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
Current assets – Inventories
• Quick ratio =
Current liabilities
Asset Management Ratios
Accounts receivable
• Avg. collection period =
Annual credit sales/365
Cost of sales
• Inventory turnover =
Average inventory
Sales
• Fixed-asset turnover =
Net fixed assets
Sales
• Total asset turnover =
Total assets
Financial Leverage Management
Total debt
• Debt ratio =
Total assets
Total debt
• Debt-to-equity ratio =
Total equity
EBIT
• Times interest earned =
Interest charges
EBIT
+
Lease
pmts
• Fixed charge coverage =
Interest + Lease pmt
+ P/S div before tax
+ Before tax sinking fund
Profitability Ratios
Sales – Cost of sales
• Gross profit margin =
Sales
EAT
• Net profit margin =
Sales
EAT
• ROI =
Total assets
EAT
• ROE =
Stockholders’ equity
Market-Based Ratios
Marketing price per share
• P/E ratio =
Current earnings per share
Market price per share
• Market to book ratio =
Book value per share
Dividend Policy Ratios
Dividends per share
• Payout ratio =
EPS
Expected dividends per share
• Dividend yield =
Stock price
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
Dupont Analysis
• An excellent way to present ratio
analysis for an assignment or for an
on-the-job presentation
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 and to the proportion of
recurring income to total income.
• 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 and inversely related to the
amount of its hidden liabilities.
Problems in Reporting
• Time of revenue recognition
• Establishment of reserves
• Amortization of intangible assets
• Including all losses and debt
• “Pro forma” profitability measures
Balance Sheet Quality Issues
• Charging off assets
• Hidden liabilities
• Hidden assets
• Off balance sheet financing
Analysis Based on the Market
Value of the Firm
• Market value added
(MVA) = Market value – Capital
– The capital market’s assessment of the
accumulated NPV of all of the firm’s past
and present projected investment
projects
• Economic value added
(EVA) = (r – k)  Capital
– The yearly contribution of a firm’s
operations to the creation of MVA
Problems Caused by Inflation
• Inventory profit as a result of timing of
price increases
• Inventory valuation methods
– (LIFO)
– (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 is the relevant source of value
for the firm.
• ATCF = EAT + 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.