EVALUATION AND USE OF FINANCIAL RATIOS IN ASSESSING MANAGEMENT EXCELLENCE Beverly L. Little Department of Business Administration Northwestern Louisiana University Natchitoches, Louisiana Introduction In their 1982 best-seller, In Search of Excellence, Thomas J. Peters and Robert H. Waterman, Jr. identify a number of American companies which exemplify excellence in management. Their research was extensive, encom- passing months of personal interviews and on-sight exploration. From this research, eight attributes emerged as characterizing the most innovative, excellently-managed companies: a bias for action; closeness to the customer; autonomy and entrepreneurship; productivity through people; hands-on, value-driven philosophy (the now-famous Management by Wandering Around); sticking to the knitting; simple form, lean staff; and simultaneous loose-tight properties. Innovation is not an end itself, but a means to success. Therefore, in order to be included in the final list a company had to meet certain financial criteria. An excellent company had to have been in the top half of its industry in four of six standards: tnree measures of growth (compound asset growth, compound equity growth, and ratio of market price to book price) and three measures of return on capital (average return on capital, average return on equity, average return on sales) over the twenty-year period 1961-1980 (5). Purpose of the Study The value of analysis of accounting information in judging the perfor- mance of a company is generally accepted in the financial community. The purpose of this study was to examine the companies deemed as excellent in light of recent accounting data to determine if the claim of excellence was c,?nfirmed. The hypothesis was that the results of the analyses performed would support the contention of excellence, and thereby, substantiate the value of accounting analysis as a tool for the evaluation of the management of a business enterprise. 35 Methodology From Peters and Waterman's final list of fourteen, data was available though COMPUSTAT for thirteen: Boeing, Caterpillar, Dana, Delta Airlines, Digital, Emerson Electric, Fluor, Hewlett-Packard, IBM, Johnson and John- son, McDonald's, Proctor & Gamble, and 3M. (Bechtel was not available). Regular financial statements, common-size financial statements, and finan- cial ratios for these thirteen firms and their corresponding industries were generated by COMPUSTAT for the five most recent years available, 1978- 1982. The companies themselves were excluded from the industry composit- e; in cases when more than one of the firms were in the same industry (Hewlett-Packard, IBM, and Digital; and Johnson and Johnson, and 3M) each was compared to a composite from which all were excluded. A list of the companies used in compiling the industry composite figures is provided in Appendix A. The measures selected for analysis in this study were five of the most widely-reported and standard ratios: acid-test ratio, debt to asset ratio, inventory turnover, accounts receivable turnover, and return on invest- ment. These represent the basic areas of liquidity, leverage, activity, and profitability. Each of the ratios will be treated separately. The focus of this analysis was to assess the performance of each company over the five-year period and to compare each company with composite ratios for its industry. Analysis of Ratios Acid-Test Ratio The acid-test ratio is a measure of a firm's liquidity based on those assets most quickly convertible into cash. It shows the relationship of a firm's cash, cash equivalents, and accounts receivable to its current liabilities. It is a sterner test of liquidity than is the current ratio (current assets/current liabilities) because it does not include inventory. The exclusion of inventory relieves the ratio of any distortion due to variations in inventory accounting methods but also discounts the liquidity of fast-turning