Professional Documents
Culture Documents
Evaluating a
Firm’s Financial
Performance
Principle 5:
Conflicts of interest cause agency problems
Principle 4:
Markets are generally right
Principle 3:
Risk requires a reward
Note:
Interest is not paid with income but with cash
Oftentimes, firms are required to repay part of
the principal annually
Thus, times interest earned is only a crude
measure of the firm’s capacity to service its
debt.
Times Interest 5X 7X
Earned
Davies Example
ROE = $42M / $203M
= .207 or 20.7%
Owners of Davies are receiving a higher return
(20.7%) compared to the peer group (18%).
One of the reasons for higher ROE for Davies is the
higher debt used by Davies. Higher debt translates to
higher ROE under favorable business conditions.
EVA = (r – k) A
where:
r = Operating return on assets
k = Total cost of capital
A = Amount of capital
(or Total Assets)