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1. Finance 311 1
Chapter 4
Evaluation of
Financial
Performance

2. Finance 311 2
Introduction
 This chapter introduces financial
statement analysis techniques that are
used to accurately evaluate a
company’s performance. We will
assume that the financial statements
are fairly and accurately presented.

3. Finance 311 3
Financial Ratios
Are Used By
 Management for planning and evaluating
 Credit managers and bankers to estimate
the riskiness of potential borrowers
 Investors to evaluate corporate securities
 Managers to identify and assess potential
merger candidates
 Widely used and accepted technique
 Use started in the 1920s

4. Finance 311 4
Ratio Analysis
 Many, many ratios
 Choose the ones that are most relevant for
you
 Must be compared with a standard and
also the past (three years, for example)
 A financial ratio is only an indicator
 One can possibly manipulate ratios
 Accounting differences in firms
 WorldCom (MCI), ENRON, HealthSouth,
Ahold, Tyco, etc.

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Ratio Classifications
 Liquidity
 Asset management
 Financial leverage management
 Profitability
 Market-based
 Dividend policy

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Major Financial
Statements Balance sheet
 Common-sized balance sheet shows
assets, liabilities, and equity as a % of total
assets
 Income statement
 Common-sized income statement
shows income and expense items as a %
of net sales
 Statement of cash flows

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Common-Sized Statements
 Publicly-owned firms must publish
financial statements quarterly and
annually
 Widely used in banking and investments

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Liquidity Ratios
 Current ratio = Current assets
Current liabilities
 Quick ratio = Current assets - Inventories
Current liabilities
Aging Schedule for Accounts Receivable

9. Finance 311 9
Asset Management
Ratios
 Average collection period =
Accounts receivable
Annual credit sales/ 365
 Inventory turnover = Cost of sales
Average inventory
 Fixed-asset turnover = Sales
Net fixed assets
 Total asset turnover = Sales
Total assets

10. Finance 311 10
Financial Leverage
Management
 Debt ratio = Total debt
Total assets
 Debt-to-equity ratio = Total debt
Total equity
 Times interest earned = EBIT
Interest charges
 Fixed charge coverage = EBIT + Lease payments
Interest + Lease payment +
P/S div before tax+ Before-tax
sinking fund

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Profitability Ratios
 Gross profit margin =
Sales - Cost of sales
Sales
 Net profit margin = EAT
Sales
 ROI = EAT
Total Assets
 ROE = EAT
Stockholders equity

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Market-Based
Ratios
 P/E ratio = Market price per share
Current earnings per share
 Market to book ratio =
Market price per share
Book value per share
Stock Price/ Free Cash Flow

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Dividend Policy
Ratios
 Payout ratio = Dividends per share
Earnings per share
 Dividend yield =
Expected dividends per share
Stock price

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Relationships Among
Ratios
 ROI = EAT x Sales = EAT
Sales Total assets Total assets
 ROE = EAT x Sales x Total assets
Sales Total assets Equity
 ROE = Net Profit Margin x Total Asset
Turnover x Equity Multiplier

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Dupont Analysis
 Widely used in industry
 Shows impacts that operating changes
can have on returns

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Financial Ratio Analysis
 Trend analysis 2002 2003 2004
XYZ current ratio 1.9 2.2 2.3
 Cross-sectional analysis 2004
XYZ current ratio 2.3
Industry norms 2.5
 Both simultaneously 2002 2003 2004
XYZ current ratio 1.9 2.2 2.3
Industry norms 2.5 2.4 2.5

17. Finance 311 17
Some Sources of
Information
 Trading Room (406 Sirrine
Hall)
 Bridge (Telerate)
 Bloomberg
 Reuters
 General Business File of
Cooper Library
 Factiva
 Mergent Database
 TableBase
 Reuters Business Insight
 RMA Annual Statement
Studies
 Reserves on 2nd
Floor
 Visit Index Table 3 in
Library
 Annual reports
 10K’s - SEC EDGAR
Corporate Database
 Standard and Poor’s
 Value Line
 Industry Norms and
Key Business Ratios
 The Internet

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A Few of the Sources of
Information on the Web
 http://www.bloomberg.com/
 http://www.sec.gov/
 http://finance.yahoo.com/
 http://www.dnbcorp.com/
 http://www.rmahq.org/
 http://www.moodys.com/
 http://www.hoovers.com/
 But, please be careful. Remember you get
what you pay for…

