Chapter 3 Evaluation of Financial Performance

1. Finance 311 1 Chapter 3 Evaluation of Financial Performance

2. Finance 311 2 Introduction This chapter introduces financial statement analysis techniques that are used to accurately evaluate a company’s performance. We will assume that the financial statements are fairly and accurately presented.

3. Finance 311 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. Finance 311 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. Finance 311 5 Ratio Classifications Liquidity Asset management Financial leverage management Profitability Market-based Dividend policy

6. Finance 311 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. Finance 311 7 Common-Sized Statements Publicly-owned firms must publish financial statements quarterly and annually Widely used in banking and investments

8. Finance 311 8 Liquidity Ratios Current ratio = Current assets Current liabilities Quick ratio = Current assets - Inventories Current liabilities Aging Schedule for Accounts Receivable

9. Finance 311 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. Finance 311 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. Finance 311 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. Finance 311 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. Finance 311 13 Dividend Policy Ratios Payout ratio = Dividends per share Earnings per share Dividend yield = Expected dividends per share Stock price

14. Finance 311 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

15. Finance 311 15 Dupont Analysis Widely used in industry Shows impacts that operating changes can have on returns

16. Finance 311 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

17. Finance 311 17 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 10K’s - SEC EDGAR Corporate Database Standard and Poor’s Value Line Industry Norms and Key Business Ratios The Internet

18. Finance 311 18 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…

19. Finance 311 19 Quality of a firm’s 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 firm’s balance sheet is positively related to the ratio of the market value of the firm’s 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

20. Finance 311 20 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. Finance 311 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. Finance 311 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 Symbol[Beta

23. Finance 311 23 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.

24. Finance 311 24 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 market’s assessment of the accumulated NPV of all of the firm’s past and present projected investment projects.

25. Finance 311 25 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

26. Finance 311 26 EVA - Continued The yearly contribution of a firm’s 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.

27. Finance 311 27 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. Finance 311 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

29. Finance 311 29 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

30. Finance 311 30 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. Finance 311 31 Complex International Aspects of Financial Statement Analysis Influenced by fluctuating exchange rates SFAS No. 52 deals with foreign currency translation

32. Finance 311 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

33. Finance 311 33 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