chapter 14 financial ratios and firm performance

Chapter 14

Financial Ratios and Firm

Performance

© 2013 Pearson Education, Inc. All rights reserved. 14-2

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.


14.1 Financial Statements

Just like a doctor takes a look at a patient’s x-rays or cat-scan when diagnosing health problems, 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 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.


14.1 (A) Benchmarking

• The financial statements constitute fairly complex documents involving a whole bunch of numbers.

• Absolute values – tell us something about the amount of assets, liabilities,

equity, revenues, expenses, and taxes of a firm, – 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.


14.1 (A) Benchmarking (continued)Table 14.1 Cogswell Cola’s Abbreviated Income Statements ($ in thousands)


14.1 (A) Benchmarking (continued)

• 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.



Figure 14.3



Figure 14.4



• 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.


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.


14.2 Financial Ratios (continued)

5 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.


14.2 (A) Short-Term Solvency: Liquidity Ratios

• Measure a company’s ability to cover its short-term debt obligations in a timely manner:

• 3 key liquidity ratios include: The current ratio, quick ratio, and cash ratio.


14.2 (A) 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 arebeing 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.

Table 14.2 Liquidity Ratios 2011 for Cogswell Cola and Spacely Spritzers


14.2 (B) Long-Term Solvency: Solvency or 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.


14.2 (B) Long-Term Solvency: Long-Term Solvency: Solvency or Financial Leverage Ratios


14.2 (B) Long-Term Solvency: Long-Term Solvency: Solvency or 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.

Table 14.3 Financial Leverage Ratios 2011 for Cogswell Cola and Spacely Spritzers


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.

• Equations 14.7 – 14.11 can be used to calculate 5 key asset management ratios.


14.2 (C) 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

Table 14.4 Asset Management Ratios 2011 for Cogswell Cola and Spacely Spritzers


14.2 (D) 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.


14.2 (D) Profitability Ratios (continued)

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

Table 14.5 Profitability Ratios 2011 for Cogswell Cola and Spacely Spritzers


14.2 (E) 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.


14.2 (E) Market Value Ratios (continued)

• 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.


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 seem to have good expectations about their performance and are therefore paying fairly high prices relative to their earnings book values.


14.2 (F) DuPont 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.


14.2 (F) DuPont 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 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 5 areas and accordingly reach conclusions or make recommendations for changes.


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


14.3 (A) Cola Wars

Table 14.6 Key Financial Ratios and Accounts for PepsiCo and Coca-Cola (as of December 31, 2010)


14.3 (A) Cola Wars

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


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 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).


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, which is why comparing company ratios with industry averages can be very useful and more informative.

Table 14.8 Financial Ratios: Industry Averages


Additional Problems with AnswersProblem 1

Constructing an Income Statement. Using the income and expense account information for Tri-Mark Products Inc. listed below, construct an income statement for the year ended 31st December, 2009.

Shares outstanding: 1,575,000Tax rate: 35%Interest expense: $3,540,000Revenue: $950,500,000Depreciation: $50,000,000Selling, general, and administrative expense: $85,000,000Other income: $1,350,000Research and development: $5,200,000Cost of goods sold: $730,000,000


Additional Problems with AnswersProblem 1 (Answer)

Tri-mark Products Incorporated

Income Statement for the year ended 31st Dec. 2009 ('000s)

Revenue

$ 950,500

Cost of goods sold $ 730,000

Gross Profit $ 220,500 Operating expenses

Selling, general and administrative expenses $ 85,000

R&D $ 5,200

Depreciation $ 50,000

Operating Income $ 80,300

Other Income $ 1,350

EBIT

$ 81,650

Interest Expense $ 3,540

Taxable Income $ 78,110

Taxes $ 27,339

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

$ 3.03



Constructing a Balance Sheet. Construct Tri-Mark Incorporated’s 2009 year-end Balance Sheet using the asset, liability, and equity accounts listed below:

Retained Earnings $60,500,000

Accounts Payable $57,000,000Accounts Receivable $43,000,000Common Stock $89,676,000Cash $6,336,000Short Term Debt $1,500,000Inventory $42,000,000Goodwill $30,000,000Long Term Debt $74,000,000Other Non-Current Liabilities $15,000,000PP&E $225,000,000Other Non-Current Assets $14,000,000Long-Term Investments $25,340,000Other Current Assets $12,000,000



Tri-mark Products Inc.

