Chapter 4

Measuring
Book Cover
10e
Corporate
Performance

Copyright © 2018
Copyright by The
© 2020 McGraw-Hill
by The Companies,
McGraw-Hill Inc.
Companies, [Link] 4- 1
rightsreserved
reserved
 Topics Covered

4.1 How Financial Ratios Relate to Shareholder Value

4.2 Measuring Market Value and Market Value Added
4.3 Economic Value Added and Accounting Rates of
Return
4.4 Measuring Efficiency
4.5 The Du Pont System
4.6 Measuring Financial Leverage
4.7 Measuring Liquidity
4.8 Interpreting Financial Ratios

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 4- 2

Value and Value Added

4- 3
Market Value and Market Value Added
(1 of 6)

 Market Capitalization
– Total market value of equity, equal to share
price times number of shares outstanding
Market capitalization = (#shares) × (price per share)

 Market Value Added

– Market capitalization minus book value of
equity
MVA = market capitalization – book value of equity

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 4- 4

Market Value and Market Value Added
(2 of 6)

TABLE 4.1 Target’s income statement, year ending February 1, 2020

$ Million % of Sales
Net sales 78,112 100.0%
Cost of goods sold 54,864 70.2%
Selling, general & administrative expenses 16,233 20.8%
Depreciation 2,357 3.0%
Earnings before interest and income taxes (EBIT) 4,658 6.0%
Other income 21 0.0%
Interest expense 477 0.6%
Taxable income 4,202 5.4%
Taxes 921 1.2%
Net income 3,281 4.2%
Allocation of net income
Dividends 1,330 1.7%
Addition to retained earnings 1,951 2.5%
4- 5
 Market Value and Market Value Added
(3 of 6)

TABLE 4.2 Target’s balance sheet (figures in $ millions)

Year Year
Ending Ending Year Ending Year Ending
February 1 February 1 February 1 February 1
Assets 2020 2019 Liabilities and shareholders’ Equity 2020 2019
Current assets
Cash and marketable securities 2,577 1,556 Current liabilities
Receivables 498 632 Debt due for repayment 161 1,052
Inventories 8,992 9,497 Accounts payable 9,920 9,761
Other current assets 835 834 Other current liabilities 4,406 4,201
Total current assets 12,902 12,519 Total current liabilities 14,487 15,014
Fixed Assets Long-term debt 11,338 10,223
Tangible fixed assets Other long-term liabilities 5,121 4,756
Property, plant, and equipment 48,183 46,185
Less accumulated depreciation 19,664 18,687 Total liabilities 30,946 29,993
Net tangible fixed assets 28,519 27,498
Shareholders’ equity
Goodwill & other intangible assets 686 699 Common stock and other paid-in capital 6,268 6,085
Other fixed assets 672 574 Retained earnings 5,565 5,212
Total shareholders’ equity 11,833 11,297
Total Assets 42,779 41,290
Total liabilities and shareholders’ equity 42,779 41,290

4- 6
Market Value and Market Value Added
(4 of 6)

 Target Market Value Added ($ millions)

Market capitalization =$109.50 × 500 = $54,765

Market value added = $54,765 − $11,833 = $42,932

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 4- 7

Market Value and Market Value Added
(5 of 6)

 Market-to-Book Ratio
– Ratio of market value of equity to book value
of equity

market value of equity

Target's Market-to-book ratio 
book value of equity
$54, 765 million

$11,833 million
 4.63
Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 4- 8
Market Value and Market Value Added
(6 of 6)

TABLE 4.3 Stock market measures of company performance.

Companies are ranked by market value added (dollar values in
millions). Market Value Market-to-Book
Stock Added Ratio
Microsoft 1,436 13.56
Apple 1,391 18.72
Procter & Gamble 252 6.65
Coca-Cola 175 10.62
Intel 173 3.26
Verizon 167 3.77
Adobe 127 13.08
Walt Disney 114 2.29
Lowe’s 80 41.79
AT&T 36 1.20
Source: Authors’ calculations using data from Yahoo! Finance, July 5, 2020.

