Chapter 4

Evaluating a Firm’s Financial Performance

Foundations of FinanceArthur J. Keown John D. MartinJ. William Petty David F. Scott, Jr.

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Learning Objectives

After reading this chapter, you should be able to:

§ Explain the purpose and importance of financial analysis.

§ Calculate and use a comprehensive set of measurements to evaluate a company’s performance.

§ Describe the limitations of financial ratio analysis.

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Principles Used in this Chapter

• Principle 7: Managers Won’t Work the Owners Unless it is their best Interest.

• Principle 5: The Curse of Competitive Markets – Why It’s Hard to Find Exceptionally Profitable Markets.

• Principle 1: The Risk Return Trade-Off – We Won’t Take on Additional Risk Unless We Expect to Be Compensated with Additional Return.

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Financial Ratios

• Ratios give us two ways of making meaningful comparisons of a firm’s financial data:– Trends across time– Comparisons with other firms’

ratios

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Uses of Financial Ratios within the Firm

• Identify deficiencies in a firm’s performance and take corrective actions.

• Evaluate employees’ performance and determine incentive compensation.

• Compare the financial performance of different divisions within the firm

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Uses of Financial Ratios within the Firm

• Prepare financial projections, both at the firm and division levels.

• Understand the financial performance of competitors

• Evaluate the financial condition of a major supplier.

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Uses of Financial Ratios Outside the Firm

• Lenders in deciding whether or not to make a loan to a company.

• Credit-rating agencies in determining a firm’s credit worthiness.

• Investors in deciding whether or not to invest in a company.

• Major suppliers in deciding to sell and grant credit terms to a company.

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Measuring Key Financial Relationships

• How liquid is the firm?• Is management generating adequate

operating profits on the firm’s assets?

• How is the firm financing its assets?• Is management providing a good

return on the capital provided by the shareholders?

• Is the management team creating shareholder value?

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How Liquid Is a Firm?

• Liquidity is the ability to have cash available when needed to meet its financial obligations

• Measured by two approaches:– Comparing the firm’s assets that

are relatively liquid– Examines the firm’s ability to

convert accounts receivables and inventory into cash in a timely basis

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Measuring Liquidity: Approach 1

• Compare a firm’s current assets with current liabilities– Current Ratio– Acid Test or Quick Ratio

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Current Ratio

• Compares cash and current assets that should be converted into cash during the year with the liabilities that should be paid within the year

• Current assets/Current liabilities

Starbucks Example:Current ratio= $922M / $591M = 1.67

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Acid Test or Quick Ratio

• Compares cash and current assets (minus inventory) that should be converted into cash during the year with the liabilities that should be paid within the year.

• Cash and accounts receivable/Current liabilities

Starbucks ExampleQuick Ratio=

($350M + $114M) / $591M =1.05

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Measuring Liquidity:Approach 2

• Measures a firm’s ability to convert accounts receivable and inventory into cash– Average Collection Period– Accounts Receivable Turnover– Inventory Turnover– Cash Conversion Cycle

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Average Collection Period

• How long it takes to collect the firm’s receivables

• Accounts receivable/(Annual credit sales/365)

Starbucks Example:Avg. Collection Period =

$114M / $1.68M= 68.1 days

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Accounts Receivable Turnover

• How many times accounts receivable are “rolled over” during a year

• Credit sales/Accounts receivable

Starbucks ExampleAccounts Receivable Turnover =

$611M / $114M = 5.36X

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Inventory Turnover

• How many times is inventory rolled over during the year?

• Cost of goods sold/Inventory

Starbucks ExampleInventory Turnover=

$3,207M / $342M = 9.38X

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Starbucks vs. Peer Group

Ratio Starbucks PeersCurrentRatio

1.67 2.02

QuickRatio

1.05 1.54

Avg. Collection Period

68.1 days 93 days

Accounts Receivable Turnover

5.36X 3.90X

Inventory Turnover

9.38X 8.5X

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Is Management Generating Adequate Operating Profits on the Firm’s Assets?

• Operating Return on Assets (OROA)

• Operating Profit Margin• Total Asset Turnover• Fixed Asset Turnover

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Operating Return on Assets

• Level of profits relative to total assets • Operating return/Total assets

Starbucks ExampleOperating Return On Assets =

$436M / $2,672M = .163 or 16.3%

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Operating Profit Margin

• Examines how effective the company is managing its operations

• Operating profit/Sales

Starbucks ExampleOperating Profit Margin =

$436M / $4,067M = .107 or 10.7%

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Total Asset Turnover

• How efficiently a firm is using its assets in generating sales

• Sales/Total assets

Starbucks ExampleTotal Asset Turnover =

$4,076M / $2,672M = 1.53X

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Fixed Asset Turnover

• Examines investment in fixed assets for sales being produced

• Sales/Fixed assets

Starbucks ExampleFixed Asset Turnover =

$4,076M / $1,750M = 2.33X

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Starbucks vs. Peer Group

Ratio Starbucks PeersOperating Return on Assets

16.3% 14.9%

Operating Profit Margin

10.7% 11.8%

Total Asset Turnover

1.53X 1.26X

Fixed Asset Turnover

2.33X 2.75X

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How Is the Firm Financing Its Assets?

• Does the firm finance assets more by debt of equity?– Debt Ratio– Times Interest Earned

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Debt Ratio

• What percentage of the firm’s assets are financed by debt?

• Total debt/Total assets

Starbucks ExampleDebt ratio =

$591M / $2,672M = .221 or 22.1%

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Times Interest Earned

• Examines the amount of operating income available to service interest payments

• Operating income/Interest

Starbucks ExampleTimes Interest Earned =

$436M / $3M = 145.3X

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Starbucks vs. Peer Group

Ratio Starbucks PeersDebt Ratio 22.1% 25%

Times Interest Earned

145.3X 46.0X

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Is Management Providing a Good Return on the Capital Provided by the Shareholders?

• Are the earnings available to shareholders attractive

• Return on equity• Net income/Common equity

Starbucks ExampleReturn on Equity

= $268M / $208M = .129 or 12.9%

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Starbucks vs. Peer Group

Ratio Starbucks PeersReturn onEquity

12.9% 12.0%

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How Is Management Doing Creating Shareholder Value?

• These ratios indicate what investors think of management’s past performance and future prospects. Two approaches:– Price/Earnings ratio– Price/Book ratio

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Price/Earnings Ratio

• Measures how much investors are willing to pay for $1 of reported earnings

• Price per share/Earnings per share

Starbucks ExamplePrice/Earnings Ratio =

$35.00 / $0.69 = 51X

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Price/Book Ratio

• Compares the market value of a share of stock to the book value per share of the reported equity on the balance sheet

• Price per share/Equity book value per share

Starbucks Example Price/Book Ratio =

$35.00 / $5.32= 6.58X

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Starbucks vs. S&P Index Price

Ratio Starbucks S&PPrice/EarningsRatio

51X 24X

Price/Book Ratio 6.58X 3X

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Economic Value Added (EVA)

• Measures a firm’s economic profit, rather than accounting profit

• Recognizes a cost of equity and a cost of debt

• EVA = (r-k) X Cwhere:r = Operating return on assetsk = Total cost of capitalC = Amount of capital (Total Assets)

invested in the firm

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Limitations of Ratio Analysis

• Difficulty in identifying industry categories or finding peers

• Published peer group or industry averages are only approximations

• Accounting practices differ among firms• Financial ratios can be too high or too low• Industry averages may not provide a

desirable target ratio or norm• Use of average account balances to offset

effects of seasonality