Balance Sheet as at year ended 31st December 2009 (‘000s)

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

Owner’s 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



• Common size statements: Re-state Tri-Mark Incorporated’s 2009 financial statements as common-size statements and comment on them



Assets:

% of Total Assets Liabilities:

% of Total Assets

Current Assets

Current Liabilities

Cash $6,336 0.02

Accounts Payable $57,000 0.14

Accts. Rec. $43,000 0.11

Short Term Debt $1,500 0.00

Inventory $42,000 0.11

TOTAL Current Liab.

$58,500 0.15

Other Current $12,000 0.03

Long Term Debt $74,000 0.19

Total Current $103,336 0.26

Other Liabilities $15,000 0.04

L- T Inv. $25,340 0.06

Total Liabilities

$147,500 0.37

PP&E $225,000 0.57

Owner’s Equity

Goodwill $30,000 0.08

Common Stock

$189,676 0.48

Other Assets $14,000 0.04

Retained Earnings

$60,500 0.15

Total Assets $397,676 1.00 Total OE

$250,176 0.63 Total Liab. And OE $397,676 1.00



Compute and analyze financial ratios. Using the 2009 income statement and balance sheet of Trimark Products Inc., as constructed in problems 1 and 2 above, compute its financial ratios. How is the firm doing relative to its industry in the areas of liquidity, asset management, leverage, and profitability?


Additional Problems with AnswersProblem 4 (continued)

Ratio Industry Average

Current Ratio 2.200 Quick Ratio (or Acid Test Ratio) 1.500 Cash Ratio 0.135 Debt Ratio 0.430 Cash Coverage 10.600 Day’s Sales in Receivables 29.000 Total Asset Turnover 2.800 Inventory Turnover 20.100 Day’s Sales in Inventory 11.500 Receivables Turnover 32.000 Profit Margin 0.045 Return on Assets 0.126 Return on Equity 0.221



Trimark Industry Average

Current Ratio

1.766 2.200 Quick Ratio (or Acid Ratio Test) 1.048 1.500 Cash Ratio

0.108 0.135

Debt Ratio

0.371 0.430 Cash Coverage

37.189 10.600

Day’s Sales in Receivables

16.512 12.000

Total Asset Turnover

2.390 2.800

Inventory Turnover

28.808 30.100

Day’s 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


Additional Problems with AnswersProblem 4 (Answer) (continued)

Analysis:

Liquidity: Trimark’s liquidity ratios are below the industry average indicating that they might need to look into their management of current assets and liabilities.

Leverage: Trimark’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: Trimark’s asset turnover ratios are all below the average. It needs to tighten up collections, and manage its inventory more efficiently.

Profitability: Trimark has a good control on cost of goods sold. Its net profit margin is better than the industry and so is its ROA. The industry, however, is returning a higher rate to the shareholders on average, primarily due to the higher debt levels.



DuPont Analysis. Based on the ratios calculated in problem 4 above, and in conjunction with the industry averages given, conduct a DuPont analysis on Trimark’s key profitability ratios.



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 Assets

Total 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)


Additional Problems with AnswersProblem 5 (Answer) (continued)

Trimark Industry

Debt 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

Despite a lower Total Asset Turnover ratio, Trimark’s ROA (12.8%) is better than that of the industry (12.6%), primarily due to its higher net profit margin. The industry, however, has a higher ROE (22.1%) due to its higher debt ratio and correspondingly higher equity multiplier.


Figure 14.1 Cogswell Cola Balance Sheet


Figure 14.2 Cogswell Cola Income Statement

chapter 14 financial ratios and firm performance

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