Evaluation of Financial Performance
This chapter deals with the evaluation of financial performance using financial statement
analysis. It is useful in assessing firm performance and in identifying the major strengths and
weaknesses of the business.
I. Financial ratios are used in many ways by different people.
A. Ratios are used internally by management for planning and for evaluating
B. Ratios are used by credit managers to estimate the riskiness of potential
C. Ratios are used by investors to evaluate the stocks and bonds of various
D. Ratios are used by managers to identify and assess potential merger candidates.
II. A financial ratio is a relationship that indicates something about a firm's activities, such
as the ratio between the firm's current assets and current liabilities or between its accounts
receivable and annual sales. Financial ratios are frequently grouped into four types of
A. Liquidity ratios indicate the ability of the firm to meet short-term financial
B. Asset management ratios indicate how efficiently the firm is utilizing its
C. Financial leverage management ratios indicate the firm's capacity to meet its debt
obligations, both short-term and long-term.
D. Profitability ratios measure the total effectiveness of management in generating
Evaluation of Financial Performance 21
profits on sales, assets, and owners' investment.
E. Dividend policy ratios indicate the dividend practices of the firm.
F. In addition to these four types of ratios, there are market-based ratios which
measure the financial market's assessment of a company's performance.
G. The firm's major financial statements are published quarterly and annually.
1. The Balance Sheet contains information on a firm's assets, liabilities, and
stockholders' equity at the end of each period.
2. The Income Statement presents the firm's net sales, cost of sales, other
operating expenses, interest expenses, taxes, and net income for the
3. The Statement of Cash Flows lists how a firm generated cash flows from
its operations, how it used cash in investing activities, and how it obtained
cash from financing activities.
H. Common-size statements are also helpful in financial analysis.
1. A common-size balance sheet shows the firm's assets and liabilities as a
percentage of total assets (rather than as dollar amounts).
2. A common-size income statement shows the firm's income and expense
items as a percentage of net sales (rather than as dollar amounts).
III. The data for constructing ratios generally comes from a firm's balance sheet, income
statement, and statement of cash flows.
A. Liquidity ratios:
Current ratio =
Current assets - Inventories
Quick (Acid test) ratio =
The quick ratio can also be adjusted downward by removing accounts receivable
over 90 days old from the numerator of the quick ratio.
An aging schedule shows the liquidity of accounts receivable. The aging
schedule, for example, might show the amount and percentage of total accounts
receivable in several age categories, such as less than 30 days old, 30 to 60 days
22 Chapter 3
old, 60 to 90 days old, and over 90 days old.
B. Asset Management Ratios:
Average collection period =
Annual credit sales / 365
Cost of sales
Inventory turnover =
Fixed - asset turnover =
Net fixed assets
Total asset turnover =
C. Financial Leverage Management Ratios:
Debt ratio =
Debt - to - equity ratio =
Earnings before interest and taxes (EBIT)
Times interest earned =
Fixed charge coverage =
EBIT + Lease payments
Preferred dividends Before tax
Interest + Lease payments + +
before tax sinking fund
D. Profitability Ratios:
Evaluation of Financial Performance 23
Sales - Cost of sales
Gross profit margin =
Earnings after taxes (EAT)
Net profit margin =
Earnings after taxes (EAT)
Return on investment (ROI) =
Earnings after taxes (EAT)
Return on stockholders equity =
E. Market-Based Ratios
Market price per share
Market to book Ratio = P / B =
Book value per share
Market price per share
Price to earnings ratio = P / E =
Current earnings per share
F. Dividend Policy Ratios:
Dividends per share
Payout ratio =
Earnings per share
Expected dividend per share
Dividend yield =
IV. The effective use of financial ratio analysis requires some experience and effort. There
are some basic approaches to financial ratio analysis, some basic interrelationships among
ratios, and sources of information which can enhance the analyst's effectiveness.
A. Two common types of ratio analysis are time-series and cross-sectional analysis.
1. Trend or time-series analysis--This requires the analyst to examine the
ratios of a firm for several periods. This shows whether the firm's
financial condition is improving or deteriorating over time.
2. Cross-sectional analysis--The analyst compares the ratios of the firm to
the industry norms or other individual firms in the industry.
24 Chapter 3
3. Frequently, time-series and cross-sectional analyses are pooled and
B. There are simple logical relationships among many of the ratios.
1. Return on Investment=Net profit Margin x Total Asset Turnover.
EAT Sales EAT
ROI = =
Sales Total assets Total assets
2. Return on Stockholders' Equity = Return on Investment x Equity
Multiplier. (The equity multiplier is the ratio of assets to equity).
EAT Total assets
Total assets Stockholders
Net profit Total asset Equity
margin turnover multiplier
3. Dupont analysis--A Dupont Chart, such as the one in the textbook,
presents some of the major ratios in a logical, organized fashion. This
Dupont Chart provides a good starting point for analyzing the firm. For
example, suppose a firm's return on stockholders' equity is considered low.
Refer to the chart; is this because of a low ROI or a low equity multiplier
(or both)? If the ROI is too low, is this due to a low net profit margin or
low total asset turnover (or both)? If the net profit margin is low, which
expenses are out of line?
C. Sources of information on industries--The most popular sources of information
about ratios for different businesses and industries are
Industry Norms and Key Business Ratios published by Dun and
Statement Studies from Robert Morris Associates
Reports of the Federal Trade Commission (FTC) and the Securities
and Exchange Commission (SEC)
Prentice-Hall's Almanac of Business and Industrial Financial
Financial Studies of Small Business from Financial Research
Evaluation of Financial Performance 25
Moody's or Standard and Poor's Industrial, Financial,
Transportation, and Over-the-Counter manuals
Annual reports and 10K's from corporations
Trade associations and trade journals
publications of some commercial banks.
