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7.4.2 Ratio Analysis 

 Ratios are useful tools of financial analysis (Marck 2014; Healy & Cohen 2000; Tracy 2012).
Sometimes, ratios of significant financial data are more meaningful than the raw data
themselves.
 They also provide an instant picture of the financial condition, operation, and profitability of
a company, provided that the trends and deviations reflected by the ratios are interpreted
properly. 
Ratio analyses are subject to two constraints: past performance and various accounting methods.
 Past performance is not a sure basis for projecting the company’s condition in the future.
 Various accounting methods employed by different companies may result in different financial
figures (e.g., inventory accounting and depreciation), rendering a comparison that is less
meaningful between companies in the same industry.  
When performing ratio analyses, it is advisable to follow this set of generally recommended
guidelines:
1. Focus on a limited number of significant ratios.
2. Collect data over a number of past periods to identify the prevalent trends.
3. Present results in graphic or tabular form according to standards (e.g., industrial averages).
4. Concentrate on all major variations from the standards.
5. Investigate the causes of these variations by cross-checking with other ratios and raw financial
data.
Sources of information on ratios and other financial measures are typically reported regularly and
made available for use by the public in publications such as Value Line Investment Survey, Standard &
Poor’s Industrial Survey, and Moody’s Investors Services.

 Example 7.4 For the years 2012–2013, the financial statements of XYZ Company are
given in Tables 7.8 and 7.9. Define the performance ratios of the company.
o Answer 7.4 The 2012 performance ratios of XYZ Corporation are…

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o
7.4.3 Economic Value Added
 Developed by Stern Stewart & Company in 1989, economic value added (EVA) is an
improved valuation method for asset-intensive companies or projects.
 EVA is defined as the after-tax-adjusted net operating income of a company minus the total
cost of capital spent during the same accounting period.
 It is also equal to the return on capital minus the cost of capital, or the economic value above
and beyond the cost of capital (Stewart 2013; Ismail 2011). Sometimes EVA is also called
economic profit. In equation form, it is defined as

EVA may also be applied to a single project by calculating the after-tax cash flows generated by
the project minus the cost of capital spent for the project. For example, the NPV equation can be modified
as follows:

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7.5 Balanced Scorecard

 All financial ratios are determined on the basis of past performance data; they are “trailing”
indicators, and as such, they cannot foretell the future performance of a company.
 financial ratios are oriented toward the short term, usually from one quarter to another,
company management is inadvertently forced to overemphasize short-term financial results,
often to the extent of neglecting the company’s long-term growth.
Attempts have been made in the past to modify these ratios as corporate measurement metrics.
Kaplan (1996) suggests that corporate measurement metrics are to be defined to cover four areas:
• Financial: Shareholder value
• Customers: Time, quality, performance and service, and cost
• Internal business processes: Core competencies and responsiveness to customer needs
• Innovation and corporate learning: Value added to the customer, new products, and continuous
refinement

 The significance of the balanced scorecard lies in its balanced focus on both short-term actions as
well as long-term corporate growth. Spending adequate company effort on innovation to bring
out new products is promoting long-term health.
 Ideally, metrics should be set up to track outcomes in both short-term performance and long-term
health, which is related to company growth prospects, capabilities, relationships, and assets, to
enable future cash flows.
 Companies must create metrics to track outcome in both performance and health. Specifically,
Kaplan (1996) advocates the use of a total of 15–20 metrics to cover these four areas to guide the
company as it moves forward.
As an illustrative example, the balanced scorecard metrics for a manufacturing company may
contain the following:

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 In general, balanced scorecard metrics for a given company must be developed according to
its corporate strategy and vision, using a top-down approach. Doing so will ensure that
performance metrics at lower management levels are properly aligned with the overall
corporate goals. A unique strength of balanced scorecard metrics is that they link the
company’s long-term strategy with its short-term actions.
 Marketing and Refining Division raised its standing from last to first in its industry after
having implemented a balanced scorecard.
o Person (2013) recommends that managers, when implementing a balanced scorecard,
o take personal ownership,
o nurture a core group of champions,
o educate team members,
o keep the program simple,
o integrate the scorecard into their own leadership systems,
o orchestrate the dynamics of scorecard meetings,
o communicate the scorecard widely,
o resist the urge for perfection,
o be ruthless about implementation,
o and look beyond the numbers to achieve cultural transformation of the company.
 Contributions made by engineering managers in these nonfinancial areas will likely become
readily and more favorably recognized in the future.

7.6 Capital Formation

 Capital formation refers to activities undertaken by a company to raise capital for short term and
long-term investment purposes (Piketty 2014; Sherman 2012).
 In general, the net income earned by most companies, plus their internal resources of retained
earnings, are not sufficient to finance all investments needed to achieve both their short-term and
long-term corporate objectives. Even if these internal resources are sufficient, some companies
still engage in external financing due to valid reasons related to tax and strategic management
flexibility.
 Many companies routinely pursue some external financing resources, such as equity or debt
financing, or both.

