0.0 3.5 10.2
Total stockholders' equity 31.5 33.7 36.8 51.2 56.7 60.1
Total liabilities and shareholders' equity 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

Continued

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 2-12

TABLE 2-3 (Continued) Timberland Company

Common-Size Financial Statements, 1994-1998,
and Industry Income Statement
Industry
1994 1995 1996 1997 1998 Average*

Net sales 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

Cost of sales 65.0 66.3 60.6 58.5 58.3 60.8
Gross profit 35.0 33.7 39.4 41.5 41.7 39.2
Selling, general, and
Administrative expense 25.8 29.4 28.9 28.4 28.6 29.3
Depreciation and amortization 2.4 2.9 3.1 2.5 2.1 1.8
Total operating expenses 28.2 32.3 32.0 31.0 30.7 31.0

Continued

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 2-13
TABLE 2-3 (Concluded) Timberland Company
Common-Size Financial Statements, 1994-1998,
and Industry Income Statement

Operating income 6.8 1.4 7.4 10.5 11.0 8.2

Interest expense 2.4 3.5 3.0 1.9 1.1 0.7
Other expense (income) - 0.2 (0.1) 0.2 (0.2) (0.2)
Extraordinary expense (income) - 0.6 - - - 0.4
Total nonoperating expense 2.3 4.2 2.9 2.0 0.9 0.9
Income before income taxes 4.4 (2.9) 4.5 8.5 10.1 7.3
Provision for income taxes 1.6 (1.1) 1.5 2.5 3.2 2.7
Net income 2.8 (1.8) 3.0 5.9 6.9 4.6

* Sample consists of five representative shoe companies: Brown Group, Kenneth Cole, Nike,
Stride Rite, and Wolverine World Wide.

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 2-14

TABLE 2-4 Selected Ratios for Representative Industries, 1998

(Upper-quartile, median, and lower-quartile values)
Total Total
Current Liabilities Collection Net Sales to Assets to Profit Return Return
Lines of Business and Ratio to Net Worth Period Inventory Net Sales Margin on Assets on Equity
Number of Firms Reporting (times) (%) (days) (times) (%) (%) (%) (%)
Agriculture, forestry, and fishing:
Beef Cattle, Feedlot (64) 1.8 34.5 22.9 15.2 37.1 6.0 10.7 29.0
1.4 117.6 41.8 8.6 59.8 3.0 4.5 14.7
1.1 290.2 68.0 3.3 78.3 1.1 3.0 4.8
Lawn and graden services (700) 3.2 46.3 21.5 85.9 25.1 9.4 21.5 48.2
1.7 97.0 35.8 35.1 34.7 3.9 9.9 20.7
1.1 189.0 59.1 15.7 48.1 1.2 3.4 8.5
Manufacturing:
Mens and boys shirts (59) 3.8 48.4 28.1 14.5 31.2 5.5 10.2 29.0
2.6 77.5 45.5 5.3 47.9 3.1 6.4 11.3
1.9 122.7 65.3 3.6 61.1 0.8 0.6 1.8
Mens Footwear, execpt athletic (17) 4.3 33.7 34.8 7.2 48.7 6.1 12.8 21.7
3.3 51.8 51.5 4.6 66.2 4.8 8.6 16.5
2.0 96.9 71.3 4.2 69.2 3.8 6.1 9.6
Semiconductors and related devices (172) 5.0 23.2 43.6 12.6 53.9 11.5 14.3 23.0
2.9 48.7 55.1 7.1 94.4 4.2 6.4 13.0
1.7 100.7 73.2 4.8 147.2 (3.1) (2.8) (4.5)

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 TABLE 2-4 (Continued) Selected Ratios for 2-15

