Assessing Financial Performance Using Business Ratios

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Topic 3

• Assessing Financial Performance Using Business
  Ratios

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Learning Objectives

• LO 3.1 Calculate the various business ratios
  using real world financial statements using
  Excel.
• LO 3.2 Calculate the DuPont identity using
  Excel.
• LO 3.3 Use business ratios and the DuPont
  identity to analyze the financial standing of the
  firm in comparison to both the history of the
  firm and external benchmarks.
• LO 3.4 Use the Key Business Ratios database to
  investigate firm and industry ratio benchmarks.

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Excel Features Annuity Functions

• NPER(rate, pmt, pv, fv, type)
• Total number of periods
• RATE(nper,pmt,pv,fv,type,guess)
• Interest rate per period
• guess may be necessary if program gets stuck
• PMT(rate,nper,pv,fv,type)
• Constant payment amount
• PPMT(rate,per,nper,pv,fv,type)
• Principal component of PMT
• IPMT(rate,per,nper,pv,fv,type)
• Interest component of PMT

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Key Concepts and Skills

• Know how to standardize financial statements for
  comparison purposes
• Know how to compute and interpret important
  financial ratios

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Chapter Outline

• 3.1 Financial Statements Analysis
• 3.2 Ratio Analysis
• 3.3 The Du Pont Identity
• 3.4 Using Financial Statement Information

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3.1 Standardizing 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.

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3.2 Ratio Analysis

• Ratios also allow for better comparison through
  time or between companies
• As we look at each ratio, ask yourself
• How is the ratio computed?
• What is the ratio trying to measure and why?
• What is the unit of measurement?
• What does the value indicate?
• How can we improve the companys ratio?

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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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Custom Ratios

• Traditional ratios are the most useful for
  general applications.
• To meet specific needs, you can construct your
  own ratios.

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Liquidity Ratios

• Current Ratio
• Quick Ratio
• Cash Ratio

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Liquidity Ratios

• Liquidity is the ability to convert assets to
  cash with significant loss of value
• Differing time horizons for liquidity
• Cash Ratio ______________
• Quick Ratio ______________
• Current Ratio _____________

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Leverage Ratios

• Total Debt Ratio
• Debt/Equity Ratio
• Equity Multiplier

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Coverage Ratios

• Times Interest Earned
• Cash Coverage

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Coverage Ratios Custom

• Son of Cash Coverage
• What might be an application?

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Leverage and Coverage Ratios

• These are measures of the long-term
  sustainability of the firm.
• Bankruptcy is a function of debt.
• Leverage ratios measure how much debt.
• Coverage ratios measure how well the firm can
  support its debt.

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Inventory Ratios

• Inventory Turnover
• Days Sales in Inventory

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Receivables Ratios

• Receivables Turnover
• Days Sales in Receivables

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Turnover Ratios

• Total Asset Turnover
• It is not unusual for TAT lt 1, especially if a
  firm has a large amount of fixed assets.

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Turnover Ratios Custom

• Fixed Asset Turnover
• What might be an application?

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Turnover Ratios

• Inventory, receivables and turnover ratios
  measure how efficiently we different asset
  classes with reference to some standard, e.g.,
  sales.
• One goal is to produce sales. The Total Asset
  Turnover Ratio measures the relationship between
  sales and a dollar spend on total assets.
• For example if the ratio were 5 times, that
  would mean that, on average, 1.00 in assets were
  needed to generate 5.00 in sales.

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Profitability Measures

• Profit Margin
• Return on Assets (ROA)
• Return on Equity (ROE)

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Market Value Measures

• Market Price 88 per share
• Shares outstanding 33 million
• PE Ratio
• Market-to-Book Ratio

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Market Value Measures Custom

• Instead of using book value, we could use Tobins
  Q
• Why Tobins Q rather than Book Value?

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3.3 The Du Pont Identity
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Extending the Du Pont Identity
x
x




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Using the Du Pont Identity

• Profit margin is a measure of the firms
  operating efficiencyhow well it controls costs.
• Total asset turnover is a measure of the firms
  asset use efficiencyhow well it manages its
  assets.
• Equity multiplier is a measure of the firms
  financial leverage.

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3.4 Using Ratios

• Ratios are not very helpful by themselves they
  need to be compared to something
• Time-Trend Analysis
• Used to see how the firms performance is
  changing through time
• Peer Group Analysis
• Compare to similar companies or within industries
• ______ codes

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Web Resources

• Research Port (UMD Libraries)
• Key Business Ratios
• Ratios and ranges for SIC industries
• Mergent Online
• Ratios for particular firms

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Potential Problems

• There is no underlying theory, so there is no way
  to know which ratios are most relevant.
• Benchmarking is difficult for diversified firms.
• Globalization and international competition makes
  comparison more difficult because of differences
  in accounting regulations.
• Firms use varying accounting procedures.
• Firms have different fiscal years.
• Extraordinary, or one-time, events