D. There are several computerized data bases which can be used to assist in financial
analysis. Standard and Poors provides the Compustat data base, which contains
balance sheet, income statement, stock price and dividend information. The Value
Line data base is available in both hard copy and microcomputer format (called
Value Screen). The Disclosure data base is available on microcomputers. Many
of these and other databases of interest are available through on-line services such
as Compuserve and America On-Line. Many databases may also be accessed via
V. Although ratios can provide valuable information, they can be misleading for a
number of reasons.
A. Ratios are only as reliable as the accounting data on which they are based.
B. Industry “average” ratios may not be very meaningful if there is significant
dispersion in the ratio for the industry.
C. Industry classifications may be defined too broadly to make reliable comparative
analysis between a firm and a particular industry average.
D. Financial ratios provide a historical assessment of performance which may or may
not be a useful basis for making future projections.
E. Comparing a firm’s ratios with industry norms provides a relative measure of
performance, not an absolute measure. For example, a firm’s profitability ratios
may be relatively better than its industry average, but on an absolute basis it may
be poor compared to the universe of firms.
VI. The final assessment of the firm’s financial condition depends on its quality of earnings
and quality of the balance sheet.
A. 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. Poor quality of earnings is signaled by the following:
1. Large non-cash component in the earnings.
2. Significant non-recurring transactions in the income figure.
26 Chapter 3
B. The "quality" of a firm's balance sheet is positively related to the ratio of the
market value of the firm's assets to the book value of assets and inversely related
to the amount of its hidden liabilities. Poor balance sheet quality is indicated by
1. Presence of hidden liabilities.
2. Presence of obsolete inventory.
3. Assets have market values significantly below book values.
VII. Traditional financial analysis focuses on a set of financial ratios, primarily derived from
accounting information. There are important new measures based on the market value of
A. Market Value Added (MVA) is defined as the market value of debt, preferred
equity, and common equity capitalization less capital. Capital is a measure of the
cash raised from investors or retained from earnings to fund new investments in
the business since the company's inception.
MVA is the capital market's assessment of the accumulated Net Present Value
(NPV) of all of the firm's past and projected investment projects.
MVA = Market value - Capital
B. Economic Value Added (EVA) is a measure of operating performance that
indicates how successful the firm has been at increasing its MVA in a given year.
EVA is defined as:
Return on Cost of
EVA = - Capital = [r - k] Capital
total capital capital
r = net operating profits after tax divided by beginning-of-year capital,
k = weighted after-tax cost of capital.
C. EVA can be thought of as the incremental contribution of a firm's operations to
the creation of MVA. Managers find the MVA and EVA concepts to be a useful
complement to traditional financial analysis.
VIII. Inflation can make it difficult to assess performance over time or across firms.
A. During inflation, the last-in, first-out (LIFO) inventory valuation method results in
lower reported profits and lower taxes than the first-in, first-out (FIFO) method.
B. If inflation causes a rise in interest rates, the value of long-term debt will decline.
Evaluation of Financial Performance 27
C. Inflation can have an impact on a firm's reported earnings. For example,
inventory valuation methods or cost accounting systems will influence earnings.
IX. Many key performance measures rely on accounting income measures. Financially,
accounting income is not the relevant source of value for a firm -- cash flow is.
A. A firm's after-tax cash flow (ATCF) is its net income (EAT) plus noncash
The depreciation expense recorded for a particular year is an allocation of an
asset's original cost and does not represent a current cash outlay. Deferred taxes
occur when the tax amount reported to stockholders exceeds the cash actually
paid. This arises oftentimes because firms use accelerated depreciation for tax
purposes and straight-line depreciation for financial reporting purposes. A firm's
reported taxes include a current portion (which is paid in cash) and a deferred
portion (which is a future liability of the firm). Since depreciation and deferred
taxes are not cash outflows, they are added back to the firm's net income to get
ATCF = EAT + Noncash charges
ATCF = EAT + Depreciation + Deferred taxes
B. The Statement of Cash Flows is a major portion of the firm's financial statements,
along with the balance sheet and income statement.
1. The Statement of Cash Flows shows the effects of the firm's operating,
investing, and financing activities on its cash balance:
increase (decrease)= Net cash provided (used) by operating activities
+ Net cash provided (used) by investing activities
+ Net cash provided (used) by financing activities
2. There are two ways that the Statement of Cash Flows may be prepared, the
direct method and the indirect method.
a. In the direct method, all actual cash flows are grouped into the
three categories above in order to present the net cash provided by
operating, investing, or financing.
b. In the indirect method, several adjustments are made to the firm's
income statement to create the Statement. The indirect method is
the one that virtually all companies use in their public financial
reports. While the details in the direct and indirect method will
differ, the final results will be identical.
28 Chapter 3
X. The dollar amount of foreign earnings will depend on the exchange rate for the countries
where foreign income is earned. In addition, exchange rate fluctuations will give rise to
accounts such as "cumulative foreign exchange translation adjustment" or "translation
adjustments" in the stockholders' equity portion of the balance sheet.
XI. Auditing firms as well as government agencies and financial statement users (such as
investors, lenders, or banks) want financial statements to present a complete, fair, and
accurate picture of the firm's financial position. An important ethical concern is the
possibility of manipulation or fraud in the presentation of a firm's financial position.