Corporate performance
analysis
Financial ratio analysis and
rating
Helena Sůvová
Guest lecture for the Czech University
of Agriculture
October, 2010
1
Content of the lecture
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Sources of financial ratios (indicators), users
of corporate performance analysis
Basic groups of financial ratios
Objectives and caveats
Comprehensive systems of financial ratios,
default prediction models
Credit rating – external, internal
Summary of the lecture
Assignments for the tutorial
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Sources of financial ratios
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Financial statements: balance sheet, income
statement, statement of cash flows, statement of
retained earnings
! Important: accounting /reporting standards
– GAAP
– IFRS or IFRS European version
– CAS
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Accounting units registered on a regulated securities
market in a EU Member State must report in IFRS –
EU adjusted
Accrual accounting – recognizes timing X cash inflow
– outflow: differences caused by: accrual principle,
depreciation, taxes
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Sources of financial ratios
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Current efforts in accounting rules in
response to economic crisis:
– Global accounting standards by 2011
– the application of fair value in illiquid
markets ?
– off balance sheet items – more
transparency, tightening rules
– improved disclosures related to risk
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Example statements
WW company
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Example statements
WW company
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Sources of financial
ratios, users
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Other sources: web pages of individual
firms, internet databases, paid databases –
Magnus, Ariadna
Users of corporate performance analysis:
stockholders, creditors, managers,
employees, business partners (customers,
suppliers), journalists, students, public
generally
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Basic groups of financial
ratios
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5 basic groups:
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liquidity ratios
debt management ratios (leverage ratios)
asset management ratios (activity ratios)
profitability ratios
market value (valuation) ratios
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Basic groups of financial
ratios
1) Liquidity ratios
firm´s ability to pay its obligations in the short
term
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– current ratio = current assets/current liabilities
– quick ratio = (current assets –
inventory)/current liabilities
– cash ratio = (cash + near-cash)/current liabilities
– net working cap. to total assets = (curr.assets –
curr. liab.)/total assets
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Basic groups of financial
ratios
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2) Debt management ratios
characterize relative mix of debt and equity financing and
measures the long term debt paying ability of the firm
– debt ratio = total liabilities (total debt)/total assets
– financial leverage = total assets/equity
– long term debt ratio = long term debt/ total assets
– interest coverage ratio (times interest earned) =
EBIT/interest expense
– fixed payment coverage = (EBIT + lease payments)/(interest
+ lease payments + 1/(1-T) * (principal payments +
preferred stock dividends))
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Basic groups of financial
ratios
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2) Debt management ratios
Economy
High leverage
Low leverage
Upturn
+ (chance of
high profits)
- (low chance of
high profits)
Downturn
- (large risk of
loss)
+ (low chance of
high losses)
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Basic groups of financial
ratios
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3) Asset managemet ratios
= asset utilization/efficiency
turnover is measured in sales or costs
– accounts receivable turnover = net credit
sales/avrg accounts receivable
– receivable collection period = 365/accounts
receivable turnover
– inventory turnover = cost of goods sold/ avrg
inventory
– inventory collection period (avrg age of invetory)
= 365/inventory turnover ratio
– fixed assets turnover = sales/ (net) fixed assets
– avrg payment period = accounts payable/avrg
purchases per day
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Basic groups of financial
ratios
4) Profitability ratios
final answer about the effectivness of business
– profit margin on sales (net profit margin) = net
income/ sales
( or EAT/sales)
– gross profit margin = (sales-costs of goods
sold)/sales
– return on (total) assets ROA = EBIT/ total assets
– …… but also ROA = EAT/total assets
– return on equity ROE = net income/ equity
– …. or EAT/equity or EACS/equity
EACS = earnings available for common stockholders
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Basic groups of financial ratios –
ROE in different Czech industries
2004, 2005
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Basic groups of financial
ratios
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5) Market value ratios
most comprehensive measures of performance
– P/E ratio = price of share/earnings per share
– market to book ratio (M/B ratio) = market
value/book value
– EPS = EACS/number of shares
EACS = earnings available to common stockholders
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Objectives, caveats
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Financial ratio = mathematical relationship among
several variables (numbers), stated in %, times,
days
Financial ratios are used to analyze firm´s financial
performace, however do not provide all answers
Ratios are not standardized
Ratios should not be analyzed in isolation to judge
overall performance of a firm (x just specific
aspect)
Accounting standards affect the ratios
Financial statements: annual, quarterly, monthly
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Objectives, caveats
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Comparisons:
– cross sectional - industry norms, key
competitors,
– time series, trends – comparisons with previous
periods
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Comparability:
– use the same ratio formulas
– preferably use audited (annual) statements
based on the same accounting standards
– be aware of valuation of assets
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Objectives, caveats
Example of cross-sectional and time-series
analysis
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Comprehensive systems of
financial ratios, default
prediction models
Financial analysis may become a part of other
corporate performance analyses
„ Example = credit analysis, rating
„ Questions of credit manager: How much money can
I lend? How much risk am I exposed?
