Topic 3

ASSESSING FIRM’S FINANCIAL

PERFORMANCE
 Learning Objectives
• To explain the ratio categories and calculation of ratio.
• To define the financial ratios.
• To explain the use of financial ratios in trend and
cross sectional analysis in valuing the company’s
performance.
• To explain the execution of common size analysis.
• To elaborate the DuPont analysis and connection
between ratios.
• To clarify the boundaries of ratio analysis.

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 Standardized Financial
Statements
• Common-Size Balance Sheets
– Compute all accounts as a percent of total assets
• Common-Size Income Statements
– Compute all line items as a percent of sales
• Standardized statements make it easier to compare
financial information, particularly as the company grows
• They are also useful for comparing companies of different
sizes, particularly within the same industry
• Common-base year statement: a standardized financial
statement presenting all items relative to certain base year
amount
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 Ratio Analysis
• Financial ratios: relationship determined from a firm’s financial
information and used for comparison purposes.
• Ratios allow for better comparison through time (Time-Trend
Analysis) or between companies (Peer Group Analysis)
• As we look at each ratio, ask yourself what the ratio is trying to
measure and why that information is important
Categories of Financial Ratios
• Short-term solvency or liquidity ratios
• Long-term solvency or financial leverage ratios
• Asset management or turnover ratios
• Profitability ratios
• Market value ratios
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 1)Liquidity Ratios:
1) Current ratio = Current assets/Current liabilities
This ratio measures the degree of liquidity by comparing its current
assets to its current liabilities. Higher figure means that the
business financial condition is better as it has enough liquid assets
for its operation.

2) Quick ratio = (current assets-inventory/current liabilities)

This ratio is a more stringent measure of liquidity than the current
ratio. It excludes inventories and other current assets that are least
liquid from current assets. Higher ratio shows that the business has
enough quick assets or liquid assets to cover its short term debt
immediately.

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3) Cash ratio = cash/current liabilities

4) Net working capital to total assets= net working

capital/ total assets.

5) Interval measures=current asset/ average daily operating

cost
average daily operating cost = COGS/365 days

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 2) ASSET MANAGEMENT/ ACTIVITY/
EFFICIENCY RATIOS
1) Average collection periods (ACP)= Accounts receivable/ (Annual credit
sales/365)

Days’ Sales in Receivables = 365 / Receivables Turnover

The ratio measures how long a firm takes to collect its credit
accounts. The lower the figure is better.

2) Account receivable turnover = sales/accounts receivables

This ratio measures how often accounts receivables are “rolled over” during a
year. Higher ratio illustrates that the firm can collect its debt more frequent and
thus has few bad debts.

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3) Inventory turnover = costs of good sold/inventory
It measures the number of times a firm’s inventories are sold and
replaced during the year. Higher ratio indicates that inventory can
be sold and replaced more frequently.

4) Day’s dales in inventory= 365 days/inventory turnover

5) Fixed asset turnover = sales/net fixed assets

This ratio is an overall measure of asset efficiency based on the
relation between firm’s sales and the total assets. Higher ratio
indicates that firm is managing its assets more effectively.

6) Total asset turnover = sales/total assets

Higher ratio is favored because it indicates the effectiveness of the
firm in generating sales from its total assets.

7) NWC Turnover = sales/NWC

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 3)PROFITABILITY RATIOS
1) Gross profit margin= gross profit/ sales

The gross profit margin is a measure of the gross profit earned on sales. The gross profit margin
considers the firm's cost of goods sold, but does not include other costs. Higher ratio is better.

2) Net profit margin = Net income/sales

A higher profit margin indicates a more profitable company that has better control over its costs
compared to its competitors.

3) Operating Profit Margin(OPM) = Operating profit/Sales

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

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4) Return on assets (ROA) = Net income/total assets
This evaluates how effectively the company employs its
assets to generate a return. It measures efficiency.
Higher ratio is better.

5) Return on equity (ROE) = Net income/ common equity

Return on equity is the bottom line measure for the shareholders,
measuring the profits earned for each dollar invested in the firm's
stock. Higher ratio is favored because the firm can generate better
return to the owner of the firm.

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 4)LEVERAGE RATIOS
1) Debt ratio = total debt/total assets
This ratio measures the extent to which a firm has been financed with debt. More debt
financing results in more financial risk.

2) Times interest earned= EBIT/interest

The times interest earned ratio indicates how well the firm's earnings can cover the
interest payments on its debt. Higher ratio shows better ability in meeting interest
payment.

3) Debt to equity ratio = total debt/total equity

This ratio indicates what proportion of equity and debt the company is using to finance
its assets. A high debt to equity ratio could indicate that the company may be
overleveraged, and should look for ways to reduce its debt.

4) Equity multiplier = total assets/total equity or = 1+ (total debt/total equity)

5) Cash coverage =(EBIT+depreciation) / interest

6) Long-term debt ratio = LTD / (LTD + TE)

 5)MARKET VALUE RATIOS
1) Earning per share (EPS) = Net income/number of shares outstanding
It represents the portion of a firm's earnings that is allocated to each share of common
stock.

2) Price earning ratio (PE) = price per share/earnings per share

The ratio indicates how much investors are willing to pay per dollar of current earnings.
As such, high P/E Ratios are associated with growth stocks. The most common
measure of how expensive a stock is.

3) Price (market) to book ratio=price per share/book value per share

his ratio measures how much a company worth at present, in comparison with the
amount of capital invested by current and past shareholders into it.

4) Book value per share= Total equity/Number of shares outstanding

The ratio of stockholder equity to the number of common stocks. Book value per share
should not be thought of as an indicator of economic worth, since it reflects accounting
valuation (and not necessarily market valuation).

5) price/sales per share = price per share/ sales per share

where sales per share= sales / number of shares outstanding 12
 Deriving the Du Pont Identity
• ROE = NI / TE
• Multiply by 1 (TA/TA) and then rearrange
– ROE = (NI / TE) (TA / TA)
– ROE = (NI / TA) (TA / TE)
– = ROA * EM
• Multiply by 1 (Sales/Sales) again and then rearrange
– ROE = (NI / TA) (TA / TE) (Sales / Sales)
– ROE = (NI / Sales) (Sales / TA) (TA / TE)
– ROE = PM * TAT * EM
Profit margin is a measure of the firm’s operating efficiency – how well it controls costs
Total asset turnover is a measure of the firm’s asset use efficiency – how well does it manage its
assets
Equity multiplier is a measure of the firm’s financial leverage

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 3.7 Dupont Analysis
STEP 1

STEP 2

STEP 3

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Extended Du Pont Chart

Insert Figure 3.1 (Extended DuPont Chart)

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 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 different
divisions within the firm.
Prepare, at both firm and division levels, financial
projections.
Understand the financial performance of the firm’s
competitors.
Evaluate the financial condition of a major supplier.
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 Uses of Financial Ratios:
Outside the Firm
Financial ratios are used by:
• Lenders in deciding whether or not to make a loan 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 grant
credit terms to a company.

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 The 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.
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