Chapter 3 Evaluation of Financial Performance

1
Chapter 3 Evaluation of Financial Performance
2
Introduction

• This chapter introduces financial statement
  analysis techniques that are used to accurately
  evaluate a companys performance. We will assume
  that the financial statements are fairly and
  accurately presented.

3
Financial Ratios Are Used By

• Management for planning and evaluating
• Credit managers and bankers to estimate the
  riskiness of potential borrowers
• Investors to evaluate corporate securities
• Managers to identify and assess potential merger
  candidates
• Widely used and accepted technique
• Use started in the 1920s

4
Ratio Analysis

• Many, many ratios
• Choose the ones that are most relevant for you
• Must be compared with a standard and also the
  past (three years, for example)
• A financial ratio is only an indicator
• One can possibly manipulate ratios
• Accounting differences in firms
• WorldCom (MCI), ENRON, HealthSouth, Ahold, Tyco,
  etc.

5
Ratio Classifications

• Liquidity
• Asset management
• Financial leverage management
• Profitability
• Market-based
• Dividend policy

6
Major Financial Statements

• Balance sheet
• Common-sized balance sheet shows assets,
  liabilities, and equity as a of total assets
• Income statement
• Common-sized income statement shows income and
  expense items as a of net sales
• Statement of cash flows

7
Common-Sized Statements

• Publicly-owned firms must publish financial
  statements quarterly and annually
• Widely used in banking and investments

8
Liquidity Ratios

• Current ratio Current assets
• Current liabilities
• Quick ratio Current assets - Inventories
• Current liabilities
• Aging Schedule for Accounts Receivable

9
Asset Management Ratios

• Average collection period
  Accounts receivable
• Annual credit sales/ 365
• Inventory turnover Cost of sales
• Average
  inventory
• Fixed-asset turnover Sales
• Net fixed
  assets
• Total asset turnover Sales
• Total assets

10
Financial Leverage Management

• Debt ratio Total debt
• Total assets
• Debt-to-equity ratio Total debt
• Total equity
• Times interest earned EBIT
• Interest
  charges
• Fixed charge coverage EBIT Lease payments
• Interest
  Lease payment P/S div before tax
  Before-tax sinking fund

11
Profitability Ratios

• Gross profit margin Sales - Cost of
  sales
• Sales
• Net profit margin EAT
• Sales
• ROI EAT
• Total Assets
• ROE EAT
• Stockholders equity

12
Market-Based Ratios

• P/E ratio Market price per share
• Current earnings per share
• Market to book ratio Market price per
  share
• Book value per share
• Stock Price/ Free Cash Flow

13
Dividend Policy Ratios

• Payout ratio Dividends per share
• Earnings per share
• Dividend yield Expected dividends per
  share
• Stock price

14
Relationships Among Ratios

• ROI EAT x Sales EAT
• Sales Total assets Total
  assets
• ROE EAT x Sales x Total assets
• Sales Total assets Equity
• ROE Net Profit Margin x Total Asset
  Turnover x Equity Multiplier

DuPont Analysis
15
Dupont Analysis

• Widely used in industry
• Shows impacts that operating changes can have on
  returns

16
Financial Ratio Analysis

• Trend analysis 2002 2003 2004
• XYZ current ratio 1.9 2.2
  2.3
• Cross-sectional analysis 2004
• XYZ current ratio
  2.3
• Industry norms
  2.5
• Both simultaneously 2002 2003 2004
• XYZ current ratio 1.9 2.2
  2.3
• Industry norms 2.5 2.4 2.5

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Some Sources of Information

• Trading Room (406 Sirrine Hall)
• Bridge (Telerate)
• Bloomberg
• Reuters
• General Business File of Cooper Library
• Factiva
• Mergent Database
• TableBase
• Reuters Business Insight
• RMA Annual Statement Studies
• Reserves on 2nd Floor

• Visit Index Table 3 in Library
• Annual reports
• 10Ks - SEC EDGAR Corporate Database
• Standard and Poors
• Value Line
• Industry Norms and Key Business Ratios
• The Internet

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A Few of the Sources of Information on the Web

• http//www.bloomberg.com/
• http//www.sec.gov/
• http//finance.yahoo.com/
• http//www.dnbcorp.com/
• http//www.rmahq.org/
• http//www.moodys.com/
• http//www.hoovers.com/
• But, please be careful. Remember you get what you
  pay for

