Download - Evaluating firm financial performance
Chapter 4
Evaluating a Firm’s Financial Performance
Foundations of FinanceArthur J. Keown John D. MartinJ. William Petty David F. Scott, Jr.
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Learning Objectives
After reading this chapter, you should be able to:
§ Explain the purpose and importance of financial analysis.
§ Calculate and use a comprehensive set of measurements to evaluate a company’s performance.
§ Describe the limitations of financial ratio analysis.
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Principles Used in this Chapter
• Principle 7: Managers Won’t Work the Owners Unless it is their best Interest.
• Principle 5: The Curse of Competitive Markets – Why It’s Hard to Find Exceptionally Profitable Markets.
• Principle 1: The Risk Return Trade-Off – We Won’t Take on Additional Risk Unless We Expect to Be Compensated with Additional Return.
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Financial Ratios
• Ratios give us two ways of making meaningful comparisons of a firm’s financial data:– Trends across time– Comparisons with other firms’
ratios
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Uses of Financial Ratios within the Firm
• Identify deficiencies in a firm’s performance and take corrective actions.
• Evaluate employees’ performance and determine incentive compensation.
• Compare the financial performance of different divisions within the firm
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Uses of Financial Ratios within the Firm
• Prepare financial projections, both at the firm and division levels.
• Understand the financial performance of competitors
• Evaluate the financial condition of a major supplier.
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Uses of Financial Ratios Outside the Firm
• Lenders in deciding whether or not to make a loan to a company.
• Credit-rating agencies in determining a firm’s credit worthiness.
• Investors in deciding whether or not to invest in a company.
• Major suppliers in deciding to sell and grant credit terms to a company.
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Measuring Key Financial Relationships
• How liquid is the firm?• Is management generating adequate
operating profits on the firm’s assets?
• How is the firm financing its assets?• Is management providing a good
return on the capital provided by the shareholders?
• Is the management team creating shareholder value?
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How Liquid Is a Firm?
• Liquidity is the ability to have cash available when needed to meet its financial obligations
• Measured by two approaches:– Comparing the firm’s assets that
are relatively liquid– Examines the firm’s ability to
convert accounts receivables and inventory into cash in a timely basis
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Measuring Liquidity: Approach 1
• Compare a firm’s current assets with current liabilities– Current Ratio– Acid Test or Quick Ratio
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Current Ratio
• Compares cash and current assets that should be converted into cash during the year with the liabilities that should be paid within the year
• Current assets/Current liabilities
Starbucks Example:Current ratio= $922M / $591M = 1.67
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Acid Test or Quick Ratio
• Compares cash and current assets (minus inventory) that should be converted into cash during the year with the liabilities that should be paid within the year.
• Cash and accounts receivable/Current liabilities
Starbucks ExampleQuick Ratio=
($350M + $114M) / $591M =1.05
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Measuring Liquidity:Approach 2
• Measures a firm’s ability to convert accounts receivable and inventory into cash– Average Collection Period– Accounts Receivable Turnover– Inventory Turnover– Cash Conversion Cycle
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Average Collection Period
• How long it takes to collect the firm’s receivables
• Accounts receivable/(Annual credit sales/365)
Starbucks Example:Avg. Collection Period =
$114M / $1.68M= 68.1 days
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Accounts Receivable Turnover
• How many times accounts receivable are “rolled over” during a year
• Credit sales/Accounts receivable
Starbucks ExampleAccounts Receivable Turnover =
$611M / $114M = 5.36X
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Inventory Turnover
• How many times is inventory rolled over during the year?
• Cost of goods sold/Inventory
Starbucks ExampleInventory Turnover=
$3,207M / $342M = 9.38X
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Starbucks vs. Peer Group
Ratio Starbucks PeersCurrentRatio
1.67 2.02
QuickRatio
1.05 1.54
Avg. Collection Period
68.1 days 93 days
Accounts Receivable Turnover
5.36X 3.90X
Inventory Turnover
9.38X 8.5X
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Is Management Generating Adequate Operating Profits on the Firm’s Assets?
• Operating Return on Assets (OROA)
• Operating Profit Margin• Total Asset Turnover• Fixed Asset Turnover
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Operating Return on Assets
• Level of profits relative to total assets • Operating return/Total assets
Starbucks ExampleOperating Return On Assets =
$436M / $2,672M = .163 or 16.3%
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Operating Profit Margin
• Examines how effective the company is managing its operations
• Operating profit/Sales
Starbucks ExampleOperating Profit Margin =
$436M / $4,067M = .107 or 10.7%
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Total Asset Turnover
• How efficiently a firm is using its assets in generating sales
• Sales/Total assets
Starbucks ExampleTotal Asset Turnover =
$4,076M / $2,672M = 1.53X
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Fixed Asset Turnover
• Examines investment in fixed assets for sales being produced
• Sales/Fixed assets
Starbucks ExampleFixed Asset Turnover =
$4,076M / $1,750M = 2.33X
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Starbucks vs. Peer Group
Ratio Starbucks PeersOperating Return on Assets
16.3% 14.9%
Operating Profit Margin
10.7% 11.8%
Total Asset Turnover
1.53X 1.26X
Fixed Asset Turnover
2.33X 2.75X
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How Is the Firm Financing Its Assets?
• Does the firm finance assets more by debt of equity?– Debt Ratio– Times Interest Earned
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Debt Ratio
• What percentage of the firm’s assets are financed by debt?
• Total debt/Total assets
Starbucks ExampleDebt ratio =
$591M / $2,672M = .221 or 22.1%
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Times Interest Earned
• Examines the amount of operating income available to service interest payments
• Operating income/Interest
Starbucks ExampleTimes Interest Earned =
$436M / $3M = 145.3X
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Starbucks vs. Peer Group
Ratio Starbucks PeersDebt Ratio 22.1% 25%
Times Interest Earned
145.3X 46.0X
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Is Management Providing a Good Return on the Capital Provided by the Shareholders?
• Are the earnings available to shareholders attractive
• Return on equity• Net income/Common equity
Starbucks ExampleReturn on Equity
= $268M / $208M = .129 or 12.9%
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Starbucks vs. Peer Group
Ratio Starbucks PeersReturn onEquity
12.9% 12.0%
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How Is Management Doing Creating Shareholder Value?
• These ratios indicate what investors think of management’s past performance and future prospects. Two approaches:– Price/Earnings ratio– Price/Book ratio
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Price/Earnings Ratio
• Measures how much investors are willing to pay for $1 of reported earnings
• Price per share/Earnings per share
Starbucks ExamplePrice/Earnings Ratio =
$35.00 / $0.69 = 51X
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Price/Book Ratio
• Compares the market value of a share of stock to the book value per share of the reported equity on the balance sheet
• Price per share/Equity book value per share
Starbucks Example Price/Book Ratio =
$35.00 / $5.32= 6.58X
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Starbucks vs. S&P Index Price
Ratio Starbucks S&PPrice/EarningsRatio
51X 24X
Price/Book Ratio 6.58X 3X
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Economic Value Added (EVA)
• Measures a firm’s economic profit, rather than accounting profit
• Recognizes a cost of equity and a cost of debt
• EVA = (r-k) X Cwhere:r = Operating return on assetsk = Total cost of capitalC = Amount of capital (Total Assets)
invested in the firm
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Limitations of Ratio Analysis
• Difficulty in identifying industry categories or finding peers
• Published peer group or industry averages are only approximations
• Accounting practices differ among firms• Financial ratios can be too high or too low• Industry averages may not provide a
desirable target ratio or norm• Use of average account balances to offset
effects of seasonality