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Evaluation of Financial Performance

©2006 Thomson/South-Western

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Introduction

This chapter introduces financial statement analysis techniques that are used to accurately evaluate a company’s performance.

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Financial Ratios Are Used By

Management for planning and evaluating Credit managers to estimate the riskiness

of potential borrowers Investors to evaluate corporate securities Managers to identify and assess potential

merger candidates

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Ratio Classifications

Liquidity

Asset management

Financial leverage management

Profitability

Market-based

Dividend policy

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Financial Statements

Balance sheet Common-sized balance sheet shows assets,

liabilities, and equity as a percent of total assets.

Income statement Common-sized income statement shows

income and expense items as a percent of net sales.

Statement of cash flows

Common-Size Balance Sheet

Common-Size Income Statement

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Statement of Cash Flow

Presents the effects of operating, investing, and financing on the cash balance Direct method presents the effects to net cash

provided by operating, investing, and financing. Indirect method presents the adjustments to net

income showing the effects to net cash. Used for public financial reports

The final results for both are identical.

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Liquidity Ratios

Current ratio =

Quick ratio =

Current assetsCurrent liabilities

Current assets – InventoriesCurrent liabilities

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Asset Management Ratios

Avg. collection period =

Inventory turnover =

Fixed-asset turnover =

Total asset turnover =

Cost of sales Average inventory

Sales Net fixed assets

Sales Total assets

Accounts receivable Annual credit sales/365

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Financial Leverage Management Debt ratio =

Debt-to-equity ratio =

Times interest earned =

Fixed charge coverage =

Total debtTotal assets

Total debtTotal equity

EBIT Interest charges

EBIT + Lease pmts (Interest + Lease pmt+ P/S div before tax

+ pre-tax sinking fund)

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Profitability Ratios

Gross profit margin =

Net profit margin =

ROI =

ROE =

Sales – Cost of salesSales

EATSales

EAT Total assets

EAT Stockholders’ equity

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Market-based Ratios

P/E ratio =

Market to book ratio =

Marketing price per shareCurrent earnings per share

Market price per shareBook value per share

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Dividend Policy Ratios

Payout ratio =

Dividend yield =

Dividends per shareEPS

Expected dividends per shareStock price

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Financial Ratio Analysis

Trend analysis 20X0 X1 X2

XYZ current ratio 1.9 2.2 2.3

Cross-sectional analysis 20X2

XYZ current ratio 2.3

Industry norms 2.5

Both simultaneously 20X0 X1 X2

XYZ current ratio 1.9 2.2 2.3

Industry norms 2.5 2.4 2.5

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Relationships Among Ratios

ROI =

ROE =

ROE =

EATSales

SalesTotal assets

EATTotal assets

=

EATSales

SalesTotal assets

Total assetsEquity

Net profitmargin

Total assetsturnover

Equitymultiplier

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Dupont Analysis

An excellent way to present ratio analysis for an assignment or for an on-the-job presentation

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Sources of Information

Dun and Bradstreet Robert Morris

Associates Prentice-Hall’s

Almanac of Business and Industrial Ratios

Moody’s Standard and Poor’s

Annual reports 10Ks Trade associations Trade journals Commercial banks Financial Research

Associates Computerized

databases

Sources of Information on the Web http://finance.yahoo.com/ http://www.dnbcorp.com/ http://www.rmahq.org/ http://www.sec.gov/ http://www.moodys.com/ http://www.hoovers.com/ http://www.bloomberg.com/

A Word of Caution

Ratios are only as reliable as the accounting data on which they are based

Firms that compile industry norms often do not report information about the dispersion of the individual values around the mean ratio

Comparative analysis depends on availability of data

Financial ratios provide historic record

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Quality and Financial Analysis The quality of a firm’s earnings is positively

related to the proportion of cash earnings to total earnings and to the proportion of recurring income to total income.

The quality of a firm’s balance sheet is positively related to the ratio of the market value of the firm’s assets to book value of the assets and inversely related to the amount of its hidden liabilities.

Problems in Reporting

Time of revenue recognition

Establishment of reserves

Amortization of intangible assets

Including all losses and debt

“Pro forma” profitability measures

Sarbanes-Oxley

Transparency of information

Accountability in the reporting process

Integrity in financial reporting

Balance Sheet Quality Issues Charging off assets

Hidden liabilities

Hidden assets

Off balance sheet financing

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Analysis Based on the Market Value of the Firm Market value added

(MVA) = Market value – Capital The capital market’s assessment of the

accumulated NPV of all of the firm’s past and present projected investment projects

Economic value added (EVA) = (r – k) Capital The yearly contribution of a firm’s operations

to the creation of MVA

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Problems Caused by Inflation Inventory profit as a result of timing of

price increases Inventory valuation methods

(LIFO) (FIFO)

Rising interest rates causing a decline in the value of long-term debt

Differences in the reporting of earnings Recognition of sales

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The Cash Flow Concept

Accounting income vs. Cash flow

Cash flow is the relevant source of value

for the firm.

ATCF = EAT + Noncash charges Noncash charges = Depreciation + Deferred taxes

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Complex international aspects of financial statement analysis Influenced by fluctuating exchange

rates

Statement of Accounting Standards No. 52 deals with foreign currency translation.

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Accuracy of Financial Statements

External auditor

Generally accepted accounting principles

Corporations pose for a financial statement like people pose for a picture.