Key management ratios : the clearest guide to the critical numbers that drive your business

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Key management ratios

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Key management ratios

The clearest guide to the critical numbers

that drive your business

fourth edition

Ciaran Walsh

WKMR_A01.QXD 11/24/05 12:53 PM Page iii

PEARSON EDUCATION LIMITED

Edinburgh Gate

Harlow CM20 2JE

Tel: +44 (0)1279 623623

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Website: www.pearsoned.co.uk

First published 1996

Second edition 1998

Third edition 2003

Fouth edition published in Great Britain 2006

© Ciaran Walsh 2006

The right of Ciaran Walsh to be identified as author of this work has been asserted by him in

accordance with the Copyright, Designs and Patents Act 1988.

ISBN-13: 978-0-273-70731-8

ISBN-10: 0-273-70731-0

British Library Cataloguing-in-Publication Data

A catalogue record for this book is available from the British Library

Library of Congress Cataloging-in-Publication Data

Walsh, Ciaran.

Key management ratios : the clearest guide to the critical numbers that drive your

business / Ciaran Walsh.-- 4th ed.

p. cm.

Includes index.

ISBN-13: 978-0-273-70731-8 (alk. paper)

ISBN-10: 0-273-70731-0 (alk. paper)

1. Ratio analysis. 2. Management--Statistical methods. 3. Statistical decision. I. Title.

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Ciaran Walsh is Senior Finance Specialist at the Irish Management

Institute, Dublin.

He is trained both as an economist and an accountant (BSc (Econ)

London, CIMA) and had 15 years’ industrial experience before joining the

academic world.

His work with senior managers over many years has enabled him to

develop his own unique approach to training in corporate finance. As a

consequence, he has lectured in most European countries, the Middle

East and Eastern Europe.

His main research interest is to identify and computerize the links that

tie corporate growth and capital structure into stockmarket valuation.

He lives in Dublin and is married with six children.

He can be contacted at [email protected]

About the author v

About the author

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To our grandchildren

Rebecca

Isobel

Benjamin

Eleanor

Sophie

Eve

Hanna

Holly

Grace

Aaron

Alice

Zoe

Imogen

Kate

Lei Xiao Shun

WKMR_A01.QXD 11/24/05 12:53 PM Page vi

Contents vii

Acknowledgments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xii

Foreword . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xiii

Key for symbols . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xiv

PART I FOUNDATIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

1 Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Why do you need this book? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

The form and logic . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5

The philosophy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5

Excitement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6

Data that makes sense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6

2 Financial statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11

The balance sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .14

Balance sheet structure – fixed assets . . . . . . . . . . . . . . . . . . . . . . . .18

Balance sheet structure – liabilities . . . . . . . . . . . . . . . . . . . . . . . . . .20

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .24

3 Balance sheet terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .26

The terms used . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .26

4 Profit and loss account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .36

Working data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .42

Contents

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PART II OPERATING PERFORMANCE . . . . . . . . . . . . . . . . . . . . . . 47

5 Measures of performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49

Relationships between the balance sheet and profit and

loss account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .50

The ratios ‘return on total assets’ and ‘return on equity’ . . . . . . . .52

Balance sheet layouts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .54

6 Operating performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59

Return on investment (ROI) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .61

Return on equity (ROE) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .62

Return on total assets (ROTA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .64

Standards of operating performance . . . . . . . . . . . . . . . . . . . . . . . . .66

7 Performance drivers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81

Operating performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .82

Operating profit model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .88

PART III CORPORATE LIQUIDITY . . . . . . . . . . . . . . . . . . . . . . . . . . 95

8 Cash flow cycle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97

Corporate liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .99

The cash cycle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100

Measures of liquidity – long and short analysis . . . . . . . . . . . . . . . 110

9 Liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113

Short-term liquidity measures . . . . . . . . . . . . . . . . . . . . . . . . . . . . .115

Current ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .116

Quick ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .118

Working capital to sales ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120

Working capital days . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122

10 Financial strength . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125

Interest cover . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .126

‘Debt to equity’ ratio (D/E) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .128

Leverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .134

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .136

viii Contents

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11 Cash flow . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137

The cash flow statement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .139

Sources and uses of funds – method . . . . . . . . . . . . . . . . . . . . . . . .140

Opening and closing cash reconciliation . . . . . . . . . . . . . . . . . . . . .144

Long and short analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .146

Financial reporting standards . . . . . . . . . . . . . . . . . . . . . . . . . . . . .150

PART IV DETERMINANTS OF CORPORATE VALUE . . . . . . . . 153

12 Corporate valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .156

Share values . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .158

13 Financial leverage and corporate valuation . . . . . . . . . . 175

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .176

Financial leverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .176

V chart . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .178

Market to book ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .182

14 Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 189

Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .190

Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .194

Growth equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .196

Application to acquisitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .202

PART V MANAGEMENT DECISION-MAKING . . . . . . . . . . . . . 205

15 Cost, volume and price relationships . . . . . . . . . . . . . . . . 207

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .209

Costing illustration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .210

Contribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .214

Break-even (B/E) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .220

Contribution to sales percentage (CPS) . . . . . . . . . . . . . . . . . . . . . .226

