Chapter 3
Measuring and Evaluating
Financial Performance
Measuring and Evaluating
• A good understanding of finances helps an analyst evaluate
the performance of a company
• No single number fully tells the story of a company.
– It requires that we look at many different aspects of the business
• Ratios analysis helps us tease out the most intimate details
of a firm to help us determine how it is performing
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Methods
• There are a few methods we are going to use to help us
understand how our company is performing
– Horizontal analysis
– Vertical analysis
– Ratio analysis
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Methods
• Horizontal analysis
– Also known as trend analysis, is a way of helping financial
statement users recognize important financial changes that are
occurring over time.
– The purpose here is to compare similar line items in a company’s
financial statements from period to period to help determine if
there are trends
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Methods
• Horizontal analysis
– Also some times call time-series analysis
– Horizontal analysis can help us find sustainable trends that have
been (or will) affect the company into the future
– The general formula we use for horizontal analysis is
– Year to year change [%] = (Current year total – Prior year total)/
prior year total
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Methods
• Horizontal analysis
– When performing our horizontal analysis, we may get some
percentages that are larger than others
– Certainly, the larger figures will catch our attention, but just
because it is a large percentage change doesn’t mean its material
– Remember, if the denominator of the calculation is a small number
(relatively speaking), it will result in a large percentage.
• So when we are looking at the results of the analysis, we need to keep
the dollar amounts in mind too
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Methods
• Horizontal analysis example
– From p. 252, Exh 13.1
– Year over year change in current assets=
• (13900-13362)/13362 = 4%
– Year over year change in Cash
• (1421 – 519)/519 = 174%
– Yes, the change in cash is large, but the cash account started at a
very small number compared to some of the other numbers on the
balance sheet
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Methods
• Horizontal analysis more examples
– From p. 252, Exh 13.2
– Year over year change in revenues =
• (66176 – 71288)/71288 = -7.2%
– Year over year change in Net Income
• (2661 – 2260)/2660 = 17.7%
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Example
• Let’s do E13-3 Part 1, p273
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Methods
• Vertical analysis
– Focuses on important relationships between items on the same
financial statement
– Sometimes we call this “common-size” analysis
• We call it “common-size”, because we pick a number on
the statement and take every other number as a percentage
of that number
– (in the case of the BS it is usually Total Assets and in the case of
the Income Statement it is usually top line Revenue)
• This approach helps us to see which figures are material
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Methods
• Vertical analysis example
– From p.253, Exh 13.3, we see an example of a common size
balance sheet
– All numbers are calculated as a percent of Total Assets (or Total
Liabilities + Owner’s Equity)
– This helps us see that:
• Inventories as well as Property and Equipment are significant portions
of the asset side of the balance sheet
• It also shows us that most of the Liabilities and Shareholders’ Equity
section is financed first by equity, then Long Term liabilities, then
Current liabilities
– From Exh 13.4, we see that
• Cost of Sales is the largest expense on the income statement
• We also see that Operating and Other Expenses are large (compared
to other items on the income statement)
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Example
• Let’s do E13-3 Part 2, p273
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Methods
• Ratio analysis
– Uses information from multiple statements to understand what is
going on with the company
– Ratios use figures from all financial statements to tell a story about
the company
– As we will see in the next few slides, ratios can be categorized into
several categories
– Your book talks about 3
• Profitability
• Liquidity
• Solvency
– I will add a fourth and fifth
• Efficiency and Market
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Ratio Analysis
• When performing ratios analysis, we often include balance
sheet and income statement accounts in the formulae
• When using a formula that includes both income statement
(revenues and expenses) as well as balance sheet account (like
cash, AR, Inventory, total assets, etc), we will often take an
average of the beginning and ending period balances
• To take an average, take the number shown for the balance
sheet account for Year 1 (say, 2004) and Year 2 (say, 2005),
add them together and divide by 2
• Example: Total Asset Turnover = Net Sales / (Avg Total
Assets)
– Total Asset Turnover = Net Sales / ((Total Assets in Year 1 + Total
Assets in Year 2)/2)
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Liquidity and Efficiency
• Liquidity refers to the availability of resources to address
short-term obligations
• Efficiency refers to how well a company uses its resources
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Liquidity
• Working Capital = Current Assets – Current Liabilities
– If this figure is greater than 0, then there is resources available to
pay short-term obligations
• Cash to Asset Ratio = Cash / Total Assets
– Helps to figure out how much of the total assets is cash
– The higher the figure, the safer/more liquid the company is
– But, also the higher this figure, the more inefficient the company is
being with its cash
• Cash earns no return sitting in bank accounts
• The objective is to invest it in Capital Assets, intellectual knowledge
or production so that it earns a return
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Liquidity
• Current Ratio = Current Assets/Current Liabilities
– The current ratio is a measure of the firm’s ability to pay bills as
they come due.
