Copyright © 2010 Pearson Prentice Hall. All rights reserved. Chapter 14 Financial Ratios and Firm Performance

Copyright © 2010 Pearson Prentice Hall. All rights reserved Learning Objectives 1.Create, understand, and interpret common-size financial statements. 2.Calculate and interpret financial ratios. 3.Compare different company performances using financial ratios, historical financial ratio trends, and industry ratios.

Copyright © 2010 Pearson Prentice Hall. All rights reserved Financial Statements Just as a doctor takes a look at a patient’s X-rays or CAT-scan when diagnosing health problems, a manager or analyst can take a look at a firm’s primary financial statements--i. e., the income statement and the balance sheet--when trying to gauge the status or performance of a firm. Income statement  periodic recording of the sources of revenue and expenses of a firm Balance sheet  provides a point-in-time snapshot of the firm’s assets, liabilities, and owners’ equity.

Copyright © 2010 Pearson Prentice Hall. All rights reserved (A) Benchmarking The financial statements  constitute fairly complex documents involving a whole bunch of numbers. Absolute values –tell us something about the amount of assets, liabilities, equity, revenues, expenses, and taxes of a firm, –difficult to really gauge what’s going on, primarily because of size and maturity differences among firms. –requires “benchmarking” against some standard. One common method of benchmarking is to compare a firm’s current performance against that of its own performance over a 3-5 year period (trend analysis) by looking at the growth rate in various key items such as sales, costs, and profits.

Copyright © 2010 Pearson Prentice Hall. All rights reserved (A) Benchmarking (continued) TABLE 14.1 Cogswell Cola ’ s Abbreviated Income Statements ($ in thousands)

Copyright © 2010 Pearson Prentice Hall. All rights reserved (A) Benchmarking (continued) Another useful way to make some sense out of all the numbers is to recast the income statement and the balance sheet into common-size statements by expressing each income statement item as a percent of sales and each balance sheet item as a percent of total assets.

Copyright © 2010 Pearson Prentice Hall. All rights reserved (A) Benchmarking (continued) Figure 14.3

Copyright © 2010 Pearson Prentice Hall. All rights reserved (A) Benchmarking (continued) Figure 14.4

Copyright © 2010 Pearson Prentice Hall. All rights reserved (A) Benchmarking (continued) Benchmarking is a good starting point to detect trends (if any) in a firm’s performance and to make quick comparisons of key financial statement values with competitors on a relative basis. More in-depth diagnosis requires individual item analyses and comparisons, which are best done by conducting ratio analysis.

Copyright © 2010 Pearson Prentice Hall. All rights reserved Financial Ratios Financial ratios are relationships between different accounts from financial statements— usually the income statement and the balance sheet—that serve as performance indicators Because they are relative values, financial ratios allow for meaningful comparisons across time, between competitors, and with industry averages.

Copyright © 2010 Pearson Prentice Hall. All rights reserved Financial Ratios (continued) Five key areas of a firm’s performance can be analyzed by using financial ratios: 1. Liquidity ratios: Can the company meet its obligations over the short term? 2.Solvency ratios (also known as financial leverage ratios): Can the company meet its obligations over the long term? 3. Asset management ratios: How efficiently is the company managing its assets to generate sales? 4.Profitability ratios: How well has the company performed overall? 5.Market value ratios: How does the market (investors) view the company’s financial prospects? Can also conduct a Du Pont analysis, which involves a breakdown of the return on equity into its three components of profit margin, turnover, and leverage.

