Evaluating A

Firm’s
Financial
Performance
WEEK 2
Agenda
➢Balance Sheet
➢Income Statement
➢Uses and limitations of Financial Statements
➢Ratio Analysis
Financial
Performance
Performance?
Financial Performance
➢Financial performance is a complete evaluation
of a company’s overall standing in categories such
as assets, liabilities, equity, expenses, revenue,
and overall profitability. It is measured through
various business-related formulas that allow users
to calculate exact details regarding a company’s
potential effectiveness.
Financial Statements and Reports
Of the various reports corporations issue to their stockholders, the annual report is probably the
most important. Two types of information are given in this report.

❖First, there is a verbal section, often presented as a letter from the chairman, that describes the
firm’s operating results during the past year and discusses new developments that will affect
future operations.

❖Second, the annual report presents four basic financial statements — the balance sheet, the
income statement, the statement of retained earnings, and the statement of cash flows. Taken
together, these statements give an accounting picture of the firm’s operations and financial
position. Detailed data are provided for the two or three most recent years, along with historical
summaries of key operating statistics for the past 5 or 10 years.
What is Financial Performance?
•Assets
•Liabilities
•Equity
•Revenue
•Profitability
 Asset
An asset is a resource owned or controlled by an individual, corporation, or government with the
expectation that it will generate a positive economic benefit.

❖Cash and cash equivalents

❖Accounts Receivable

❖Inventory

❖Investments

❖PPE (Property, Plant, and Equipment)

❖Vehicles

❖Furniture

❖Patents (intangible asset)

 Liabilities
A liability is something a person or company owes, usually a sum of money. Liabilities are settled over
time through the transfer of economic benefits including money, goods, or services.

❖A liability (generally speaking) is something that is owed to somebody else.

❖Liability can also mean a legal or regulatory risk or obligation.

❖In accounting, companies book liabilities in opposition to assets.

❖Current liabilities are a company's short-term financial obligations that are due
within one year or a normal operating cycle (e.g. accounts payable).

❖Long-term (non-current) liabilities are obligations listed on the balance sheet

not due for more than a year.
 Equity

Equity is the value attributable to the owners of a business.

Equity, also called shareholders' equity or owners' equity for

privately held corporations, is the amount of money given to a
company's shareholders if all of its assets were sold and all of its
debts were paid off.
Revenue
Revenue is the money generated from normal business operations, calculated as the average sales
price times the number of units sold.
❖ Revenue, often referred to as sales or the top line, is the money received
from normal business operations.

❖ Operating income is revenue (from the sale of goods or services) less

operating expenses.

❖ Non-operating income is infrequent or nonrecurring income derived from

secondary sources (e.g., lawsuit proceeds).

❖ Non-business entities such as governments, nonprofits, or individuals also

report revenue, though calculations and sources for each differ.

❖ Revenue is only sale proceeds, while income or profit incorporate the

expenses to generate revenue and report the net (not gross) earnings.
Profitability
Profitability is a measure of an
organization’s profit relative to its
expenses. Organizations that are
more efficient will realize more
profit as a percentage of their
expenses than a less efficient
organization, which must spend
more to generate the same profit.
Balance Sheet
Balance Sheet
A statement of the firm’s financial position at a specific point in time.
Points about the balance sheet are worth noting:
1. Cash versus other assets.

2. Liabilities versus stockholders’ equity.

3. Preferred versus common stock.

4. Breakdown of the common equity accounts.

5. Inventory accounting.

6. Depreciation methods.

7. The time dimension.

Balance Sheet
1. Cash versus other assets.

Convert this to
cash?
Balance Sheet
2. Liabilities versus stockholders’ equity.
Balance Sheet
3. Preferred versus common stock.

