Chapter 4

Chapter 4

Evaluating a Firm’s Financial

Performance

Learning Objectives

• Explain the purpose and importance of financial analysis.

• Calculate and use a comprehensive set of measurements to evaluate a company’s performance.

• Describe the limitations of financial ratio analysis.

THE PURPOSE OF FINANCIAL ANALYSIS

The Purpose of Financial Analysis

Financial Analysis using Ratios • A popular way to analyze the financial statements is

by computing ratios. A ratio is a relationship between two numbers, e.g., a given ratio of A:B = 30:10 means A is 3 times B.

• A ratio by itself may have no meaning. Hence, a given ratio is compared to: – ratios from previous years

– ratios of other firms and/or leaders in the same industry

Uses of Financial Ratios: Within the Firm

• Identify deficiencies in a firm’s performance and take corrective action.

• Evaluate employee performance and determine incentive compensation.

• Compare the financial performance of the firm’s different divisions.

Uses of Financial Ratios: Within the Firm

• Prepare, at both firm and division levels, financial projections.

• Understand the financial performance of the firm’s competitors.

• Evaluate the financial condition of a major supplier.

Uses of Financial Ratios: Outside the Firm

Financial ratios are used by: • Lenders in deciding whether or not to lend to a

company.

• Credit-rating agencies in determining a firm’s credit worthiness.

• Investors (shareholders and bondholders) in deciding whether or not to invest in a company.

• Major suppliers in deciding to whether or not to extend credit to a company and/or in designing the specific credit terms.

MEASURING KEY FINANCIAL

RELATIONSHIPS

Question 1 How Liquid Is the Firm? Can It Pay Its Bills?

• A liquid asset is one that can be converted quickly and routinely into cash at the current market price.

• Liquidity measures the firm’s ability to pay its bills on time. It indicates the ease with which non-cash assets can be converted to cash to meet the financial obligations.

How Liquid Is the Firm?

Liquidity is measured by two approaches: – Comparing the firm’s current assets and current

liabilities – Examining the firm’s ability to convert accounts

receivables and inventory into cash on a timely basis

Measuring Liquidity: Perspective 1

Compare a firm’s current assets with current liabilities using:

– Current Ratio – Acid Test or Quick Ratio

Current Ratio

• Current ratio compares a firm’s current assets to its current liabilities.

Coca-Cola = $32,986M ÷ $32,274M = 1.02

• Coca-Cola has only $1.02 in current assets for every $1 in current liabilities. Coca-Cola’s liquidity is lower than that of PepsiCo, which has a current ratio of 1.14.

Acid Test or Quick Ratio

• Quick ratio compares cash and current assets (minus inventory) that can be converted into cash during the year with the liabilities that should be paid within the year.

Coca-Cola = ($21,675+ $4,466M) ÷ ($32,374M) = 0.81

• Coca-Cola has 81 cents in quick assets for every $1 in current debt. Coca-Cola is slightly less liquid than PepsiCo, which has 85 cents for every $1 in current debt.

Measuring Liquidity: Perspective 2

• Measures a firm’s ability to convert accounts receivable and inventory into cash:

– Days in Receivables or Average Collection Period

– Inventory Turnover

Days in Receivables (Average Collection Period)

• How long does it take to collect the firm’s receivables?

Coca-Cola = ($4,466M) ÷ ($45,998M/365) = 35.44 days

• Coca-Cola (at 35.44 days) is slightly faster than PepsiCo (at 36.41 days) in collecting accounts receivable.

Accounts Receivable Turnover

• How many times are the accounts receivable “rolled-over” each year?

Coca-Cola = $45,998M ÷ $4,466M = 10.30X

• The conclusion is the same—Coca-Cola (10.30X) is slightly faster than PepsiCo (10.33X) in collecting accounts receivable.

Days in Inventory

• How long is the inventory held before being sold?

Coca-Cola = ($3,100M) ÷ ($17,889M ÷ 365)= 63.25 days

• Coca-Cola carries inventory for a longer time than PepsiCo (37.15 days).

Inventory Turnover

• How many times are the firm’s inventories sold and replaced during the year?

Coca-Cola = $17,889M ÷ $3,100M= 5.77X

• The conclusion is the same—Coca-Cola moves inventory much slower than PepsiCo (9.83X).

Question 2: Are the Firm’s Managers Generating Adequate Operating Profits from the Company’s Assets?

• This question focuses on the profitability of the assets in which the firm has invested. We consider the following ratios to answer the question: – Operating Return on Assets

– Operating Profit Margin – Total Asset Turnover – Fixed Assets Turnover

Operating Return on Assets (ORA)

• ORA indicates the level of operating profits relative to the firm’s total assets.

Coca-Cola = $9,707M ÷ $92,023M = 0.105 or 10.5%

• Thus managers are generating 10.5 cents of operating profit for every $1 of assets which is quite a bit less than PepsiCo (13.7%)

Disaggregation of Operating Return on Assets

Managing Operations: Operating Profit Margin (OPM)

• OPM examines how effective the company is in managing its cost of goods sold and operating expenses that determine the operating profit.