inventory (I, p. 72). As can be seen from Table I, no distinct pattern emerges that allows the analyst to conclude excellence on the basis of liquidity. The only similarity is the presence of wider swings in the company's ratio than in that of its industry. Boeing Company and Caterpillar maintained higher average acid- test ratios than did their industries, but experienced wider swings. McDon- aId's and Johnson and Johnson experienced wider swings than did the industry, but maintained ~ower averages. Proctor and Gamble, Dana, Fluor, Delta and 3M maintained lower acid-test ratios than did their industries. IBM, Hewlett-Packard, Digital, and Emerson, maintained higher acid-test ratios than did their industries. 36 Table 1 Acid-Test Ratio 1978-1982 High Low Average IBM 1.41 .93 1.15 H-P 1.69 1.23 1.38 Digital 2.95 2.25 2.49 Industry .91 .82 .86 Dana .95 .80 .87 Industry 1.11 .89 1.04 Delta .82 .53 .63 Industry .97 .59 .75 Emerson 1.10 1.00 1.04 Industry .91 .82 .86 Fluor 1.03 .65 .87 Industry 1.31 1.12 1.19 J&J 1.86 1.25 1.43 3M 1.46 1.03 1.20 Industry 1.83 1.40 1.51 McDonald's .82 .33 .55 Industry .77 .70 .74 Boeing 1.23 .24 .73 Industry .67 .51 .58 Caterpillar 1.15 .45 .72 Industry .79 .50 .67 P&G 1.14 .75 .89 Industry 1.35 1.14 1.24 Debt to Assset Ratio The ratio of total debt to total assets is a measure of the percentage of total funds provided by creditors (financial leverage). This ratio is of interest to owners, who may wish to limit their investment by augmenting it with debt, 37 but who do not want their control of the company to be overly diluted. Potential creditors are concerned with, the level of owner investment and a firm's ability to meet its liabilities. Incurring debt requires a fixed payment of interest charges. Accompanying sales growth in excess of that required to meet such fixed charges can magnify earnings. Therefore, the debt/asset ratio should be evaluated in conjunction with a profitability measure (6, p. 140). Table 2 Total Debtlrotal Assets 1978-1982 High Low Average IBM .12 .03 .09 H-P .09 .06 .07 Digital .03 .19 .13 Industry .27 .22 .24 Dana .26 .19 .23 Industry .24 .21 .22 Delta .24 .10 .13 Industry .53 .41 .46 Emerson .15 .08 .11 Industry .13 .11 .12 Fluor .26 .18 .13 Industry .36 .26 .31 J&J .08 .04 .07 3M .12 .09 .11 Industry .22 .19 .21 McDonald's .44 .35 .40 Industry .34 .30 .32 Boeing .06 .02 .04 Industry .13 .06 .10 Caterpillar .36 .23 .27 Industry .26 .20 .22 P&G .17 .14 .15 Industry .27 .17 .23 38 As can be seen in Table 2, ten of the companies, IBM, Hewlett-Packard, Digital, Delta, Emerson, Fluor, Johnson and Johnson, 3M, Boeing, and Proctor and Gamble maintained debt/asset ratios lower in every case than those of their respective industries. Dana experienced wider swings then did their industry, and averaged about the same. Caterpillar and McDon- aid's maintained debt/asset ratios higher in every case than those of their composite industries. While the average debt ratios ranged from .04 for Boeing to .40 for McDonald's, it can be seen that most of the excellent companies' use of debt is less than that of their competitors. Inventory Turnover Inventory turnover (cost of goods sold/average inventory) is a measure of the speed with which inventories move through the business. This ratio is of significance because inventory represents an investment for the purpose of making a profit. It would appear that the faster a business turns its inventory the better, but this is true only to a point. A high turnover should not be achieved at the expense of a low gross margin or an inventory level that is too low. On the other hand, while a firm must maintain inventory adequate to generate sales, excessive inventories require costs of storage and insurance and tie up funds that could be used otherwise (4, p. 52). Table 3 Inventory Turnover 1978-1982 High Low Average IBM 4.4 3.3 3.8 H-P 3.0 2.4 2.7 Digital 2.1 1.8 1.9 Industry 2.9 2.8 2.8 Dana 4.2 3.3 3.7 