Chapter 4 - Evaluating a Firm's Financial Performance

Acid Test or Quick Ratio =

(Cash + Accounts Receivable) / Current Liabilities

Economic Value Added (EVA) =

(Operating Return Assets x Cost of Capital) x Total Assets

Acid-Test Ratio =

(cash + accounts receivable) / current liabilities

Economic Value Added (EVA) =

(operating return on assets - cost of capital) x total assets

Liquidity is measured by two approaches:

1. Comparing the firm's current assets and current liabilities 2. Examining the firm's ability to convert accounts receivables and inventory into cash on a timely basis

Direct Relationship between Inventory Turnover and the Days in Inventory Ratio

365 days / inventory turnover = days in inventory

Direct relationship between Accounts Receivable Turnover and the Days in Receivable Ratio

365 days / receivables turnover = days in receivables

Days in receivables (average collection period)

A firm's accounts receivable divided by the company's average daily credit sales (annual credit sales / 365). This ratio expresses how many days on average it takes to collect receivables.

Return on equity

A firm's net income divided by its common book equity. This ratio is the accounting rate of return earned on the common stockholders' investment.

Times interest earned

A firm's operating profits divided by interest expense. This ratio measures a firm's ability to meet its interest payments from its annual operating earnings.

Operating profit margin

A firm's operating profits divided by sales. This ratio serves as an overall measure of operating effectiveness.

Fixed-asset turnover

A firm's sales divided by its net fixed assets. This ratio indicates how efficiently the firm is using its fixed assets.

Total asset turnover

A firm's sales divided by its total assets. This ratio is an overall measure of asset efficiency based on the relation between a firm's sales and the total assets.

Days in Receivables =

Accounts Receivable / Daily Credit Sales = Accounts Receivable / (Annual Credit Sales / 365)

Accounts Receivable Turnover =

Annual Credit Sales / Accounts Receivable

Inventory Turnover =

COGS / Inventory

Inventory Turnover =

COGS / inventory

Current Ratio =

Current Assets / Current Liabilities

Four Uses of Financial Ratios: Outside of 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.

Fixed-Assets Turnover =

Sales / Net Fixed Assets

Total Asset Turnover =

Sales / Total Assets

Economic value added

Sometimes referred to as economic profit. Differs from accounting profits in that both interest expense and a return to the shareholders are deducted from revenues in its calculation. Accounting profit reflects the deduction of interest expense only.

Inventory turnover

a firm's COGS divided by its inventory. This ratio measures the number of times a firm's inventories are sold and replaced during the year, that is, the relative liquidity of the inventories.

Accounts receivable turnover ratio

a firm's credit sales divided by its accounts receivable. This ratio expresses how often accounts receivable are "rolled over" during a year.

Current Ratio compares . . .

a firm's current assets to its current liabilities

Debt ratio

a firm's total liabilities divided by its total assets. It is a ratio that measures the extent to which a firm has been financed with debt.

Financial ratios

accounting data restated in relative terms in order to help people identify some of the financial strengths and weaknesses of a company

Days in Receivables =

accounts receivable / daily credit sales

Acid Test or 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

Common equity includes both

common stock and retained earnings

Account Receivable Turnover =

credit sales / accounts receivable

Accounts Receivable Turnover =

credit sales / accounts receivable

Current Ratio =

current assets / current liabilities

Managing Assets: Fixed Asset Turnover examines . . .

efficiency in generating sales from investment in "fixed assets"

Managing Operations: Operating Profit Margin (OPM) examines . . .

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

Price/Earnings Ratio measures . . .

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

Asset efficiency

how well a firm is managing its assets

Days in Inventory =

inventory / daily COGS

Price / Earnings Ratio =

market price per share / earnings per share

Price / Book Ratio =

market price per share / equity-book value per share

Return on Equity =

net income / total common equity

Times Interest Earned =

operating income / interest expense

Operating Profit Margin =

operating income / sales

Operating Return on Assets =

operating income / total assets

Fixed Asset Turnover =

sales / net fixed assets

Total Asset Turnover =

sales / total assets

Liquidity

the ability to easily convert an asset into cash without significant loss of its value

Times Interest Earned indicates . . .

the amount of operating income available to pay interest payments

Current ratio

the firm's current assets divided by its current liabilities. This ratio provides an indicator of the company's ability to pay its bills on time by comparing its current assets (assets expected to be turned into cash within a year) to its current liabilities (the firm's liabilities that must be paid within a year)

Operating Return on Assets (ORA) indicates . . .

the level of operating profits relative to the firm's total assets

Debt Ratio indicates . . .

the percentage of the firm's assets that are financed by debt (implying that the balance is financed by equity)

Price/earnings ratio

the price the market places on $1 of a firm's earnings. For example, if a firm has an earning per share of $2 and a stock price of $30 per share, its price/earnings ratio is $15 (30 / 2)

Operating return on assets (OROA)

the ratio of a firm's operating income divided by its total assets. This ratio indicates the rate of return being earned on the firm's assets.

Managing Assets: Total Asset Turnover measures . . .

this ratio measures how efficiently a firm is using its assets in generating sales

Debt Ratio =

total debt / total assets

The Purpose of Financial Analysis

uses historical financial statements to measure a company's performance and in making financial projections of future performance. - A popular way to analyze the financial statements is by computing ratios. A ratio is a relationship between two numbers.

