Ratios -Liquidity, Turnover, Effectiveness; ROIC-WACC spread

JWI 530 Financial Management I, Week5 Summary, 2/9/13
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Ratios - Liquidity, Turnover, Effectiveness, and ROIC - WACC spread are powerful financial tools with which a firm's health can be quickly evaluated vs competition.

Ratios help judge firm's capacity to squeeze profits efficiently - compare the firm's ratios vs competition and against itself over time.

Work the Balance Sheet : it is the best place to study operational/structural health of a business

I. Liquidity Ratios
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How well positioned is a company to meet its near-term obligations?
How to side step a Chapter11 filing ?

1. Current ratio = current assets/current liabilities  (tgt 2-3)
Does the firm have enough cash to meet its daily operating responsibilities?

2. Quick Ratio (Acid Test) = (Current Assets - Inventories)/Current liabilities (tgt >1-2)
If and when in a pinch, how well can a company meet its short term financial obligations without any cash coming in from sales ?

3. Debt/Equity Ratio (tgt <0.7)
D/E ratio = Financial leverage; must be below peer average

4. Interest coverage Ratio = Earnings before interest and Tax (EBIT) / Interest Expense (tgt >1.5)
Does the company have the ability to meet its short-term debt obligations using cash it generates from operations?
- EBIT is the amount of money the firm is bringing in on a Quarterly or yearly basis = Operating Cash Flow

II. Turnover Ratios
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5. Day Sales Outstanding = 365 (Accounts Receivable/Total Credit Sales)
How effectively is the firm managing its capital & collecting its due credit from customers?
How strong are the products ?
How is the DSO trend over time ?

6. Inventory Turn Over = Revenue/Inventory or COGS/Inventory
How long does it takes for an item to transform from a finished product to cash on the books ?
How fast does business move products faster than competition ?
Higher ITOs desirable => company turning over products quickly; company products in high demand eg. Apple 63.2
Downward spike in inventory turnover may indicate something bad is beginning to happen in business (net income, revenue could be hit next)


III. Effectiveness Ratios
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7. Return on Equity (ROE) = Net Income / Shareholder's Equity (tgt >10%)
How effectively/efficiently is a firm using the finances its owners have provided ?
For every dollar firm gets from shareholders, what ROE % is returned back to book value of business?

Positives
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Most widely used gauge of returns for Wall Street
Analysis takes shareholder's POV
Number is easy to calculate
Brilliant and Flexible - comparable across industries
Excellent first indicator that a firm's management team is making high quality decisions

Flaws
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Fails to capture debt maintained by firm
ROE can be flat to rising while financial health deteriorates
Profit margin, asset turn over could be falling
Unscrupulous management might be increasing debt to mask that fall
Debt has a crippling effect on a company
Backward looking - High ROE does not necessarily mean the firm is laying a solid foundation for future high returns
Can never be certain a firm can replicate its past success
Can be manipulated - companies report financials differently
Not useful for assessing firms that have negative earnings
Definitions of net income varies by firm eg. income statement: some items may not be expensed


8. Return on Assets = Net income (profit)/Total Assets
How effectively is a firm using its cash, property, equipment ?
Does the business generate sufficient return on large investments it makes on regular basis ?

Limitations:
Does not translate across industries unlike ROE.
Capital intensive and mfg or energy companies need more assets to run their business - they will have lower ROAs than consulting firms
One time items can distort net income - rolling average of net income and total assets key to normalize
Backward looking metric - future may not follow past success


IVa. ROIC - WACC Spread
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Return on Invested Capital (ROIC) = NOPAT/InvestedCapital = OperatingIncome (1-taxrate)/InvestedCapital
How much money does the firm makes back on capital sunk into business ?
Is the firm clearing the hurdle ?
Is the firm doing better job in value creation than competition ?
How effective is the company's management and business's competitive advantage ?
What assets are truly working to create value for shareholders?

Invested Capital = Total Assets - Excess cash and investments - Non interest bearing current liabilities

Figure out which assets are actually ***invested in the business*** and working for shareholders
eg. current portion of long term debt (interest bearing liability)

Strip out those that are not
- cash that does not provide operating return for shareholders (note: insurance firms collect cash and invest as operations)
- Investments are capital that the company can tap if needed but irrelevant to operations
- Most current liabilities (interest free): accounts payable, accrued expenses, accrued salaries, unearned revenue, income taxes payable

NOPAT (Net Operating Profit After Tax) = Operating income (1-taxrate)
What is the profitability of core operations?

Measures operating profit made for all investors (shareholders & debt holders)
Profits paid to shareholders + interest paid on debt


WACC
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Proportional weighting of costs of various kinds of capitals a firm uses to operate its business
From balance sheet: Find total debt, shareholder's equity in $ amount
Determine relative proportion of capital of each: debt (d %), equity (e%)
Figure out After tax cost of debt: Cd %
Figure out Cost of Equity expected: Ce%
WACC = Cd% * (d%) + Ce% * (e%)


Persistent +ve Spread between ROIC and WACC
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=> company produced a lot of value vs what it plugs into the business
=> good decision making
=> higher than market average means company has earned a competitive advantage; doing something others cannot
=> great business; something special is happening
=> sustainable outperformance

Negative ROIC - WACC spread
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0 to negative: Destroying value; stay clear of the company or project
exception:
startups like RIM; concept takes off after a period of low and negative ROIC
expanding firms like FexEx => create periods of excellent profitability in future
is it falling over time? => is firm expanding ?


IVb. Ways to increase value ie higher positive ROIC WACC spread
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[OperatingIncome (1-taxrate)/InvestedCapital] - [ Cd% * (d%) + Ce% * (e%)]

(1) Create more value
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Improve operational performance ie ROIC
Invest in higher return projects with Sustainable Competitive advantage
Use capital more efficiently eg. drive high asset turnover
Decrease WACC
Invest in more value creating projects
Get rid of value destroying projects

(2) Lower WACC
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(i) Capital structure policy (Brigham, Enhhardt, 2011)
Target Capital Structure: Mix of debt, preferred stock and common equity to minimize WACC
Lower WACC by using more debt instead of equity
Disadvantage: increased risk of debt and risk for equity
Optimal cost structure mminimizes WACC and simultaneously maximizes intrinsic value of stock
(ii) Dividend policy
If payout ratio is too high the firm must issue new stock to fund its capital budget
(iii) Investment policy

Brilliant week!  The finance section of the Annual reports are a pleasure to read now.
Dr DP