Evaluating firm financial performance

Chapter 4

Evaluating a Firm’s Financial Performance

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

Chapter 4 Evaluating a Firm’s Performance

Pearson Prentice HallFoundations of Finance4 - 2

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.



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.



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



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



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.



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.



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?



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



Measuring Liquidity: Approach 1

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



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



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



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



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



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



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



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



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



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%



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%



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



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




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



How Is the Firm Financing Its Assets?

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



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%



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




Ratio Starbucks PeersDebt Ratio 22.1% 25%

Times Interest Earned

145.3X 46.0X



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%




Ratio Starbucks PeersReturn onEquity

12.9% 12.0%



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



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



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



Starbucks vs. S&P Index Price

Ratio Starbucks S&PPrice/EarningsRatio

51X 24X

Price/Book Ratio 6.58X 3X



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



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

Evaluating firm financial performance

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