Evaluate Financial Performance with Ratios

Chapter 3
Evaluation of Financial
Performance
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a
publicly accessible website, in whole or in part.

 This chapter introduces the basics of ratio
analysis for evaluating a firm’s financial
performance
2

Introduction
 Uses of Financial Analysis
 Identifies the major strengths and
weaknesses of a firm
 Used by:
 Financial Managers
 Credit Managers
 Security Analysts
 Bankers
 Unions
3

Introduction
 Interpreting Financial Ratios
 Ratios standardize various elements of
financial data for differences in the size of
a series of financial data
 Use to make comparisons
 Over time
 Between firms
4

Introduction
 Basic Classifications of Financial
Ratios
 Liquidity
 Asset Management
 Financial Leverage
 Profitability
 Market-Based
 Dividend Policy
 Calculated from Financial Statements
5

What are the key financial
statements?
6

Key Financial Statements
 Balance Sheet
 Income Statement
 Common Size Financial Statements
 Statement of Cash Flows
7

 Balance Sheet
 Assets
 Liabilities
 Stockholders’ Equity
8

9

 Income Statement
 Net Sales
 Cost of Sales
 Other Operating Expenses
 Interest Expenses
 Taxes
 Earnings After Tax, aka
 Net Income
 Net Earnings
 Net Profit
10

11

 Common-Size Financial Statements
 Common-Size Balance Sheet
 Common-Size Income Statement
 Statement of Cash Flows shows how:
 Cash was generated from operations
 Cash was used in investing activities
 Cash was obtained from financing
activities
12

13

14

Basic Classifications of Financial Ratios
 Liquidity Ratios
 Current Ratio
 Quick Ratio
15
Current Assets
Current Ratio =
Current Liabilities
Current Assets - Inventories
Quick Ratio =
Current Liabilities

 Asset Management Ratios
 Average Collection Period
 Inventory Turnover Ratio
16
Accounts ReceivableAverage Collection Period =
Annual Credit Sales 365÷
Cost of SalesInventory Turnover =
Average Inventory

 Asset Management Ratios
 Fixed-Asset Turnover Ratio
 Total Asset Turnover Ratio
17
SalesFixed-Asset Turnover =
Net Fixed Assets
SalesTotal Asset Turnover =
Total Assets

 Financial Leverage Management Ratios
 Debt Ratio
 Debt-to-Equity Ratio
18
Total DebtDebt Ratio =
Total Assets
Total DebtDebt-to-Equity =
Total Equity

 Financial Leverage Management Ratios
 Times Interest Earned Ratio
 Fixed-Charge Ratio
19
Earnings Before Interest and Taxes (EBIT)Times Interest Earned =
Interest Charges
EBIT + Lease PayamentsFixed-Charge Coverage Ratio =
Interest + Lease Payments
+ Preferred Dividends Before Tax
+ Before-Tax Sinking Fund

 Profitability Ratios
 Gross Profit Margin Ratio
 Net Profit Margin Ratio
20
Sales - Cost of SalesGross Profit Margin =
Sales
Earnings After Taxes (EAT)Net Profit Margin =
Sales

 Profitability Ratios
 Return on Investment (Total Assets) Ratio
 Return on Shareholders’ Equity Ratio
21
Earnings After Taxes (EAT)Return on Investment =
Total Assets
Earnings After Taxes (EAT)Return on Shareholders' Equity =
Stockholders' Equity

 Market-Based Ratios
 Price-to-Earnings (P/E) Ratio
 Market Price-to-Book Value Ratio
22
Market Price Per ShareP/E =
Current Earnings Per Share
Market Price Per ShareP/BV =
Book Value Per Share

 Dividend Policy Ratios
 Payout Ratio
 Dividend Yield
23
Dividends Per SharePayout Ratio =
Earnings Per Share
Expected Divided Per ShareDividend Yield =
Stock Price

 Compared to Industry Average
 Compared to Best Performers
 At one point in time
 Ratios compared
 Trend Analysis
 Ratios over time
24
Using Financial Ratios

Trend Analysis
25

Trend Analysis
26

Trend Analysis
27

Analysis of Profitability: Return on
Investment
28
EAT EAT Sales
ROI =
Total Assets Sales Total Assets
= ×

Analysis of Profitability: Return on
Investment
29

Analyzing Profitability Through Return
on Shareholder’s Equity
30
Return on Stockholders' Equity = Net Profit Market Total Asset Turnover Equity Multiplier
Earnings After Tax Sales
Sales Total Assets
× ×
× ×
Total Assets
Stockholders' Equity

Sources of Comparative Financial Data
 Dun & Bradstreet
 Risk Management Association
 Quarterly Financial Report for
Manufacturing Companies
 Moody’s (Mergent)
 Standard & Poor’s
 10K Reports
 Annual Reports
31

Words of Caution About Financial Ratio
Analysis
 Ratios are only as reliable as the
accounting data on which they are based
 Be cautious of industry norms without
some measure of dispersion
 Comparative analysis depends on the
availability of data for each industry
 Ratios look at historic information
32

Analysis
 Seasonal factors can distort ratios
 Inflation distorts firms’ balance sheets
 “Window Dressing” techniques can make
statements & ratios look better
 Different operating & accounting practices
distort comparison
 Difficult to tell if a ratio is “good” or “bad”
 What is the “Quality” of the earnings?
33

Analysis
 Ratios must be evaluated
 Can serve as “red flags”
 Tools for better management
34

Can a firm “manage’ its
earnings?
35

Earnings and Balance Sheet Quality and
Financial Analysis
 Earnings Quality
 High-quality earnings tend to be cash
earnings
 Distortions in earnings can arise from
such issues as:
 the time of revenue recognition
 the establishment of reserves for such items as
loan loss provisions in banking
 the amortization of intangible assets
36

Financial Analysis
 Earnings Quality
 Earnings Management “Tricks”
 Timing asset sales in a way that keeps earnings
growing at a smooth rate
 Acceleration of shipments at the end of a
quarter to increase reported sales
 Capitalizing normal operating expenses
 Extending depreciable life of assets
 Using big write-offs and using “spin” control to
explain bad earnings
 Using reserves to smooth earnings
37

Financial Analysis
 Balance Sheet Quality
 Charging off assets
 Hidden liabilities
 Hidden assets
 Off balance sheet financing
38

Market Valued Added: An Alternative
Measure of Performance
 The Market Value Added (MVA) Concept
 MVA = Market Value – Capital
 Economic Value Added (EVA)
 EVA = [r – k] x Capital
 r = Return on Total Capital
 k = Cost of Capital
39

Evaluate Financial Performance with Ratios

Recommended

Recommended

More Related Content

What's hot

What's hot (18)

Viewers also liked

Viewers also liked (15)

Similar to Evaluate Financial Performance with Ratios

Similar to Evaluate Financial Performance with Ratios (20)

Evaluate Financial Performance with Ratios