 Consider, e.g., Coca Cola vs. Intel

– Similar MVA, different market-to-book ratio. Why?
Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 4- 9
 EVA and Accounting ROR (1 of 6)

 Economic Value Added (EVA)

• After-tax operating income minus a charge for the cost
of capital employed.
• Also called residual income.
• Net dollar return after deducting the cost of capital.

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 4- 10

EVA and Accounting ROR (2 of 6)

 EVA = after tax operating income -

(cost of capital × total capitalization)

 After tax operating income =

(1 - tax rate) × interest expense + net income
• Recall: Net Income = (EBIT – Interest) x (1-t)

 Total capitalization =
long-term debt + shareholder’s equity

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 4- 11

 EVA and Accounting ROR (3 of 6)

 Target EVA (in $ millions)

After-tax operating income = (1 −.21) × $477 + $3,281

= $3,658
Total capitalization = $10,223 + $11,297 = $21,520

EVA = $3,658 − (.076 × 21,520)

= $2,022

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 4- 12

 EVA and Accounting ROR (4 of 6)

TABLE 4.4 Economic value added, year ending second quarter 2020.

1. After-Tax
2. Cost of 3. Total Long- 5. Return on 6. Excess
Interest + Net 4. EVA
Capital Term Capital Capital (ROC), % return, %
Income (1) − (2) × (3)
(WACC), % ($ million) (1) ÷ (3) (5) − (2)
($ million)
Microsoft 46,328 9.3 168,992 30,659 27.4 18.1
Apple 59,681 10.3 182,295 40,900 32.7 22.4
Intel 21,297 8.1 102,812 12,994 20.7 12.6
Verizon 21,156 5.3 161,327 12,588 13.1 7.8
Adobe 5,352 7.9 11,519 4,436 46.5 38.5
Procter & Gamble 13,394 6.3 67,565 9,111 19.8 13.5
Coca-Cola 9,667 6.5 44,345 6,765 21.8 15.3
Lowe’s 4,848 10.0 18,035 3,052 26.9 16.9
AT&T 1,085 5.6 333,658 −17,646 0.3 −5.3
Walt Disney −1,563 8.8 127,006 −12,767 −1.2 −10.1

4- 13
EVA and Accounting ROR (5 of 6)

 Return on Capital (ROC)

– Net income plus after-tax interest as a
percentage of long-term capital
 Return on Assets (ROA)
– Net income plus after-tax interest as a
percentage of total assets
 Return on Equity (ROE)
– Net income as a percentage of shareholders’
equity

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 4- 14

 EVA and Accounting ROR (6 of 6)

Target Profitability Measurements

after  tax operating income $3, 658
Return on capital    .170
total capitalization, start of year $21, 520

after  tax operating income $3,658

Return on assets    .089
total assets, start of year $41, 290

net income $3, 281

Return on equity    .290
equity, start of year $11, 297

Note: ROC, ROA, and ROE are also commonly calculated with average values in the
denominator.

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 4- 15

Measuring Efficiency – Asset Turnover Ratio

Sales
Asset turnover ratio =
Total assets at start of year

For Target:

Sales
Asset turnover ratio = = = 1.89
Total assets at start of year 41,

Note: Asset turnover ratio is commonly calculated with average

total assets in the denominator.