Representative Industries, 1998 (Upper-quartile,

median, and lower-quartile values)
Total Total
Current Liabilities Collection Net Sales to Assets to Profit Return Return
Lines of Business and Ratio to Net Worth Period Inventory Net Sales Margin on Assets on Equity
Number of Firms Reporting (times) (%) (days) (times) (%) (%) (%) (%)
Electronic computers (142) 3.0 44.5 33.3 20.7 28.2 5.4 10.1 28.4
1.9 106.9 54.0 10.5 58 1.2 4.6 11.7
1.3 243.7 90.9 6.1 96.4 (1.0) 0.4 0.4
Wholesale trade:
Sporting and recreactional goods (404) 3.4 45.5 17.9 10.6 25.1 4.9 12.5 30.0
2.0 104.8 32.1 6.1 35.0 1.9 4.8 10.8
1.4 217.2 51.5 3.8 51.2 0.5 1.1 2.8
Women's and childern's clothing (505) 4.0 34.2 14.6 15.6 21.3 5.3 17.8 42.9
2.0 93.7 34.9 7.8 31.5 2.4 6.5 15.4
1.3 198.4 53.4 4.9 43.8 0.8 1.9 5.3
Retail trade:
Department stores (242) 6.4 20.0 3.2 5.7 33.5 4.0 8.6 16.1
3.1 68.2 11.2 4.4 48.3 1.5 3.8 6.8
1.9 145.3 35.1 3.0 64.0 (0.1) 0.8 1.8
Grocery stores (965) 3.1 37.8 1.1 27.8 14.5 3.0 13.4 30.5
1.7 88.3 3.3 18.7 20.6 1.5 5.5 12.6
1.1 206.4 6.2 12.5 32.4 0.5 1.7 4.9

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 TABLE 2-4 (Concluded) Selected Ratios for 2-16

Representative Industries, 1998 (Upper-quartile,

median, and lower-quartile values)
Total Total
Current Liabilities Collection Net Sales to Assets to Profit Return Return
Lines of Business and Ratio to Net Worth Period Inventory Net Sales Margin on Assets on Equity
Number of Firms Reporting (times) (%) (days) (times) (%) (%) (%) (%)
Jewelry stores (860) 6.0 23.6 6.0 3.7 45.3 9.8 14.5 27.3
3.0 56.7 15.7 2.5 63.1 4.2 6.2 11.8
1.8 133.8 39.3 1.7 88.3 1.4 2.3 4.4
Services:
Beauty shops (100) 5.6 21.1 4.8 100.9 13.4 12.0 31.7 101.5
1.7 71.9 10.4 56.1 26.8 5.7 17.0 36.2
1.0 139.9 28.3 26.7 63.4 3.2 7.9 13.7
Legal services (405) 6.3 21.9 10.8 39.8 14.2 32.2 74.5 124.6
2.4 53.5 32.5 6.8 26.5 8.8 21.3 34.2
1.3 116.7 92.8 4.8 46.4 1.2 1.5 3.2
College and universities (88) 2.8 18.1 8.0 192.0 126.5 22.7 10.7 14.2
1.6 44.2 16.1 99.4 199.3 11.2 6.7 10.3
1.0 80.9 40.4 53.7 266.9 4.1 2.6 3.6

Source: Industry Norms & Key Business Ratios, 1998-99, Desktop Edition, Dun & Bradstreet, a company of The Dun & Bradstreet Corporation.
Reprinted with permission.

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 2-17
TABLE 2-5 Definitions of Principal Ratios
Appearing in Chapter
Profitability ratios:
Return on equity = Net income/Shareholders’ equity
Return on assets = Net income/Assets
Return on invested capital = Earnings before interest and taxes x (1 – Tax rate)
Interest-bearing debt + Shareholders’ equity
Profit margin = Net income/Sales
Gross margin = Gross profit/Sales
Price to earnings = Price per share/Earnings per share

Turnover control ratios:

Asset turnover = Sales/Assets
Fixed-asset turnover = Sales/Net property, plant, and equipment
Inventory turnover = Cost of goods sold/Ending inventory
Collection period = Accounts receivable/Credit sales per day
(If credit sales unavailable, use sales.)

Days’ sales in cash = Cash and securities/Sales per day

Payables period = Accounts payable/Credit purchases per day
(If purchases unavailable, use cost of goods sold.)

