1. Financial Ratios and Firm Performance
Chapter 14
Financial Ratios and Firm Performance

2. 14.1 Financial Statements
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 measure 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.

3. 14.1 (A) Benchmarking Financial statements tell us Absolute values:
tell us something about the amount of assets, liabilities, equity, revenues, expenses, and taxes of a firm,
difficult to really measure what’s going on, primarily because of size differences among firms. 
requires “benchmarking” against some standard.
What is benchmarking?
It is the process of comparing a company’s current performance against its own previous performance or that of its competitors.
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.

4. 14.1 Trend Analysis
TABLE Cogswell Cola’s Abbreviated Income Statements ($ in thousands)

5. 14.1 (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 analysis requires individual item analyses and comparisons, which are best done by conducting ratio analysis.

6. 14.2 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.

7. 14.2 Financial Ratios (continued)
Five key areas of a firm’s performance can be analyzed by using financial ratios: 
Liquidity ratios: Can the company meet its obligations over the short term?
Solvency ratios (also known as financial leverage ratios): Can the company meet its obligations over the long term?
Asset management ratios: How efficiently is the company managing its assets to generate sales?
Profitability ratios: How well has the company performed overall?
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.

8. 14.2 (A) Short-Term Solvency: Liquidity Ratios
Measure a company’s ability to cover its short-term debt obligations in a timely manner. The higher the liquidity ratio the better the better liquidity and short-term solvency issues of the company.
Three key liquidity ratios include the current ratio, the quick ratio, and the cash ratio:

9. Current Ratio: It indicates the extent to which current liabilities are covered by current assets.
Quick Ratio/Acid ratio: It is very similar to current ratio, but we subtract the inventories from current assets because they are least liquid assets.
Cash Ratio: It indicates the per cent of current liabilities covered by the current cash on hand.

10. 14.2 (A) Short-Term Solvency: Liquidity Ratios
TABLE Liquidity Ratios 2008 for Cogswell Cola and Spacely Spritzers
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.

11. 14.2 (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.

12. 14.2 (B) Long-Term Solvency: Financial Leverage Ratios
The higher the TIE and cash coverage ratio, the greater the ability of the company to cover its interest expense obligations.
Another name for debt ratio is leverage level, total liabilities is also called total debt.

13. Debt ratio: It indicates the amount of debt for every dollar of assets.
Times interest earned ratio: It indicates the ability of the company to meet its interest expense obligations from EBIT.
Cash coverage ratio: It indicates the ability of the company to generate cash from operations to meet its financial obligations.

14. 14.2 (B) Long-Term Solvency: Financial Leverage Ratios
TABLE Financial Leverage Ratios 2008 for Cogswell Cola and Spacely Spritzers
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.

15. 14.2 (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.

16. Inventory turnover: It indicates the time required for the inventory to be sold and restocked(replaced) in a year.
Day’s sales in inventory: It indicates the length of time that the inventory was on shelf before sold at the company.
Receivables turnover: It measures the number of times per year payment was collected on credit accounts.
Day’s sales in receivables(Collection period or Days sales outstanding): It indicates the length of time that customers took to pay their credit purchases.
Total asset turnover: It indicates how well the assets are being used to generate revenue.

17. 14.2 (C) Asset Management Ratios
TABLE Asset Management Ratios 2008 for Cogswell Cola and Spacely Spritzers
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

18. 14.2 (D) Profitability Ratios
Profitability ratios measure a firm’s effectiveness in turning sales or assets into profits.

19. Profit margin: It indicates the profit per dollar of sales.
Return on assets: It indicates how well the assets are generating income.
Return on equity: It indicates how much profit is being generated for the owners based on their ownership investment.

20. 14.2 (D) Profitability Ratios (continued)
Table Profitability Ratios 2008 for Cogswell Cola and Spacely Spritzers
As far as profitability is concerned, Cogswell is outperforming Spacely by about 3%.