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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.
Large non-cash component in the earnings
Significant non-recurring transactions in the income figure
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 assets and inversely
related to the amount of its hidden liabilities.
Presence of obsolete inventories and charging off
assets
Hidden assets
Assets have market values significantly below book values

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Problems in Reporting
 Time of revenue recognition
 Pension Fund Earnings Assumptions
 Amortization of intangible assets
 Including all losses and debt
 Off-Balance-Sheet Financing - ENRON

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Ratios Can Be Misleading
 Differing accounting practices
 Might be significant dispersion in the
ratio for the industry
 Many firms operate in more than one
industry - Industry classification
 Financial ratios provide a historical
record of performance

22. Finance 311 22
The Bridge System
 Turn on Monitor
 Log on
 Click on Telerate
 Double Click on the background
 Go to Analytics Page
 Type: /LU/Company for Ticker Symbol
 Type: the Ticker Symbol/CF
 CF = Corporate Fundamentals
 Scroll through the Corporate Fundamentals
 Type: the Ticker Symbol[Beta

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To Obtain the Latest
Corporate News
 Tab to another page in Telerate
 Double click on the background
 Go to News Watch
 Right Click then Search by Ticker Symbol
 Type in the Ticker Symbol
 Then double click on any headline story to
bring up the entire story.
 You can print out the story or possibly save it
to a disk.

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Analysis Based on the
Market Value of the
Firm
 Market value added ( MVA ) = Total
Market value – Total Capital
MVA is the market value of debt, preferred
stock, and common equity less the Capital
raised by investors or Retained Earnings.
The capital market’s assessment of the
accumulated NPV of all of the firm’s past
and present projected investment projects.

25. Finance 311 25
Economic Value Added (EVA)
 Economic value added ( EVA ) = [ Return
on total capital (r) – Cost of Capital (k )] x
Capital
 EVA = EBIT(1 – Corporate tax rate) –
(Operating Capital)(k)
 r = net operating profits after taxes divided by
beginning of year capital (Return on Capital)
 k = Weighted After-Tax Cost of Capital

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EVA - Continued
The yearly contribution of a firm’s operations
to the creation of MVA.
 EVA measures the extent to which the firm
has increased shareholder value in a given
year.
 EVA represents the residual value that
remains after the cost of all capital, including
equity capital has been deducted.

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Increase Economic Value
Added (EVA)
 Increase operating efficiency
 Commit new resources that promise a
high return
 Redirect resources to more productive
uses
 Make prudent use of tax benefits of
debt financing

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Problems Caused by
Inflation Inventory profit as a result of timing of
price increases
 Inventory valuation methods
( LIFO ) ( FIFO )
 Rising interest rates causes a decline in
the value of long term debt
 Differences in the reporting of earnings
 Understatement of fixed assets
 Recognition of sales

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The Cash Flow
Concept
 Accounting income Vs Cash flow
 Cash flow is the relevant source of value for the
firm
 ATCF = EAT + Noncash charges
 ATCF = EAT + Depreciation + Deferred taxes
 Free Cash Flow (FCF) = EBIT(1 – T) – Net
Investment in operating capital
 FCF = (EBIT(1 – T) + Depreciation) – Gross
investment in operating capital

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Statement of Cash
Flows
 Presents the net cash provided by
operating, investing, or financing
activities
 Direct method presents the net cash
provided by operating, investing, or
financing activities
 Indirect method presents the adjustments
to net income to show net cash provided
Used for public financial reports
 The final results are identical

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Complex International
Aspects of Financial
Statement Analysis
 Influenced by fluctuating exchange
rates
 SFAS No. 52 deals with foreign
currency translation

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Accuracy of Financial
Statements
 External auditor
 Generally accepted accounting
principles
 People pose for a picture like a
corporation poses for a financial
statement
 Sarbanes-Oxley Act of 2002

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Conclusion
 Financial Statements
 Balance Sheet
 Income Statement
 Statement of Cash
Flows
 Common-sized
 Sarbanes-Oxley Act
 Ratios
 Liquidity
 Asset management
 Financial leverage
 Profitability
 Market-based
 Dividend policy
 DuPont Analysis
 Sources of
information
 Market Value Added
 Economic Value
Added