Corporate performance analysis
Financial ratio analysis and rating
Helena Sůvová
Guest lecture for the Czech University of
Agriculture
Course: Corporate Finance
October, 2007
1
Content of the lecture
Sources of financial ratios (indicators), users of
corporate performance analysis
 Objectives and caveats
 Basic groups of financial ratios
 Comprehensive systems of financial ratios,
default prediction models
 Credit rating – external, internal
 Summary of the lecture
 Assignments for the tutorial

2
Sources of financial ratios


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


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 –
otflow: differences caused by: accrual principle,
depreciation, taxes
3
Sources of financial ratios, users
Other sources: web pages of individual firms,
internet databases, paid databases – Magnus,
Ariadna
 Users of corporate performance analysis:
stockholders, managers, employees, business
partners (customers, suppliers), journalists,
students, public generally

4
Objectives, caveats






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
5
Objectives, caveats

Comparisons:
• cross sectional - industry norms, key competitors,
• time series, trends – comparisons with previous
periods

Comparability:
• use the same ratio formulas
• preferably use audited (annual) statements based on
the same accounting standards
• be aware of valuation of assets
6
Objectives, caveats
Example of cross-sectional and time-series analysis
7
Basic groups of financial ratios

5 basic groups:
•
•
•
•
•

liquidity ratios
debt management ratios (leverage ratios)
asset management ratios (activity ratios)
profitability ratios
market value (valuation) ratios
1) Liquidity ratios
firm´s ability to pay its obligations in the short term
•
•
•
•
current ratio = current assets/current liabilities (1,5)
quick ratio = (current assets – inventory)/current liabilities (1)
cash ratio = (cash + near-cash)/current liabilities (0,25)
net working cap. to total assets = (curr.assets – curr. liab.)/total assets
8
Basic groups of financial ratios

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 (0,5)
• financial leverage = total assets/equity
• long term debt ratio = long term debt/ total assets
• interest coverage ratio (times interest earned) = EBIT/interest
expense (5)
• fixed payment coverage = (EBIT + lease payments)/(interest +
lease payments + 1/(1-T) * (principal payments + preferred stock
dividends))
9
Basic groups of financial ratios

3) Asset managemet ratios
= asset utilization/efficiency
turnover is measured in sales or costs
• accounts receivable turnover = net credit sales/avrg accounts
receivable (60)
• receivable collection period = 365/accounts receivable turnover
(60)
• inventory turnover = cost of goods sold/ avrg inventory
• inventory collection period (avrg age of invetory) = 365/inventory
turnover ratio (60)
• fixed assets turnover = sales/ (net) fixed assets
• avrg payment period = accounts payable/avrg purchases per day
10
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 EACS/sales)
• gross profit margin = (sales-costs of goods sold)/sales
• return on (total) assets ROA = EBIT/ total assets
• …… but also ROA = EACS/total assets
• return on equity ROE = net income/ equity
• …. or EACS/equity
EACS = earnings available for common stockholders
11
Basic groups of financial ratios – ROE in
different Czech industries 2004, 2005
12
Basic groups of financial ratios
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
13
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

14
Comprehensive systems of financial
ratios, default prediction models


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



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
15
Comprehensive systems of financial
ratios, default prediction models

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
16
Comprehensive systems of financial
ratios, default prediction models


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
17
Example of more complex pyramid system
:
18
Credit rating – external, internal


Credit rating = opinion of the general creditworthiness of
an obligor. It represents the relative level of default risk.
Rating scale – from AAA to D
• 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
19
Credit rating – external, internal
This is an ideal through-the-cycle rating:
20
Credit rating – external, internal

Types of rating:
• issue-specific X issuer rating
• long-term X short-term rating
• international (foreign currency) X local rating

Rating methodology usually includes the assessment of:
• 1) Business risk
–
–
–
–
–
–
–
–
–
Country risk
Industry characteristics
Company position
Product portfolio/Marketing
Technology
Cost efficiency
Strategic and operational management
competence
Profitability/Peer group comparisons
21
Credit rating – external, internal
• 2) Financial risk


–
Accounting
–
–
–
–
–
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
22
Credit rating – external, internal

Basic ratios used in rating methodology:
•
•
•
•
•


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.“
23
Credit rating – external, internal





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)
24
Summary of the lecture



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-determined purposes.
25
Assignments for the tutorial
What are some important caveats to remember when analyzing
financial ratios?
For which business is inventory turnover important?
1.
2.
•
•
•
•
3.
4.
5.
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? (Q8.8)
26
Assignments for the tutorial
6.
7.
What does a credit rating mean?
Web case:
–
–
–
6.

9.
10.
GO TO www. hoovers. com In the search box at the top of the page, enter UAL, select "by ticker" from
the dropdown list, then click GO.
Who are the top competitors to United Airlines?
Who is the CEO of United Airlines?
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.
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?
Look at the financial statemets of ČEZ and make simple Du Pont analysis by using
ROA, ROE and financial leverage in 2004/5.
27