Chapter
3
Evaluation of Financial
Performance
Copyright ©2003 South-Western/Thomson Learning
Introduction
• This chapter introduces financial
statement analysis techniques that
are used to accurately evaluate a
company’s performance.
Financial Ratios Are Used By
• Management for planning and evaluating
• Credit managers to estimate the
riskiness of potential borrowers
• Investors to evaluate corporate
securities
• Managers to identify and assess
potential merger candidates
Ratio Classifications
• Liquidity
• Asset management
• Financial leverage management
• Profitability
• Market-based
• Dividend policy
Major Financial Statements
• Balance sheet
– Common-sized balance sheet shows
assets, liabilities, and equity as a percent of
total assets.
• Income statement
– Common-sized income statement shows
income and expense items as a percent of
net sales.
• Statement of cash flows
Liquidity Ratios
Current
assets
• Current ratio =
Current liabilities
• Quick ratio = Current assets – Inventories
Current liabilities
• Quick ratio, sometimes called the “acid
test,” is a more stringent measure of
liquidity than the current ratio.
• Liquidity ratios are quick measures of a
firm’s ability to provide sufficient cash to
conduct business over the next few
months.
Asset Management Ratios
• Avg. collection period =
• Inventory turnover =
Accounts receivable
Annual credit sales/365
Cost of sales
Average inventory
Sales
• Fixed-asset turnover =
Net fixed assets
Sales
• Total asset turnover =
Total assets
Asset Management Ratios
• Asset management ratios indicate how
much a firm has invested in a particular
type of asset (or group of assets) relative
to the revenue the asset is producing.
• By comparing asset management ratios
for the various asset accounts of a firm
with established industry norms, the
analyst can determine how efficiently the
firm is allocating its resources.
Financial Leverage Management
Total debt
Total assets
Total
debt
• Debt-to-equity ratio =
Total equity
EBIT
• Times interest earned =
Interest charges
• Debt ratio =
• Fixed charge coverage
• =
EBIT + Lease pmts
Interest + Lease pmts+ P/S div before tax
+ Before tax sinking fund
Financial Leverage Management
• Financial leverage management ratios
measure the degree to which a company
is employing financial leverage and, as
such, of interest to creditors and owners
alike.
Profitability Ratios
Sales – Cost of sales
• Gross profit margin =
Sales
EAT
• Net profit margin =
Sales
EAT
• ROI =
Total assets
EAT
• ROE =
Stockholders’ equity
Profitability Ratios
• Profitability ratios measure how
effectively a firm’s management is
generating profits on sales, total
assets, and, most importantly,
stockholders’ investment.
Market-Based Ratios
Market price per share
• P/E ratio =
Current earnings per share
• In general, the lower the firm’s risk, the
higher its P/E ratio should be. In addition,
the better the growth prospects of its
earnings, the greater is the P/E multiple.
Market-Based Ratios
Market price per share
• Market to book ratio =
Book value per share
• Generally, the higher the rate of return a
firm is earning on its common equity
relative to the return required by
investors (the cost of common equity),
the higher will be this ratio.
Market-Based Ratios
• Book value:
– In reference to assets, cost minus
accumulated depreciated.
– In reference to stock, the value of one share
of stock on a corporation’s books.
Market-Based Ratios
• Market-based ratios reflect the financial
market’s assessment of the performance
of a firm.
• For example, if the accounting ratios of a
firm suggest that the firm has more risk
than the average firm in the industry and
has lower profit prospects, this
information should be reflected in a
lower market price of that firm’s stock.
Dividend Policy Ratios
• Payout ratio = Dividends per share
Earnings per share
Expected dividends per share
• Dividend yield =
Stock price per share
• Stocks with a low dividend yield often indicate
high expected future growth.
• Dividend policy ratios give insights regarding a
firm’s dividend strategies and its future growth
prospects.
Summary of Ratios
• Liquidity Ratios:
– Current ratio: 流動性比率
– Quick ratio: 速動比率
– Acid test ratio: 酸性測驗比率
Summary of Ratios
• Asset Management Ratios:
– Average collection period: 平均收現期
– Inventory turnover ratio: 存貨週轉率
– Fixed-asset turnover ratio: 固定資產週轉率
– Total-asset turnover ratio: 總資產週轉率
Summary of Ratios
• Financial Leverage Management
Ratios:
– Debt ratio: 負債比率
– Debt-to-equity ratio: 負債權益比
– Times interest earned ratio: 利息保障倍數
– Fixed charge coverage ratio: 固定費用保障
倍數
– Equity Multiplier: 權益乘數
Summary of Ratios
• Profitability Ratios:
– Gross profit margin ratio: 邊際毛利率
– Net profit margin ratio: 邊際淨利率
– Return on investment (assets): 資產報酬率
– Return on equity: 權益報酬率
Summary of Ratios
• Market-Based Ratios:
– P/E (price-earnings) ratio: 本益比
– Market to book ratio: 市價淨值比
Summary of Ratios
• Dividend Policy Ratios:
– Dividend payout ratio: 股利(息)發放率
– Dividend yield: 股利(息)收益率
Summary of Ratios
• EBIT (earnings before interest and
taxes): 息前及稅前盈餘
• EAT (earnings after taxes): 稅後盈餘
• Note:
Assets = Liabilities + Owner’s Equity
• See examples in Table 3.5.
