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3
Evaluation of Financial Performance
©2006 Thomson/South-Western
2
Introduction
This chapter introduces financial statement analysis techniques that are used to accurately evaluate a company’s performance.
3
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
4
Ratio Classifications
Liquidity
Asset management
Financial leverage management
Profitability
Market-based
Dividend policy
5
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
8
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)
12
Profitability Ratios
Gross profit margin =
Net profit margin =
ROI =
ROE =
Sales – Cost of salesSales
EATSales
EAT Total assets
EAT Stockholders’ equity
13
Market-based Ratios
P/E ratio =
Market to book ratio =
Marketing price per shareCurrent earnings per share
Market price per shareBook value per share
14
Dividend Policy Ratios
Payout ratio =
Dividend yield =
Dividends per shareEPS
Expected dividends per shareStock price
15
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
17
Dupont Analysis
An excellent way to present ratio analysis for an assignment or for an on-the-job presentation
19
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
22
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
26
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
27
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
28
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
29
Complex international aspects of financial statement analysis Influenced by fluctuating exchange
rates
Statement of Accounting Standards No. 52 deals with foreign currency translation.
30
Accuracy of Financial Statements
External auditor
Generally accepted accounting principles
Corporations pose for a financial statement like people pose for a picture.