Finance

by Raaga

Evaluating a Firms Financial Performance

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 companys performance. Describe the limitations of financial ratio analysis.

Principles Used in this Chapter

Principle 7: Managers Wont Work the Owners Unless it is their best Interest. Principle 5: The Curse of Competitive Markets Why Its Hard to Find Exceptionally Profitable Markets. Principle 1: The Risk Return Trade-Off We Wont Take on Additional Risk Unless We Expect to Be Compensated with Additional Return.

Financial Ratios
Ratios give us two ways of making meaningful comparisons of a firms financial data:
Trends across time Comparisons with other firms ratios

Uses of Financial Ratios within the Firm

Identify deficiencies in a firms performance and take corrective actions. Evaluate employees performance and determine incentive compensation. Compare the financial performance of different divisions within the firm

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.

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 firms 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.

Measuring Key Financial Relationships

How liquid is the firm? Is management generating adequate operating profits on the firms 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?

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 firms assets that are relatively liquid Examines the firms ability to convert accounts receivables and inventory into cash in a timely basis

Measuring Liquidity: Approach 1

Compare a firms current assets with current liabilities
Current Ratio Acid Test or Quick Ratio

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

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 Example Quick Ratio= ($350M + $114M) / $591M =1.05

Measuring Liquidity: Approach 2

Measures a firms ability to convert accounts receivable and inventory into cash
Average Collection Period Accounts Receivable Turnover Inventory Turnover Cash Conversion Cycle

Average Collection Period

How long it takes to collect the firms receivables Accounts receivable/(Annual credit sales/365) Starbucks Example: Avg. Collection Period = $114M / $1.68M= 68.1 days

Accounts Receivable Turnover

How many times accounts receivable are rolled over during a year Credit sales/Accounts receivable Starbucks Example Accounts Receivable Turnover = $611M / $114M = 5.36X

Inventory Turnover
How many times is inventory rolled over during the year? Cost of goods sold/Inventory
Starbucks Example Inventory Turnover= $3,207M / $342M = 9.38X

Starbucks vs. Peer Group

Ratio
Current Ratio Quick Ratio Avg. Collection Period Accounts Receivable Turnover

Starbucks 1.67
1.05 68.1 days 5.36X

Peers 2.02
1.54 93 days 3.90X

Inventory Turnover 9.38X

8.5X

Is Management Generating Adequate Operating Profits on the Firms Assets?

Operating Return on Assets (OROA) Operating Profit Margin Total Asset Turnover Fixed Asset Turnover

Operating Return on Assets

Level of profits relative to total assets Operating return/Total assets

Starbucks Example Operating Return On Assets = $436M / $2,672M = .163 or 16.3%

Operating Profit Margin

Examines how effective the company is managing its operations Operating profit/Sales Starbucks Example Operating Profit Margin = $436M / $4,067M = .107 or 10.7%

Total Asset Turnover

How efficiently a firm is using its assets in generating sales Sales/Total assets

Starbucks Example Total Asset Turnover = $4,076M / $2,672M = 1.53X

Fixed Asset Turnover

Examines investment in fixed assets for sales being produced Sales/Fixed assets
Starbucks Example Fixed Asset Turnover = $4,076M / $1,750M = 2.33X

Starbucks vs. Peer Group

Ratio
Operating Return on Assets

Starbucks 16.3%

Peers 14.9%

Operating Profit Margin

Total Asset Turnover

10.7%
1.53X

11.8%
1.26X

Fixed Asset Turnover

2.33X

2.75X

How Is the Firm Financing Its Assets?

Does the firm finance assets more by debt of equity?
Debt Ratio Times Interest Earned

Debt Ratio
What percentage of the firms assets are financed by debt? Total debt/Total assets
Starbucks Example Debt ratio = $591M / $2,672M = .221 or 22.1%

Times Interest Earned

Examines the amount of operating income available to service interest payments Operating income/Interest Starbucks Example Times Interest Earned = $436M / $3M = 145.3X

Starbucks vs. Peer Group

Ratio
Debt Ratio Times Interest Earned

Starbucks 22.1% 145.3X

Peers 25% 46.0X

 Are the earnings available to shareholders attractive Return on equity Net income/Common equity Starbucks Example Return on Equity = $268M / $208M = .129 or 12.9%

Is Management Providing a Good Return on the Capital Provided by the Shareholders?

Starbucks vs. Peer Group

Ratio Return on Equity

Starbucks 12.9%

Peers 12.0%

How Is Management Doing Creating Shareholder Value?

These ratios indicate what investors think of managements past performance and future prospects. Two approaches: Price/Earnings ratio Price/Book ratio

Price/Earnings Ratio
Measures how much investors are willing to pay for $1 of reported earnings Price per share/Earnings per share
Starbucks Example Price/Earnings Ratio = $35.00 / $0.69 = 51X

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

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