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Chapter 4 Evaluation of Financial Performance

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Introduction

This chapter introduces financial statement analysis techniques that are used to accurately evaluate a company’s performance. We will assume that the financial statements are fairly and accurately presented.

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Financial Ratios Are Used By

Management for planning and evaluating Credit managers and bankers to estimate

the riskiness of potential borrowers Investors to evaluate corporate securities Managers to identify and assess potential

merger candidates Widely used and accepted technique

Use started in the 1920s

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Ratio Analysis Many, many ratios

Choose the ones that are most relevant for you

Must be compared with a standard and also the past (three years, for example)

A financial ratio is only an indicator One can possibly manipulate ratios

Accounting differences in firms WorldCom (MCI), ENRON, HealthSouth,

Ahold, Tyco, etc.

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Ratio Classifications

Liquidity Asset management Financial leverage management Profitability Market-based Dividend policy

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Major Financial Statements

Balance sheet Common-sized balance sheet shows

assets, liabilities, and equity as a % of total assets

Income statement Common-sized income statement

shows income and expense items as a % of net sales

Statement of cash flows

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Common-Sized Statements

Publicly-owned firms must publish financial statements quarterly and annually

Widely used in banking and investments

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Liquidity Ratios Current ratio = Current assets Current liabilities

Quick ratio = Current assets - Inventories

Current liabilitiesAging Schedule for Accounts Receivable

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Asset Management Ratios

Average collection period = Accounts receivable

Annual credit sales/ 365 Inventory turnover = Cost of sales Average inventory Fixed-asset turnover = Sales Net fixed assets Total asset turnover = Sales Total assets

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Financial Leverage Management

Debt ratio = Total debt Total assets Debt-to-equity ratio = Total debt Total equity Times interest earned = EBIT Interest charges Fixed charge coverage = EBIT + Lease payments Interest + Lease payment +

P/S div before tax+ Before-tax sinking fund

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Profitability Ratios Gross profit margin = Sales - Cost of

sales Sales Net profit margin = EAT Sales ROI = EAT Total Assets ROE = EAT Stockholders equity

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Market-Based Ratios

P/E ratio = Market price per share Current earnings per share

Market to book ratio = Market price per share

Book value per shareStock Price/ Free Cash Flow

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Dividend Policy Ratios

Payout ratio = Dividends per share Earnings per share

Dividend yield = Expected dividends

per share Stock price

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Relationships Among Ratios

ROI = EAT x Sales = EAT Sales Total assets Total assets

ROE = EAT x Sales x Total assets Sales Total assets Equity

ROE = Net Profit Margin x Total Asset Turnover x Equity Multiplier

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Dupont Analysis Widely used in industry Shows impacts that operating

changes can have on returns

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Financial Ratio Analysis Trend analysis 2002 2003 2004 XYZ current ratio 1.9 2.2 2.3

Cross-sectional analysis 2004 XYZ current ratio 2.3 Industry norms 2.5

Both simultaneously 2002 2003 2004 XYZ current ratio 1.9 2.2 2.3 Industry norms 2.5 2.4 2.5

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Some Sources of Information

Trading Room (406 Sirrine Hall)

Bridge (Telerate) Bloomberg Reuters

General Business File of Cooper Library

Factiva Mergent Database TableBase Reuters Business Insight RMA Annual Statement

Studies Reserves on 2nd Floor

Visit Index Table 3 in Library

Annual reports 10K’s - SEC EDGAR

Corporate Database Standard and Poor’s Value Line Industry Norms and

Key Business Ratios The Internet

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A Few of the Sources of Information on the Web

http://www.bloomberg.com/ http://www.sec.gov/ http://finance.yahoo.com/ http://www.dnbcorp.com/ http://www.rmahq.org/ http://www.moodys.com/ http://www.hoovers.com/ But, please be careful. Remember you

get what you pay for…

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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.Large non-cash component in the earningsSignificant non-recurring transactions in the income figure

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 assets and inversely related to the amount of its hidden liabilities.Presence of obsolete inventories and charging off assetsHidden assets Assets have market values significantly below book values

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Problems in Reporting Time of revenue recognition Pension Fund Earnings Assumptions Amortization of intangible assets Including all losses and debt

Off-Balance-Sheet Financing - ENRON

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Ratios Can Be Misleading Differing accounting practices Might be significant dispersion in

the ratio for the industry Many firms operate in more than

one industry - Industry classification Financial ratios provide a historical

record of performance

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The Bridge System Turn on Monitor Log on Click on Telerate Double Click on the background Go to Analytics Page Type: /LU/Company for Ticker Symbol Type: the Ticker Symbol/CF

CF = Corporate Fundamentals Scroll through the Corporate Fundamentals Type: the Ticker Symbol[Beta

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To Obtain the Latest Corporate News

Tab to another page in Telerate Double click on the background Go to News Watch Right Click then Search by Ticker Symbol Type in the Ticker Symbol Then double click on any headline story to

bring up the entire story. You can print out the story or possibly save it to a

disk.

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Analysis Based on the Market Value of the

Firm Market value added ( MVA ) = Total

Market value – Total CapitalMVA is the market value of debt, preferred

stock, and common equity less the Capital raised by investors or Retained Earnings.

The capital market’s assessment of the accumulated NPV of all of the firm’s past and present projected investment projects.

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Economic Value Added (EVA)

Economic value added ( EVA ) = [ Return on total capital (r) – Cost of Capital (k )] x Capital

EVA = EBIT(1 – Corporate tax rate) – (Operating Capital)(k)

r = net operating profits after taxes divided by beginning of year capital (Return on Capital)

k = Weighted After-Tax Cost of Capital

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EVA - Continued

The yearly contribution of a firm’s operations to the creation of MVA.

EVA measures the extent to which the firm has increased shareholder value in a given year.

EVA represents the residual value that remains after the cost of all capital, including equity capital has been deducted.

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Increase Economic Value Added (EVA)

Increase operating efficiency Commit new resources that

promise a high return Redirect resources to more

productive uses Make prudent use of tax benefits

of debt financing

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Problems Caused by Inflation

Inventory profit as a result of timing of price increases

Inventory valuation methods ( LIFO ) ( FIFO ) Rising interest rates causes a decline in the

value of long term debt Differences in the reporting of earnings Understatement of fixed assets Recognition of sales

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The Cash Flow Concept

Accounting income Vs Cash flow Cash flow is the relevant source of value for

the firm ATCF = EAT + Noncash charges ATCF = EAT + Depreciation + Deferred taxes Free Cash Flow (FCF) = EBIT(1 – T) – Net

Investment in operating capital FCF = (EBIT(1 – T) + Depreciation) – Gross

investment in operating capital

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Statement of Cash Flows

Presents the net cash provided by operating, investing, or financing activities Direct method presents the net cash

provided by operating, investing, or financing activities

Indirect method presents the adjustments to net income to show net cash provided

Used for public financial reports The final results are identical

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Complex International Aspects of Financial Statement Analysis

Influenced by fluctuating exchange rates

SFAS No. 52 deals with foreign currency translation

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Accuracy of Financial Statements

External auditor Generally accepted accounting

principles People pose for a picture like a

corporation poses for a financial statement

Sarbanes-Oxley Act of 2002

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Conclusion Financial Statements

Balance Sheet Income Statement Statement of Cash

Flows Common-sized Sarbanes-Oxley Act

Ratios Liquidity Asset management Financial leverage

Profitability Market-based Dividend policy

DuPont Analysis Sources of

information Market Value

Added Economic Value

Added