Copyright ©2003 South-Western/Thomson Learning

Chapter 3Evaluation of Financial

Performance

Introduction

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

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

Ratio Classifications

• Liquidity

• Asset management

• Financial leverage management

• Profitability

• Market-based

• Dividend policy

Major 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

Liquidity Ratios

• Current ratio =

• Quick ratio =

Current assetsCurrent liabilities

Current assets – InventoriesCurrent liabilities

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

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

+ Before tax sinking fund

Profitability Ratios

• Gross profit margin =

• Net profit margin =

• ROI =

• ROE =

Sales – Cost of salesSales

EATSales

EAT Total assets

EAT Stockholders’ equity

Market-Based Ratios

• P/E ratio =

• Market to book ratio =

Marketing price per shareCurrent earnings per share

Market price per shareBook value per share

Dividend Policy Ratios

• Payout ratio =

• Dividend yield =

Dividends per shareEPS

Expected dividends per shareStock price

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

Relationships Among Ratios

• ROI =

• ROE =

• ROE =

EATSales

SalesTotal assets

EATTotal assets

=

EATSales

SalesTotal assets

Total assetsEquity

Net profitmargin

Total assetsturnover

Equitymultiplier

Dupont Analysis

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

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.onlinewbc.org/docs/finance/index.html

• http://www.dnbcorp.com/

• http://www.rmahq.org/

• http://www.sec.gov/

• http://www.moodys.com/

• http://www.hoovers.com/

• http://www.bloomberg.com/

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

Balance Sheet Quality Issues

• Charging off assets

• Hidden liabilities

• Hidden assets

• Off balance sheet financing

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

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

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

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.

Complex International Aspects of Financial Statement Analysis

• Influenced by fluctuating exchange rates

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

Accuracy of Financial Statements

• External auditor

• Generally accepted accounting principles

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