Copyright © 2010 Pearson Prentice Hall. All rights reserved (A) Short-Term Solvency: Liquidity Ratios Measure a company’s ability to cover its short-term debt obligations in a timely manner Three key liquidity ratios include the current ratio, the quick ratio, and the cash ratio:

Copyright © 2010 Pearson Prentice Hall. All rights reserved The liquidity ratios indicate that overall, Cogswell has better liquidity and short-term solvency than Spacely, but higher investment in current assets also means that lower yields are being realized since current assets are typically low-yielding. So we need to look at the other areas and interrelated effects of the firm’s various accounting items (A) Short-Term Solvency: Liquidity Ratios TABLE 14.2 Liquidity Ratios 2008 for Cogswell Cola and Spacely Spritzers

Copyright © 2010 Pearson Prentice Hall. All rights reserved (B) Long-Term Solvency: Financial Leverage Ratios Measure a company’s ability to meet its long-term debt obligations based on its overall debt level and earnings capacity. Failure to meet its interest obligation could put a firm into bankruptcy. Equations 14.4, 14.5, and 14.6 can be used to calculate 3 key financial leverage ratios: the debt ratio, times interest earned ratio, and cash coverage ratio.

Copyright © 2010 Pearson Prentice Hall. All rights reserved (B) Long-Term Solvency: Financial Leverage Ratios

Copyright © 2010 Pearson Prentice Hall. All rights reserved (B) Long-Term Solvency: Financial Leverage Ratios Cogswell Cola has relatively less debt and a significantly greater ability to cover its interest obligations by using either its EBIT (times interest earned ratio) or its net cash flow (cash coverage ratio) than Spacely Spritzers. Leverage must be analyzed as a combination of debt level and coverage. If a firm is heavily leveraged but has good interest coverage, it is using the interest deductibility feature of taxes to its benefit. Having a high leverage with low coverage could put the firm into a risk of bankruptcy. TABLE 14.3 Financial Leverage Ratios 2008 for Cogswell Cola and Spacely Spritzers

Copyright © 2010 Pearson Prentice Hall. All rights reserved (C) Asset Management Ratios Measure how efficiently a firm is using its assets to generate revenues or how much cash is being tied up in other assets such as receivables and inventory. Equations 14.7 – can be used to calculate 5 key asset management ratios:

Copyright © 2010 Pearson Prentice Hall. All rights reserved While Cogswell is more efficient at managing its inventory, Spacely seems to be doing a better job of collecting its receivables and utilizing its total assets in generating revenues 14.2 (C) Asset Management Ratios TABLE 14.4 Asset Management Ratios 2008 for Cogswell Cola and Spacely Spritzers

Copyright © 2010 Pearson Prentice Hall. All rights reserved (D) Profitability Ratios Profitability ratios measure a firm’s effectiveness in turning sales or assets into profits. Equations can be used to calculate 3 key profitability ratios:

Copyright © 2010 Pearson Prentice Hall. All rights reserved (D) Profitability Ratios (continued) As far as profitability is concerned, Cogswell is outperforming Spacely by about 3%. Table 14.5 Profitability Ratios 2008 for Cogswell Cola and Spacely Spritzers

Copyright © 2010 Pearson Prentice Hall. All rights reserved (E) Market Value Ratios Used to gauge how attractive or reasonable a firm’s current price is relative to its earnings, growth rate, and book value:

Copyright © 2010 Pearson Prentice Hall. All rights reserved (E) Market Value Ratios (continued) Potential investors and analysts often use these ratios as part of their valuation analysis. Typically, if a firm has a high price-to-earnings and a high market-to-book value ratio, it is an indication that investors have a good perception about the firm’s performance. However, if these ratios are very high, it could also mean that a firm is overvalued. With the price/earnings-to-growth ratio (PEG ratio), the lower it is, the more of a bargain it seems to be trading at, vis-à-vis its growth expectation.

Copyright © 2010 Pearson Prentice Hall. All rights reserved (E) Market Value Ratios (continued) RatioCogswell ColaSpacely Spritzers P/E PEG P/B The ratios seem to indicate that investors in both firms have good expectations about the firms’ performance and are therefore paying fairly high prices relative to their earnings book values.

