Copyright ©2003 South-Western/Thomson Learning

Chapter 3Evaluation of Financial

Performance

Introduction

• This chapter introduces financial statement analysis techniques that are used to accurately evaluate a company’s performance.

Financial Ratios Are Used By

• Management for planning and evaluating

• Credit managers to estimate the riskiness of potential borrowers

• Investors to evaluate corporate securities

• Managers to identify and assess potential merger candidates

Ratio Classifications

• Liquidity

• Asset management

• Financial leverage management

• Profitability

• Market-based

• Dividend policy

Major Financial Statements

• Balance sheet– Common-sized balance sheet shows

assets, liabilities, and equity as a percent of total assets.

• Income statement – Common-sized income statement shows

income and expense items as a percent of net sales.

• Statement of cash flows

Liquidity Ratios

• Current ratio =

• Quick ratio =

• Quick ratio, sometimes called the “acid test,” is a more stringent measure of liquidity than the current ratio.

• Liquidity ratios are quick measures of a firm’s ability to provide sufficient cash to conduct business over the next few months.

Current assetsCurrent liabilities

Current assets – InventoriesCurrent liabilities

Asset Management Ratios

• Avg. collection period =

• Inventory turnover =

• Fixed-asset turnover =

• Total asset turnover =

Cost of sales Average inventory

Sales Net fixed assets

Sales Total assets

Accounts receivable Annual credit sales/365

Asset Management Ratios

• Asset management ratios indicate how much a firm has invested in a particular type of asset (or group of assets) relative to the revenue the asset is producing.

• By comparing asset management ratios for the various asset accounts of a firm with established industry norms, the analyst can determine how efficiently the firm is allocating its resources.

Financial Leverage Management

• Debt ratio =

• Debt-to-equity ratio =

• Times interest earned =

• Fixed charge coverage

• =

Total debtTotal assets

Total debtTotal equity

EBIT Interest charges

EBIT + Lease pmts Interest + Lease pmts+ P/S div before tax

+ Before tax sinking fund

Financial Leverage Management

• Financial leverage management ratios measure the degree to which a company is employing financial leverage and, as such, of interest to creditors and owners alike.

Profitability Ratios

• Gross profit margin =

• Net profit margin =

• ROI =

• ROE =

Sales – Cost of salesSales

EATSales

EAT Total assets

EAT Stockholders’ equity

Profitability Ratios

• Profitability ratios measure how effectively a firm’s management is generating profits on sales, total assets, and, most importantly, stockholders’ investment.

Market-Based Ratios

• P/E ratio =

• In general, the lower the firm’s risk, the higher its P/E ratio should be. In addition, the better the growth prospects of its earnings, the greater is the P/E multiple.

Market price per shareCurrent earnings per share

Market-Based Ratios

• Market to book ratio =

• Generally, the higher the rate of return a firm is earning on its common equity relative to the return required by investors (the cost of common equity), the higher will be this ratio.

Market price per shareBook value per share

Market-Based Ratios

• Book value: – In reference to assets, cost minus

accumulated depreciated. – In reference to stock, the value of one share

of stock on a corporation’s books.

Market-Based Ratios

• Market-based ratios reflect the financial market’s assessment of the performance of a firm.

• For example, if the accounting ratios of a firm suggest that the firm has more risk than the average firm in the industry and has lower profit prospects, this information should be reflected in a lower market price of that firm’s stock.

Dividend Policy Ratios

• Payout ratio =

• Dividend yield =

• Stocks with a low dividend yield often indicate high expected future growth.

• Dividend policy ratios give insights regarding a firm’s dividend strategies and its future growth

prospects.

Dividends per shareEarnings per share

Expected dividends per shareStock price per share

Summary of Ratios

• Liquidity Ratios:– Current ratio: 流動性比率– Quick ratio: 速動比率– Acid test ratio: 酸性測驗比率

Summary of Ratios

• Asset Management Ratios: – Average collection period: 平均收現期– Inventory turnover ratio: 存貨週轉率– Fixed-asset turnover ratio: 固定資產週轉率

– Total-asset turnover ratio: 總資產週轉率

Summary of Ratios

• Financial Leverage Management Ratios: – Debt ratio: 負債比率 – Debt-to-equity ratio: 負債權益比– Times interest earned ratio: 利息保障倍數– Fixed charge coverage ratio: 固定費用保障倍數

– Equity Multiplier: 權益乘數

Summary of Ratios

• Profitability Ratios: – Gross profit margin ratio: 邊際毛利率– Net profit margin ratio: 邊際淨利率– Return on investment (assets): 資產報酬率 – Return on equity: 權益報酬率

Summary of Ratios

• Market-Based Ratios: – P/E (price-earnings) ratio: 本益比 – Market to book ratio: 市價淨值比

Summary of Ratios

• Dividend Policy Ratios: – Dividend payout ratio: 股利 (息 )發放率 – Dividend yield: 股利 (息 )收益率

Summary of Ratios

• EBIT (earnings before interest and taxes): 息前及稅前盈餘

• EAT (earnings after taxes): 稅後盈餘

• Note:

Assets = Liabilities + Owner’s Equity

• See examples in Table 3.5.

