Media and Journalism Module
Business and Economics For Reporters
10. Analysing financial performance
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This week’s lesson
• Last week - basic financial documents and
statements
• This week - analysing a company's performance
• Techniques to analyse a company’s performance:
•
•
•
•
liquidity
profitability
use of debt
return on equity
•
•
•
•
•
•
Return on Assets/Return on investment
Current ratio
Acid Test Ratio
Return on Equity
Working capital
Capital expenditure
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• Significant financial performance measures:
Evaluating ratios
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A note on evaluating ratios
• Last week - the entries on the balance
sheet and income statement
• This week - calculate financial ratios
using balance sheet and income
statement data to evaluate the
financial health of a company
BER,Ppt10.ppt
A note on evaluating ratios
• Need to compare the ratios with benchmark values
• Provide you with the accepted “rule of thumb” figure that can
help guide you to a reasonable conclusion
• Techniques to consider to evaluate ratios:
• Compare the company to similar firms in the same industry
• Compare ratios with industry averages for similar sized firms
• Good technique for smaller firms
• Data from many sources – e.g. Dun and Bradstreet and industry
professional associations
• Compare data from the same firm through time
• Changes may be caused by business cycles or management decisions
• Helps you find a worthwhile story idea
• Focusing on four main areas:
•
•
•
•
liquidity
profitability
use of debt
return on equity.
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www.dnb.com
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Liquidity
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Liquidity
• A company's ability to meet its
requirements for cash
• Necessary to meet both expected and
unexpected cash demands
• Too little liquidity can stunt growth and
ultimately lead to bankruptcy if debts
cannot be repaid
• Too much liquidity can detract from
profits, because liquid assets are low
returning investments.
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Current Ratio
Current Ratio 
Current Assets
Current Liabilitie s
• Standard measure of liquidity
• High quality companies have lower current ratios
• these companies have easy access to capital markets if
they unexpectedly require cash
• Smaller companies should have higher current
ratios to meet unexpected cash requirements
• Current Ratio should always be > 1 to be a “liquid
company”
Rule of Thumb
Current ratio for small companies = 2:1
Need for a level of safety to cover unforeseen cash needs from current assets
Business has twice as much short-term assets compared to the current liabilities
Financially safe in the short-term to meet all short-term obligations urgently
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YouGood Company
• Fictitious company operating in a
Pacific Island country
• YouGood Company origins can be
traced back to 1924
• The company currently produces:
• fresh food from local and imported raw
material – these products have a two
week shelf life
• manufacturing and packaging goods
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YouGood Company
• Fictitious
YouGood
company
example
• YouGood’s
Current
Ratio:
Current Ratio
Times
2
•What does
this graph
tell you about
YouGood
Company?
1.19
1.02
1
0.89
0
2002
2003
Years
BER,Ppt10.ppt
2004
YouGood Company – Current Ratio
• Well under the desirable ratio for a small
company
• It should aim for an increase and maintain
the ratio between 1.5 and 2 for a
manageable level of current liabilities
• Any inefficiency in managing short-term
liabilities should be rectified and stronger
credit terms negotiated only after it
builds a capability to honourably service
its financial obligations as they fall due
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Working Capital
Working Capital  Current Assets  Current Liablities
• Working Capital or internal liquidity is
expressed in dollars
• Shows whether the business has funds
available to meet short-term obligations
• Does not take into account that some
current assets are more liquid (in cash
form) than others
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YouGood Company
Working Capital  Current Assets  Current Liablities
Working Capital as a Percentage of Revenue
Percent
10.0%
5.0%
4.5%
0.3%
0.0%
2002
•What does
this graph
tell you about
YouGood
Company?
2003-2.7%
-5.0%
Years
Working Capital
BER,Ppt10.ppt
2004
YouGood Company
• YouGood Company is in trouble
• It is close to being technically insolvent
i.e. the company’s working capital needs to
vastly improve in comparison to the
revenue that it generates
Insolvency is a financial condition experienced
by a person or business entity when their assets no longer
exceed their liabilities. Commonly referred to as 'balance-sheet' insolvency,
or when the person or entity can no longer meet its debt obligations
when they come due, commonly referred to
as 'cash-flow' insolvency. (Wikipedia)
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Quick Ratio / Acid Test
Quick Ratio / Acid Test=
(Cash + Accounts Receivable + Short-term Investments)
Current Liabilities
• Measures how much liquid assets the business has
to meet short-term obligations
• The assets are cash, marketable securities and
accounts receivables
• Inventory and other short-term assets are ignored
Rule of Thumb
•Ratio should be maintained
•between 1 and 1.5:1.
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YouGood Company
Quick Ratio
Times
1
0.63
1
0.46
0.28
•What does
this graph
tell you about
YouGood
Company?
0
2002
2003
Years
Quick/Acid Ratio
BER,Ppt10.ppt
2004
YouGood Company
• Clearly demonstrated that YouGood
company is well under the desirable ratio
in this area.