Copyright © 2010 Pearson Prentice Hall. All rights reserved (F) Du Pont analysis Involves breaking down ROE into three components of the firm: 1)operating efficiency, as measured by the profit margin (net income/sales) 2)asset management efficiency, as measured by asset turnover (sales/total assets) 3)financial leverage, as measured by the equity multiplier (total assets/total equity) Equation shows that if we multiply a firm’s net profit margin by its total asset turnover ratio and its equity multiplier, we will get its return on equity:

Copyright © 2010 Pearson Prentice Hall. All rights reserved (F) Du Pont analysis (continued) Cogswell has better operational efficiency, i.e., it is better able to move sales dollars into income, but Spritzer is more efficient at utilizing its assets, and since it uses more debt, it is able to get more of its earnings to its shareholders. Although the ratios we have studied here are not the only ones that can be used to assess a firm’s performance, they are the most popular ones. It is important to look at the overall picture of the firm in all 5 areas and accordingly reach conclusions or make recommendations for changes.

Copyright © 2010 Pearson Prentice Hall. All rights reserved External Uses of Financial Statements and Industry Averages Financial statements of publicly traded companies and industry averages of key items provide the raw material for analysts and investors to make investment recommendations and decisions.

Copyright © 2010 Pearson Prentice Hall. All rights reserved (A) Cola Wars TABLE 14.6 Key Financial Ratios and Accounts for PepsiCo and Coca-Cola (through third quarter 2007)

Copyright © 2010 Pearson Prentice Hall. All rights reserved (A) Cola Wars TABLE 14.7 Some Key Ratios and Accounts for PepsiCo and Coca-Cola (Five-Year Period)

Copyright © 2010 Pearson Prentice Hall. All rights reserved (A) Cola Wars (continued) One of the first things we notice in looking over the five years of data is how similar many of the ratios are from year to year, showing remarkable consistency for these two companies. We also can see that the gross margin of Coca-Cola is consistently higher than that of PepsiCo. The debt-to-equity ratio of both firms is mostly falling over the five-year period. We can also see that ROE has been very good for both companies, although slightly better for PepsiCo. Finally, PepsiCo has very strong and growing earnings per share over this period, outperforming Coca-Cola’s EPS, but PepsiCo is also more expensive (higher current price per share).

Copyright © 2010 Pearson Prentice Hall. All rights reserved (B) Industry ratios: Industry ratios are often used as benchmarks for financial ratio analysis of individual firms. There can be significant differences in various key areas across industries, so comparing company ratios with industry averages can be useful and informative. TABLE 14.8 Financial Ratios: Industry Averages

Copyright © 2010 Pearson Prentice Hall. All rights reserved Constructing an Income Statement. Using the income and expense account information for Tri-Mark Products Inc. listed below, construct an income statement for the year ended 31 st December, Shares outstanding: 16,740,000 Tax rate: 35% Interest expense: $3,540,000 Revenue: $950,500,000 Depreciation: $50,000,000 Selling, general, and administrative expense: $85,000,000 Other income: $1,350,000 Research and development: $5,200,000 Cost of goods sold: $730,000,000 ADDITIONAL PROBLEMS WITH ANSWERS Problem 1

Copyright © 2010 Pearson Prentice Hall. All rights reserved ADDITIONAL PROBLEMS WITH ANSWERS Problem 1 (ANSWER) Tri-Mark Products, Incorporated Income Statement for the year ended 31st Dec (‘000s) Revenue$950,500 Cost of goods sold$730,000 Gross profit$220,500 Operating expenses Selling, general and administrative expenses$ 85,000 R&D$ 5,200 Depreciation$ 50,000 Operating Income$ 80,300 Other Income$ 1,350 EBIT$ 81,650 Interest Expense$ 3,540 Taxable Income$ 78,110 Taxes$ 27,339 Net Income$ 50,772 Shares Outstanding 16,740 EPS$ 303