„ Credit analysis – long time relied on financial
analysis
„ 1968 – first statistical methods used in financial
ratio analysis:
Z – Score model by Altman, based on discriminant
analysis
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Comprehensive systems of
financial ratios, default
prediction models
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1977 – updated Zeta model
1980 – KMV Corporation using modern portfolio
theory → model Credit Monitor – default risk for
publicly traded companies in North America and
Europe
models like this are called „Merton“ models
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1997 - J.P. Morgan developed Credit Metrics
1999 - Moody´s introduced Risk Calc
2002 - Kamakura Corporation credit risk models
appeared – Merton type of models, reduced form
models (similar to Z-Score), hybrid combining both
methodologies
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Comprehensive systems of
financial ratios, default
prediction models
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Z – Score: discriminates between firms that default
(fail) and those that do not
Z = 1,2 X1 + 1,4 X2 + 3,3 X3 + 0,6 X4 + 0,999 X5
X1 = working capital/total assets
X2 = retained earnings/total assets
X3 = EBIT/total assets
X4 = market value of equity/book value of total liabilities
X5 = sales/total assets
Decision-making criteria:
Z < 1,81 …. fail
Z Є (1,81; 2,99) …. grey zone
Z > 2,99 ….. on going
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Comprehensive systems of
financial ratios, default
prediction models
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Czech index for assessment of the financial
situation – IN index (index of Czech enterprise
creditworthiness)
Comprehensive financial analysis – using organized
system of financial ratios, e.g. Du Pont system or
pyramid analysis
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:
Example of pyramid system
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Credit rating – external,
internal
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Credit rating = opinion of the general creditworthiness of an
obligor. It represents the relative level of default risk.
Rating scale – from AAA to D
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investment grades: AAA, AA, A, BBB
speculative grades: BB, B, CCC, CC, C
default: D
Global rating agencies: S&P, Moody´s, Fitch
Rating by rating agencies are external (are published)
Rating methodology –
– long –term, through-the-cycle
– stress on sustainability of cash flows
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Credit rating – external,
internal
This is an ideal through-the-cycle rating:
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Credit rating – external,
internal
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Types of rating:
– issue-specific X issuer rating
– long-term X short-term rating
– international (foreign currency) X local rating
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Rating methodology usually includes the assessment of:
– 1) Business risk
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Country risk
Industry characteristics
Company position
Product portfolio/Marketing
Technology
Cost efficiency
Strategic and operational management
competence
Profitability/Peer group comparisons
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Credit rating – external,
internal
– 2) Financial risk
„ Accounting
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Corporate governance/Risk
tolerance/Financial policies
Cash-flow adequacy
Capital Structure/Asset Protection
Liquidity/Short-term factors
Ratings widely accepted by the financial markets.