Financial Ratio Analysis

• Trend analysis 20X0 X1 X2

XYZ current ratio 1.9 2.2 2.3

• Cross-sectional analysis 20X2

XYZ current ratio 2.3

Industry norms 2.5

• Both simultaneously 20X0 X1 X2

XYZ current ratio 1.9 2.2 2.3

Industry norms 2.5 2.4 2.5

Relationships Among Ratios

• ROI =

• ROE =

• ROE =

• Note: ROI = Net profit margin ratio Total asset turnover ratio

EATSales

SalesTotal assets

EATTotal assets

=

EATSales

SalesTotal assets

Total assetsEquity

Net profitmargin

Total assetsturnover

Equitymultiplier

Sources of Information

• Dun and Bradstreet• Robert Morris

Associates• Prentice-Hall’s

Almanac of Business and Industrial Ratios

• Moody’s• Standard and Poor’s

• Annual reports• 10Ks• Trade associations• Trade journals• Commercial banks• Financial Research

Associates• Computerized

databases

Sources of Information on the Web

• http://finance.yahoo.com/

• http://www.onlinewbc.org/docs/finance/index.html

• http://www.dnbcorp.com/

• http://www.rmahq.org/

• http://www.sec.gov/

• http://www.moodys.com/

• http://www.hoovers.com/

• http://www.bloomberg.com/

Quality and Financial Analysis

• The quality of a firm’s earnings is positively related to the proportion of cash earnings to total earnings which is greatly influenced by the firm’s procedures with respect to sales revenues recognition.

Quality and Financial Analysis

• For example, a firm may recognize a sale at the time a contract is signed, a down payment is made, or when the full proceeds from the sale are actually collected as cash.

• Generally, the closer the recognition of a sale is to the time the full proceeds from that sales are collected, the higher is the quality of the firm’s reported earnings.

Quality and Financial Analysis

• The quality of a firm’s earnings is positively (negatively) related to the proportion of recurring (nonrecurring) income to total income. That is, a firm’s earnings can be viewed as high (low) quality if a greater proportion of those earnings is derived from regularly recurring transactions (irregularly nonrecurring transactions).

Quality and Financial Analysis

• The 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 the assets.

• If the assets on a firm’s balance sheet have a market value equal to or greater than the book value at which they are being carried, this enhances the quality of the firm’s balance sheet.

Quality and Financial Analysis

• The quality of a firm’s balance sheet is inversely related to the amount of inventory that cannot be moved and the amount of its hidden liabilities.

• These hidden liabilities may take the form of such things as long-term lease obligations not appearing on the company’s balance sheet or uninsured losses arising from pending lawsuits.

Quality and Financial Analysis

• In contrast, some firms have significant hidden assets. These assets may be physical assets, such as real property that has appreciated in value but is carried on the firm’s books at cost, or securities that are carried on the books at cost even though the market value of these securities has increased above the original cost. These assets may also consist of intangibles, such as valuable patents or brand names.

Analysis Based on the Market Value of the Firm

• Market value added (MVA) = Market value (of debt, preferred equity, and common equity capitalization) – Capital– Capital is a measure of all 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 NPV of all of the firm’s past and present projected investment projects.

Analysis Based on the Market Value of the Firm

• Economic value added (EVA) = (r – k) Capital

where r is return on total capital (= net operating profits after tax divided by beginning of year capital) and k (= weighted after-tax cost of capital) is cost of capital.

Analysis Based on the Market Value of the Firm

• EVA is a measure of operating performance that indicates how successful a firm has been at increasing the MVA of the enterprise in any given year. In other words, EVA is the yearly contribution of a firm’s operations to the creation of MVA.

Ways to Increase EVA

• Increase operating efficiency and thereby increasing r.

• Commit new resources to the enterprise that promise a return in excess of the firm’s weighted (and risk-adjusted) cost of capital.

• Make prudent use of the tax benefits of debt financing to create value, while considering risk versus return trade-offs.

Ways to Increase EVA

• Redirect resources from projects that do not earn adequate returns (relative to the cost of capital) and show little promise of doing so in the future, to more productive uses, including the payment of dividends and reduction of debt levels if no adequate-return projects are present.

Problems Caused by Inflation

• Inventory profit as a result of the timing of price increases

• Inventory valuation methods – Last-in, first-out (LIFO): A way to avoid or defer the

necessity of reporting the higher inventory profits– First-in, first out (FIFO)

• Rising interest rates causing a decline in the value of long-term debt

• Differences in the reporting of earnings• Recognition of sales

The Cash Flow Concept

• Accounting income vs. Cash flow

• Cash flow rather than accounting income is the relevant source of value

for the firm.

• ATCF (after-tax cash flow) = EAT (earnings after taxes) + Noncash charges– Noncash charges = Depreciation +

Deferred taxes

Statement of Cash Flow

• Presents the effects of operating, investing, and financing on the cash balance– Direct method presents the effects to net

cash provided by operating, investing, and financing.

– Indirect method presents the adjustments to net income showing the effects to net cash.

• Used for public financial reports

• The final results for both are identical.

Complex International Aspects of Financial Statement Analysis

• Influenced by fluctuating exchange rates

• Statement of Accounting Standards No. 52 deals with foreign currency translation.

Accuracy of Financial Statements

• External auditor

• Generally accepted accounting principles

• Corporations pose for a financial statement like people pose for a picture.