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 4- 16

Measuring Efficiency – Inventory Turnover

cost of goods sold

Inventory turnover ratio =
inventory at start of year

,
Target′s inventory turnover ratio = = 5.8
,

inventory at start of year

Average days in inventory =
cost of goods sold/365

,497
Target′s average days in inventory = = 63 days
,864/365

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 4- 17

Measuring Efficiency – Receivables Turnover

sales
Receivables turnover =
receivables at start of year

,
eceivables turnover = = 123.6

receivables at start of year

Average collection period =
average daily sales

632
verage collection period = = 3 days
,112/365

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 4- 18

 The DuPont System (1 of 4)

 A breakdown of ROE and ROA into

component ratios

net income 3,281

Profit margin = = = .042
sales

after−tax operating income

Operating profit margin =
sales
3,281 + 1−.21 477
= = .047

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 4- 19

 The DuPont System (2 of 4)

after−tax operating income

ROA =
assets

sales after−tax operating income

ROA =
assets sales

Operating
Asset
profit
turnover
margin

4- 20
 The DuPont System (3 of 4)

after−tax operating income 3,

ROA = = = .089
assets 41,

sales after−tax operating income

ROA =
assets sales
ROA = 1.89 × .047 = .089

4- 21
 The DuPont System (4 of 4)
FIGURE 4.2 Operating profit margin versus asset turnover for 45
industries (2019).

Source: U.S. Census Bureau, Quarterly Report for Manufacturing and Trade Corporations, Fourth Quarter 2019.
4- 22
Measuring Financial Leverage (1 of 3)
long−term debt
Long-term debt ratio =
long−term debt + equity
11,338
Long-term debt ratio = = .49
11,338+11,833

long−term debt
Long-term debt-equity ratio =
equity
11,338
Long-term debt-equity ratio = =.96
11,833

total liabilities 30,

Total debt ratio = = = .72
total assets 42,
Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 4- 23
Measuring Financial Leverage (2 of 3)

EBIT 4,658
Times interest earned = = = 9.8
interest payments

EBIT + depreciation
Cash coverage ratio =
interest payments
4,658 + 2,357
= = 14.7

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 4- 24

 Measuring Financial Leverage (3 of 3)

Asset Debt
Turnover Burden

assets sales after−tax operating income net income

ROE =
equity assets sales after−tax operating income

Leverage Operating Profit

Ratio Margin

4- 25
 Measuring Liquidity (1 of 2)

net working capital

NWC to total assets ratio =
total assets
12,902 − 14,487
= .037
42,779

current assets 12,902

Current ratio = = = 0.89
current liabilities 14,487

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 4- 26

 Measuring Liquidity (2 of 2)

cash + marketable securities + receivables

Quick ratio =
current liabilties
2,577 + 498
= = .21
14,487

cash + marketable securities

Cash ratio = = =.
current liabilties 14,487

Copyright © 2020 by The McGraw-Hill Companies, Inc. All rights reserved 4- 27

 Interpreting Financial Ratios (1 of 3)
TABLE 4.6 Summary of Target’s performance measures.
Performance measures
Market value added ($ millions) market value of equity − book value of equity $11,986
Market-to-book ratio market value of equity ÷ book value of equity 4.6
Profitability Measures
Return on assets (ROA) after-tax operating income/total assets 8.9%
Return on capital (ROC) after-tax operating income/(long-term debt + equity) 17.0%
Return on equity (ROE) net income/equity 29.0%
EVA ($ millions) after-tax opera ng income − (cost of capital × capital) $2,022
Efficiency Measures
Asset turnover sales/total assets at start of year 1.89
Receivables turnover sales/receivables at start of year 123.6
Average collection period (days) receivables at start of year/daily sales 3.0
Inventory turnover cost of goods sold/inventory at start of year 5.8
Days in inventory inventories at start of year/daily cost of goods sold 63.2
Profit margin net income/sales 4.2%
Operating profit margin after-tax operating income/sales 4.7%
Leverage Measures
Long-term debt ratio long-term debt/(long-term debt + equity) 0.49
Long-term debt-equity ratio long-term debt/equity 0.96
Total debt ratio total liabilities/total assets 0.72
Times interest earned EBIT/interest payments 9.8
Cash coverage ratio (EBIT + depreciation)/interest payments 14.7
Liquidity Measures
Net working capital to assets net working capital/total assets −0.04
Current ratio current assets/current liabilities 0.89
Quick ratio (cash + marketable securities + receivables)/current liabilities 0.21
Cash ratio (cash + marketable securities)/current liabilities 0.18

4- 28
 Interpreting Financial Ratios (1 of 3)
FIGURE 4.3 Target’s financial ratios over time.

