Chapter 3 Evaluation of Financial Performance © 2001 South-Western College Publishing

2 Financial Ratios Are Used By u Management for planning and evaluating u Credit managers to estimate the riskiness of potential borrowers u Investors to evaluate corporate securities u Managers to identify and assess potential merger candidates

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

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

5 Liquidity Ratios u Current ratio = Current assets Current liabilities u Quick ratio = Current assets – Inventories Current liabilities

6 Asset Management Ratios u Ave collection period = Accounts receivable Annual credit sales/ 365 u Inventory turnover = Cost of sales Average inventory u Fixed-asset turnover = Sales Net fixed assets u Total asset turnover = Sales Total assets

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

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

9 Market-Based Ratios u P/E ratio = Market price per share Current earnings per share u Market to book ratio = Market price per share Book value per share

10 Dividend Policy Ratios u Payout ratio = Dividends per share EPS u Dividend yield = Expected dividends per share Stock price

11 Financial Ratio Analysis u Trend analysis XYZ current ratio XYZ current ratio u Cross-sectional analysis 1997 XYZ current ratio 2.3 XYZ current ratio 2.3 Industry norms 2.5 Industry norms 2.5 u Both simultaneously XYZ current ratio XYZ current ratio Industry norms Industry norms

12 Relationships Among Ratios u ROI = EAT  Sales = EAT Sales Total assets Total assets u ROE = EAT  Sales  Total assets Sales Total assets Equity u ROE = Net profit  Total Assets  Equity margin turnover multiplier

13 Dupont Analysis u An excellent way to present ratio analysis for an assignment or for an on the job presentation

14 Sources of Information u Dun and Bradstreet u Robert Morris Associates u Prentice-Hall’s Almanac of Business and Industrial Ratios u Moody’s u Standard and Poor’s u Annual reports u 10K’s u Trade associations u Trade journals u Commercial banks u Financial Research Associates u Computerized data bases

15 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. 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.

16 Analysis Based on the Market Value of the Firm u Market value added ( MVA ) = Market value - Capital u The capital market’s assessment of the accumulated NPV of all of the firm’s past and present projected investment projects. u Economic value added ( EVA ) = ( r - k )  Capital u The yearly contribution of a firm’s operations to the creation of MVA.

17 Problems Caused by Inflation u Inventory profit as a result of timing of price increases u Inventory valuation methods u ( LIFO ) ( FIFO ) u Rising interest rates causing a decline in the value of long tern debt u Differences in the reporting of earnings u Recognition of sales

18 The Cash Flow Concept u Accounting income Vs Cash flow u Cash flow is the relevant source of value for the firm u ATCF = EAT + Noncash charges = EAT + Depreciation + Deferred taxes

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

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

21 Accuracy of Financial Statements u External auditor u Generally accepted accounting principles u Corporations poses for a financial statement like people pose for a picture