2. FinancialPerformanceMeasure
In this chapter we set a foundation of knowledge about how the finances
of a business function by introducing the concepts and practice of
financial analysis and the tools used to carry them out.
In order to evaluate two or more project alternatives, it is important to
know which alternative is a better fit from a strategic and financial
perspective.
Using different analysis tools, we can become familiar with how well a
company is operating.
This chapter emphasizes financial ratio analysis.
Financial ratio analysis begins with the calculation of financial ratio.
The ratios are often grouped according to the type of information that they
provide. In this chapter, we will use profitability, activity, and solvency as groupings
for the ratios.
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3. In addition to grouping financial ratios according to the type of information
given, there are three different ways of using financial ratio analysis:
1. Cross-company ratio analysis
2. Cross-industry ratio analysis
3. Cross-trend ratio analysis
1. Cross-companyratioanalysis
Cross-company analysis is where the financial analyst compares two like
businesses.
One of the purposes of cross-company analysis is to understand
competitor’s weaknesses or strengths.
An example would be comparing Coca-Cola to Pepsi.
2. Cross-industryratioanalysis
A cross-industry analysis entails comparing a company to industry
standards.
Returning to the example of Coca-Cola, you would compare the
company to others in the nonalcoholic.
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4. This type of analysis helps to understand how the company performs, relative to
the industry as a whole.
3. Cross-trendratioanalysis
Examines financial ratios of a company.
This can be done for the purpose of understanding how a company derives
value or how the company performs.
A. ProfitabilityRatio
Calculate how much money a business is earning.
Profitability ratio is used to evaluate the company's ability to generate
income as compared to its expenses and other cost associated with the
generation of income during a particular period.
The most common profitability ratios are listed below;
1. Returnon Equity(ROE) = NetIncome
AverageStockholder’sEquity
Return on equity indicates how much profit was generated by the equity invested in
the organization.
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5. Return on equity indicates the amount of income represented by
percentage of the owner’s investment in a year.
For example, a company that has a 20 percent ROE indicates that for every
$100 invested, the company made $20 ($100 *20% = $20).
Whenever we use the term ‘‘average’’ for a ratio, we mean that the formula
is using an average based on the beginning and the end-of-year figures.
ROE tells users whether or not investors are receiving a strong return on
their investment.
Though whether or not an ROE is high or low is best measured relative to
other companies in a given industry, there is a range that is commonly
considered good. This is anything between 15% to 20% percent.
ROE can be useful for estimating what a sustainable growth rate or
dividend rate would be for a company if the ratio is either about the same
as similar companies or a bit higher.
In order to calculate an estimate of a company’s growth rate, take the
company’s ROE and multiply this by the retention ratio for the company.
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6. A company’s retention ratio is the percentage of net profits that a
company retains instead of distributing as dividends.
ROE and a Sustainable Growth Rate
Suppose two companies have the same ROE and the same net income, but
they don’t have the same retention ratios.
Company 1 has a return on Equity of 20% and distributes 35% of its net
income to its stockholders as dividends. This means that Company 1
keeps 65% of the net income it has earned.
Company 2 has a return on Equity of 20% as well and distributes 15%
of its net income in dividends to its stockholders. The is means Company
2 has a retention ratio of 85%.
The growth rate is calculated by multiplying the ROE by the retention
ratio. So, the growth rate for Company 1 is 13% (20% * 65%).
Company 2 has a growth rate of 17% (20% * 85%).
The analysis used in the above examples is called the sustainable
growth rate model.
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7. EstimatingtheDividendGrowthRate
An estimate of the dividend growth rate can be computed by taking the
payout ratio and multiplying it by the ROE.
Company 1 has a dividend growth rate of 7%, which is the return on
Equity multiplied by the payout ratio or, in this case, 20% multiplied by
35%.
Company 2 has a dividend growth rate of 3%, computed by taking 20%
times 15%.
When looking at dividend growth rates, an investor should investigate any
company that is distributing dividends that are much higher or lower than
the sustainable growth rate.