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .240

Contents ix

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16 Investment ratios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .243

Project appraisal – the problem . . . . . . . . . . . . . . . . . . . . . . . . . . . .244

Project appraisal – steps to a solution (1) . . . . . . . . . . . . . . . . . . . .246

Project appraisal – steps to a solution (2) . . . . . . . . . . . . . . . . . . . .248

Project appraisal – present value (PV) . . . . . . . . . . . . . . . . . . . . . . .250

Project appraisal – internal rate of return (IRR) . . . . . . . . . . . . . .254

Project appraisal – summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .256

17 Shareholder value added (SVA) . . . . . . . . . . . . . . . . . . . . . 259

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .261

Description . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .262

Approach to valuation (1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .266

Approach to valuation (2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .268

Value for the equity shareholders . . . . . . . . . . . . . . . . . . . . . . . . . .274

Discount factor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .276

Terminal (continuing) value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .286

Complete model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .288

18 Acquisition analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 291

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .293

Financial profile of Alpha Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .294

Financial profile of Beta Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .296

Acquisition – first offer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .298

Acquisition impact on EPS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .300

Shareholder effects – generalized . . . . . . . . . . . . . . . . . . . . . . . . . .302

Summary of effects on shareholders . . . . . . . . . . . . . . . . . . . . . . . .308

Revised offer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .310

Relative versus absolute values . . . . . . . . . . . . . . . . . . . . . . . . . . . .312

SVA models – Alpha Inc. and Beta Inc. . . . . . . . . . . . . . . . . . . . . . .316

Addendum . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .318

19 Integrity of accounting statements . . . . . . . . . . . . . . . . . . 321

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 323

Where we focus attention . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 324

Operating revenue enhancement . . . . . . . . . . . . . . . . . . . . . . . . . . .325

x Contents

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Methods of revenue enhancement – fictitious sales . . . . . . . . . . . .328

Revenue enhancement – clues for detection . . . . . . . . . . . . . . . . . .329

Operating cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .330

The balance sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .333

The cash flow statement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .339

Appendix 1: Special items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .341

Appendix 2: Companies used in the sample . . . . . . . . . . . . . . . . . . . . . .356

Appendix 3: Full set of ratio charts from sample companies . . . . . . . . .359

Appendix 4: Discounting and compounding tables . . . . . . . . . . . . . . . .376

Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .384

Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .394

Contents xi

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xii Acknowledgments

I wish to express my deep gratitude to those who helped to bring about

this publication. To Richard Stagg of Financial Times Prentice Hall, who

originated the concept and carried it through. To my friends and col￾leagues: the late John O’Sullivan, who was an unequaled source of

reference on even the most esoteric subjects, and John Dinan, who re￾started the motor after a blow-out.

I am grateful to the staff of the Irish Management Institute Library

and Dublin Central Library for their unstinted provision of all the finan￾cial data that I sought, including data from the Financial Times and Extel

Financial Ltd, and to Geraldine McDonnell and Carol Fitzpatrick, who

cheerfully coped with all the work of the section while the author was in

seclusion.

Finally, I acknowledge the debt I owe to my fellow travellers: Tom

Cullen; the late Des Hally; Diarmuid Moore; Martin Rafferty. They

ploughed the first furrows and sowed the seed.

Acknowledgments

WKMR_A01.QXD 11/24/05 12:53 PM Page xii

Foreword xiii

The subject of corporate finance is explored in a hundred books, most of

which have a formidable and forbidding aspect to them. They contain

page after page of dense text interspersed with complex equations and

obscure terminology.

The sheer volume of material and its method of presentation suggests

that this is a subject that can be conquered only by the most hardy of

adventurers. However, the truth is that the sum and substance of this

area of knowledge consists of a relatively small number of essential finan￾cial measures by means of which we can appraise the success of any

commericial enterprise.

These measures are derived from relationships that exist between vari￾ous financial parameters in the business. While each measure in itself is

simple to calculate, comprehension lies not in how to do the calculations

but in understanding what these results mean and how the results

of different measures mesh together to give a picture of the health of

a company.

The first edition of this book set out to remove the obscurity and com￾plexity so as to make the subject accessible to all business managers. It

turned out to be very successful.

In this fourth edition, the same basic structure and approach is used.

However, the examples and the benchmark data have been updated and

expanded to make the book more relevant to a wider audience.

Data has been drawn from approximately 200 companies worldwide so

the results have very wide usage.

In the third edition, a new chapter was added (chapter 18) to illustrate how

the techniques used throughout the book can be used for the analysis of a pro￾posed acquisition. It shows first how to value the two companies in relative

terms and then how to value them in absolute terms using an SVA approach.

SVA is an exciting new area of analysis that all managers will want to

become familiar with because it is one that will have most impact on their

responsibilities over the coming years.

In this fourth edition, a further chapter is added (chapter 19). This exam￾ines the subject of the integrity of accounting statements, discusses when

and how integrity may be breached and suggests methods of detection.

Foreword

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xiv Key for symbols

The following icons and the concepts they represent have been used

throughout this book.

Thinkers

Checklist/summary

Example

Key idea

Definition

Action/taking note

Key for symbols

!

?

✓

☛

%

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