Chapter 3 Evaluation of Financial Performance

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Introduction

This chapter introduces financial statement analysis techniques that are used to accurately evaluate a companys 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 WorldCom (MCI), ENRON, HealthSouth, Ahold, Tyco, etc.
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Accounting differences in firms

Ratio Classifications

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

Major Financial Statements

Common-sized balance sheet shows assets, liabilities, and equity as a % of total assets Common-sized income statement shows income and expense items as a % of net sales
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Income statement

Statement of cash flows

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 liabilities Aging 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 Finance 311

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 share Stock 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

Sales = EAT Total assets Total assets Total assets Equity

ROE = EAT x Sales x Sales Total assets

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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Trend analysis XYZ current ratio

Financial Ratio Analysis

2002 2003 2004 1.9 2.2 2.3 2004 2.3 2.5 2002 2003 2004 1.9 2.2 2.3 2.5 2.4 2.5
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Cross-sectional analysis XYZ current ratio Industry norms Both simultaneously XYZ current ratio Industry norms

Trading Room (406 Sirrine Hall)

Some Sources of Information

Bridge (Telerate) Bloomberg Reuters

General Business File of Cooper Library Factiva Mergent Database TableBase Reuters Business Insight RMA Annual Statement Studies

Visit Index Table 3 in Library Annual reports 10Ks - SEC EDGAR Corporate Database Standard and Poors Value Line Industry Norms and Key Business Ratios The Internet
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Reserves on 2nd Floor

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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 firms 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 earnings Significant non-recurring transactions in the income figure

Quality of a firms balance sheet is

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

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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 Finance 311 22

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 Capital MVA is the market value of debt, preferred stock, and common equity less the Capital raised by investors or Retained Earnings. The capital markets assessment of the accumulated NPV of all of the firms 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 firms 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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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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Problems Caused by Inflation

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

Statement of Cash Flows

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
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The final results are identical

Influenced by fluctuating exchange rates SFAS No. 52 deals with foreign currency translation

Complex International Aspects of Financial Statement Analysis

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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

Profitability Market-based Dividend policy

Ratios

Liquidity Asset management Financial leverage

DuPont Analysis Sources of information Market Value Added Economic Value Added
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