Financial Ratios and Firm
Performance
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LEARNING OBJECTIVES
1. Create, understand, and interpret common-size
financial statements.
2.Calculate and interpret financial ratios.
3. Compare different company performances using
financial ratios, historical financial ratio trends, and
industry ratios.
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14.1 Financial Statements
Just like a doctor takes a look at a patient’s x-rays or catscan when diagnosing health problems, a manager or
analyst can take a look at a firm’s primary financial
statements, the income statement and the balance sheet,
when trying to gauge the status or performance of a firm.
Income statement:
periodic recording of the
sources of revenue and
expenses of a firm,
Balance sheet:
provides a point in time
snap shot of the firm’s
assets, liabilities and
owner’s equity.
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14.1 Benchmarking
 The financial statements are a fairly complex set of
documents involving a whole bunch of numbers.
 They tell us in absolute values
 something about the amount of assets, liabilities, equity,
revenues, expenses, and taxes of a firm,
 But it is difficult to really gauge what’s going on, primarily
because of size and maturity differences among firms.
 requires “benchmarking” against some standard.
 One common method of benchmarking a is to compare a
firm’s current performance against that of its own
performance over a 3-5 year period (trend analysis), by
looking at the growth rate in various key items such as
sales, costs, and profits.
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14.1 Benchmarking
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14.1 Benchmarking
Another useful way to make some sense out of this
mess of numbers, is to re-cast the income statement
and the balance sheet into common size statements,
by expressing each income statement item as a
percent of sales and each balance sheet item as a
percent of total assets.
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14.1 Benchmarking
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14.1 Benchmarking
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14.1 Benchmarking
• Benchmarking is a good starting point to detect trends
(if any) in a firm’s performance and to make quick
comparisons of key financial statement values with
competitors on a relative basis.
• More in-depth diagnosis requires individual item
analyses and comparisons which are best done by
conducting ratio analysis.
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14.2 Financial Ratios
• Financial ratios are relationships between different
accounts from financial statements—usually the
income statement and the balance sheet—that serve as
performance indicators
• Being relative values, financial ratios allow for
meaningful comparisons across time, between
competitors, and with industry averages.
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14.2 Financial Ratios
FIVE key areas of a firm’s performance can be analyzed using
financial ratios:
1. Liquidity ratios: Can the company meet its obligations over the
short term?
2. Solvency ratios: (also known as financial leverage ratios): Can
the company meet its obligations over the long term?
3. Asset management ratios: How efficiently is the company
managing its assets to generate sales?
4. Profitability ratios: How well has the company performed
overall?
5. Market value ratios: How does the market (investors) view the
company’s financial prospects?
Can also conduct a Du Pont analysis which involves a
breakdown of the return on equity into its three components, i.e.
profit margin, turnover, and leverage.
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14.2 Short-Term Solvency: Liquidity Ratios
 Measure a company’s ability to cover its short-term
obligations in a timely manner:
 3 key liquidity ratios include: The current ratio, quick
ratio, and cash ratio.
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14.2 Short-Term Solvency: Liquidity Ratios
Cogswell has better liquidity and short-term solvency than Spacely, but,
higher investment in current assets also means that lower yields are
being realized since current assets are typically low yielding.
So, we need to look at the other areas and inter-related effects of the firm’s
various accounting items.
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14.2 Long-Term Solvency: Financial Leverage
Ratios
• Measure a company’s ability to meet its long-term debt
obligations based on its overall debt level and earnings
capacity.
• Failure to meet its interest obligation could put a firm
into bankruptcy.
• Equations 14.4, 14.5, and 14.6 can be used to calculate 3
key financial leverage ratios: the debt ratio, times
interest earned ratio, and cash coverage ratio.
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14.2 Long-Term Solvency: Financial Leverage
Ratios
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14.2 Long-Term Solvency: Financial Leverage
Ratios
Cogswell Cola has relatively less debt and a significantly greater ability to cover
its interest obligations by using either its EBIT (times interest earned ratio) or
its net cash flow (cash coverage ratio) than Spacely Spritzers.
