Acctcy Ch 6 Reading Notes

cash flow coverage ratio

operating cash flows before interest payments are factored in/interest expense

Quick ratio

(Current Assets - Inventory) / Current Liabilities (Cash + Short-term investments+Receivables) / Current Liabilities Few businesses can instantaneously convert their inventories into cash. By excluding inventory from the numerator, the quick ratio provides a measure of very immediate liquidity.

Although cash flow statements contain information enabling a user to assess a company's credit risk, financial ratios are also useful for this purpose.

*Credit risk analysis using financial ratios typically involves an assessment of liquidity and solvency.*

Understanding the relative emphasis a company places on differentiation versus low-cost leadership can be important for competitive analysis.

*Differences in the business strategies companies adopt give rise to economic differences, which are reflected as differences in profit margins, asset utilization, and profitability.* That is why we cannot look at profit margins or asset turnovers alone as a sign of success.

Before computing ROA, analysts may adjust the company's reported earnings and asset figures. These adjustments fall into *3 broad categories:*

1. Adjustments aimed at isolating a company's sustainable profits by removing nonrecurring items—analysts sometimes call these "special" items—from reported income. 2. An adjustment that eliminates after-tax interest expense from the profit calculation so that profitability comparisons over time or across companies are not affected by differences in financial structure.6 3. Adjustments for distortions related to accounting quality concerns, which involve potential adjustments to both earnings and assets, such as for LIFO liquidations. - The adjustments are made to reported Net earnings including noncontrolling interests each year to eliminate interest expense, net of its related tax savings.

*A company's ROA can increase or decrease for 2 reasons:*

1. An increase or decrease in *profit margin*. - ex. For example, a large manufacturing company might use its bargaining power to negotiate price reductions from raw material suppliers, increasing the company's profit margin, thereby increasing ROA. 2. An increase or decrease in the intensity of *asset utilization.* - ex. For example, a restaurant that was previously open only for lunch and dinner might decide to stay open 24 hours a day. Doing so would not require substantial additional investment, so the restaurant could generate more sales per dollar invested in restaurant assets, thus yielding an increase in asset utilization, which also increases ROA.

Kroger categorizes its stores into 4 types:

1. Combination food and drug stores are large enough to offer specialty departments such as natural and organic foods, pharmacies, and general merchandise, to allow for one-stop shopping. These stores typically draw their customers from a radius of about 2 to 2.5 miles. They operate under several names, including Dillons Food Stores, Harris Teeter, Kroger, Mariano's, and Ralph's. 2. Multi-department stores are larger than combination stores and have a much larger selection of nongrocery items, such as general merchandise, apparel, electronics, jewelry, and automotive products. They operate under the names Fred Meyer and Smith's. 3. Marketplace stores are smaller in size than multi-department stores, but still offer a full-service grocery, pharmacy, and an expanded general merchandise selection. They operate as Dillons, Fry's, King Soopers, Kroger, and Smith's. 4. Price impact warehouse stores are similar in size to combination stores and offer a no-frills warehouse format, operating as Food 4 Less and Ruler Foods.

*2 key strategies for achieving superior performance in any business*

1. Product and service differentiation - focuses on "unique" products or services to gain brand loyalty and attractive margins - People are willing to pay premium prices for things they value and can't get elsewhere. - Differentiation can take several forms. Examples include advanced technology and performance capabilities, consistent quality, availability in multiple colors and sizes, prompt delivery, technical support services, customer financing, distribution channels, or some other feature of importance to customers. A restaurant chain, for example, might focus on superior taste and nutritional benefits when introducing new menu items. 2. Low-cost leadership. - focuses on operating efficiencies, which permit the company to underprice the competition, achieve high sales volumes, and still make a profit on each sale - Companies can attain a low-cost position in various ways. Examples include making quantity discount purchases, having a lean administrative structure, and using production efficiencies from outsourcing or vigorous cost containment. Most companies try to do both—developing customer loyalty while controlling costs.

Financial ratios play 2 crucial roles in credit analysis.

1. They help lenders quantify a potential borrower's default risk before a loan decision is made. 2. After a loan is granted, financial ratios serve as an early warning device that alerts lenders to changes in the borrower's credit risk.

