Assessment of Business Performance

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Financial Analysis

Chapter 3



A ratio converts financial information to a percentage, oneapproach to standardization

Each ratio provides a somewhat different analysis

Liquidity—cash, working capital & cash flowrelated

Activity—turnover ratios as possible efficiency

measures

Leverage—debt & solvency analysis

Performance (or profitability)—bottom line or

earnings related

Ratios for the most recent period are usually the mostimportant



Importance Illustrates trends and patterns

Limitations Based on past data and conditions from which it

might be difficult to extrapolate future expectations Relative size is ignored (e.g., both large & small firms

can be compared) It is assumed that all numbers used are correct

(consider both possible errors and earningsmanagement)

If the numbers are not reliable, ratios are notparticularly useful



Managers To assess the efficiency and profitability of operations To judge how effectively resources of the business are

being used

Owners The way company’s earnings are used and distributed The relative value of shares within the security markets

Lenders & Creditors Concerned about the company’s liquidity and cash flow

that affects its ability to make interest payments due themand eventually to repay the principal payment.



Operational analysis CGS Ratio(cost of sales/total sales) Gross Margin (gross profit/ total sales) Profit Margin (NI/total Sales) EBIT Margin (EBIT/total Sales)

EBITDA Margin [(EBIT+D+A)/total Sales] NOPAT Margin [Operating Income*(1-tax rate)/total sales] Operating expense analysis (expense/total sales) Contribution Analysis [(sales-direct cost)/total sales]

Resource management Asset turnover (Sales/total assets)

Working capital management▪ Inventory turnover (sales/avg. inventory)

▪ Receivable turnover(sales/receivables)▪ Payable turnover (sales/payables )▪ Average days inventory in stock: 365/inventory turnover▪ Average days receivables outstanding: 365/receivables turnover▪ Average days payable outstanding: 365/payables turnover▪ Length of operating cycle: average days inventory + average days receivables

Profitability ROA (NI/Total assets)



Investment return ROE (NI/OE) EPS (Net profit to common equity/# of shares

outstanding)

Disposition of earnings Dividend yield (dividend per share/ price per share) Payout ratio (cash dividend per share/ EPS)

Market indicators Earnings multiple (share price/EPS) Value of firm



Liquidity Current ratio (current assets/current liabilities) Acid test ratio [(cash+cash equivalents+A/R)/current

liabilities] Financial leverage

Debt to assets ratio (Total debt/total assets) Debt to capitalization (LTD/net assets)

Debt to equity ratio (total debt/OE)

Debt services Interest coverage (EBIT/interest expense)



By analyzing each of the three levers thatleads to Return on Equity – ROE:

Profitability of the operations How efficient assets are being made to work

Leverage ( the right mix of Equity to Debt)



A way of visualizing the information so thateveryone can see it

Is a good tool for getting people started inunderstanding how they can have an impacton results

Helps to identify sources of strength andweakness in current performance

Helps to focus attention on value drivers



Profit Margin Total Asset Turnover

ROA Equity Multiplier

ROE





a. How the firm stands on aspecific date.

b. What BW owned.c. Amounts owed bycustomers.

d. Future expense itemsalready paid.

e. Cash/likely convertible tocash within 1 year.

f. Original amount paid. g. Acc. deductions for wear and

tear.

Cash and C.E. $ 90 Acct. Rec.c

394

Inventories 696Prepaid Exp d 5Accum Tax Prepay 10

Current Assetse $1,195Fixed Assets (@Cost)f 1030 Less:

Acc. Depr.g

(329) NetFix. Assets $ 701 Investment, LT 50 Other Assets, LT 223 Total Assets b $2,169

Basket Wonders Balance Sheet (thousands) Dec. 31, 2003a



a. Assets = Liabilities + Equity.b. What BW owed and

ownership position.c. Owed to suppliers for goodsand services.

d. Unpaid wages,salaries,taxes etc.

e. Debts payable < 1 year. f. Debts payable > 1 year. g. Original investment.h. Earnings reinvested.

Notes Payable $ 290 Acct.Payablec 94 Accrued

Taxes d

16 Other AccruedLiab. d 100Current Liab. e $ 500

Long-Term Debt f 530 Shareholders’ Equity

Com. Stock ($1 par) g

200 Add Pdin Capital g 729 RetainedEarnings h 210 Total Equity $1,139

Total Liab/Equitya,b $2,169

Basket Wonders Balance Sheet (thousands) Dec. 31, 2003



a. Measures profitability over a

time period.b. the cost of the units that

was sold to customers

c. Sales comm., adv., officers’salaries, etc.

d. Operating income.

e. Cost of borrowed funds.

f. Taxable income.

g. Amount earned for

shareholders.

Net Sales $ 2,211

Cost of Goods Sold b

1,599 GrossProfit $ 612 SG&A Expenses c

402 EBITd $210 Interest Expensee 59

EBT f $ 151Income Taxes 60 EATg

$ 91 CashDividends 38 Increasein RE $ 53

Basket Wonders Income Statement (in thousands) for Year Ending December 31, 2003a

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Assessment of Business Performance