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8. 2. Return on asset ratio
Return on assets (ROA) is a ratio that measures a company's profitability
relative to its total assets.
A rising ROA indicates improving efficiency, while an ROA that is falling
suggests a company might be spending too much on equipment and other assets
relative to the profits it is earning from those investments.
The basic formula for ROA is to divide a company's net income by its average
total assets, and then multiply the result by 100 to convert the final figure into a
percentage.
Note: When calculating average total assets, you can apply the formula: Average
total assets = (total assets for current year) + (total assets for previous year) / 2.
Example 1
Here is what the financial statements reported:
Net income: $150,000.00
Average total assets: $800,000.00
Simply divide the company's net income ($150,000) by its average total assets
($800,000). 150,000 / 800,000 = 0.1875. Then convert the resulting quotient to
represent the company's return on assets as a percentage (0.1875 x 100 =
18.75%). The company's return on assets is 18.75%.
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9. 3. Netprofitmargin(NPM) = NetIncome
Sales
Net profit margin measures how much net income is generated as a
percentage of revenues received.
Net profit margin helps investors assess if a company's management is
generating enough profit from its sales and whether operating costs and
overhead costs are being contained.
Net profit margin is one of the most important indicators of a company's
overall financial health.
For example, a company can have growing revenue, but if its operating
costs are increasing at a faster rate than revenue, its net profit margin will
shrink.
Example#1
Company XYZ and ABC both operate in the same industry. Which
company has a higher net profit margin?
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10. Company XYZ: Net Profit Margin = 30%
Company ABC: Net Profit Margin = 35.56%
Company ABC has a higher net profit margin.
Example#2
Company A and company B have net profit margins of 12% and 15%
respectively. Both companies earned $150 in revenue. How much net
profit did each company make?
Company A: Net Profit = Net Margin * Revenue = 12% * $150 = $18
Company B: Net Profit = Net Margin * Revenue = 15% * $150 = $22.50
Example#3
Company A and B earned $83.50 and $67.22 in net profit respectively.
Both companies have a net profit margin of 18.22%. How much revenue
did each company earn?
Company A: Revenue = $83.50/18.22% = $458.29
Company B: Revenue = $67.22/18.22% = $368.94
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11. 4. GrossProfitMargin(GPM) = GrossProfit
Sales
Gross profit margin (GPM) indicates the percentage of profit derived on
each dollar of sales after paying for the cost of the sale but before operating
expenses, interest expense, and income taxes.
Example#1
Shoe-maker might sell a pair of shoes for £50. They cost £15 to make,
yielding the retailer a gross profit of £35. This equates to a margin of 70%.
Example#2
Imagine the company is an accounting firm that audits other businesses. A
single audit sells for £500 and costs £100 to produce, yielding a gross profit
of £400. This is a margin of 80%.
It indicates how efficiently you are using your resources to produce your
goods or deliver your services.
A high gross profit margin generally indicates you’re making money on a
product, whereas a low margin means your sale price is not much higher
than the cost.
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12. B. ActivityRatio
The next financial ratios to be familiar with are the activity ratios, which
measure the amount of assets needed to support operations.
Activity ratios measure how well an organization uses its assets to generate
revenue.
The most common activity ratios are listed below;
1.TotalAssetTurnoverRatio(TATR) = Sales
AverageTotalAssets
The asset turnover ratio measures the efficiency of a company's assets in
generating revenue or sales.
A higher ratio implies that the company is efficient in generating sales or
revenues from its asset base. A lower ratio indicates that a company is not
using its assets efficiently and may have internal problems.
If your company has $1,000 of assets and sales of $2,000, you would say
that the TATR is 2. You have used that $1,000 of assets twice to create
$1,000 worth of sales.
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13. Example#1
Sally’s Tech Company is a tech start up company that manufactures a new
tablet computer. Sally is currently looking for new investors and has a
meeting with an angel investor. The investor wants to know how well
Sally uses her assets to produce sales, so he asks for her financial
statements.
