C H A P T E R
1 9
Financial
Statement
Analysis
647
A closely related statistic to the interest burden ratio is the
interest coverage ratio, or
times interest earned. The ratio is defined as
Interest coverage 5 EBIT/Interest expense
A high coverage ratio indicates that the likelihood of bankruptcy is low because annual
earnings are significantly greater than annual interest obligations. It is widely used by both
lenders and borrowers in determining the firm’s debt capacity and is a major determinant
of the firm’s bond rating.
Factor 5, the ratio of assets to equity, is a measure of the firm’s degree of financial lever-
age. It is called the leverage ratio and is equal to 1 plus the total debt-to-equity ratio.
4
In our
numerical example in Table 19.7 , Nodett has a leverage ratio of 1, while Somdett’s is 1.667.
From our discussion in Section 19.2, we know that financial leverage helps boost ROE
only if ROA is greater than the interest rate on the firm’s debt. How is this fact reflected in
the ratios of Table 19.7 ?
The answer is that to measure the full impact of leverage in this framework, the analyst
must take the product of the interest burden and leverage ratios (i.e., factors 2 and 5, shown
in Table 19.7 as column 6). For Nodett, factor 6, which we call the compound leverage factor,
remains a constant 1.0 under all three scenarios. But for Somdett, we see that the compound
leverage factor is greater than 1 in normal years (1.134) and in good years (1.311), indicating
the positive contribution of financial leverage to ROE. It is less than 1 in bad years, reflecting
the fact that when ROA falls below the interest rate, ROE falls with increased use of debt.
We can summarize all of these relationships as follows. From Equation 19.2,
ROE 5 Tax burden 3 Interest burden 3 Margin 3 Turnover 3 Leverage
Because
ROA
5 Margin 3 Turnover
(19.3)
and
Compound leverage factor 5 Interest burden 3 Leverage
we can decompose ROE equivalently as follows:
ROE
5 Tax burden 3 ROA 3 Compound leverage factor
(19.4)
Equation 19.3 shows that ROA is the product of margin and turnover. High values of
one of these ratios are often accompanied by low values of the other. For example, Walmart
has low profit margins but high turnover, while Tiffany has high margins but low turnover.
Firms would love to have high values for both margin and turnover, but this generally will
not be possible: Retailers with high markups will sacrifice sales volume, and conversely,
those with low turnover need high margins just to remain viable. Therefore, comparing
these ratios in isolation usually is meaningful only in evaluating firms following similar
strategies in the same industry. Cross-industry comparison can be misleading.
Figure 19.2 shows evidence of the turnover-profit margin trade-off. Industries with high
turnover such as groceries or retail apparel tend to have low profit margins, while indus-
tries with high margins such as utilities tend to have low turnover. The two curved lines
in the figure trace out turnover-margin combinations that result in an ROA of either 3%
or 6%. You can see that most industries lie inside of this range, so ROA across industries
demonstrates far less variation than either turnover or margin taken in isolation.
4
Assets
Equity
5
Equity
1 Debt
Equity
5 1 1
Debt
Equity
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648
P A R T V
Security
Analysis
Consider two firms with the same ROA of 10% per year. The first is a discount super-
market chain, the second is a gas and electric utility.
As Table 19.8 shows, the supermarket chain has a “low” profit margin of 2% and
achieves a 10% ROA by “turning over” its assets five times per year. The capital-intensive
utility, on the other hand, has a “low” asset turnover ratio of only .5 times per year and
achieves its 10% ROA through its higher, 20%, profit margin. The point here is that a
“low” margin or asset turnover ratio need not indicate a troubled firm. Each ratio must
be interpreted in light of industry norms.
Example 19.3
Margin versus Turnover
0.5
1.0
1.5
Asset Turnover
2.0
2.5
3.0
0.0
0
2
4
Profit Margin (%)
6
8
10
12
14
ROA
= 6%
Utilities
Oil & Gas
Extraction
Amusements
Hotels
Petroleum
Personal Services
Food Products
Transportation
Equipment
Restaurants
Industrial
Equipment
Wholesalers–
Nondurables
Wholesalers–
Durables
Retailing–Apparel
Retailing–General
Merchandise
Grocery Stores
Paper
Lumber
Metals
Communications
Agricultural
Production
Printing and Publishing
Airlines
Health Services
ROA
= 3%
Figure 19.2
Median ROA, profit margin, and asset turnover for 23 industries, 1990–2004
Source: “Figure D: ROAs of Sample Firms (1977–1986)” from Thomas I. Selling and Clyde P. Stickney, ”The Effects of Business Environ-
ments and Strategy on a Firm’s Rate of Return on Assets.” Copyright 1989. CFA Institute, Reproduced and republished from Financial
Analysis Journal, January–February 1989, pp. 43–52, with permission from the CFA Institute. All rights reserved. Updates courtesy of
Professors James Wahlen, Stephen Baginski, and Mark Bradshaw.
Do a ratio decomposition analysis for the Mordett Corporation of Concept Check 1, preparing a table
similar to Table 19.7 .
CONCEPT CHECK
19.2
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