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• Quality of a firms earnings is positively
  related to the proportion of cash earnings to
  total earnings and to the proportion of recurring
  income to total income.
• Large non-cash component in the
  earnings Significant non-recurring transactions
  in the income figure
• Quality of a firms balance sheet is positively
  related to the ratio of the market value of the
  firms assets to book value of assets and
  inversely related to the amount of its hidden
  liabilities.
• Presence of obsolete inventories and charging
  off assets
• Hidden assets
• Assets have market values significantly below
  book values

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Problems in Reporting

• Time of revenue recognition
• Pension Fund Earnings Assumptions
• Amortization of intangible assets
• Including all losses and debt
• Off-Balance-Sheet Financing - ENRON

21
Ratios Can Be Misleading

• Differing accounting practices
• Might be significant dispersion in the ratio for
  the industry
• Many firms operate in more than one industry -
  Industry classification
• Financial ratios provide a historical record of
  performance

22
The Bridge System

• Turn on Monitor
• Log on
• Click on Telerate
• Double Click on the background
• Go to Analytics Page
• Type /LU/Company for Ticker Symbol
• Type the Ticker Symbol/CF
• CF Corporate Fundamentals
• Scroll through the Corporate Fundamentals
• Type the Ticker SymbolBeta

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To Obtain the Latest Corporate News

• Tab to another page in Telerate
• Double click on the background
• Go to News Watch
• Right Click then Search by Ticker Symbol
• Type in the Ticker Symbol
• Then double click on any headline story to bring
  up the entire story.
• You can print out the story or possibly save it
  to a disk.

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Analysis Based on the Market Value of the Firm

• Market value added ( MVA ) Total Market value
  Total Capital
• MVA is the market value of debt, preferred stock,
  and common equity less the Capital raised by
  investors or Retained Earnings.
• The capital markets assessment of the
  accumulated NPV of all of the firms past and
  present projected investment projects.

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Economic Value Added (EVA)

• Economic value added ( EVA ) Return on total
  capital (r) Cost of Capital (k ) x Capital
• EVA EBIT(1 Corporate tax rate) (Operating
  Capital)(k)
• r net operating profits after taxes divided by
  beginning of year capital (Return on Capital)
• k Weighted After-Tax Cost of Capital

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EVA - Continued

• The yearly contribution of a firms operations
  to the creation of MVA.
• EVA measures the extent to which the firm has
  increased shareholder value in a given year.
• EVA represents the residual value that remains
  after the cost of all capital, including equity
  capital has been deducted.

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Increase Economic Value Added (EVA)

• Increase operating efficiency
• Commit new resources that promise a high return
• Redirect resources to more productive uses
• Make prudent use of tax benefits of debt financing

28
Problems Caused by Inflation

• Inventory profit as a result of timing of price
  increases
• Inventory valuation methods
• ( LIFO ) ( FIFO )
• Rising interest rates causes a decline in the
  value of long term debt
• Differences in the reporting of earnings
• Understatement of fixed assets
• Recognition of sales

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The Cash Flow Concept

• Accounting income Vs Cash flow
• Cash flow is the relevant source of value for the
  firm
• ATCF EAT Noncash charges
• ATCF EAT Depreciation Deferred taxes
• Free Cash Flow (FCF) EBIT(1 T) Net
  Investment in operating capital
• FCF (EBIT(1 T) Depreciation) Gross
  investment in operating capital

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Statement of Cash Flows

• Presents the net cash provided by operating,
  investing, or financing activities
• Direct method presents the net cash provided by
  operating, investing, or financing activities
• Indirect method presents the adjustments to net
  income to show net cash provided
• Used for public financial reports
• The final results are identical

31
Complex International Aspects of Financial
Statement Analysis

• Influenced by fluctuating exchange rates
• SFAS No. 52 deals with foreign currency
  translation

32
Accuracy of Financial Statements

• External auditor
• Generally accepted accounting principles
• People pose for a picture like a corporation
  poses for a financial statement
• Sarbanes-Oxley Act of 2002

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Conclusion

• Financial Statements
• Balance Sheet
• Income Statement
• Statement of Cash Flows
• Common-sized
• Sarbanes-Oxley Act
• Ratios
• Liquidity
• Asset management
• Financial leverage

• Profitability
• Market-based
• Dividend policy
• DuPont Analysis
• Sources of information
• Market Value Added
• Economic Value Added