Rating is an example of comprehensive
assessment: financial factors (including ratio
analysis) must be completed by non-financial
factors + expert judgement
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Credit rating – external,
internal
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Basic ratios used in rating methodology:
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growth of EBITDA
growth of profit margin
debt ratio
interest coverage ratio
liquidity
Interpretation of ratios is never straightforward
„Rating is as much art as it is a science.“
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Credit rating – external,
internal
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Internal rating systems – used for internal
purposes of financial institutions
similar basis as external rating by rating agencies,
but tailor-made for internal portfolio and needs
methodology based on model, completed by expert
judgement
usage: credit approvals, limit setting, pricing,
internal reporting, setting strategy
for homogenous portfolios (e.g. retail loans) –
scoring systems (automatic assessment)
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Summary of the lecture
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Financial statements are basic source of financial
analysis which is based on financial ratios.
Interpretation of ratios is not straigtforward, for
comprehensive view must be be completed by nonfinancial information and expert judgement.
Financial analysis makes part of other analyses –
credit analysis, credit rating, default prediction –
used by certain users for pre-detrmined purposes.
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Assignments for the
tutorial
What are some important caveats to remember when analyzing
financial ratios?
1.
Why are the accounting standards important for financial analysis?
What are accounting misdeeds (accounting numbers manipulation)?
2.
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3.
4.
5.
For which business is inventory turnover important?
manufacturing (production) company
wholesaler
retailer
service sector
How can a firm have a high current ratio and still be unable to pay
its bills? (Q 8.6.)
„The higher the rates of return on assets, the better the firm´s
managament“. Is this true? (Q 8.7.)
What factors would you examine if a firm´s ROA was too low and
decreasing? (Q8.8)
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Assignments for the
tutorial
6.
7.
What does a credit rating mean?
Web case:
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GO TO www. hoovers.
hoovers. com In the search box at the top of the page, enter UAL, select
select
"by ticker" from the dropdown list, then click GO.
What are the key financials of United Airlines?
Who is the CEO of United Airlines?
What is the competitive landscape?
Analyze the financial situation of UAL.
8.
Springfield Medical Devices, Inc., has a current assets valued at $15
million, inventory at $12 million, and current liabilities valued at $6 million.
The cost of goods sold was $60 million. Based on this information, its
current ratio is: a) 2.5 b) 0.25 c)0.5 d) 3.0. What is the inventory
turnover?
9.
P2-20 on page 93 of Gitman textbook : Zach Industries
Look at the financial statements of ČEZ and make simple Du Pont analysis
by using ROA, ROE and financial leverage in 2004/5.
10.
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Assignments for the
tutorial
11.
12.
13.
14.
Look at the data on Wisconsin Furniture Company (see Problem 8.3,
page 197 of the textbook) and indicate the possible error in the
management by calculating financial indicators. How could the company
improve its performance?
Which ratio is of the highest importance for short term creditors?
What if the financial ratios of a firm are far from industry average?
Look at the Bluestone Metals, Inc. (manufacturer of prefabricated metal
parts) results. What do you think of CEO´s claim that the firm is using
lean manufacturing model and soon be profitable?
2002
2003
2004
2005
2006
Current
ratio
1.4
1.3
1.6
1.8
2.2
Quick ratio
1.3
1.2
0.8
0.6
0.4
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Assignments for the
tutorial
15.
16.
17.
How would you present a complete
financial ratio analysis to the CEO of a
company to give him an overall picture
of financial situation of the company?
In which comprehensive systems of
corporate performance analysis are
financial ratios used?
Pelican Paper, Inc. and Timberland
Forest, Inc. are rivals in the manufacture
of craft papers. Compare their leverage
and profitability.
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Calculate their debt ratio and times
interest earned ratio
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Calculate ROA and ROE
Which company is more profitable? What
is the impact of larger debt of
Timberland Forest? What are the
risks that Timberland's investors
undertake? (P2-17)
Item
Pelican Paper,
Inc.
Timberland
Forest, Inc.
Total assets
$ 10 000 000
$ 10 000 000
Total equity
9 000 000
5 000 000
Total debt
1 000 000
1 000 000
100 000
500 000
$ 25 000 000
$ 25 000 000
EBIT
6 250 000
6 250 000
Net income
3 690 000
3 450 000
Annual
interest
Total sales
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