7.6.1 Equity Financing

 Equity financing is the raising of capital by issuing company stocks.
 Stocks are certificates of company ownership, which typically carry a par value of $1.
 Shareholders are those who own stocks.
o They have the residual claims to what is left of the firm’s assets after the firm has
satisfied other high-priority claimants (e.g., bondholders, bankruptcy lawyers, and unpaid
employees).
 Basically, there are two kinds of stocks:
o common stocks and
o preferred stocks (whose dividends have a priority over those of common stocks).
 Companies may issue new stocks to raise capital. The process requires the approval of the
company’s board of directors (which mirrors the interests of all shareholders), because such a
move may result in the dilution of company ownership.

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The capital received by issuing stocks has a cost made up of the following components: the cost of
equity capital, which includes the stock issuing fees; the dividends to be paid in future years; and the
capital gains through stock price appreciation expected by investors in the future. Typically, this cost
of equity is set to equal the return of an equity calculated by using the well-known capital asset
pricing model (CAPM) (Hart 2014). The CAPM defines the return of an equity as (see Figure 7.1)

Since the value of Beta is based on historical data, numerous financial analysts view it as a major
deficiency of the CAPM model. Another deficiency is its lack of timing constraints. The same cost is
assumed to be valid for capital projects of a 2- or 10-year duration. In practice, when evaluating a specific
capital investment project, some companies adjust the value of Beta manually in order to arrive at a
pertinent cost of equity capital.

7.6.2 Debt Financing

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 Debt is the liabilities incurred by the company to make contractual payments (e.g.,
interest payments) under specified terms.
 Debt represents a fixed prior claim against the company’s assets and poses a financial
risk to the company.
 Debts are usually secured by a certain part of the company’s assets.
 Creditors have the legal power to enforce payments and thus potentially drive companies
into bankruptcy.
 When a company declares bankruptcy, it must satisfy the claims of creditors in a specific
order:
o (a) secured debts (bonds or loans),
o (b) lawyers’ fees,
o (c) unpaid wages, and
o (d) stockholders.
 Note that bankruptcy lawyers have a payment priority ahead of the hardworking
employees and risk averse shareholders (Chaplinsky 2010).
 Companies seeking debt financing through the issuance of bonds also need to engage an
underwriting firm and follow a set of prescribed steps. There are several types of bonds:
o corporate bonds,
o (b) mortgage bonds,
o (c) convertible bonds (convertible to stocks at a fixed price by a given date), and
o (d) debentures (unsecured bonds).
 The length of debts may be short term (less than one year’s duration), intermediate (one
to seven years), or long term (more than seven years). There is also an underwriting fee
associated with this type of public offering.
 The cost of debt capital includes the underwriting fee, bond rate, or interest rate to be paid in
future periods, the opportunity cost associated with the diminished company growth
opportunity, and other costs.
 The opportunity cost related to reduced growth opportunity results from the fact that highly
leveraged companies can no longer be as aggressive in pursuing new growth business
opportunities as they might be in the case of no or minimum leverage. The obligatory interest
burdens tend to temper the
company’s otherwise bold
investment strategies. These
burdens also constrain the
company’s investment flexibility
and thus cause the company to
lose the potential benefits that
it could otherwise have
realized from such new
opportunities.
 The other costs could result
from one or more of the
following:
o (1) suboptimal
forecasts;
o (2) vulnerability of the company to attacks by competitors;
o (3) the company’s inability to access additional debt capital, if needed; and
o (4) the cost of bankruptcy

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Example 7.5
Innovative Products is a company that has enjoyed a high growth rate in recent years. Its growth
has been largely financed by the retained earnings that belong to the common stockholders (see
Table 7.10).
For the last three years, the company has earned an average annual net income of $75,000, after
having paid an annual interest of $8,000 and the annual taxes of $50,000. The company’s tax rate is 40%.
Company management is considering the strategy of raising $750,000 to double its production
volume. Of this amount, $500,000 would be used to (1) build an addition to the current office building,
(2) purchase new IT equipment, and (3) install an advanced Enterprise Resources Planning (ERP)
software system. The remaining amount would be needed for working capital to add inventories and to
enhance marketing and selling activities.
Market research suggests that, despite a doubling of the company’s sales volume, the product price
can be kept at the current level. The EBIT is projected to be $275,000. Two specific financing options are
to be evaluated closely:
1. Sell enough additional stock at $30 per share to raise $750,000.
2. Sell 20-year bonds at 5% interest, totaling $500,000.
Determine which financing option is to be favored from the standpoint of earning per share.

Answer 7.5
Earnings per share is defined as the company’s net income divided by the number of outstanding
common stocks. To compare the earning per share data for these two financing options, the income
statement must be constructed as in Table 7.11. The following explanations may be helpful:

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In general, an increase in leverage (e.g., adding more debts) reduces the firm’s WACC. This is due to the
tax deductibility of interest payments associated with the debt. For many companies, WACC is typically
in the range of 8%–16%.

7.6.4 Effect of Financial Leverage

 Financial leverage denotes the use of debts in financing corporate projects. A measure of
financial leverage is given by the leverage ratio D/V.
 The company is said to be highly leveraged if its leverage ratio is more than 0.5 (Mathis 2014).
 Leverage ratio is known to have an impact on both the variability of reportable earning per share
and the return on equity values. This is illustrated by the following example.

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