Coca-Cola = $9,707M ÷ $45,998M = 0.211 or 21.1% • Coca-Cola managers are better than PepsiCo in

managing the cost of goods sold and operating expenses, as the Operating Profit Margin for PepsiCo is only 14.5%.

Managing Assets: Total Asset Turnover

• This ratio measures how efficiently a firm is using its assets in generating sales.

Coca-Cola = $45,998M ÷ $92,023M = .50X

• Coca-Cola is generating 50 cents in sales for every $1 invested in assets, which is much lower than PepsiCo (.95X).

Managing Assets: Fixed Asset Turnover

• Examines efficiency in generating sales from investment in “fixed assets”

Coca-Cola = $45,998M ÷ $14,633M = 3.14X

• Coca-Cola generates $3.14 in sales for every $1 invested in fixed assets, which is lower than PepsiCo (3.87X)

Question 3: How Is the Firm Financing Its Assets?

• Here we examine the question: Does the firm finance its assets by debt or equity or both? We use the following two ratios to answer the question:

– Debt Ratio – Times Interest Earned

Debt Ratio

• This ratio indicates the percentage of the firm’s assets that are financed by debt (implying that the balance is financed by equity).

Coca-Cola = $61,703M ÷ $92,023M = 0.671 or 67.1%

• Coca-Cola finances 67% of its assets by debt and 33% by equity compared to PepsiCo financing 75% of its assets by debt.

Times Interest Earned

• This ratio indicates the amount of operating income available to service interest payments.

Coca-Cola = $9,707M ÷ $483M = 20.1X

• Coca-Cola’s operating income is 20 times the annual interest expense and higher than PepsiCo (10.63X) due to its relatively higher operating profits.

Times Interest Earned

Note: • Interest is not paid with income but with

cash. • Oftentimes, firms are required to repay part

of the principal annually. • Thus, times interest earned is only a crude

measure of the firm’s capacity to service its debt.

Question 4: Are the Firm’s Managers Providing a Good Return on the Capital Provided by the Company’s Shareholders?

• This is analyzed by computing the firm’s accounting return on common stockholder’s investment or return on equity (ROE).

• Note: Common equity includes both common stock and retained earnings.

ROE

Coca-Cola = $7,098M ÷ $30,320M = 0.234 or 23.4%

• Owners of Coca-Cola are receiving a lower return (23.4%) compared to PepsiCo (37.1%).

• One of the reasons for lower ROE is the lower operating return on assets generated by Coca-Cola (10.5% for Coca-Cola v. 13.7% for Pepsi-Co). A lower return on the firm’s assets will always result in a lower return on equity and vise versa.

• Also, Coca-Cola uses less debt (67% for Coca-Cola v. 75% for Pepsi-Co). Higher debt translates to higher ROE under favorable business conditions.

Question 5: Are the Firm’s Managers Creating Shareholder Value?

• We can use two approaches to answer this question:

– Market value ratios (P/E) – Economic Value Added (EVA)

• These ratios indicate what investors think of management’s past performance and future prospects.

Price/Earnings Ratio

• Measures how much investors are willing to pay for $1 of reported earnings.

Coca-Cola = $42.00 ÷ $1.60 = 26.25X • Investors are willing pay more for Coca-Cola for

every dollar of earnings per share compared to PepsiCo ($26.25 for Coca-Cola versus $22.09 for PepsiCo).

Price/Book Ratio

• Compares the market value of a share of stock to the book value per share of the reported equity on the balance sheet.

Coca-Cola = $42.00 ÷ $6.81 = 6.17X • A ratio greater than 1 indicates that the shares are more

valuable than what the shareholders originally paid. The ratio is lower than PepsiCo ratio of 8.19X suggesting that PepsiCo is perceived as having better growth prospects relative to its risk.

Economic Value Added (EVATM)

• Shareholder value is created if the firm earns a return on capital that is greater than the investors’ required rate of return.

• EVA attempts to measure a firm’s economic profit, rather than accounting profit. EVA recognizes the cost of equity in addition to the cost of debt (interest expense).

EVA for Coca-Cola

• Operating return on assets = 10.5% • Total assets = $92.023 billion • Assume cost of capital = 10%

EVA = (.105% – .10)* $92.023B = $460.115M

SUMMARY OF RATIOS

THE LIMITATIONS OF FINANCIAL RATIO

ANALYSIS

The Limitations of Financial Ratio Analysis

1. It is sometimes difficult to identify industry categories or comparable peers.

2. The published peer group or industry averages are only approximations.

3. Industry averages may not provide a desirable target ratio.

4. Accounting practices differ widely among firms. 5. A high or low ratio does not automatically lead to a

specific conclusion. 6. Seasons may bias the numbers in the financial

statements.

Key Terms

• Accounts receivable turnover ratio

• Acid-test (quick) ratio • Asset efficiency • Current ratio • Days in inventory • Days in receivables (average

collection period) • Debt ratio • Economic value added • Financial ratios • Fixed-asset turnover

• Inventory turnover • Liquidity • Operating profit margin • Operating return on assets

(OROA) • Price/book ratio • Price/earnings ratio • Return on equity • Times interest earned • Total asset turnover

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