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Cash Ratio Cash Ratio  (Cash  Marketable Securities )
Current Liabilitie s
• The cash ratio measures the extent to
which a company can quickly liquidate
assets and cover short-term liabilities
• For a bank this is the cash held by the bank
as a proportion of deposits in the bank
• Cash ratio is also called liquidity ratio or
cash asset ratio
Rule of Thumb
•Ratio maintained at between 0.5 and 1:1.
• But excess cash should not be tied up in unproductive accounts
•such as bank deposits, which could be returning interest lower
•than if the funds were to be invested
into the business and earning more.
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YouGood Company
(Cash  Marketable Securities )
Cash Ratio 
Current Liabilitie s
Cash Ratio
Times
0.5
•What does
this graph
tell you about
YouGood
Company?
0.0
0.00
2002
0.01
2003
-0.5
Years
Cash Ratio
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0.05
2004
YouGood Company
• Clearly demonstrates that YouGood
Company is well under the desirable ratio
in this area.
• YouGood does not have any cash or
securities to meet its liabilities
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Profitability
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Profitability
• Common measures of profitability:
• net profit margin
• return on assets
• Each measure provides a different
perspective about the firm's profits
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Return on Assets (ROA)
Net Pr ofit
ROA 
Total Assets
• ROA percentage shows how profitable a company's assets are
in generating revenue
•
"what the company can do with what it's got“
• how many dollars of earnings they derive from each dollar of assets
they control
• the rate of return provided by the book value of the company's
assets.
• Useful for comparing competing companies in the same
industry
• Number will vary widely across different industries
• Companies requiring large initial investments will generally
have lower return on assets
• EBITD - Earning Before Interest, Taxes and Depreciation
• this figure ignores the depreciated value of assets during the year
• EBITD does not take into account the capital or financing
structure of the business assets
• does include the book value of current and non-current assets
• high return on assets provides
a buffer for more financial risks
BER,Ppt10.ppt
YouGood Company
ROA 
Net Pr ofit
Total Assets
Return on Assets
4%
3.4%
3.2%
Percent
3%
2%
1%
0%
-1%
•What does
this graph
tell you about
YouGood
Company?
2002
-1.2%
2003
-2%
Years
Return on Assets
BER,Ppt10.ppt
2004
YouGood Company
• Clearly see is that the YouGood Company
has been generating very low levels of
return on its assets
• as low as -1.2%
• but it is improving from it’s worst ever point,
where it had a high negative return on the
assets.
BER,Ppt10.ppt
Net Profit Margin
Net Income
NPM 
Total Sales
• An important measure of profitability - Net Profit Margin (NPM)
• Indicates the percentage of each dollar of sales that the firm is able
to flow to the bottom line as profit
• A function of:
• price of the product - sales revenue
• efficiency of operations - cost of goods sold
• A firm selling a unique product to a captive market may be able to
charge a premium price and therefore generate greater NPM
• On the other hand, a firm selling a generic product in a highly
competitive market will have a low NPM – this company must be
very efficient or it will not survive
• A positive result indicates that the company was able to make a
profit
• the revenues generated during the year were more than enough to
cover for all expenses
• basis for determining how much company tax is owed to the
government
BER,Ppt10.ppt
Net Income
NPM 
Total Sales
YouGood Company
Net Profit Margin
10%
Percent
5%
1%
1%
0%
2002
•What does
this graph
tell you about
YouGood
Company?
2003
-5%
Years
Net Profit Margin
BER,Ppt10.ppt
1%
2004
YouGood Company
• NPM is very low and in order to achieve
greater profitability the company will have
to reduce its expenses and increase its
productivity
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Fixed Asset Turnover
Fixed Asset Turnover 
Sales
Total Assets
• The number of times that the real assets turnover (tangible
assets that are invested in and maintained by the company)
• How often assets are being “financed” from revenues
• Figure indicates how effectively the company generates sales
from its asset base.
• The more effective the company in generating sales revenue
the higher the asset turnover
• Differences in industries cause differences in asset structure
and total asset turnover
• A high turnover means that the assets are able to generate a
high level of revenue as opposed to being inefficient and
unproductive
• An average measure and each asset needs to be considered
separately to judge their performance and capabilities
BER,Ppt10.ppt
YouGood Company
Fixed Asset Turnover 
Fixed Asset Turnover (Times)
Times
8
•What does
this graph
tell you about
YouGood
Company?
5.4
5.8
2003
2004
4
0
Years
Fixed Asset Turnover - (Times in a Year)
BER,Ppt10.ppt
Sales
Total Assets
YouGood Company
• YouGood’s cannot achieve the margins /returns required
for continued growth
• the fixed asset turnover at its present level and would
need to increase to above 10 in order to do so
• For companies that have a large investment in inventory,
it is useful to calculate the inventory turnover ratio,
which is the cost of goods sold (from the income
statement) divided by the inventory (shown on the
balance sheet)
• Too low a turnover indicates too much investment in
inventory, whereas too high a turnover could cause lost
sales due to lack of merchandise to meet customer
demand.
