Chapter 15 Financial Ratios and Firm Performance

1
Chapter 15Financial Ratios and Firm Performance

• Financial Statements
• Internal Uses of Financial Statements
• Financial Ratios
• External Uses of Financial Statements

2
Financial Statements

• Review from Chapter 10
• Three Amigos
• Income Statement
• Balance Sheet
• Sources and Uses of Cash
• Accounting Identity
• Assets Liabilities Owners Equity
• Double entry bookkeeping
• Benchmarking against self or competition

3
Internal Uses of Financial Statements

• Analyze firm performance
• Comparison of actual performance to forecasts
  (budgets)
• Use standard costs for comparison
• Breakdown performance into key areas
• Sales
• Production
• Labor
• Overhead

4
Internal Uses of Financial Statements

• Example Sales Variance Analysis
• Price Analysis
• Actual Price x Actual Quantity vs. Forecasted
  Price x Actual Quantity
• Actual gt Forecast, favorable variance
• Volume Analysis
• Forecast Price x Actual Quantity vs. Forecast
  Price x Forecast Quantity
• Actual gt Forecast, favorable variance
• Sum variance for total Sales Analysis

5
Internal Uses of Financial Statements

• Other Variances
• Production
• Labor and Material
• Overhead
• EBIT Variance sum of Sales, Production, and
  Overhead
• Be careful with interpreting favorable and
  unfavorable variances
• Variance analysis is an aid to understanding the
  performance of the business

6
Financial Ratios

• Comparing accounts for analysis of firm
  performance or potential strengthens and
  weaknesses
• Five areas
• Liquidity
• Solvency
• Asset Management
• Profitability
• Market Value

7
Financial Ratios

• Liquidity
• Ability to meet short term cash outflow
• Poor liquidity sign of trouble ahead in keeping
  operations going
• Common Liquidity Ratios
• Current Ratio
• Cash Debt Coverage Ratio
• Quick Ratio
• Cash Ratio

8
Financial Ratios

• Solvency
• Long-term ability to meet cash outflow
• Indicates borrowing capacity in future
• Common Solvency Ratios
• Debt Ratio
• Times Interest Earned
• Cash Coverage Ratio
• Capital Expenditure Ratio

9
Financial Ratios

• Asset Management
• Utilization of assets by management
• How assets are being used to generate profits
• Common Asset Management Ratios
• Inventory Turnover
• Days Sales in Inventory
• Receivables Turnover
• Total Asset Turnover Ratio

10
Financial Ratios

• Profitability
• Overall performance of the firm
• Return to the owners
• Common Profitability Ratios
• Profit Margin
• Return on Assets
• Return on Equity

11
Financial Ratios

• Market Value
• Concern of potential investors
• DuPont Extension of components of ROE
• Common Market Value Ratios
• Earnings Per Share (EPS)
• Price Earnings Ratio
• DuPont Analysis
• Operating efficiency, management efficiency, and
  financial leverage
• ROE components

12
External Uses of Financial Statements

• Financial Analysts provide external view of
  performance
• Why?
• For clients that are seeking to buy (make an
  investment)
• For clients that need to sell (disinvest)
• Finance is still about buying and selling
• Comparing firmsCola Wars
• Which firm would you buy?
• Why?
• Across Industries Ratios reveal operating
  standards

13
Problems

• Problem 9 Pro Forma Financial Statements
• Problem 11 Variance Analysis
• Problem 13 Liquidity Ratio
• Problem 17 DuPont Identity
• Problem 19 Company Analysis