Copyright © 2010 Pearson Prentice Hall. All rights reserved ADDITIONAL PROBLEMS WITH ANSWERS Problem 2 Constructing a Balance Sheet. Construct Tri-Mark Incorporated’s 2009 year-end Balance Sheet using the asset, liability, and equity accounts listed below: Retained Earnings $60,500,000 Accounts Payable $57,000,000 Accounts Receivable $43,000,000 Common Stock $189,676,000 Cash $6,336,000 Short Term Debt $1,500,000 Inventory $42,000,000 Goodwill $30,000,000 Long Term Debt $74,000,000 Other Non-Current Liabilities $15,000,000 PP&E $225,000,000 Other Non-Current Assets $14,000,000 Long-Term Investments $25,340,000 Other Current Assets $12,000,000

Copyright © 2010 Pearson Prentice Hall. All rights reserved ADDITIONAL PROBLEMS WITH ANSWERS Problem 2 (ANSWER) Tri-Mark Products, Inc. Balance Sheet for the year ended 31st December 2009 (‘000s) Assets:Liabilities: Current AssetsCurrent Liabilities Cash $ 6,336Accounts Payable$ 57,000 Accts. Rec.$ 43,000Short-Term Debt$ 1,500 Inventory$ 42,000Total Current Liabilities $ 58,500 Other Current $ 12,000Long-Term Debt$ 74,000 Total Current$ 103,336Other Liabilities$ 15,000 L-T Inv.$ 25,340Total Liabilities$ 147,500 PP&E $ 225,000Owners’ Equity Goodwill$ 30,000Common Stock$ 189,676 Other Assets $ 14,000Retained Earnings $ 60,500 Total OE$ 250,176 Total Assets$ 397,676Total Liab. And OE$ 397,676

Copyright © 2010 Pearson Prentice Hall. All rights reserved ADDITIONAL PROBLEMS WITH ANSWERS Problem 3 Common size statements. Restate Tri- Mark Incorporated’s 2009 financial statements as common-size statements and comment on them.

Copyright © 2010 Pearson Prentice Hall. All rights reserved ADDITIONAL PROBLEMS WITH ANSWERS Problem 3 (Answer) Assets: % of Total assetsLiabilities: % of Total Assets Current AssetsCurrent Liabilities Cash$ 6, Accounts Payable$ 57, Accts. Rec.$ 43, Short Term Debt$ 1, Inventory$ 42, TOTAL Current Liabilities $ 58, Other Current$ 12, Long Term Debt$ 74, Total Current$103, Other Liabilities$ 15, L-T Inv.$ 25, Total Libilities$147, PP&E$225, Owner’s Equity Goodwill$ 30, Common Stock$189, Other Assets$ 14, Retained Earnings$ 60, Total Assets$397, Total OE$250, Total Liability And OE$397,

Copyright © 2010 Pearson Prentice Hall. All rights reserved Continued Tri-Mark Products Incorporated Common-Size Income Statement as of 31st Dec ('000s) Revenue $ 950, % Cost of goods sold $ 730, % Gross Profit$ 220, % Operating expenses Selling, general and administrative expenses $ 85,0008.9% R&D $ 5,2000.5% Depreciation$ 50,0005.3% Operating Income $ 80,3008.4% Other Income $ 1,3500.1% EBIT $ 81,6508.6% Interest Expense$ 3,5400.4% Taxable Income$ 78,1108.2% Taxes $ 27,3392.9% Net Income$ 50,7725.3% Shares Outstanding 16,740 EPS $ 3.03 Tri-Mark’s cost of goods sold is 76.8% of its revenue. Its gross margin is 23.2%, while its net profit margin is 5.3%. It would be useful to compare these key cost and profit ratios over time and against a suitable benchmark so as to get a better idea of the firm’s overall performance.

Copyright © 2010 Pearson Prentice Hall. All rights reserved ADDITIONAL PROBLEMS WITH ANSWERS Problem 4 Compute and analyze financial ratios. Using the 2009 income statement and balance sheet of Tri-Mark Products Inc., as constructed in Problems 1 and 2 above, compute its financial ratios. How is the firm doing relative to its industry in the areas of liquidity, asset management, leverage, and profitability?