Industry 5.8 5.4 5.8 Delta 114.1 55.0 83.3 Industry 23.9 21.4 22.0 Emerson 2.8 2.5 2.7 Industry 5.7 4.9 5.4 Fluor 57.7 21.0 37.6 Industry 10.5 5.4 7.7 39 J&J 3.0 2.5 2.9 3M 2.3 2.8 2.3 Industry 4.9 4.5 4.7 McDonald's 78.1 71.1 73.9 Industry 28.3 18.3 24.2 Boeing 10.4 1.9 6.2 Industry 4.1 3.7 3.8 Caterpillar 3.9 2.8 3.5 Industry 3.0 2.8 2.9 P&G 5.5 5.2 5.3 Industry 4.6 3.8 4.3 As can be seen in Table 3, no definite pattern emerges as to the speed with which inventory is turned over. Eight of the companies (IBM, Hewlett- Packard, Delta, Fluor, McDonald's, Boeing, Caterpillar, and Proctor and Gamble) turned their inventory over more rapidly than did their respective industries. Boeing's average was almost double that of its industry; Delta's was four times their industry average. McDonald's low of 71.1 compares to 18.3 for the industry. Both Johnson and Johnson and 3M turned their inventory more slowly then did their industry; Digital, Emerson, and Dana also underperformed their industries in turnover of inventory. Accounts Receivable Turnover For any firm which sells largely on credit, accounts receivable are a significant source of working capital. Accounts receivable turnover is a measure of the speed with which accounts receivable are turned into cash. It is related directly to the firm's credit policies, which should be loose enough to encourage sales but tight enough to avoid losses through uncollectibles. Assuming an appropriate credit policy, the more times per year receivables are turned, the better the cash flow (1). Table 4 Accounts Receivable Turnover 1978-1982 IBM H-P Digital Industry High 6.7 5.8 5.0 4.8 40 Low 5.2 5.4 4.1 4.4 Average 5.8 5.6 4.4 4.6 Dana 9.4 6.6 7.7 Industry 7.6 7.0 7.5 Delta 12.6 10.6 11.7 Industry 9.7 8.5 8.8 Emerson 7.5 6.7 6.8 Industry 5.8 5.5 5.6 Fluor 10.1 8.4 9.2 Industry 7.2 4.7 5.8 J&J 8.2 7.9 8.0 3M 6.1 5.8 5.9 Industry 7.2 6.8 6.9 McDonald's 36.2 33.1 35.9 Industry 18.0 16.2 16.7 Boeing 18.9 13.6 16.8 Industry 8.9 8.2 8.6 Caterpillar 10.7 5.6 9.3 Industry 11.4 7.4 9.4 P&G 14.7 13.7 14.1 Industry 8.7 7.7 8.4 A definite pattern emerges from Table 4. Ten of the thirteen companies, (IBM, Hewlett-Packard, Dana, Delta, Emerson, Fluor, Johnson and John- son, Boeing, Proctor and Gamble, and McDonald's) exceeded their indus- tries' accounts receivable turnovers, and Caterpillar averaged only slightly below its industry. Only Digital and 3M were consistently below their industries. It could be said with some degree of certainty that excellently managed companies collect their accounts receivable more rapidly than do their industries. Return on Investment The measures of liquidity, leverage, and activity used above reveal speci- fic things about a firm, but measures of profitability show the end result of management's decisions. In a 1982 survey funded by Deloitte, Haskins and Sells, profitability ratios were rated as the most important by financial 41 executives (2). The measure of profitability examined herein was return on investment (net income/total assets). Table 5 Return on Investment 1978-1982 High Low Average IBM .15 .11 .13 H-P .12 .11 .11 Digital .11 .09 .10 Industry .06 .04 .05 Dana .10 .03 .07 Industry .07 .03 .05 Delta .08 .01 .05 Industry .05 -.02 .007 Emerson .13 .12 .13 Industry .08 .06 .07 Fluor .08 .03 .06 Industry .09 .07 .08 J&J .13 .12 .12 3M .14 .11 .13 Industry .09 .08 .08 McDonald's .09 .08 .08 Industry .06 .05 .06 Boeing .10 .04 .08 Industry .07 .03 .05 Caterpillar .08 -.03 .05 Industry .08 -.12 .02 P&G .10 .10 .10 Industry .08 .08 .08 As can be seen from Table 5, twelve of the companies' return on invest- ment exceeded that of its industry, with only Fluor underperforming its industry. Caterpillar's return on investment of -.03 in 1982 compares favorably to the - .12 composite figure for the industry. The largest margins 42 of outperformance were by IBM, Hewlett-Packard, Digital, and Emerson. The return on investment ratios for these