– If too low, then company can be at risk of meeting short-term
obligations. If too high, then there may be too much invested in
short-term assets
• Quick Ratio = (Cash + Marketable Securities + Net
Receivables)/Current Liabilities
– It is a more stringent measure of the firm’s ability to pay its bills
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Efficiency
• Accounts Receivable Turnover = Net Sales / (Average Net
Accounts Receivable)
– Where average AR = (beginning AR + ending AR)/2
– This measures how fast a company collects its receivables
– The higher the turnover, the shorter the time between sales and
collecting cash.
• Days Sales in Receivables = (Avg Net AR)/Net Sales x 365
– average number of days it takes to collect accounts receivable (number
of days of sales in receivables)
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Efficiency
• Inventory Turnover = COGS/Average Inventory
– Where average inventory = (beginning inventory + ending
inventory)/2
– Measures the number of times the inventory is turned over
– Generally, a high inventory turnover is an indicator of good
inventory management.
– But a high ratio can also mean there is a shortage of inventory,
which may mean the company may miss a sale due to an out-ofstock situation.
– A low turnover may indicate overstocking or obsolete inventory.
• Days Sales in Inventory = Avg Inventory/COGS x 365
– shows the average number of days it will take to sell your
inventory (number of days sales @ cost in inventory)
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Efficiency
• Total Asset Turnover = Sales / Avg Total Assets
– It is a measure of how many times Sales pays for Assets
• Capital Asset Turnover = Sales / Avg Capital Assets
– Measures the efficient use of the just the big ticket items.
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Solvency
• While liquidity is concerned about ability to meet short-term
obligations, Solvency is concerned about the company’s longterm viability and its ability to cover long-term debt.
• One of the most important elements of solvency analysis is the
analysis of a company's capital structure.
– Capital Structure refers to a company's sources of finances: debt and
equity
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Solvency
• Debt Ratio = Total Liabilities / Total Assets
– Measures the % of creditor funding of assets
• Equity Ratio = Total Owner’s Equity / Total Assets
– Measures the % of owner funding of assets
• Debt to Equity Ratio = Total Debt / Total Equity
– A measure of leverage, which compares the amount of skin in the game that the
owners have versus the creditors
– Too much debt can put the business at risk. But debt is also a growth
instrument. Too little debt may mean there are opportunities that are being
missed.
• Debt Coverage Ratio = (Net Income + Non-cash expenses like Depreciation
and Amortization) / Debt
– Shows how much the cash profits are available to repay debt.
– Lenders look at this ratio to determine if there is adequate cash to make loan
payments.
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Solvency
• Times Interest Earned = Income before Interest and Taxes /
Interest Expense
– This ratio is used to reflect the riskiness of repayments with interest to
creditors.
– It shows how many times over the earnings of a business covers their
interest obligations
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Solvency
• Capital Acquisitions Ratio = Net Cash from Ops / Cash paid
for PPE
– Where PPE = Property, Plant and Equipment
– Most companies need equipment to run
– Most equipment eventually wears out and needs to be replaced
– A good measure of performance is to determine whether the company’s
cash from ongoing operations can pay for the equipment that it needs
– This ratio helps us understand how much of the company's operating
cash is going toward replacing equipment
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Profitability
• Profitability refers to a company’s ability to generate an
adequate return on invested capital. The return is the
amount of earnings, usually this is net income after interest
and taxes
• Profit Margin = Net Income / Sales
– Measures how effectively a firm is able to convert sales to profits
(remembering that Net Income is Sales less all expenses)
– May also be measured as EBITDA/Sales where EBITDA stands
for Earnings Before Interest, Taxes, Depreciation and
Amortization
– The thought here is that the ITDA portion does not generally
contribute directly to generating sales and so should not be
considered in the calculation of Net Profit Margin
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Profitability
• Gross Profit Ratio = Gross Profit/Net Sales,
– where Gross Profit = (Total Sales – COGS)
– Measures how effectively COGS are used to generate sales
– In a manufacturing company, sufficient gross profit is required to
cover operating expenses.
