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  1. 1. Chapter 3 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 performance. B. Ratios are used by credit managers to estimate the riskiness of potential borrowers. C. Ratios are used by investors to evaluate the stocks and bonds of various corporations. 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 ratios. A. Liquidity ratios indicate the ability of the firm to meet short-term financial obligations. B. Asset management ratios indicate how efficiently the firm is utilizing its resources. C. Financial leverage management ratios indicate the firm's capacity to meet its debt obligations, both short-term and long-term. 20 D. Profitability ratios measure the total effectiveness of management in generating
  2. 2. 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 period. 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 assets Current ratio = Current liabilities Current assets - Inventories Quick (Acid test) ratio = Current liabilities 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
  3. 3. 22 Chapter 3 old, 60 to 90 days old, and over 90 days old. B. Asset Management Ratios: Accounts receivable Average collection period = Annual credit sales / 365 Cost of sales Inventory turnover = Average inventory Sales Fixed - asset turnover = Net fixed assets Sales Total asset turnover = Total assets C. Financial Leverage Management Ratios: Total debt Debt ratio = Total assets Total debt Debt - to - equity ratio = Total equity Earnings before interest and taxes (EBIT) Times interest earned = Interest charges Fixed charge coverage = EBIT + Lease payments Preferred dividends Before tax Interest + Lease payments + + before tax sinking fund D. Profitability Ratios:
  4. 4. Evaluation of Financial Performance 23 Sales - Cost of sales Gross profit margin = Sales Earnings after taxes (EAT) Net profit margin = Sales Earnings after taxes (EAT) Return on investment (ROI) = Total assets Earnings after taxes (EAT) Return on stockholders equity = 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 = Stock price 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.
  5. 5. 24 Chapter 3 3. Frequently, time-series and cross-sectional analyses are pooled and performed simultaneously. 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). Return on EAT Total assets stockholders = Total assets Stockholders equity equity Return on Net profit Total asset Equity stockholders = margin turnover multiplier equity 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 Bradstreet (D&B) 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 Ratios Financial Studies of Small Business from Financial Research Associates
  6. 6. 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 the Internet. 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.
  7. 7. 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 the following: 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 the firm. 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 where 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.
  8. 8. 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 charges: 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. 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: Net cash 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.
  9. 9. 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.