Leverage must be analyzed as a combination of debt level and coverage. If a
firm is heavily leveraged but has good interest coverage, it is using the interest
deductibility feature of taxes to its benefit. Having a high leverage with low
coverage could put the firm into a risk of bankruptcy.
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14.2 Asset Management Ratios
 Measure how efficiently a firm is using its assets to generate revenues
or how much cash is being tied up in other assets such as receivables
and inventory.
 Equations 14.7 – 14.11 can be used to calculate 5 key asset management
ratios.
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14.2 Asset Management Ratios
While Cogswell is more efficient at managing its inventory,
Spacely seems to be doing a better job of collecting its receivables
and utilizing its total assets in generating revenues
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14.2 Profitability Ratios
Profitability ratios such as net profit margin,
returns on assets, and return on equity, measure a
firm’s effectiveness in turning sales or assets into
profits.
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14.2 Profitability Ratios
As far as profitability is concerned, Cogswell is
outperforming Spacely in moving revenue to the
bottom line but they are very close in terms of overall
effectiveness in producing profits.
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14.2 Market Value Ratios
Used to gauge how attractive or reasonable a firm’s
current price is relative to its earnings, growth rate, and
book value.
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14.2 Market Value Ratios
• Potential investors and analysts often use these
•
•
•
ratios as part of their valuation analysis.
Typically, if a firm has a high price to earnings and a
high market to book value ratio, it is an indication
that investors have a good perception about the
firm’s performance.
However, if these ratios are very high it could also
mean that a firm is over-valued.
With the price/earnings to growth ratio (PEG ratio),
the lower it is, the more of a bargain it seems to be
trading at, vis-à-vis its growth expectation.
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14.2 Market Value Ratios
Ratio
P/E
PEG
P/B
Cogswell Cola
15.41
1.28
5.49
Spacely Spritzers
13.01
0.86
4.17
The ratios seem to indicate that investors in both firms seem
to have good expectations about their performance and are
therefore paying fairly high prices relative to their earnings
book values.
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14.2 Du Pont analysis
Involves breaking down ROE into three components of the firm:
(1) operating efficiency, as measured by the profit margin (net
income/sales);
(2) asset management efficiency, as measured by asset turnover
(sales/total assets); and
(3) financial leverage, as measured by the equity multiplier (total
assets/total equity).
Equation 14.19 shows that if we multiply a firm’s net profit
margin by its total asset turnover ratio and its equity multiplier,
we will get its return on equity.
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14.2 Du Pont analysis
Cogswell has better operational efficiency and is better able to move sales
dollars into income, but Spritzer is more efficient at utilizing its assets, and
since it uses more debt, it is able to get more of its earnings to its
shareholders. Although these 14 ratios are not the only ones that can be
used to assess a firm’s performance, they are the most popular ones.
It is important to look at the overall picture of the firm in all five areas and
accordingly reach conclusions or make recommendations for changes.
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14.3 External Uses of Financial
Statements and Industry Averages
Financial statements of publicly traded companies
and industry averages of key items provide the raw
material for analysts and investors to make
investment recommendations and decisions
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14.3 Cola Wars
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14.3 Cola Wars
 One of the first things we notice in looking over the five years of
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data is how similar many of the ratios are from year to year,
showing remarkable consistency for these two companies.
We also can see that the gross margin of Coca-Cola is
consistently higher than that of PepsiCo.
The debt to equity ratio of both firms is mostly falling over the
five-year period.
We also can see that ROE has been very good for both
companies, although slightly better for PepsiCo.
Finally, PepsiCo has very strong and growing earnings per share
over this period, outperforming Coca-Cola’s EPS, but PepsiCo is
also more expensive (higher current price per share).
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14.3 Industry ratios
• Industry ratios are often used as benchmarks for
financial ratio analysis of individual firms.
• There can be significant differences in various key
areas across industries, which is why comparing
company ratios with industry averages can be very
useful and more informative.
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