copyright © 2010 pearson prentice hall. all rights reserved. chapter 14 financial ratios and firm...

Copyright © 2010 Pearson Prentice Hall. All rights reserved.

Chapter 14

Financial Ratios and Firm Performance


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14.1 Financial Statements

A manager or analyst can take a look at a firm’s primary financial statements--i. e., the income statement and the balance sheet--when trying to measure 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 snapshot of the firm’s assets, liabilities, and

owners’ equity.


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14.1 (A) Benchmarking

• Financial statements tell us Absolute values: – tell us something about the amount of assets, liabilities, equity, revenues, expenses, and taxes of a firm,

– difficult to really measure what’s going on, primarily because of size differences among firms.

– requires “benchmarking” against some standard.

– What is benchmarking?– It is the process of comparing a company’s current performance against its own previous performance or that of its competitors.

• One common method of benchmarking 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 Trend Analysis

TABLE 14.1 Cogswell Cola’s Abbreviated Income Statements ($ in thousands)


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14.1 (A) Benchmarking (continued)

• 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 analysis 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

• Because they are relative values, financial ratios allow for meaningful comparisons across time, between competitors, and with industry averages.


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14.2 Financial Ratios (continued)

• Five key areas of a firm’s performance can be analyzed by 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 of profit margin, turnover, and leverage.


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14.2 (A) Short-Term Solvency: Liquidity Ratios

• Measure a company’s ability to cover its short-term debt obligations in a timely manner. The higher the liquidity ratio the better the better liquidity and short-term solvency issues of the company.

• Three key liquidity ratios include the current

ratio, the quick ratio, and the cash ratio:


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• Current Ratio: It indicates the extent to which current liabilities are covered by current assets.

• Quick Ratio/Acid ratio: It is very similar to current ratio, but we subtract the inventories from current assets because they are least liquid assets.

• Cash Ratio: It indicates the per cent of current liabilities covered by the current cash on hand.


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The liquidity ratios indicate that overall, 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 interrelated effects of the firm’s various accounting items.

14.2 (A) Short-Term Solvency: Liquidity Ratios

TABLE 14.2 Liquidity Ratios 2008 for Cogswell Cola and Spacely Spritzers


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14.2 (B) 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.


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• The higher the TIE and cash coverage ratio, the greater the ability of the company to cover its interest expense obligations.

• Another name for debt ratio is leverage level, total liabilities is also called total debt.


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• Debt ratio: It indicates the amount of debt for every dollar of assets.

• Times interest earned ratio: It indicates the ability of the company to meet its interest expense obligations from EBIT.

• Cash coverage ratio: It indicates the ability of the company to generate cash from operations to meet its financial obligations.


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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.

TABLE 14.3 Financial Leverage Ratios 2008 for Cogswell Cola and Spacely Spritzers


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14.2 (C) 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.


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• Inventory turnover: It indicates the time required for the inventory to be sold and restocked(replaced) in a year.

• Day’s sales in inventory: It indicates the length of time that the inventory was on shelf before sold at the company.

• Receivables turnover: It measures the number of times per year payment was collected on credit accounts.

• Day’s sales in receivables(Collection period or Days sales outstanding): It indicates the length of time that customers took to pay their credit purchases.

• Total asset turnover: It indicates how well the assets are being used to generate revenue.


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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

14.2 (C) Asset Management Ratios

TABLE 14.4 Asset Management Ratios 2008 for Cogswell Cola and Spacely Spritzers


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14.2 (D) Profitability Ratios

• Profitability ratios measure a firm’s effectiveness in turning sales or assets into profits.


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• Profit margin: It indicates the profit per dollar of sales.

• Return on assets: It indicates how well the assets are generating income.

• Return on equity: It indicates how much profit is being generated for the owners based on their ownership investment.


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14.2 (D) Profitability Ratios (continued)

As far as profitability is concerned, Cogswell is outperforming Spacely by about 3%.

Table 14.5 Profitability Ratios 2008 for Cogswell Cola and Spacely Spritzers


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14.2 (E) Market Value Ratios

Used to measure how attractive or reasonable a firm’s current price is relative to its earnings, growth rate, and book value:


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• Price to earnings ratio: It shows the dollar amount investors will pay for $1 of current earnings.

• Price/earnings to growth ratio: is an adjustment to P/E ratio to account for growth.

• Market to book value: It is the ratio of stock’s market price to its book value.

• Book value per share =total equity divided by number of shares outstanding.


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14.2 (E) 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 view about the firm’s performance. Companies with high P/E ratio are usually growth companies and those with low P/E ratio are mature or stable companies. A low market to book ratio indicates that the market for shares of the company is depressed.

• However, if these ratios are very high, it could also mean that a firm is overvalued.

• With the price/earnings-to-growth ratio (PEG ratio), the lower it is, the more of a bargain (cheap price) it seems to be trading at, in respect of its growth expectation.


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14.2 (E) Market Value Ratios (continued)

Ratio Cogswell Cola Spacely Spritzers

P/E 15.41 13.01 PEG 1.28 0.86 P/B 5.49 4.17

The ratios seem to indicate that investors in both firms have good expectations about the firms’ performance and are therefore paying fairly high prices relative to their earnings book values.


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14.2 (F) Du Pont analysis

Du Pont Analysis takes a step further in analyzing the firm performance by 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)3) financial leverage, as measured by the equity

multiplier (total assets/total equity)

This 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 (F) Du Pont analysis (continued)

• Cogswell has better operational efficiency, i.e., it is better able to move sales dollars into income, but Spritzer is more efficient at utilizing its assets, and it uses more debt, it is able to get more of its earnings to its shareholders.