Here is what the financial statements reported:
Beginning Assets: $50,000
Ending Assets: $100,000
Net Sales: $25,000
Sally’s ratio is only .33. This means that for every dollar in assets, Sally
only generates 33 cents. In other words, Sally’s start up in not very
efficient with its use of assets.
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14. 2. FixedAssetTurnoverRatio(FATR)= Sales
AverageFixedAssets
Indicates how efficient an organization is at generating sales given its level
of fixed assets.
Is particularly important in manufacturing, as it indicates how well the firm
is using assets to produce sales; the higher the ratio, the more efficient the
operation.
It assesses the ability of a company to efficiently generate net sales from its
machines and equipment.
When the business is underperforming in sales and has a relatively high
amount of investment in fixed assets, the FAT ratio may be low.
It indicates that there is greater efficiency in regards to managing fixed
assets; therefore, it gives higher returns on asset investments.
There is no exact ratio or range to determine whether or not a company is
efficient at generating revenue on such assets. This can only be discovered
if a comparison is made between a company’s most recent ratio and
previous periods or ratios of other similar businesses or industry standards.
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15. Example#1
Let us consider two independent companies X and Y, that manufactures
office furniture and distribute it to the sellers as well as customers in
various regions of the USA. The following information for both the
companies is available: Based on the information, calculate the fixed
assets turnover ratio for both the companies. Also, compare and determine
which company is more efficient in using its fixed assets?
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Particulars Company X Company Y
Net Sales During the Year $75,000 $90,000
Opening Net Fixed Assets $22,000 $26,000
Closing Net Fixed Assets $25,000 $28,000
16. Company Y generates a sales revenue of $3.34 for each dollar invested in
fixed assets as compared to company X, which generates a sales revenue of
$3.19 for each dollar invested in fixed assets. Based on the above
comparison, it can be said that Company Y is slightly more efficient in
utilizing its fixed assets.
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17. 3. currentratio
The current ratio is a liquidity and efficiency ratio that measures a firm’s
ability to pay off its short-term liabilities with its current assets.
The current ratio formula is: Current Ratio = Current Assets / Current
Liabilities.
The current ratio helps investors and creditors understand the liquidity of a
company and how easily that company will be able to pay off its current
liabilities.
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18. This ratio expresses a firm’s current debt in terms of current assets. So a
current ratio of 4 would mean that the company has 4 times more current
assets than current liabilities.
A higher current ratio is always more favorable than a lower current ratio
because it shows the company can more easily make current debt
payments.
Example#1
Charlie’s Skate Shop sells ice-skating equipment to local hockey teams.
Charlie is applying for loans to help fund his dream of building an indoor
skate rink. Charlie’s bank asks for his balance sheet so they can analysis his
current debt levels. According to Charlie’s balance sheet he reported
$100,000 of current liabilities and only $25,000 of current assets.
Charlie only has enough current assets to pay off 25 percent of his current
liabilities. This shows that Charlie is highly leveraged and highly risky.
Banks would prefer a current ratio of at least 1 or 2, so that all the current
liabilities would be covered by the current assets. Since Charlie’s ratio is so
low, it is unlikely that he will get approved for his loan.
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19. Example#2
On December 31, 2016, the balance sheet of Marshal company shows the
total current assets of $1,100,000 and the total current liabilities of
$400,000. Your are required to compute current ratio of the company.
The current ratio is 2.75 which means the company’s currents assets are
2.75 times more than its current liabilities.
Example#3
The following data has been extracted from the financial statements of two
companies – company A and company B.
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20. Both company A and company B have the same current ratio (2:1). Do both
the companies have equal ability to pay its short-term obligations? The
answer to this question is a “no” because company B is likely to have
difficulties in paying its short-term obligations. Most of its current assets
consist of inventory which might not be quickly convertible into cash. The
company A, on the other hand, is likely to pay its current obligations as and
when they become due because a large portion of its current assets consists
of cash and receivables. Accounts receivable are generally considered more
liquid assets in nature and thereby have a better chance to be quickly
converted into cash than inventories.