Finished goods

365 x Avg finished goods inventory/Cost of goods sold

Raw materials ratio

365 x Avg raw materials inventory/Raw materials used

Work in process

365 x Avg work-in-process inventory/cost of goods manufactured

Days Accounts Receivable Outstanding

365/accounts receivable turnover

Days inventory held

365/inventory turnover

Financial Ratios and Default Risk

A company is in default when it fails to make a required loan payment on time. Lenders can respond to a default in several ways. At one end of the spectrum, lenders may simply adjust the loan payment schedule to better suit the company's anticipated operating cash flows. This response is appropriate when the default stems from a temporary cash flow shortfall and the borrower is fundamentally sound. If the borrower has a serious cash flow problem, lenders may modify the payment schedule in exchange for an increased interest rate or additional collateral, such as receivables, inventory, or equipment. If the borrower's cash flow problem is extreme, lenders may petition a court to judge the borrower insolvent.

Cash Flow from Operating Activities

A company's cash flow from operations refers to the amount of cash it is able to generate from ongoing core business activities. Generating cash from operations is essential to any company's long-term economic viability. However, not every company can be expected to produce positive operating cash flows every year. Even financially healthy companies must sometimes spend more cash on their operating activities than they receive from customers. The analyst must evaluate each possible explanation to discover what economic forces are responsible for the company's negative operating cash flows and whether positive cash flows from operating activities are likely to be generated in the future. Creditors are unlikely to keep lending to a business that continually fails to generate an acceptable level of cash flow from operations.

Cash Flow Analysis

Although a company's earnings are important, an analysis of its cash flows is central to credit evaluations and lending decisions.

RECAP 1

Analysts must be vigilant about the possibility that accounting distortions are present and complicate the interpretation of financial ratios, percentage relations, and trend indices. No tool of financial statement analysis is completely immune to distortions caused by GAAP or by management's reporting choices.

BASIC APPROACHES

Analysts use financial statements and financial data in many ways and for many different purposes. 2 purposes: time-series analysis and cross-sectional analysis

Inventory in a manufacturing firm must pass through three stages of the operating cycle:

As raw material, from purchase to the start of production. As work in process, over the length of the production cycle. As finished goods, from completion of production until it is sold.

Operating cash flow to total liabilities

Cash flow from continuing operations/Avg current liabilities plus long-term debt measure of long-term solvency, compares a company's operating cash flow to its total liabilities This ratio shows a company's ability to generate cash from operations to service both short-term and long-term borrowings.

Financial Statement Analysis and Accounting Quality

Cause-of-change analysis, common-size statements, trend statements, and financial ratios are powerful tools for understanding how a company got where it is today and where the company might be heading tomorrow. -- But because these tools are built around reported accounting data, they are no better than the data on which they rely. A company that uses aggressive accounting methods to appear more profitable will also present a more favorable picture in a financial analysis. Analysts need a thorough understanding of accounting rules and a keen eye for information in the financial statement notes so they are aware of how accounting rules and choices have affected the reported results.

Timing differences between cash inflows and cash outflows create the need to borrow. Cash flow analysis helps lenders identify why cash flow imbalances occur and whether the imbalance is temporary.

Commercial banks, insurance companies, pension funds, and other lenders will lend the needed cash only if there is a high probability that the borrower's future cash inflows will be sufficient to repay the loan. Credit analysts rely on their understanding of the company, its business strategy and the competitive environment, and the adequacy of its past cash flows as a basis for forecasting future cash flows and assessing the company's financial flexibility under stress.

Not every company in an industry earns the same rate of return on its assets. Some earn more than the industry average ROA, while others earn less.

Companies that fall below the industry average ROA strive to grow sales, improve operating efficiency, and better manage assets so that they can become competitive again. Those fortunate enough to earn more than the industry average ROA struggle to maintain their competitive advantage—through differentiation or low-cost leadership—and to stay on top. This ebb and flow of competition show up as differences in ROA and in its profit margin and asset turnover components.

When lenders want to know about a company's ability to pay debts on time, they assess its credit risk.

Credit risk assessment often begins with a cash flow statement because it shows the company's operating cash flows along with its financing and investment needs. A low credit risk company generates operating cash flows substantially in excess of what are required to sustain its business activities. The lender also can use liquidity and solvency ratios to assess credit risk.

interest coverage ratio

EBITDA / Interest Expense indicates how many times interest expense is covered by operating profits before taxes and interest are factored in A criticism of the traditional interest coverage ratio is that it uses earnings rather than operating cash flows in the numerator.

Numerous and interrelated risks influence a company's ability to generate cash.

Each of these risks ultimately affects a company's operating performance, net income, and cash flows.

