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

2. 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.

3. 14.1 Financial Statements
Just like 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 snap shot of the firm’s assets, liabilities and owner’s equity.

4. 14.1 (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 a 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.

5. 14.1 (A) Benchmarking (continued)
Table 14.1 Cogswell Cola’s Abbreviated Income Statements ($ in thousands)

6. 14.1 (A) Benchmarking (continued)
Another useful way to make some sense out of this mess of numbers, is to re-cast 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.

7. 14.1 (A) Benchmarking (continued)
Figure 14.3

8. 14.1 (A) Benchmarking (continued)
Figure 14.4

9. 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 diagnosis requires individual item analyses and comparisons which are best done by conducting ratio analysis.

10. 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
Being relative values, financial ratios allow for meaningful comparisons across time, between competitors, and with industry averages.

11. 14.2 Financial Ratios (continued)
5 key areas of a firm’s performance can be analyzed 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, i.e. profit margin, turnover, and leverage.

12. 14.2 (A) Short-Term Solvency: Liquidity Ratios
Measure a company’s ability to cover its short-term debt obligations in a timely manner:
3 key liquidity ratios include: The current ratio, quick ratio, and cash ratio.

13. 14.2 (A) Short-Term Solvency: Liquidity Ratios
Table Liquidity Ratios 2011 for Cogswell Cola and Spacely Spritzers
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 inter-related effects of the firm’s various accounting items.

14. 14.2 (B) Long-Term Solvency: Solvency or 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.

15. 14.2 (B) Long-Term Solvency: Long-Term Solvency: Solvency or Financial Leverage Ratios

16. 14.2 (B) Long-Term Solvency: Long-Term Solvency: Solvency or Financial Leverage Ratios
Table Financial Leverage Ratios 2011 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.

17. 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.
Equations 14.7 – can be used to calculate 5 key asset management ratios.

18. 14.2 (C) Asset Management Ratios
Table Asset Management Ratios 2011 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

19. 14.2 (D) Profitability Ratios
Profitability ratios such as net profit margin, returns on assets, and return on equity, measure a firm’s effectiveness in turning sales or assets into profits.

20. 14.2 (D) Profitability Ratios (continued)
Table Profitability Ratios 2011 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 gauge how attractive or reasonable a firm’s current price is relative to its earnings, growth rate, and book value.

22. 14.2 (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 over-valued.
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.

23. 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 seem to have good expectations about their performance and are therefore paying fairly high prices relative to their earnings book values.

24. 14.2 (F) DuPont analysis
Involves 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); and
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.

25. 14.2 (F) DuPont 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 these 14 ratios 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.

26. 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

27. 14.3 (A) Cola Wars
Table Key Financial Ratios and Accounts for PepsiCo and Coca-Cola (as of December 31, 2010)

28. 14.3 (A) Cola Wars
Table Some Key Ratios for PepsiCo and Coca-Cola (Five-Year Period)

29. 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 also can 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). 

30. 14.3 (B) Industry ratios:
Table 14.8 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, which is why comparing company ratios with industry averages can be very useful and more informative.

31. Additional Problems with Answers Problem 1
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 31st December, 2009.
Shares outstanding: 1,575,000
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

32. Additional Problems with Answers Problem 1 (Answer)

33. 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 $89,676,000
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

34. Additional Problems with Answers Problem 2 (Answer)

35. Additional Problems with Answers Problem 3
Common size statements: Re-state Tri-Mark Incorporated’s 2009 financial statements as common-size statements and comment on them

36. Additional Problems with Answers Problem 3 (Answer)

37. Additional Problems with Answers Problem 4
Compute and analyze financial ratios. Using the 2009 income statement and balance sheet of Trimark 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?

38. Additional Problems with Answers Problem 4 (continued)

39. Additional Problems with Answers Problem 4 (Answer)

40. Additional Problems with Answers Problem 4 (Answer) (continued)
Analysis: Liquidity: Trimark’s liquidity ratios are below the industry average indicating that they might need to look into their management of current assets and liabilities. Leverage: Trimark’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: Trimark’s asset turnover ratios are all below the average. It needs to tighten up collections, and manage its inventory more efficiently. Profitability: Trimark has a good control on cost of goods sold. Its net profit margin is better than the industry and so is its ROA. The industry, however, is returning a higher rate to the shareholders on average, primarily due to the higher debt levels.

41. Additional Problems with Answers Problem 5
DuPont Analysis. Based on the ratios calculated in problem 4 above, and in conjunction with the industry averages given, conduct a DuPont analysis on Trimark’s key profitability ratios.

42. 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)

43. Additional Problems with Answers Problem 5 (Answer) (continued)
Despite a lower Total Asset Turnover ratio, Trimark’s ROA (12.8%) is better than that of the industry (12.6%), primarily due to its higher net profit margin. The industry, however, has a higher ROE (22.1%) due to its higher debt ratio and correspondingly higher equity multiplier.

44. Figure 14.1 Cogswell Cola Balance Sheet

45. Figure 14.2 Cogswell Cola Income Statement