Chapter 4: Measuring Corporate Performance Flashcards
How do you measure whether a public corporation has delivered value for its shareholders? (LO4-1)
For a public corporation, this is relatively easy. Start with market capitalization, which equals price per share times the number of shares outstanding. The difference between market capitalization and the book value of equity measures the market value added by the firm’s investments and operations. The book value of equity is the cumulative investment (including reinvested earnings) by shareholders in the company. The ratio of market value to book value is another way of expressing value added.
For private corporations, financial managers and analysts have to turn to other performance measures because stock prices are not available.
What measures are used to assess financial performance? (LO4-2)
Financial managers and analysts track return on equity (ROE), which is the ratio of net income to shareholders’ equity. But net income is calculated after interest expense, so ROE depends on the debt ratio. The return on capital (ROC) and the return on assets (ROA) are better measures of operating performance. These are the ratios of after-tax operating income to total capitalization (long-term debt plus shareholders’ equity) and to total assets. ROC should be compared with the company’s cost of capital. EVA (economic value added or residual income) deducts the cost of capital from operating income. If EVA is positive, then the firm’s operations are adding value for shareholders.
What are the standard measures of profitability, efficiency, leverage, and liquidity? (LO4-3)
Profitability ratios measure return on sales. Efficiency ratios measure how intensively the firm uses its assets. Leverage ratios measure how much the firm has borrowed and its obligations to pay interest. Liquidity ratios measure how easily the firm can obtain cash.
Financial ratios crop up repeatedly in financial discussions and contracts. For example, banks and bondholders usually demand limits on debt ratios or interest coverage.
What determines the return on assets and equity? (LO4-4)
The Du Pont system links financial ratios together to explain the return on assets and equity. Return on assets is the product of asset turnover and operating profit margin. Return on equity is the product of the leverage ratio, asset turnover, operating profit margin, and debt burden.
What are some potential pitfalls in financial statement analysis? (LO4-5)
Financial statement analysis will rarely be useful if done mechanically. Financial ratios do not provide final answers, although they should prompt the right questions. In addition, accounting entries do not always reflect current market values, and in rare cases account- ing is not transparent because unscrupulous managers make up good news and hide bad news in financial statements.
You will need a benchmark to assess a company’s financial condition. Therefore, analysts usually compare financial ratios with the company’s ratios in earlier years and with ratios of other firms in the same business.