Common-Size and Trend Analysis Income Statements

Financial analysts use common-size and trend statements of net income to help spot changes in a company's cost structure and profit performance.

SUMMARY

Financial ratios, along with common-size and trend statements, provide analysts powerful tools for tracking a company's performance over time, for making comparisons among different companies, and for assessing compliance with contractual benchmarks. Here are some things to remember about those tools: *There is no single "correct" way to compute many financial ratios.* In this chapter, we have shown you how to compute common financial ratios using widely accepted methods. But not every analyst calculates these ratios in exactly the same way. Why? Sometimes it's a matter of personal taste or industry practice (for example, operating profit ratios for retail companies often exclude depreciation and rent). At other times, it's because the analyst is attempting to make the numbers more comparable across companies or over time. *Financial ratios don't always provide the answers, but they can help you ask the right questions.* It's useful to know that a company's profitability or credit risk has improved (or declined), but it's even more important to know why the change occurred. Did consumer demand increase, or was the company stealing market share from competitors? Were operating costs reduced, and, if so, which ones? Use the financial ratios and the other tools in this chapter to guide your analysis. They can help you to ask the right questions and tell you where to look for answers. *Is it the economics of the business or is it the accounting?* Watch out for accounting distortions that can complicate your interpretation of financial ratios and other comparisons. Remember that the analyst's task is to "get behind the numbers"—that is, to develop a solid understanding of the company's economic activities and how industry fundamentals have shaped where the company is today and where it will be tomorrow.

From our analysis of Kroger and its financial statements, we can come to four conclusions:

Financial statements help the analyst gain a sharper understanding of the company's economic condition and its prospects for the future. Informed financial statement analysis begins with knowledge of the company and its industry. Cause-of-change analysis helps identify the various reasons a particular quantity, such as net income, changed from one period to another. Common-size and trend statements provide a convenient way to organize financial statement information so that major financial components and changes can be easily recognized.

Correcting for Distortions from Excess Cash and Investments

For some companies, common-size balance sheets can give the appearance that certain operating assets are growing or shrinking relative to the overall size of the business when in fact they are not. This happens because nonoperating investments, such as securities that are purchased in order to earn a return on excess cash prior to its being redeployed, contribute to total assets. If the level of investment is fluctuating, operating assets like equipment and inventory will fluctuate as a percentage of total assets, even if their levels are stable relative to just the assets used in the business's operations.

When operating profits and cash flows move in tandem, both versions of the ratio will yield similar results.

However, when the two measures diverge—for example, during a period in which the company experiences rapid growth—income may be a poor substitute for cash flow. In that case, the cash flow coverage ratio is preferable as a solvency measure. After all, cash (not operating profits) is what the company needs to make its required interest payments.

The payment of a cash dividend is viewed as an important signal by many financial analysts and investors.

Management presumably "signals" its expectations about the future through its dividend policy. A cash dividend increase is viewed as an indication that management expects future operating cash flows to be favorable—to the extent it can sustain the higher dividend. A reduction in cash dividends is interpreted as an indication that management expects future operating cash flows to decrease and remain at this decreased level. Research tends to corroborate dividend signaling. Increases and decreases in cash dividend payments are (on average) associated with subsequent earnings and operating cash flow changes in the same direction.

Financial Ratios and Profitability Analysis

Most evaluations of profit performance begin with the *return on assets (ROA) ratio* where EBI refers to the company's earnings before interest for a particular period (such as a year) and average assets represents the average book value of total assets over that same time period. EBI/Avg assets

*ROCE*

If you want to gauge a company's profit performance from its shareholders' viewpoint, use ROCE. *measures a company's performance in using capital provided by common shareholders to generate earnings* considers how the company finances its assets interest charged on loans, dividends declared on preferred stock, and net earnings attributable to noncontrolling interests are all subtracted to arrive at net income attributable to common shareholders Affected by 1. ROA and 2. the degree of financial leverage employed by the company For firms that do not employ much financial leverage, ROCE is not much more volatile than ROA

Cash Flow from Investing Activities

In the investing section of the cash flow statement, companies present cash flows related to expansion or contraction of fixed assets, as well as cash flows related to nonoperating investments. These cash flows include capital expenditures and asset sales, acquisitions and divestitures, and purchases and sales or maturities of securities classified as available for sale. changes in a company's capital expenditures or fixed asset sales over time must be analyzed carefully A sharp reduction in capital expenditures for an emerging growth company may indicate that the company is suffering from a temporary cash shortage. - Decreased capital expenditures may also signal a more fundamental change in management's expectations about the company's growth opportunities and its competitive environment. Similarly, an increase in fixed asset sales could mean that management needs to raise cash quickly or that it is eliminating excess production capacity. The analyst needs to evaluate each of these possibilities because they have very different implications for the company's future operating cash flows.

