Chapter 14
Financial Ratios
and Firm
Performance
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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.
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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.
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14.1 Trend Analysis
TABLE 14.1 Cogswell Cola’s Abbreviated Income Statements ($ in
thousands)
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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.
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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.
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14.2 Financial Ratios (continued)
•
Five key areas of a firm’s performance can be analyzed by
using financial ratios:
1.
2.
3.
4.
5.
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.
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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:
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• 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.
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14.2 (A) Short-Term Solvency:
Liquidity Ratios
TABLE 14.2 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.
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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.
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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.
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• 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.
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14.2 (B) Long-Term Solvency:
Financial Leverage Ratios
TABLE 14.3 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.
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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.
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• 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.
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14.2 (C) Asset Management Ratios
TABLE 14.4 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
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14.2 (D) Profitability Ratios
• Profitability ratios measure a firm’s effectiveness
in turning sales or assets into profits.
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• 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.
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14.2 (D) Profitability Ratios
(continued)
Table 14.5 Profitability Ratios 2008 for Cogswell Cola and Spacely
Spritzers
As far as profitability is concerned,
Cogswell is outperforming Spacely by
about 3%.
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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:
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• 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.
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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.
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14.2 (E) Market Value Ratios
(continued)
Ratio
P/E
PEG
P/B
Cogswell Cola
15.41
1.28
5.49
Spacely Spritzers
13.01
0.86
4.17
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.
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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:
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)
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:
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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.
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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.
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Another example of comparison
between competitors
TABLE 14.6 Key Financial Ratios and Accounts for PepsiCo and
Coca-Cola (through third quarter 2007)
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14.3 (A) Cola Wars
TABLE 14.7 Some Key Ratios and Accounts for PepsiCo
and Coca-Cola (Five-Year Period)
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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).
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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, so comparing company ratios with
industry averages can be useful and informative.
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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?
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ADDITIONAL PROBLEMS WITH
ANSWERS
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
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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
Accts. Rec.
$
43,000
Inventory
$
42,000
Other Current
$
12,000
Long-Term Debt
Total Current
$ 103,336
Other Liabilities
L-T Inv.
$
PP&E
$ 225,000
Goodwill
$
30,000
Common Stock
$ 189,676
Other Assets
$
14,000
Retained Earnings
$
25,340
Accounts Payable
$
57,000
Short-Term Debt
$
1,500
$
58,500
Total Current
Liabilities
Total Liabilities
$ 397,676
$
15,000
$ 147,500
Owners’ Equity
Total OE
Total Assets
$ 74,000
Total Liab. And OE
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60,500
$ 250,176
$ 397,676
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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
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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
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
Total Asset Turnover
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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.
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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 TriMark’s key profitability ratios.
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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)
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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
1.59
1.75
Equity multiplier = 1/(1 -debt ratio)
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.
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