Coca-Cola and PepsiCo Comparison • What a higher Operating Profit Margin and Asset Turnover Ratio indicates

• A higher Operating profit margin indicates that Coca-Cola (21.1%) manages their expenses better than PepsiCo (14.5%). • A higher Asset turnover ratio (particularly inventory) indicates that PepsiCo (.95 vs .50) manages their assets better and are more liquid. • PepsiCo's better management of assets (13.7 vs 10.5) makes them appear to be in a better overall position when measuring operating return on assets.

Question 1: How Liquid Is the Firm? Can It Pay Its Bills? • What is a liquid asset and what does it measure

• 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.

Perspective 1: Compare a firm's current assets with current liabilities using what two ratios

• Current Ratio • Acid Test or Quick Ratio

Six Firm Liquidity Ratios

• Current Ratio • Acid-test Ratio • Days in Receivables • Account Receivable Turnover • Days in Inventory • Inventory Turnover

Perspective 2: Measure a firm's ability to convert accounts receivable and inventory into cash using what approaches

• Days in Receivables or Average Collection Period • Accounts Receivable Turnover ----------------------------------------- • Days in Inventory • Inventory Turnover

Question 3: How Is the Firm Financing Its Assets? • Does the firm finance its assets by debt, equity, or both, and the two ratios to consider

• Debt Ratio • Times Interest Earned

Two Financing Decisions Ratios

• Debt Ratio • Times Interest Earned

Five Questions that Financial Ratios Help Answer

• How liquid is the firm? • Are the firm's managers generating adequate operating profits on the company's assets? • How is the firm financing its assets? • Are the firm's managers providing a good return on the capital provided by the shareholders? • Are the firm's managers creating shareholder value?

Six 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. • Prepare financial projections of the firm. • Understand the financial performance of the firm's competitors. • Evaluate the financial condition of a major supplier.

The Six Limitations of Financial Ratio Analysis

• It is sometimes difficult to identify industry categories or comparable peers • The published peer group or industry averages are only approximations • Industry averages may not provide a desirable target ratio • Accounting practices differ widely among firms. • A high or low ratio does not automatically lead to a specific conclusion • Seasons may bias the numbers in the financial statements

Six Operating Profitability Ratios

• Operating Return on Assets • Operating Profit Margin • Total Asset Turnover • Accounts Receivable Turnover • Inventory Turnover • Fixed Asset Turnover

Economic Value Added (EVA) • Creating shareholder value and what it measures

• 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)

Three Creating Shareholder Value Ratios

• price / earnings ratio • price / book ratio • Economic Value Added (EVA)

A popular way to analyze the financial statements is by computing ratios. A given ratio may be compared to:

• ratios from previous years • ratios of other firms and/or leaders in the same industry

Debt Ratio =

Total Debt / Total Assets

Operating Profit Margin (OPM) =

Operating Profits / Sales

Operating Return on Assets (ORA) =

Operating Profits / Total Assets

Days in Receivables (Average Collection Period) calculates

How long does it take to collect the firm's receivables

Days in Inventory calculates . . .

How long the inventory is held before being sold

Accounts Receivable Turnover calculates

How many times are the accounts receivable "rolled-over" each year

Inventory Turnover calculates . . .

How many times the firm's inventories are sold and replaced during the year

Days in Inventory =

Inventory / Daily COGS = Inventory / (Annual COGS / 365)

Days in inventory

Inventory divided by daily cost of goods sold. This ratio measures the number of days a firm's inventories are held on average before being sold; it also indicates the quality of the inventory

Price/Earnings Ratio =

Market Price Per Share / Earnings Per Share

Return on Equity =

Net Income / Total Common Equity

Breakdown of Operating Return on Assets

ORA = Operating Profit Margin x Total Asset Turnover which can be calculated as: (Operating Profits / Sales) x (Sales / Total Assets) ____________________________________ = ORA

Times Interest Earned =

Operating Profits / Interest Expense

Price/book ratio

The market value of a share of the firm's stock divided by the book value per share of the firm's reported equity in the balance sheet. Indicates the market price placed on $1 of capital that was invested by shareholders.

Acid-test (quick) ratio

The sum of a firm's cash and accounts receivable divided by its current liabilities. This ratio is a more stringent measure of liquidity than the current ratio because it excludes inventories and other current assets (those that are least liquid) from the numerator.

Question 2: Are the Firm's Managers Generating Adequate Operating Profits from the Company's Assets? • Four ratios to consider and what they focus on

These ratios focus on the profit the assets of the firm are generating: • Operating Return on Assets • Operating Profit Margin • Total Asset Turnover • Fixed Assets Turnover

Question 5: Are the Firm's Managers Creating Shareholder Value? • The two approaches to answering this question and what they indicate

These ratios indicate what investors think of management's past performance and future prospects: • Market value ratios: - Price/Earnings Ratio - Price/Book ratio • Economic Value Added (EVA)

Question 4: Are the Firm's Managers Providing a Good Return on the Capital Provided by the Company's Shareholders? • How to analyze this

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