Financial leverage works two ways.

It makes good years better by increasing the shareholders' return, but it also makes bad years worse by decreasing the shareholders' return. Whether a year is "good" or "bad" in this context depends on whether the company earns more on each borrowed dollar than it pays out in interest, net of taxes.

long-term debt to assets

Long-Term Liabilities/Total Assets

*Accounts receivable turnover*

Net Sales / Average Accounts Receivable

*Cause-of-Change Analysis*

One way to quantify the components of change The idea is to show the effects of individual changes on the change in some performance metric of interest With each change, we observe the effect on the performance metric until we have changed every component of the model. A negative effective tax rate indicates there is something unusual going on in that year affecting income taxes, and suggests that modeling income tax expense as a simple percentage of pre-tax income is not sufficient.

Until recently, GAAP required only finance leases (then called "capital leases") to be reported in the balance sheet.

Operating leases were "off-balance-sheet" items—meaning they were not included in the reported asset and liability numbers but were instead disclosed in notes that accompany the financial statements. So, U.S. GAAP required that capital leases "pass through the filter" to the balance sheet, but it filtered out operating leases, sending them to the notes. Analysts could—and did—use these notes to recast the balance sheet so that all leases were treated the same way, and the GAAP filter was overcome.

RETURN ON COMMON EQUITY AND FINANCIAL LEVERAGE

ROCE

Rates of return that are higher than the industry floor stimulate more competition as existing companies innovate and expand their market reach or as new companies enter the industry.

These developments lead to an eventual erosion of profitability and advantage.

Debt ratios vary by industry.

Retailers use short-term debt and trade credit to finance inventory purchases. Electric utilities, on the other hand, rely on long-term debt to support their sizable investments in power-generating facilities and transmission lines. Electric utilities also have relatively predictable operating cash flows because energy demand is reasonably stable and competition is limited by regulators. Companies whose sales fluctuate widely due to changing economic conditions generally employ less debt because the fixed interest charges can be difficult to meet during bad times. - These cyclical companies tend to have smaller debt-to-asset ratios.

Examining Kroger's Financial Statements

Sales increased from $108.5 billion in fiscal 2014 to $122.7 billion in fiscal 2017, a compound annual growth rate of 4.2%. Net earnings including noncontrolling interests also grew over this period, from $1,747 million to $1,889 million, although it actually fell the last two years, having peaked at $2,049 million in 2015. There are many reasons why Kroger's net earnings including noncontrolling interests grew modestly from fiscal 2014 to fiscal 2017. - sales were up over the period - despite the sales growth, Kroger's operating margin declined, resulting in lower operating profit - And Kroger's effective income tax provision was actually negative in 2017, indicating it recorded a tax benefit despite having almost $1.5 billion of net earnings before income tax (benefit) expense.

Short-Term Liquidity

Short-term liquidity problems can arise when operating cash inflows don't match outflows. Liquidity problems can arise when cash inflows from customers lag behind the cash outflows to employees, suppliers, and others because the company does not have sufficient funds to make the payments on a timely basis. The operating cycle must not only generate sufficient cash to supply working capital needs, but also provide cash to service debt as payments become due. Companies that are not liquid—and are therefore not able to pay obligations as they come due—may be forced into bankruptcy.

Long-Term Solvency

Solvency refers to a company's ability to generate a stream of cash inflows sufficient to maintain its productive capacity and still meet the interest and principal payments on its long-term debt. A company that cannot make timely debt service payments becomes insolvent and may be compelled to reorganize or liquidate.

We often estimate the average of a balance sheet amount for a period by taking the beginning and ending balances in that account.

That methodology assumes the change happened evenly through the year or, alternatively, happened in the middle of the year. When there is a large change due to a particular event, such as in this case, it is not clear the two-point average is a reliable estimate of the actual average during year. Even if we had a more precise measure of the average by incorporating in the computation the exact date and amount of the change in receivables due to the transaction with TD Bank, the statistic for that year would be meaningless.