• Return on Assets = Net Income / Avg Total Assets
– Can be used to determine how often assets are being paid for. It is
a more stringent measure of asset coverage than the Asset
Turnover ratio since Return on Assets is calculated with net Profit
rather than Sales
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Profitability
• Return on Equity = (Net Income – Preferred Dividends) /
Avg Common Shareholders Equity
– Determines the rate of return on investment in the business
– Should be compared with other investment alternatives, such as a
savings account, stock or bond returns to see if there is a more
effective way to earn money
• Earnings Per Share = Net Income – Preferred Dividends /
(Weighted Average Number of Common Shares
Outstanding)
– Amount of money earned per common share
• Book Value Per Share = Shareholder’s Equity / (Weighted
Average Number of Common Shares Outstanding)
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Profitability
• Quality of Income = Net Income from Ops / Net Income
– We see this sort of assessment show up as another ratio: EBITDA
– As discussed, EBITDA is Earnings Before Interest, Taxes,
Depreciation and Amortization
– It is a good assessment of how well the main ongoing operations of
the business are perfomring
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Capital Market Analysis
• Market analysis is useful when we are analyzing
company’s traded in public markets (stock exchanges)
• These calculations use share price as part of their analysis
– Share price is a reflection of what the market thinks the company is
worth
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Capital Market Analysis
• Price Earnings Ratio (PE Ratio) = (Market Price of Common
Stock Per Share) / (Earnings per share)
– A key ratio used in stock valuation to determine whether a stock is over
or under valued or to determine future direction of stock movement
• Price to Book Ratio (PB Ratio) = (Market Price of Common
Stock Per Share) / (Owner’s Equity / no. outstanding shares)
– Used to determine how much the market has valued the stock more/less
than the book value
– Keep in mind that the book value is based on GAAP (which uses all of
the guidelines of relevance, comparison, historical value, amortization
calculation rules, etc)
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Capital Market Analysis
• Dividend Yield = Annual Dividends per share / market price
per share
– This is a means of comparing the dividend paying performance of
different investment alternatives
• Payout Ratio = Dividends per Share / Earnings Per Share
– This is a measure of how much of the earnings were paid to owners as
dividends
– We’d like this number to be in the range of 40 to 70%
– The newer companies tend to have a low payout ratio
• They are keeping earnings to grow the company
– Mature companies tend to pay out more
• They are returning profits to owners
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Capital Market Analysis
• Free Cash Flow Payout Ratio (FCFPR) =
– Dividends per Share / Free Cash Flow (FCF)
– FCFPR measures how much cash is being paid out as dividends from
the cash generated by the business
– FCF = Cash flow from Operating Activities – Cash flow from
Investing Activities
• A measure of financial performance calculated as operating cash flow
minus capital expenditures.
• Free cash flow (FCF) represents the cash that a company is able to
generate after laying out the money required to maintain or expand its
asset base.
• Free cash flow is important because it allows a company to pursue
opportunities that enhance shareholder value.
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Summary
• As mentioned earlier, ratios are not to be used in a vacuum
• Ratios can be compared with each other in a number of
ways
– Comparison across different companies in the same industry
– Comparison within a company across previous periods
– Comparison within a company of past performance with future
budgeted performance
– General and subjective standards which use rules of thumb to offer
information
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Example
• Let’s try PA13-5 , p281
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD
Example
• Try exercises E13-3, E13-4, E13-8, M13-1 to 3, PA13-1,
PA13-2, PA13-5
Financial Accounting
Dave Ludwick, P.Eng, MBA, PMP, PhD