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 2-18
TABLE 2-5 (Concluded) Definitions of Principal
Ratios Appearing in Chapter
Leverage and liquidity ratios:
Assets to equity = Assets/Shareholders’ equity
Debt to assets = Total liabilities/Assets
(Interest-bearing debt is often substituted for of total liabilities.)

Debt to equity = Total liabilities/Shareholders’ equity

Times interest earned
Times burden covered
Debt to assets (market value)
Debt to equity (market value)
Current ratio
Acid test
= Earnings before interest and taxes/Interest expense
= Earnings before interest and taxes
Interest expense + Principal payments/(1 – Tax rate)
= Total liabilities/No. of shares of stock x Price per share
= Total liabilities
No. of shares of stock x Price per share + Total liabilities
= Current assets/Current liabilities
= Current assets – Inventory
Current liabilities

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 2-19
FIGURE 2A-1 Percentage Balance Sheets of
Companies in Four Countries

Assets
Germany* Japan U.K. U.S.**
0%

20%

Other long-term assets

Net fixed assets 40%
Other current assets
Inventory
Accounts receivable 60%

Cash & securities

80%

100%
1983 1995 1983 1995 1983 1995 1983 1994

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 2-20
FIGURE 2A-1 (Concluded) Percentage Balance
Sheets of Companies in Four Countries
Liabilities
Germany Japan U.K. U.S.
0%

20%

Equity
40%
Lt. liabilities
Other current liabilities
Accounts payable
60%
Notes payable

80%

100%
1983 1995 1983 1995 1983 1995 1983 1994

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 2-21
TABLE 2A-1 Ratio Analysis of Companies in Various
Countries and Regions, 1998, Median Values
Latin US
England Germany Japan Asia America S&P 100
Number of companies 91 14 29 37 83 100

Profitability ratios:
Return on equity (%) 11.4 11.3 3.9 10.5 12.6 14.3
Return on assets (%) 5.0 3.2 1.2 4.5 6.0 3.8
Return on invested capital (%) 10.0 9.1 2.5 6.5 9.5 9.9
Profit margin (%) 4.8 3.6 2.1 10.8 10.0 6.3
Gross margin (%) 32.6 38.2 33.5 44.3 40.6 36.2
Price to earnings (X) 14.3 27.6 29.2 12.8 14.3 20.6

Turnover-control ratios:
Asset turnover (X) 1.0 1.0 0.9 0.5 0.6 0.8
Fixed-asset turnover (X) 3.4 3.3 3.5 1.1 1.1 3.1
Inventory turnover (X) 8.1 5.9 3.7 5.9 6.0 5.4
Collection period (days) 72.3 81.2 64.9 56.6 64.8 61.1
Days' sales in cash (days) 52.3 39.5 55.9 81.8 25.7 16.1
Payables period (days) 54.4 50.2 62.8 59.7 56.0 49.5

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 2-22
TABLE 2A-1 (Concluded) Ratio Analysis of Companies
in Various Countries and Regions, 1998, Median Values
Leverage and liquidity ratios:
Assets to equity (%) 2.3 2.9 3.0 1.8 2.2 2.9
Debt to assets (%) 62.7 66.0 66.4 47.3 53.6 65.9
Debt to equity (%) 130.8 194.3 197.9 78.7 108.5 194.0
Times interest earned (X) 4.9 8.5 4.6 4.0 3.8 4.9
Times burden covered (X) 2.0 0.8 0.3 1.6 1.7 2.2
Debt to assets (market
value %) 29.6 40.1 42.0 27.6 33.9 34.3
Debt to equity (market
value %) 42.1 68.5 72.4 38.2 51.2 52.2
Current ratio (X) 1.5 1.5 1.4 1.4 1.3 1.3
Acid test (X) 1.1 1.3 1.1 1.2 0.9 0.9

Sample consists of nonfinancial companies incorporated in indicated geographic regions w hose stock trades on U.S.
markets, most as American Depository Receipts (ADRs). The Asia sample excludes Japan. Companies in the S&P 100
sample are members of the Standard & Poors' index of the 100 largest U.S. industrial firms.

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