Copyright © 2010 Pearson Prentice Hall. All rights reserved ADDITIONAL PROBLEMS WITH ANSWERS Problem 4 (continued) RatioIndustry Average Current Ratio2.200 Quick Ratio (or Acid Test Ratio)1.500 Cash Ratio0.135 Debt Ratio0.430 Cash Coverage Days’ Sales in Receivables Total Asset Turnover2.800 Inventory Turnover Days’ Sales in Inventory Receivables Turnover Profit Margin0.045 Return on Assets0.126 Return on Equity0.221

Copyright © 2010 Pearson Prentice Hall. All rights reserved ADDITIONAL PROBLEMS WITH ANSWERS Problem 4 (Answer) Tri-MarkIndustry Average Current Ratio Quick Ratio (or Acid Test Ratio) Cash Ratio Debt Ratio Cash Coverage Days’ Sales in Receivables Total Asset Turnover Inventory Turnover Days’ Sales in Inventory Receivables Turnover Profit Margin Return on Assets Return on Equity

Copyright © 2010 Pearson Prentice Hall. All rights reserved ADDITIONAL PROBLEMS WITH ANSWERS Problem 4 (Answer continued) Analysis: Liquidity: Tri-Mark’s liquidity ratios are below the industry average indicating that it might need to look into its management of current assets and liabilities. Leverage: Tri-Mark’s debt ratio is much lower than the industry average, and its cash coverage is more than 3 time the average, indicating that if it needs to borrow long-term debt it should not have much of a problem. Asset management: Tri-Mark’s asset turnover ratios are all below the average. It needs to tighten up collections and manage its inventory more efficiently. Profitability: Tri-Mark has a good control on cost of goods sold. Its net profit margin is better than that of the industry, and so is its ROA. The industry, however, is returning a higher rate to the shareholders on average, primarily because of the higher debt levels.

Copyright © 2010 Pearson Prentice Hall. All rights reserved ADDITIONAL PROBLEMS WITH ANSWERS Problem 5 Du Pont Analysis. Based on the ratios calculated in Problem 4, and in conjunction with the industry averages given, conduct a Du Pont analysis on Tri-Mark’s key profitability ratios.

Copyright © 2010 Pearson Prentice Hall. All rights reserved ADDITIONAL PROBLEMS WITH ANSWERS Problem 5 (Answer) According to the Du Pont breakdown, we have ROE = Net Profit Margin * Total Asset Turnover * Equity Multiplier  ROE = NI/S * S/TA * TA/Equity Note: since we don’t have the accounting information for the average, we have to figure out the industry’s equity multiplier by some algebraic manipulation. Equity Multiplier = Total Assets/Equity Now, debt ratio = Total Debt/Total Assets Total Assets = Total Debt + Equity  (Total Debt/Total Assets) +( Equity/Total assets) = 1  Equity/Total Assets = 1 – (Total Debt/Total Assets)  TA/E = 1/(1-TD/TA)

Copyright © 2010 Pearson Prentice Hall. All rights reserved ADDITIONAL PROBLEMS WITH ANSWERS Problem 5– (Answer) Despite a lower total asset turnover ratio, Tri-Mark’s ROA (12.8%) is better than that of the industry (12.6%), primarily because of its higher net profit margin. The industry, however, has a higher ROE (22.1%) because of its higher debt ratio and correspondingly higher equity multiplier. Tri-MarkIndustry Debt Ratio Total Asset Turnover Profit Margin Return on Assets Return on Equity Equity multiplier = 1/(1 -debt ratio)

Copyright © 2010 Pearson Prentice Hall. All rights reserved Figure 14.1 Cogswell Cola Balance Sheet

Copyright © 2010 Pearson Prentice Hall. All rights reserved Figure 14.2 Cogswell Cola Income Statement