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

2. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-2 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. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-3 14.1 Financial Statements A financial 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. Net Income = revenues - expenses Balance sheet  provides a point-in-time snapshot of the firm’s assets, liabilities, and owners’ equity assets = liabilities + owner’s equity

4. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-4 14.1 (A) Benchmarking The financial statements  constitute fairly complex documents involving absolute values. 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.

5. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-5 14.1 (A) Benchmarking Benchmarking: comparing the firm’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.

6. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-6 14.1 (A) Benchmarking (continued) TABLE 14.1 Cogswell Cola’s Abbreviated Income Statements ($ in thousands)

7. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-7 14.1 (A) Benchmarking (continued) The second method of benchmarking is to compare the firm’s performance against that of its competitors. However, firms often have different sizes. The solution 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

8. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-8 14.1 (A) Benchmarking (continued) Figure 14.3

9. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-9 14.1 (A) Benchmarking (continued) Figure 14.4

10. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-10 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.

11. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-11 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.

12. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-12 14.2 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.

13. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-13 14.2 (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:

14. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-14 14.2 (A) Short-Term Solvency: Liquidity Ratios-Continued Current ratio: measures the extent to which current liabilities are covered by current assets. Quick ratio: measures the extent to which current liabilities are covered by current assets without inventories which are the least liquid assets. Cash ratio: measures the extent to which current liabilities are covered by cash.  The higher the liquidity ratio the better the liquidity position.

15. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-15 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. 14.2 (A) Short-Term Solvency: Liquidity Ratios TABLE 14.2 Liquidity Ratios 2008 for Cogswell Cola and Spacely Spritzers

16. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-16 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. With financial leverage ratios, we want to know interest expenses can be met with normal operations or not. Failure to meet its interest obligation could put a firm into bankruptcy.

17. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-17 14.2 (B) Long-Term Solvency: Financial Leverage Ratios 3 key financial leverage ratios: the debt ratio, times interest earned ratio, and cash coverage ratio.

18. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-18 14.2 (B) Long-Term Solvency: Financial Leverage Ratios Debt ratio (leverage ratio): measures the amount of debt for every dollar of assets. Times interest earned (TIE)ratio: measures the ability to cover interest expenses from EBIT. Cash coverage ratio: measures the ability to generate cash from operations to meet financial obligations.  Higher TIE ratio and higher cash coverage ratio means greater ability to cover the interest expenses

19. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-19 14.2 (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

20. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-20 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. 5 key asset management ratios:

21. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-21 14.2 (C) Asset Management Ratios Inventory turnover: measure the time required for the inventory to be sold and replaced in a year. Day’s sales in inventory: measures the length of time the inventory was on self before being sold. Receivable turnover: measures the number of times per year payment is collected on credit. Day’s sales in receivables, collection period or Day’s sales outstanding (DSO):measures the length of time customers take to pay their credit purchases. Total assets turnover: measures how well assets are being used to generate revenues.

22. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-22 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

23. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-23 14.2 (D) Profitability Ratios Profitability ratios measure a firm’s effectiveness in turning sales or assets into profits. 3 key profitability ratios:

24. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-24 14.2 (D) Profitability Ratios Profit margin: measures the amount of profit per dollar of sales. Return on assets(ROA): measures how well the assets are generating income. Return on equity(ROE): measures the amount of profit being generated for owners based on their investment.  The higher the profitability ratio, the better it is.

25. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-25 14.2 (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

26. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-26 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:

27. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-27 14.2 (E) Market Value Ratios Price to earning (P/E) ratio: measures the amount of dollar investor will pay for every $1 of earnings. Price/earnings to growth(PEG ratio)ratio: adjustment of P/E ratio to account for growth. Market to book ratio: percentage of stock’s market price to its book value.

28. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-28 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 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.

29. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-29 14.2 (E) Market Value Ratios (continued) RatioCogswell ColaSpacely Spritzers P/E15.4113.01 PEG 1.280.86 P/B 5.494.17 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.

30. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-30 14.2 (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 14.19 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:

31. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-31 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 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.

32. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-32 ADDITIONAL PROBLEMS WITH ANSWERS Problem 1 Tri-Mark Products, Incorporated Income Statement for the year ended 31st Dec. 2009 (‘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

33. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-33 ADDITIONAL PROBLEMS WITH ANSWERS Problem 1 (continued) 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

34. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-34 ADDITIONAL PROBLEMS WITH ANSWERS Problem 1 (continued) Compute and analyze financial ratios. Using the 2009 income statement and balance sheet of Tri-Mark Products Inc. above, compute its financial ratios. How is the firm doing relative to its industry in the areas of liquidity, asset management, leverage, and profitability?

35. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-35 ADDITIONAL PROBLEMS WITH ANSWERS Problem 1 (continued) RatioIndustry Average Current Ratio2.200 Quick Ratio (or Acid Test Ratio)1.500 Cash Ratio0.135 Debt Ratio0.430 Cash Coverage10.600 Days’ Sales in Receivables29.000 Total Asset Turnover2.800 Inventory Turnover20.100 Days’ Sales in Inventory11.500 Receivables Turnover32.000 Profit Margin0.045 Return on Assets0.126 Return on Equity0.221

36. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-36 ADDITIONAL PROBLEMS WITH ANSWERS Problem 1 (Answer) Tri-MarkIndustry Average Current Ratio1.7662.200 Quick Ratio (or Acid Test Ratio)1.0481.500 Cash Ratio0.1080.135 Debt Ratio0.3710.430 Cash Coverage37.18910.600 Days’ Sales in Receivables16.51229.000 Total Asset Turnover2.3902.800 Inventory Turnover28.80830.100 Days’ Sales in Inventory12.67011.500 Receivables Turnover22.10530.000 Profit Margin0.0530.045 Return on Assets0.1280.126 Return on Equity0.2030.221

37. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-37 ADDITIONAL PROBLEMS WITH ANSWERS Problem 1 (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. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-38 ADDITIONAL PROBLEMS WITH ANSWERS Problem 2 Du Pont Analysis. Based on the ratios calculated in Problem 1, and in conjunction with the industry averages given, conduct a Du Pont analysis on Tri-Mark’s key profitability ratios.

39. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-39 ADDITIONAL PROBLEMS WITH ANSWERS Problem 2 (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)

40. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-40 ADDITIONAL PROBLEMS WITH ANSWERS Problem 2– (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 Ratio0.3710.430 Total Asset Turnover2.3902.800 Profit Margin0.0530.045 Return on Assets0.1280.126 Return on Equity0.2030.221 Equity multiplier = 1/(1 -debt ratio)1.591.75

41. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-41 Figure 14.1 Cogswell Cola Balance Sheet

42. Copyright © 2010 Pearson Prentice Hall. All rights reserved. 14-42 Figure 14.2 Cogswell Cola Income Statement