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Break
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Use of debt
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Financial leverage
• Financial leverage is the use of fixed cost funds such
as debt or preferred stock to increase the common
stockholder's return
• For example, if the firm can borrow at 8% and earn a rate
of return on assets (ROA) of, say 12 percent, the 4 percent
above the cost of funds will accrue directly to the common
shareholders
• Conversely, if earnings decline and the company's return on
assets falls below 8 percent, the deficit must be borne
entirely by the common shareholders
• Using debt in the firm produces a stream of earnings that
has greater risk than would occur in the same firm if it had
less debt
Rule of Thumb
There is no rule of thumb to indicate
the proper amount
of debt for a firm.
BER,Ppt10.ppt
Financial leverage
• Major factors:
• management's willingness to accept financial risk
• earnings predictability
• company whose earnings stream is predictable can have a higher debt
ratio and try to take advantage of the leverage it provides
• tax advantage of using debt
• (remember that interest expense is tax deductible for the firm while
preferred and common dividends are not
• Some debt is considered advantageous for a company
• Two debt ratios:
• debt to total assets ratio, or the debt ratio:
• debt ratio = the sum of all the liability accounts divided by total assets
• equity multiplier:
• equity multiplier = total assets divided by the common equity account
• a firm totally financed by equity will have a multiplier of 1.00
• the larger the number the more highly leveraged is the firm
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Return on equity
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Return on Equity (ROE)
• The level of after tax profits the shareholders were
able to earn on their book value shareholding in the
company
• ROE represents the rate of return the company
earned on the book value of its equity investment
• The higher the number, the greater the return the company
is earning for its shareholders
• If you are investigating a company remember that
ROE should be considered a relative measure and
evaluate it along with the opportunity cost of capital
or the returns on investments that could have been
earned on alternative investments of similar risk
profile
BER,Ppt10.ppt
YouGood Company
Return on Equity
8%
7.3%
7%
Percent
6%
5%
5.1%
4.4%
4%
3%
2%
1%
•What does
this graph
tell you about
YouGood
Company?
0%
2002
2003
2004
Years
Return on Ow ner's Equity (ROE) - End of Year
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YouGood Company
• Follows a similar pattern to that of its
ROA
• assets are not generating adequate
profits (as opposed to generating
revenue)
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Capital Expenditures
• Funds spent on real assets that are
necessary for the business and are expected
to generate revenue from its operations
• Capital expenditures are necessary:
• to replace aging assets
• for maintenance of existing assets
• investing in new assets due to changes in
technology
• capacity for generating additional revenue can be
increased as part of the ongoing business
activities or during the expansionary phase of a
business
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YouGood Company
Capital expenditues (net of disposals)
$1,400,000
$1,259,693
$1,200,000
Dollars
$1,000,000
$800,000
$600,000
$435,848
$400,000
•What does
this graph
tell you about
YouGood
Company?
$200,000
$2004
2003
Years
BER,Ppt10.ppt
YouGood Company
• Depreciation is the non-cash expense item that
accounts for the aging, obsolescence and wear
and tear of the physical assets of a business
• Historically, the company has had its assets
depreciated annually in the region of $500,000
to $700,000
• Its current replenishment of assets are falling
in book value each year
• Does not seem adequate for maintaining or
growing the business
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What does it all mean?
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Putting it all together?
• A lot of very detailed and specific
information about financial analysis
• Don’t be alarmed by all this information you are not expected to be a financial expert
• Making you aware of the depth of
information available in financial statements
• Motivate you to further study by using one
of the many texts available about financial
analysis
BER,Ppt10.ppt
Putting it all together?
• As journalists you can access the
findings of financial analysts and those
preparing investment advice for
potential shareholders
• They can perform some of the hard
work for you but:
• they look at the company from a financial
perspective
• not as a journalist
• their motivation is profit, not news!
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Putting it all together?
• Knowledge of terms familiar to the chief
executive or chief financial officer will:
• increase your credibility
• help you to develop questions
• structure interviews to get the best possible
information for a story
• Always ask experts to help you understand
and interpret the numbers you might
calculate
• Your job as a business journalist is to get
behind the numbers and interpret what they
tell you about the firm in order to get a good
story
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Closure
The important thing is not to stop questioning.
Albert Einstein
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Summary
• Furthering financial analysis skills
• not intended to make you financial analysts
• provide you with information to perform effectively as business
journalists
• We discussed a method of analysing a company by
considering:
•
•
•
•
liquidity
profitability
use of debt
return on equity.
•
•
•
•
•
•
Return on Assets/Return on investment
Current ratio
Acid Test Ratio
Return on Equity
Working capital
Capital expenditure.
• Significant financial performance measures, including:
BER,Ppt10.ppt
Coming up!
• The sharemarket:
• what are the significance of price changes
• how it works
• what conclusions you can draw from findings
• Specifically we are going to examine:
• Stocks, bonds and mutual funds: how they are
bought and sold
• how prices are determined
• how to read stock tables for business journalism
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http://www.guardian.co.tt/archives/2005-03-10/bussguardian11.html