Chapter 5

Financial Analysis 4 , 5 & 9

Discussion Questions
4.

In205BMhaduretqoyi7f6pc.,wsHl-kPnao4erthUdmpcROsIfwkvibolanrtdecshe data below:

IBM
NOPAT/Sales
Sales/Net Assets
Effective After-Tax
Rate

Interest

Net Financial Leverage

HP

9.0%

2.7%

2.16

2.73

2.4%

1.1%

0.42

-0.16

ROE can be decomposed as follows:

ROE = Operating ROA + spread x net financial leverage
Using this decomposition, ROE depends on a companys return on assets
(which can in turn be decomposed into return on sales and operating asset
turnover), and leverage gain from leverage (which is driven by whether the
firm can generate a higher return on assets than the after tax cost of debt
financing and leverage . Differences in these factors will drive differences in
ROE.
Return on Sales measures a firms profit per dollar of sales. As a profitability
measure, higher return on sales suggests possible greater efficiency of
operations or lower tax rates. Clearly, IBMs return on sales of 9% is much
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higher than that for HP (2.7%), and plays a key role in explaining the
differences in ROE.
The differences in return on sales for the two firms could be driven by
several factors. It could arise if IBMs strategy was to focus on a higher
margin business than HP. IBM has divested its low margin PC business and
grown its higher margin equipment and consulting businesses. In contrast,
HP continues to focus on equipment and the difficult PC business.
Asset Turnover assesses how productively a firm uses its assets. A higher
asset turnover ratio suggests that a fixed level of assets generates a greater
level of sales, i.e., the firm put its assets to more productive uses. The
differences for IBM and HP also reflect differences in strategy. HP has
focused more on the low-margin, but high turnover PC business, whereas
IBM is focused on the higher-margin but lower turnover business.
The product of the return on sales and asset turnover is ROA. IBMs ROA is
19.4% whereas HPs is 7.4%. As a result, it appears that IBMs strategy has
been more effective in generating superior asset returns than HPs
strategy.
Leverage describes the capital structure of the firm. If a firm is able to
generate higher returns from using funds raised from debt than the after tax
cost of debt, it will be able to generate additional value for stockholders.
Both IBM and HP are able to generate higher ROAs than the after-tax
cost of interest.
However, since IBM has a much higher ROA than HP, its borrowing spread
also gives it a potential edge. The spread for IBM is 17% (19.4%-2.4%)
whereas HPs spread is only 6.3% (7.4% - 1.1%). These differences are then
magnified by the debt policy of the two companies. Perhaps because its
business is strong, IBM has more leverage in its capital structure than
HP. HPs leverage is actually negative, indicating that it has more cash and
short-term investments than interest-bearing debt.
However, its shareholders bear a short-term cost for this, since its negative
leverage dampens the ROA. The net effect is that ROE is less than ROA
(6.4% versus 7.4%). The difference is simply the spread of 6.3% times its
Net Financial Leverage (-0.16). In contrast, IBM takes advantage of
positive leverage so that its ROE is greater than ROA (26.7% versus
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19.4%). Once again, the difference is the spread of 17% times its Net
Financial Leverage (0.42).

5.Joe Investor asserts, A company cannot grow faster than its

sustainable growth rate. True or false? Explain why.
False.

The sustainable growth rate is the speed at which a company can expand
without changing either its level of profitability or its financial policies.
Mechanically, sustainable growth rate = ROE (1 dividend payout ratio).
From this equation, we see that ROE and the dividend payout ratio
determine the funds remaining in the firm and available to finance the firms
growth. If a company wants to exceed its sustainable growth rate, it can:
a. increase its return on equity by improving its profitability (return on
sales),
b. increasing its asset turnover,
c. increasing leverage,
d. it can reduce its dividend payout rate, thereby increasing funds
available for reinvestment.

9. What are the potential benchmarks that you could use to compare a
companys financial ratios? What are the pros and cons of these
alternatives?
Comparison to Firms Prior History. By comparing the company with
itself over time, it is possible to document changes (improvements or
declines) in the companys performance. Changes in capital structure or
improvements in gross margins or return on assets may evolve slowly as the
firm implements the necessary changes in operations and financing.
Only by looking at the pattern of these changes over time can we see if the
individual changes in financial ratios from year to year are permanent or
temporary. However, this approach does not tell us how well the firm is
doing compared to other companies. For example, a firm may appear to have
performed poorly (well) relative to its own historical performance, yet
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relative to other firms in the economy or its own industry, it may have
performed quite well (poorly).
Comparison to Firms Expected or Budgeted Performance. This could
be relative to management or external analysts forecasts. These types of
comparisons can be very helpful by showing how well the firm has
performed relative to expectations. An obvious limitation is that the
comparisons are only meaningful if the expectations are carefully
constructed.
Comparison to Industry Average. Industry average financial ratios provide
a benchmark against which to interpret individual company ratios. A firms
return on sales, asset turnover, and financial leverage can be compared to
industry averages. What are the implications if a firm has a lower return on
equity or lower days payable than the industry? Are any differences
consistent with the firms operating policies and goals? Industry
comparisons can provide only a partial picture if the industry as a whole has
performed well or poorly, or if the firm is following a different strategy from
other firms in the industry. It can also be quite difficult to assess what the
appropriate industry comparison group is, since many firms operate in more
than one business segment.
Comparison to Market. Benchmarking the performance of an individual
firm against the market can be informative. Ultimately, investors want to
allocate resources within the economy as a whole. A firm that is a strong
performer relative to its industry may therefore be a relatively weak overall
performer if its industry is underperforming. However, market analysis can
be difficult for many key financial ratios which are industry specific and do
not lend themselves to cross-industry comparison or evaluation.
For example, important ratios for banks include those on regulatory capital,
which are not relevant for most other industries. Working capital ratios
typically differ across industries, so that it makes little sense to compare
days inventory or days receivable for a supermarket relative to the same
ratios for a steel manufacturer. Finally, differences in ratios can arise because
of differences in business risk across industries. For example, ROEs and
leverage are likely to be very different for construction firms than for
supermarkets.