Preferred stock is a hybrid, or a cross

between common stock and debt. In the
event of bankruptcy, preferred stock ranks
below debt but above common stock. Also,
the preferred dividend is fixed, so
preferred stockholders do not benefit if
the company’s earnings grow. Finally,
many firms do not use any preferred stock,
and those that do generally do not use
much of it. Therefore, when the term
“equity” is used in finance, we generally
mean “common equity” unless the word
“total” is included.
Balance Sheet
Breakdown of the common equity accounts.

• The breakdown of the common equity accounts

is important for some purposes but not for
others. For example, a potential stockholder
would want to know whether the company
actually earned the funds reported in its equity
accounts or whether the funds came mainly
from selling stock. A potential creditor, on the
other hand, would be more interested in the
total equity the owners have in the firm and
would be less concerned with the source of the
equity.

Retained Earnings. The portion of the firm’s

earnings that has been saved rather than paid out
as dividends.
Balance Sheet
Inventory accounting.
.
• FIFO Method
• LIFO Method

Since Allied Co. uses FIFO, and since inflation has been
occurring, (a) its balance sheet inventories are higher
than they would have been had it used LIFO, (b) its cost
of goods sold is lower than it would have been under
LIFO, and (c) its reported profits are therefore higher. In
Allied’s case, if the company had elected to switch to
LIFO in 2001, its balance sheet figure for inventories
would have been $585,000,000 rather than
$615,000,000, and its earnings would have been
reduced by $18,000,000. Thus, the inventory valuation
method can have a significant effect on financial
statements. This is important when an analyst is
comparing different companies.
Balance Sheet • Most companies prepare two sets of financial
Depreciation methods
statements — one for tax purposes and one for
reporting to stockholders. Generally, they use
the most accelerated method permitted under
the law to calculate depreciation for tax
purposes, but they use a straight line, which
results in a lower depreciation charge, for
stockholder reporting.

Allied has elected to use rapid depreciation for both

stockholder reporting and tax purposes. Had Allied
elected to use straight-line depreciation for
stockholder reporting, its 2001 depreciation expense
would have been $25,000,000 less, so the $1 billion
shown for “net plant” on its balance sheet would
have been $25,000,000 higher. Its net income and
its retained earnings would also have been higher.
Balance Sheet
The time dimension.

• The balance sheet may be thought of as a

snapshot of the firm’s financial position at a
point in time — for example, on December 31,
2000. Thus, on December 31, 2000, Allied had
$80 million of cash and marketable securities,
but this account had been reduced to $10
million by the end of 2001. The balance sheet
changes every day as inventories are increased
or decreased, as fixed assets are added or
retired, as bank loans are increased or
decreased, and so on.
Income Statement
Income Statement
A statement summarizing the firm’s revenues and expenses over an accounting period, generally a quarter
or a year.
Income Statement Component
Depreciation. The charge reflects the cost of assets used up in the production
process. Depreciation is not a cash outlay.

Tangible Assets. Physical assets such as plant and equipment.

Amortization. A noncash charge is similar to depreciation except that it is used to

write off the costs of intangible assets.

Intangible Assets. Assets such as patents, copyrights, trademarks, and goodwill.

EBITDA. Earnings before interest, taxes, depreciation, and amortization.

Income Statement
Retained Earnings
Statement of Retained Earnings
A statement reporting how much of the firm’s earnings were retained in the business rather than
paid out in dividends. The figure for retained earnings that appears here is the sum of the annual
retained earnings for each year of the firm’s history.
Net Cash Flow
Statement of Cash Flow
Net Cash Flow
➢The actual net cash, as opposed to accounting net income, that a firm generates during some specified
period.

➢The firm’s net income is important, but cash flow is even more important because dividends must be
paid in cash and because cash is necessary to purchase the assets required to continue operations.

➢Companies can use cash flow for product development, marketing efforts, technology investments,
buying back stock or issuing dividends, reducing debt, or improving employee benefits.

➢Business executives use these pieces of data to make decisions about the future of their company. Over
time, a company that does not have a positive net cash flow will fail.
Statement of Cash Flows
Net Cash Flow and Net Income