excellently managed companies roughly parallel their industry, but are consistently above. Referring to Table 2, it is noteworthy that IBM, Digital, Hewlett-Packard, Delta, Emerson, Johnson and Johnson, 3M, Boeing, and Proctor and Gamble maintained higher returns on investment with lower levels of financial leverage than did their industries. Summary and Conclusions It appears from this study that the analysis of financial ratios generally backs up the contention of excellent management for the five companies examined. This is not to say that in every case the company outperformed its industry, but in terms of accounts receivable turnover, debt/asset ratios, and return on investment (and in general, inventory turnover) the comparisons were favorable. Ratio analysis is a useful tool of financial analysis, but the user should be aware of its limitations. A particular ratio should not be taken out of context, that is, viewed independently of its relation to other information about the company, the industry, or even the economy as a whole. But in such a comparison there arises another major weakness of ratios, the inconsistency of their computations (3, p. 78). One choosing to compare companies based on ratios should be sure those ratios were computed using similar bases. One means of countering this is to obtain all the ratios under consideration from one source. Despite these weaknesses, ratios are valuable. They provide an inexpen- sive, easily obtained means of analysis for the average investor or analyst. Studies such as Peters and Waterman's provide excellent in-depth informa- tion, but they are impractical or impossible for most people. When viewed from a cost/benefit perspective, financial ratios provide starting points from which more detailed study can be done. APPENDIX A COMPANIES INCLUDED IN INDUSTRY COMPOSITES IBM, et al. Burroughs Control Data NCR Pitney-Bowes Speed-O-Print Xerox Emerson Aeroflex Labs Conrac General Electric Dana Arrow Automotive Arvin Industries Borg-Warner Donaldson Dynalectron Echlin Fruehauf Facet Enterprises Hastings Mfg. Kysar Raymark 43 Delta AMR Corp-Del Alaska Airlines Aloha, Inc. Eastern Air Lines Frontier Holdings Hawaiian Airlines KLM Royal Muse Air Northwest Airlines Ozark Airlines PSA Litton N.A. Philips Tractor Westinghouse Caterpillar Allis-Chambers Am. Hoist and Derrick Bucyrus-Erie CMI Clark Equipment Pengo Prodor &t Gamble Clorox Colgate-Palmolive Economic Laboratory NCH Oaklite Stephan Chemical J at J, 3M Am. Controlled Ind. Bemis Co. Dennison IPea Papercraft Rexham Tambrands Technical Tape Tranzonic Standard Products Superior Products Transway Wynn's Boeing Bangor Punta Cessna Glatfelter General Dynamics Grumman McDonnel Douglas Fluor AMCA Int. Alpha Portland Banister Cont. Elgin Foster Wheeler Great Lakes Halliburton McDowell Ent. Morrison-Knudson L.E. Myers Group Perini REFERENCES Pan Am Piedmont Aviation Republic Airlines Texas Air Tiger TWA VAL USAIR Western Airlines World Airways McDonald's ARA Services Carrol's Devl. Church's Collins Denny's Frisch's Helm Resources Kapok Tree Inns Marriott Pizza Inn Ponderosa Restaurant Assoc. SAGA Corp. 1. Bernstein, Leopold A., The Analysis of Financial Statements Home- wood, Illinois: Dow Jones-Irwin, 1978. 2. Gibson, Charles H., "How Industry Perceives Financial Ratios," Man- agement Accounting, (April, 1982): 13. 3. Gibson, Charles H., "The Need for Disclosure of Uniform Financial Ratios," The Journal of Accountancy, (May, 1980): 78. 4. Helfert, Erich A., Techniques ofFinancial Analysis Homewood, Illinois: Dow Jones-Irwin, 1972. 5. Investors Management Sciences, Inc., Compustat Englewood, CO: McGraw-Hill Company. 6. Peters, Thomas J., and Robert H. Waterman, Jr. In Search of Excellence New York: Harper and Row, 1982. 7. Weston, J. Fred, and Eugene F. Brigham, Managerial Finance Hinsdale, Illinois: The Dryden Press, 1981. 44 Evaluation and Use of Financial Ratios in Assessing Management Excellence