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21. 4. quickratio
The quick ratio or acid test ratio is a liquidity ratio that measures the
ability of a company to pay its current liabilities when they come due with
only quick assets. Quick assets are current assets that can be converted to
cash within 90 days or in the short-term. Cash, cash equivalents, short-
term investments or marketable securities, and current accounts receivable
are considered quick assets.
It shows how well a company can quickly convert its assets into cash in
order to pay off its current liabilities.
The quick ratio is calculated by adding cash, cash equivalents, short-term
investments, and current receivables together then dividing them by
current liabilities.
Higher quick ratios are more favorable for companies because it shows
there are more quick assets than current liabilities.
A company with a quick ratio of 1 indicates that quick assets equal current
assets. An acid ratio of 2 shows that the company has twice as many quick
assets than current liabilities.
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22. Example#1
Let’s assume Carole’s Clothing Store is applying for a loan to remodel the
storefront. The bank asks Carole for a detailed balance sheet, so it can
compute the quick ratio. Carole’s balance sheet included the following
accounts:
Cash: $10,000
Accounts Receivable: $5,000
Inventory: $5,000
Stock Investments: $1,000
Current Liabilities: $15,000
Carole’s quick ratio is 1.07. This means that Carole can pay off all of her
current liabilities with quick assets
A quick ratio that is equal to or greater than 1 means the company has
enough liquid assets to meet its short-term obligations.
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23. C. SolvencyRatios
A solvency ratio examines a firm's ability to meet its long-term debts and
obligations.
The main solvency ratios include the debt-to-assets ratio, the interest
coverage ratio, and the debt-to-equity ratio.
3.1 Debtto EquityRatio(D2E)= AverageTotalDebt
AverageStockholder’sEquity
The debt to equity ratio compares a company’s total debt to total equity.
The debt to equity ratio shows the percentage of company financing that
comes from creditors and investors.
A higher debt to equity ratio indicates that more creditor financing (bank
loans) is used than investor financing (shareholders).
A debt ratio of .5 means that there are half as many liabilities than there is
equity.
A lower debt to equity ratio usually implies a more financially stable
business. Companies with a higher debt to equity ratio are considered
more risky to creditors and investors than companies with a lower ratio.
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24. Example #1
Assume a company has $100,000 of bank lines of credit and a $500,000
mortgage on its property. The shareholders of the company have invested
$1.2 million. The debt to equity ratio is 0.5.
3.2 debt to asset ratio
The debt to asset ratio measures the amount of total assets that are financed
by creditors instead of investors.
In other words, it shows what percentage of assets is funded by borrowing
compared with the percentage of resources that are funded by the investors.
The debt to assets ratio formula is calculated by dividing total liabilities by
total assets.
It calculates total debt as a percentage of total assets.
If debt to assets equals 1, it means the company has the same amount of
liabilities as it has assets.
A company with a DTA of greater than 1 means the company has more
liabilities than assets. This company is extremely leveraged and highly
risky to invest in or lend.
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25. A company with a DTA of less than 1 shows that it has more assets than
liabilities and could pay off its obligations by selling its assets if it needed
to.
Example #1
Ted’s Body Shop is an automotive repair shop in the Atlanta area. He is
applying for a loan to build out a new facility that will accommodate more
lifts. Currently, Ted has $100,000 of assets and $50,000 of liabilities.
Ted’s DTA is .5 because he has twice as many assets as liabilities. Ted’s
bank would take this into consideration during his loan application
process.
For instance, if his industry had an average DTA of 1.25, you would think
Ted is doing a great job. The opposite is true if the industry standard was
10 percent. It’s always important to compare a calculation like this to other
companies in the industry.
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26. Illustration: Financialstatement analysis
The following financial statements of Walker Ltd were
prepared in accordance with New Zealand GAAPs. Walker Ltd
is a diversified enterprise with its main interests in the
manufacture and retail of plastic products.
The financial statements of Walker Ltd need to be analyzed.
An investor is considering purchasing shares in the company.
Relevant ratios need to be selected and calculated and a report
needs to be written for the investor. The report should evaluate
the company’s performance and position.