Common-Size and Trend Analysis Balance Sheets

The common-size balance sheets and trend analyses illustrate the stability of a company's asset mix and financial structure

Common-Size and Trend Analysis Cash Flow Statements

The common-size statements are constructed by dividing each cash flow item by sales for the year

*Debt ratios provide information about the amount of long-term debt in a company's financial structure*

The more a company relies on long-term borrowing to finance its business activities, the higher is its debt ratio and the greater is the long-term solvency risk. There are several variations in debt ratios. Two commonly used ratios are long-term debt to assets and long-term debt to tangible assets:

Cash Flow from Financing Activities

The most significant source of external financing for most companies is debt. Determining this optimal debt level involves a trade-off between two competing economic forces—taxes and costs of financial distress. Highly levered firms have a greater risk of financial distress and perhaps even bankruptcy - This risk is costly, not just because investors could lose their investments, but because distressed firms' operations suffer. For example, customers may be reluctant to do business with a firm that may not survive, and suppliers may not offer trade credit, making it more difficult to operate. The precise point at which these two forces counterbalance one another varies from company to company and over time.

Financial statements do not always provide a complete and faithful picture of a company's activities and condition

The raw data needed for a complete and faithful picture do not always reach the financial reports because the information is filtered by generally accepted accounting principles (GAAP) and by management's accounting discretion. - Both factors can distort the reported information and the analyst's view of the company.

A CASE IN POINT: GETTING BEHIND THE NUMBERS AT KROGER

Today, retail grocery chains act as intermediaries, bringing producers and consumers together. They buy products from many suppliers and transport those products to retail stores where customers can choose among them. The grocery industry is one of the most fragmented U.S. retail sectors. In 2017, about 82% of U.S. supermarkets belonged to a chain, defined as 11 or more stores under common ownership. Those stores accounted for almost 95% of all supermarket sales and had average annual revenues of about $20.4 million. Independent supermarkets (10 or fewer stores under common ownership) accounted for the other 18% of stores and 5% of supermarket sales, with average sales per store of $5.3 million. The industry is undergoing change, with many stores adding online ordering and delivery, among other features, in order to attract more tech-savvy customers and those whose time is at a premium.

U.S. GAAP requires each lease into which a lessee enters to be classified as either

a finance lease or an operating lease.

More timely payment of accounts payable would lead to

a lower average payable balance, a higher turnover ratio, and fewer days outstanding.

Founded in 1883, Kroger is second in size only to Walmart

almost double the size of the average supermarket in the country (33,000 square feet) About 80% of Kroger's supermarkets include a pharmacy, and just over half have fuel centers. More than 1,000 Kroger stores now offer online ordering, and that number is growing. Kroger also operates (as of February 2, 2018) 782 convenience stores, 274 jewelry stores, and an online retailer. There were also 66 franchised convenience stores.

When computing interest coverage, many analysts use

an adjusted operating income figure that removes nonrecurring items and corrects for accounting quality distortions.

The company's restricted cash is excluded from the current and quick ratio computations

because these dollars cannot be used to pay short-term creditors.

*Long-term asset turnover*

captures information about property, plant, and equipment utilization. Sales/Long term assets

Inventory turnover ratio

cost of goods sold/average inventory

Current ratio

current assets/current liabilities include cash and noncash assets expected to be converted into cash within one year (or the operating cycle, if longer). These noncash assets can be thought of as "near cash" items. By including receivables and inventory in current assets, the current ratio reflects existing cash as well as amounts to be converted to cash in the normal operating cycle.

*Management discretion* can cloud financial analysis in several ways.

ex. managers who understand GAAP can structure transactions to achieve particular financial reporting results Management discretion can also complicate an analyst's task in areas where GAAP allows managers to choose freely from among alternative reporting methods. ex. FIFO, LIFO - These alternative methods can produce very different balance sheet and income statement figures and, as a result, numerous financial ratios and comparisons can be affected Management also has discretion over accounting estimates. - ex. Consider estimated bad debts, management's forecast of the amount of current credit sales that will never be collected from customers. - the timing of business transactions such as discretionary expenditures for advertising, research and development (R&D), or information technology

Cross-sectional analysis

helps identify similarities and differences across companies or business units at a single point in time The analyst might compare the profitability of one company in an industry to a competitor's profitability in the same year.