4- 29
 Interpreting Financial Ratios (2 of 3)
TABLE 4.7 Selected financial measures for Target and Walmart, 2020.
Target Walmart
Performance measures
Market value added ($ millions) market value of equity − book value of equity $11,986 $241,441
Market-to-book ratio market value of equity/book value of equity 4.6 4.0
Profitability Measures
Return on assets (ROA) after-tax operating income/total assets 8.9% 7.8%
Return on capital (ROC) after-tax operating income/(long-term debt + equity) 17.0% 13.9%
Return on equity (ROE) net income/equity 29.0% 19.1%
EVA ($ millions) after-tax opera ng income − cost of capital × capital $2,022 $10,147
Efficiency Measures
Asset turnover sales/total assets at start of year 1.89 2.39
Receivables turnover sales/receivables at start of year 123.6 83.4
Average collection period (days) receivables at start of year/daily sales 3.0 4.4
Inventory turnover cost of goods sold/inventory at start of year 5.8 8.9
Days in inventory inventories at start of year/daily cost of goods sold 63.2 40.9
Profit margin net income/sales 4.2% 2.9%
Operating profit margin after-tax operating income/sales 4.7% 3.3%
4- 30
 Interpreting Financial Ratios (2 of 3)

Target Walmart
Leverage Measures
Long-term debt ratio long-term debt/(long-term debt + equity) 0.49 0.35
Long-term debt-equity ratio long-term debt/equity 0.96 0.54
Total debt ratio total liabilities/total assets 0.72 0.66
Times interest earned EBIT/interest payments 9.8 8.5
Cash coverage ratio (EBIT + depreciation)/interest payments 14.7 13.1

Liquidity Measures
Net working capital to assets net working capital/total assets −0.04 −0.07
Current ratio current assets/current liabilities 0.89 0.79
Quick ratio (cash + marketable securities + 0.21 0.20
receivables)/current liabilities
Cash ratio (cash + marketable securities)/current liabilities 0.18 0.12

4- 31
 Interpreting Financial Ratios (3 of 3)
TABLE 4.8 Financial ratios for major industry groups
LT Debt Interest Current Quick Asset Profit Return on Return on
Assets Coverage Ratio Ratio Turnover Margin (%) Assets (%) Equity (%)

All manufacturing 0.26 3.02 1.30 0.91 0.54 7.08 4.62 8.92

Food products 0.27 3.22 1.46 0.93 0.73 6.00 4.88 8.62

Clothing 0.27 −0.13 1.87 1.09 0.85 −0.23 0.77 −1.34

Chemicals 0.31 3.98 1.17 0.90 0.35 17.47 6.96 15.21

Pharmaceuticals 0.33 5.10 1.20 0.97 0.30 23.98 8.26 20.12

Machinery 0.18 1.84 1.28 0.81 0.57 3.73 2.54 3.57

Computers & electronics 0.28 7.77 1.36 1.13 0.38 23.70 9.57 20.00

Motor vehicles 0.19 −0.25 1.26 0.92 0.97 −0.26 0.09 −2.05

Aerospace 0.29 2.91 1.20 0.57 0.56 6.36 4.19 20.35

Furniture 0.32 5.22 1.71 1.15 1.19 8.01 9.96 24.89

Beverage and tobacco 0.39 6.54 1.01 0.76 0.31 23.40 7.11 17.72

Paper 0.30 3.07 1.30 0.90 0.75 6.99 5.85 11.62

Retail trade 0.23 5.71 1.14 0.75 1.75 3.32 6.96 18.35

Source: U.S. Census Bureau, Quarterly Financial Report for Manufacturing, Mining, Trade, and Selected Service Industries, First Quarter 2020.
4- 32