• Although the ratios we have studied here 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 5 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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Another example of comparison between competitors

TABLE 14.6 Key Financial Ratios and Accounts for PepsiCo and Coca-Cola (through third quarter 2007)


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14.3 (A) Cola Wars

TABLE 14.7 Some Key Ratios and Accounts for PepsiCo and Coca-Cola (Five-Year Period)


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14.3 (A) Cola Wars (continued)

• One of the first things we notice in looking over the five years of 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 can also 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 (B) 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, so comparing company ratios with industry averages can be useful and informative.

TABLE 14.8 Financial Ratios: Industry Averages


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ADDITIONAL PROBLEMS WITH ANSWERS

Compute and analyze financial ratios. Using the 2009 income statement and balance sheet of Tri-Mark Products Inc., compute its financial ratios. How is the firm doing relative to its industry in the areas of liquidity, asset management, leverage, and profitability?


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Tri-Mark Products, IncorporatedIncome Statement for the year ended 31st Dec. 2009 (‘000s)

Revenue $950,500Cost of goods sold $730,000

Gross profit $220,500Operating expenses

Selling, general and administrative expenses $ 85,000R&D $ 5,200Depreciation $ 50,000

Operating Income $ 80,300Other Income $ 1,350

EBIT $ 81,650Interest Expense $ 3,540

Taxable Income $ 78,110Taxes $ 27,339

Net Income $ 50,772Shares Outstanding 16,740EPS $ 303


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Tri-Mark Products, Inc.Balance Sheet for the year ended 31st December 2009 (‘000s)

Assets: Liabilities:

Current Assets Current Liabilities

Cash $ 6,336

Accounts Payable

$ 57,000

Accts. Rec. $ 43,000 Short-Term Debt $ 1,500

Inventory $ 42,000 Total Current Liabilities

$ 58,500

Other Current $ 12,000

Long-Term Debt $ 74,000

Total Current $ 103,336 Other Liabilities

$ 15,000

L-T Inv. $ 25,340 Total Liabilities

$ 147,500

PP&E $ 225,000 Owners’ Equity

Goodwill $ 30,000 Common Stock $ 189,676

Other Assets $ 14,000

Retained Earnings

$ 60,500

Total OE $ 250,176

Total Assets $ 397,676 Total Liab. And OE

$ 397,676


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Ratio Industry AverageCurrent Ratio 2.200

Quick Ratio (or Acid Test Ratio)

1.500

Cash Ratio 0.135

Debt Ratio 0.430

Cash Coverage 10.600

Days’ Sales in Receivables 29.000

Total Asset Turnover 2.800

Inventory Turnover 20.100

Days’ Sales in Inventory 11.500

Receivables Turnover 32.000

Profit Margin 0.045

Return on Assets 0.126

Return on Equity 0.221


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Tri-Mark Industry AverageCurrent Ratio 1.766 2.200

Quick Ratio (or Acid Test Ratio)

1.048 1.500

Cash Ratio 0.108 0.135

Debt Ratio 0.371 0.430

Cash Coverage 37.189 10.600

Days’ Sales in Receivables 16.512 29.000

Total Asset Turnover 2.390 2.800

Inventory Turnover 28.808 30.100

Days’ Sales in Inventory 12.670 11.500

Receivables Turnover 22.105 30.000

Profit Margin 0.053 0.045

Return on Assets 0.128 0.126

Return on Equity 0.203 0.221


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ADDITIONAL PROBLEMS WITH ANSWERSProblem 4 (Answer continued)

Analysis: Liquidity: Tri-Mark’s liquidity ratios are below the

industry average indicating that it might need to look into its management of current assets and liabilities. Leverage: Tri-Mark’s debt ratio is much lower than the industry average, and its cash coverage is more than 3 time the average, indicating that if it needs to borrow long-term debt it should not have much of a problem. Asset management: Tri-Mark’s asset turnover ratios are all below the average. It needs to tighten up collections and manage its inventory more efficiently. Profitability: Tri-Mark has a good control on cost of goods sold. Its net profit margin is better than that of the industry, and so is its ROA. The industry, however, is returning a higher rate to the shareholders on average, primarily because of the higher debt levels.


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Du Pont Analysis. Based on the ratios calculated in the previous problem, and in conjunction with the industry averages given, conduct a Du Pont analysis on Tri-Mark’s key profitability ratios.


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According to the Du Pont breakdown, we have ROE = Net Profit Margin * Total Asset Turnover * Equity Multiplier ROE = NI/S * S/TA * TA/Equity

Note: since we don’t have the accounting information for the average, we have to figure out the industry’s equity multiplier by some algebraic manipulation.

Equity Multiplier = Total Assets/Equity Now, debt ratio = Total Debt/Total AssetsTotal Assets = Total Debt + Equity

(Total Debt/Total Assets) +( Equity/Total assets) = 1 Equity/Total Assets = 1 – (Total Debt/Total Assets) TA/E = 1/(1-TD/TA)


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Despite a lower total asset turnover ratio, Tri-Mark’s ROA (12.8%) is better than that of the industry (12.6%), primarily because of its higher net profit margin. The industry, however, has a higher ROE (22.1%) because of its higher debt ratio and correspondingly higher equity multiplier.

Tri-Mark IndustryDebt Ratio 0.371 0.430

Total Asset Turnover 2.390 2.800

Profit Margin 0.053 0.045

Return on Assets 0.128 0.126

Return on Equity 0.203 0.221

Equity multiplier = 1/(1 -debt ratio) 1.59 1.75

copyright © 2010 pearson prentice hall. all rights reserved. chapter 14 financial ratios and firm...

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