Time-series analysis

helps identify trends for a single company or business unit

*Current asset turnover*

helps the analyst spot efficiency gains from improved accounts receivable and inventory management Sales/Average current assets

Of course, these graphs show the relationships between default risk and a single variable at a time. If a firm whose ROA suggested a 5% default risk was in the 80th percentile for interest coverage, that statistic would suggest the default risk was below 2%.

high Z-scores are good and low Z-scores are bad The research evidence led Altman to conclude that firms having a Z-score higher than 2.99 (think Z2) clearly fell into the "prompt payer" category—our label, not his—and were predicted to remain solvent. Firms having a Z-score of less than 1.81 (think Z1) clearly fell into the deadbeat category and were predicted to go bankrupt. Firms with Z-scores that fell between these two cutoff points landed in a gray area, where classification mistakes can be large (because the two distributions overlap) and costly.

ROA and Competitive Advantage

identifying the company's existing or potential competitive advantage—that is, the ways in which it is or could be superior to its competitors—and determining whether that competitive advantage is sustainable Several factors can explain why companies operating in the same industry—and therefore confronting similar economic conditions—can earn markedly different rates of return on their assets. Some companies gain a competitive advantage over rivals by developing unique products or services. Others do so by providing consistent quality or exceptional customer service and convenience. Still others excel because of innovative production technologies, distribution channels, or sales and marketing efforts.

Credit analysis

intended to help lenders assess a borrower's default risk, or the likelihood of loan default. Companies assigned the top rating (AAA) are very unlikely to default, even over long periods of time, and default rates over any time horizon are clearly increasing with lower ratings.

long-term debt to tangible assets

long-term debt / total tangible assets

benchmark comparison

measures a company's performance or condition against some predetermined standard

*Conflicts of interest*

pose another potential threat to the quality of financial reports arise when what is good for one party (for example, management) isn't necessarily good for another party (say, lenders or outside investors) Companies have an obligation to disclose business transactions that involve potential conflicts of interest.

*Common-size income statements*

recast each statement item as a percentage of sales Common-size income statements show how much of each sales dollar the company spent on operating expenses and other business costs and how much of each sales dollar was profit

*Liquidity*

refers to the company's short-term ability to generate cash for working capital needs and immediate debt repayment needs

*Financial leverage*

refers to the degree to which the firm finances its operations with debt rather than equity. For example, a firm with no debt is considered unlevered. A firm with relatively large amounts of debt is highly levered. Leverage is often measured with a debt-to-capital ratio (debt divided by the sum of debt and equity) or a debt-to-equity ratio (debt divided by equity)

*Solvency*

refers to the long-term ability to generate cash internally or from external sources to satisfy plant capacity needs, fuel growth, and repay debt when due

*Credit risk*

refers to the risk of nonpayment by the borrower A borrower's ability to pay its debts affects the likelihood the lender (typically a bank or insurance company) will receive the promised principal and interest payments when due

Analysts devote considerable attention to refining both the numerator and the denominator of debt ratios.

some analysts include in the numerator "hybrid" securities, or obligations that have the cash flow characteristics of balance sheet debt although they may not be classified as such on the balance sheet. Prior to the effective date of ASU 2016-02, operating leases were routinely added as debt "equivalents" in the numerator. The exclusion of intangible assets from the solvency ratio denominator is also common. This adjustment is intended to remove "soft" assets—those difficult to value reliably—from the analysis.

When there is such a severe change in an operating statistic, it is unlikely that the company just became better at managing some aspect of its business.

suggests that the company changed its strategy in some way

*Activity ratios*

tell us how efficiently the company uses its assets. can highlight efficiencies in asset management—accounts receivable collections, inventory levels, and vendor payment—and help the company spot areas needing improvement They can also highlight causes for operating cash flow mismatches. ex. accounts receivable turnover

U.S. firms' adoption of SFAS 123R

the pre-Codification standard requiring the recognition of compensation expense by firms that grant employee stock compensation, provides another example of how standards changes can make most reporting firms' earnings less comparable to their own prior history

Competition in an industry continually works to drive down the rate of return on assets toward the competitive floor

the rate of return that would be earned in the economist's "perfectly competitive" industry Companies that consistently earn rates of return above the floor are said to have a *competitive advantage.*

For firms with more financial leverage,

the ups and downs in ROA are exaggerated in the ROCE metric. when ROA is low at a highly levered firm, ROCE will be very low, perhaps even negative

Tangible net worth

usually defined as total tangible assets minus total liabilities tangible assets exclude intangibles such as goodwill, patents, and trademarks.

When ROA is high at a highly levered firm, ROCE will be

very high.

*PROFITABILITY, COMPETITION, AND BUSINESS STRATEGY*

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