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27. 2005 2006
$000 $000 $000 $000
Current Assets
Bank 33.5 41.0
Accounts receivable 240.8 210.2
Inventory 300.0 370.8
574.3 622.0
Non-current assets
Fixtures & fittings (net) 64.6 63.2
Land & buildings (net) 381.2 376.2
445.8 439.4
Total assets 1,020.1 1,061.4
Current Liabilities
Accounts payable 261.6 288.8
Income tax 60.2 76.0
321.8 364.8
Non-current liabilities
Loan 200.0 60.0
Shareholders Funds
Paid-up ordinary capital 300.0 334.1
Retained profit 198.3 302.5
498.3 636.6
Total liabilities & equity 1,020.1 1,061.4
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Walker Ltd
Statement of Financial Position as at 31 March
28. 2005 2006
$000 $000 $000 $000
Sales 2,240.8 2,681.2
Less Cost of goods sold 1,745.4 2,072.0
Gross profit 495.4 609.2
Wages & salaries 185.8 275.6
Rates 12.2 12.4
Heat & light 8.4 13.6
Insurance 4.6 7.0
Interest expense 24.0 6.2
Postage & telephone 9.0 16.4
Depreciation -
Buildings 5.0 5.0
Fixtures & fittings 27.0 276.0 32.8 369.0
Net profit before tax 219.4 240.2
Less Income tax 60.2 76.0
Net profit after tax 159.2 164.2
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Walker Ltd
Statement of Financial Performance for year ended 31 March
29. Relevantratios
Important note: The calculations of the ratios in this illustration did not use “averages” for total assets, equity
and inventory. The 2005 and 2006 year end figures were used and this is a slight variation to the formulas
provided.
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Profitability
ratios:
Benchmarks 2005 2006
Gross Profit
Margin
Industry
25%
22% 22.7%
Net Profit
Margin
Industry
7%
7.1% 6.1%
Return on
Assets
12% 15.6% 15.5%
Return on
Equity
Industry
20%
32% 26%
32. Report
• For the investor considering the purchase of shares in the
company, the return they will earn is the key financial factor
but an overall evaluation of the company’s performance and
position is also important to get a better picture of how well
the company is actually doing.
• Company’s ROE at 26% is still better than the industry
average of 20%
• Riskiness of business is being reduced by the significant
repayment of loan in 2006.
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33. • Profitability
– The NP% and ROA ratios show a small
downward trend in % over the 2 year period.
ROE% ratio show a more significant decrease
but is still better than the industry average.
– Gross Profit Margin is slightly unfavorable at
about 2.3% below the industry benchmark of
25%.
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34. • Liquidity
– Current ratios of 1.78:1 (2005) and 1.70: 1 are at above acceptable
levels but below ideal level.
– Quick ratios appear more of a concern being below acceptable levels
in both years and even more so in 2006 (0.69:1).
• Financial Structure
– Although slightly higher than D/E industry benchmark (0.67:1),
business has become less risky due to the significant repayment of
loan in 2006.
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35. Recommendation
• The strong forecast for the industry (ie general prospects looking good
and world demand for plastic products remaining strong),
• The sales growth in this business, Acceptable ratios as they are quite close
to the industry averages.
• Favorable ROE, although it has decreased, it is still better than the
industry average ROE.
• It is recommended that the investor purchase shares in the Walker Ltd
company.
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36. Sample Exam
1. On January 1, 2015, Skillmart sells €100,000, five-year, 10% bonds for
€90,000 (90% of face value). Interest is payable on July 1 and January 1.
Record the journal entry for issuance of the bond.
Calculate the total cost of borrowing.
2. The latest Earned value report of the project shows CPI = 1.2, SPI = 0.8, PV
= $500,000, SV = -$220,000. What is the Cost Variance of the project?
3. StrongBridges Ltd. was awarded a $20 million contract to build a bridge.
The estimated time to complete the project is three (3) years, with an estimated
cost of $15 million.
Costs incurred in the year 2008 $5,000,000
Costs incurred in the year 2009 $7,000,000
Costs incurred in the year 2010 $15,000,000
Calculate percentage of completion revenue for each year?