Financial Ratio Analysis
• Trend analysis
XYZ current ratio
20X0
1.9
X1
2.2
• Cross-sectional analysis
XYZ current ratio
Industry norms
• Both simultaneously
XYZ current ratio
Industry norms
20X0
1.9
2.5
X2
2.3
20X2
2.3
2.5
X1
2.2
2.4
X2
2.3
2.5
Relationships Among Ratios
EAT 
Sales
EAT
=
• ROI =
Sales Total assets
Total assets
EAT 
Sales
Total assets

• ROE =
Sales Total assets
Equity
Net profit  Total assets 
Equity
• ROE =
margin
turnover
multiplier
• Note: ROI = Net profit margin ratio  Total asset
turnover ratio
Sources of Information
• Dun and Bradstreet
• Robert Morris
Associates
• Prentice-Hall’s
Almanac of
Business and
Industrial Ratios
• Moody’s
• Standard and Poor’s
•
•
•
•
•
•
Annual reports
10Ks
Trade associations
Trade journals
Commercial banks
Financial Research
Associates
• Computerized
databases
Sources of Information on the Web
• http://finance.yahoo.com/
• http://www.onlinewbc.org/docs/finance/
index.html
• http://www.dnbcorp.com/
• http://www.rmahq.org/
• http://www.sec.gov/
• http://www.moodys.com/
• http://www.hoovers.com/
• http://www.bloomberg.com/
Quality and Financial Analysis
• The quality of a firm’s earnings is
positively related to the proportion of
cash earnings to total earnings which is
greatly influenced by the firm’s
procedures with respect to sales
revenues recognition.
Quality and Financial Analysis
• For example, a firm may recognize a
sale at the time a contract is signed, a
down payment is made, or when the full
proceeds from the sale are actually
collected as cash.
• Generally, the closer the recognition of a
sale is to the time the full proceeds from
that sales are collected, the higher is the
quality of the firm’s reported earnings.
Quality and Financial Analysis
• The quality of a firm’s earnings is
positively (negatively) related to the
proportion of recurring (nonrecurring)
income to total income. That is, a firm’s
earnings can be viewed as high (low)
quality if a greater proportion of those
earnings is derived from regularly
recurring transactions (irregularly
nonrecurring transactions).
Quality and Financial Analysis
• The quality of a firm’s balance sheet is
positively related to the ratio of the
market value of the firm’s assets to book
value of the assets.
• If the assets on a firm’s balance sheet
have a market value equal to or greater
than the book value at which they are
being carried, this enhances the quality
of the firm’s balance sheet.
Quality and Financial Analysis
• The quality of a firm’s balance sheet is
inversely related to the amount of
inventory that cannot be moved and the
amount of its hidden liabilities.
• These hidden liabilities may take the
form of such things as long-term lease
obligations not appearing on the
company’s balance sheet or uninsured
losses arising from pending lawsuits.
Quality and Financial Analysis
• In contrast, some firms have significant
hidden assets. These assets may be
physical assets, such as real property
that has appreciated in value but is
carried on the firm’s books at cost, or
securities that are carried on the books
at cost even though the market value of
these securities has increased above the
original cost. These assets may also
consist of intangibles, such as valuable
patents or brand names.
Analysis Based on the Market
Value of the Firm
• Market value added (MVA)
= Market value (of debt, preferred equity,
and common equity capitalization) –
Capital
– Capital is a measure of all the cash raised
from investors or retained from earnings to
fund new investments in the business, since
the company’s inception.
– MVA is the capital market’s assessment of
the accumulated NPV of all of the firm’s
past and present projected investment
projects.
Analysis Based on the Market Value of
the Firm
• Economic value added (EVA)
= (r – k)  Capital
where r is return on total capital (= net
operating profits after tax divided by
beginning of year capital) and k (=
weighted after-tax cost of capital) is cost
of capital.
Analysis Based on the Market Value of
the Firm
• EVA is a measure of operating
performance that indicates how
successful a firm has been at increasing
the MVA of the enterprise in any given
year. In other words, EVA is the yearly
contribution of a firm’s operations to the
creation of MVA.
Ways to Increase EVA
• Increase operating efficiency and thereby
increasing r.
• Commit new resources to the enterprise
that promise a return in excess of the firm’s
weighted (and risk-adjusted) cost of capital.
• Make prudent use of the tax benefits of
debt financing to create value, while
considering risk versus return trade-offs.
Ways to Increase EVA
• Redirect resources from projects that do
not earn adequate returns (relative to the
cost of capital) and show little promise of
doing so in the future, to more productive
uses, including the payment of dividends
and reduction of debt levels if no adequatereturn projects are present.
Problems Caused by Inflation
• Inventory profit as a result of the timing of
price increases
• Inventory valuation methods
– Last-in, first-out (LIFO): A way to avoid or defer the
necessity of reporting the higher inventory profits
– First-in, first out (FIFO)
• Rising interest rates causing a decline in the
value of long-term debt
• Differences in the reporting of earnings
• Recognition of sales
The Cash Flow Concept
• Accounting income vs. Cash flow
• Cash flow rather than accounting
income is the relevant source of value
for the firm.
• ATCF (after-tax cash flow) = EAT
(earnings after taxes) + Noncash
charges
– Noncash charges = Depreciation +
Deferred taxes
Statement of Cash Flow
• Presents the effects of operating,
investing, and financing on the cash
balance
– Direct method presents the effects to net
cash provided by operating, investing, and
financing.
– Indirect method presents the adjustments to
net income showing the effects to net cash.
• Used for public financial reports
• The final results for both are identical.
Complex International Aspects of
Financial Statement Analysis
• Influenced by fluctuating exchange rates
• Statement of Accounting Standards No.
52 deals with foreign currency
translation.
Accuracy of Financial Statements
• External auditor
• Generally accepted accounting
principles
• Corporations pose for a financial
statement like people pose for a picture.