Evaluating a Firm’s

Financial Performance

Gladys B. Dialino
When can we say that
a firm is performing
well?
Financial Ratios
 Relationships determined from a
company's financial information and used
for comparison purposes.

Financial Financial ratios help us identify some of

the financial strengths and weaknesses of a
Ratios company.

The ratios give us a way of making

meaningful comparisons of a firm’s
financial data at different points in time
and with other firms.
 Identify deficiencies in a firm's performance and take
corrective action

Evaluate employee performance and determine

incentive compensation
Uses of
Financial Compare the financial performance of different
divisions within the firm

Ratios
Within a Prepare financial projections

Firm Understand financial performance of competitors

Evaluate financial condition of suppliers/customers

 Lenders use to decided whether or not to lend

Uses of Credit-rating agencies in determining a firms

Financial credit worthiness

Ratios
Outside Investors in deciding whether or not to invest
in a company
the Firm
Suppliers in deciding whether or not to extend
credit to a company or in designing the specific
terms
 • used to measure the ability of a
Liquidity firm to pay its bills on time.
ratios Example ratios include the current
ratio and acid-test ratio.
Classificati
ons of
Financial • reflect how effectively the firm has
Ratios utilized its assets to generate sales.
Efficienc Examples of this type of ratio
include accounts receivable
y ratios turnover, inventory turnover, fixed
asset turnover, and total asset
turnover
 • used to measure the extent to which a firm
Leverage has financed its assets with outside (non-
owner) sources of funds. Example ratios
ratios include the debt ratio and times interest

Classificati
earned ratio.

ons of
Financial • serve as overall measures of the effectiveness

Ratios Profitabilit
of the firm’s management relative to sales
and/or to investment. Examples of
profitability ratios include the net profit
y ratios margin, return on total assets, operating
profit margin, operating income return on
investment, and return on common equity
We could use ratios to answer the following
important questions about a firm’s operations.

How liquid is the firm?

Is management generating adequate operating profits on the

firm's assets?
How is the firm financing its assets?

Are the owners (stockholders) receiving an adequate return on

their investment?
 QUESTION 1: HOW
LIQUID IS THE FIRM?
How liquid is the
firm?
• Liquidity
• ability to repay short-term
debt
• a company's ability to convert
its assets to cash in order to
pay its liabilities when they are
due.
 Measuring Liquidity:
Approach 1

• Current Ratio
- A ratio that indicates a firm’s
degree of liquidity by comparing
its current assets to its current
liabilities.
 Measuring Liquidity:
Approach 1

• Acid Test Ratio (Quick Ratio)

- A more stringent measure of
liquidity than the current ratio.
Subtracts the inventories from the
current assets.
 Measuring Liquidity:
Approach 2

• Average Collection Period –

expresses how rapidly the firm is
collecting its credit accounts.
 Measuring Liquidity:
Approach 2

• Accounts Receivables Turnover –

expresses how often accounts
receivable are “rolled over”
during a year
 Measuring Liquidity:
Approach 2

• Inventory Turnover – measures

the number of times a firm’s
inventories are sold and
replaced during the year.
SHORT QUIZ
1. Relationships determined from a company's financial information and used for
comparison purposes

2 – 5 Classifications of Financial Ratios

6. What is the formula in getting the Quick Ratio?

7. It is the ratio that expresses how rapidly the firm is collecting its credit
accounts.
8. The formula for Inventory Turnover is

9. It is the ratio that expresses the comparison between current assets and
current liabilities.
Answers:

1. Financial Ratios 7. Average Collection Period

2. Liquidity Ratios 8. Credit Sales / Sales
3. Efficiency Ratio 9. Current Ratio
4. Leverage Ratio 10. Liquidity – ability of a firm to
5. Profitability Ratio pay its short-term debt. /
Ability of a firm to convert its
6. non-cash assets into cash to
pay its liabilities before they
are due