21. 14.2 (E) Market Value Ratios
Used to measure how attractive or reasonable a firm’s current price is relative to its earnings, growth rate, and book value:

22. Price to earnings ratio: It shows the dollar amount investors will pay for $1 of current earnings.
Price/earnings to growth ratio: is an adjustment to P/E ratio to account for growth.
Market to book value: It is the ratio of stock’s market price to its book value.
Book value per share =total equity divided by number of shares outstanding.

23. 14.2 (E) Market Value Ratios
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 view about the firm’s performance. Companies with high P/E ratio are usually growth companies and those with low P/E ratio are mature or stable companies. A low market to book ratio indicates that the market for shares of the company is depressed.
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 (cheap price) it seems to be trading at, in respect of its growth expectation.

24. 14.2 (E) Market Value Ratios (continued)
Ratio Cogswell Cola Spacely 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.

25. 14.2 (F) Du Pont analysis
Du Pont Analysis takes a step further in analyzing the firm performance by breaking down ROE into three components of the firm:
operating efficiency, as measured by the profit margin (net income/sales)
asset management efficiency, as measured by asset turnover (sales/total assets)
financial leverage, as measured by the equity multiplier (total assets/total equity)
This 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:

26. 14.2 (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 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.

27. 14.3 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.

28. Another example of comparison between competitors
TABLE Key Financial Ratios and Accounts for PepsiCo and Coca-Cola (through third quarter 2007)

29. 14.3 (A) Cola Wars
TABLE Some Key Ratios and Accounts for PepsiCo and Coca-Cola (Five-Year Period)

30. 14.3 (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). 

31. 14.3 (B) Industry ratios:
TABLE Financial Ratios: Industry Averages
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.

32. ADDITIONAL PROBLEMS WITH ANSWERS
Compute and analyze financial ratios. Using the 2009 income statement and balance sheet of Tri-Mark Products Inc., compute its financial ratios. How is the firm doing relative to its industry in the areas of liquidity, asset management, leverage, and profitability?

33. ADDITIONAL PROBLEMS WITH ANSWERS
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 $

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

35. ADDITIONAL PROBLEMS WITH ANSWERS
Ratio
Industry Average
Current Ratio
2.200
Quick Ratio (or Acid Test Ratio)
1.500
Cash Ratio
0.135
Debt Ratio
0.430
Cash Coverage
10.600
Days’ Sales in Receivables
29.000
Total Asset Turnover
2.800
Inventory Turnover
20.100
Days’ Sales in Inventory
11.500
Receivables Turnover
32.000
Profit Margin
0.045
Return on Assets
0.126
Return on Equity
0.221

36. ADDITIONAL PROBLEMS WITH ANSWERS
Tri-Mark
Industry Average
Current Ratio
1.766
2.200
Quick Ratio (or Acid Test Ratio)
1.048
1.500
Cash Ratio
0.108
0.135
Debt Ratio
0.371
0.430
Cash Coverage
37.189
10.600
Days’ Sales in Receivables
16.512
29.000
Total Asset Turnover
2.390
2.800
Inventory Turnover
28.808
30.100
Days’ Sales in Inventory
12.670
11.500
Receivables Turnover
22.105
30.000
Profit Margin
0.053
0.045
Return on Assets
0.128
0.126
Return on Equity
0.203
0.221

37. 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.

38. ADDITIONAL PROBLEMS WITH ANSWERS
Du Pont Analysis. Based on the ratios calculated in the previous problem, and in conjunction with the industry averages given, conduct a Du Pont analysis on Tri-Mark’s key profitability ratios.

39. ADDITIONAL PROBLEMS WITH ANSWERS
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)

40. ADDITIONAL PROBLEMS WITH ANSWERS
Tri-Mark
Industry
Debt Ratio
0.371
0.430
Total Asset Turnover
2.390
2.800
Profit Margin
0.053
0.045
Return on Assets
0.128
0.126
Return on Equity
0.203
0.221
Equity multiplier = 1/(1 -debt ratio)
1.59
1.75
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.