Chapter 4: Evaluating a Firm's Financial Performance Flashcards
Explain the Purpose and Importance of Financial Analysis
A variety of groups find financial ratios useful. For instance, both managers and shareholders use them to measure and track a company’s performance over time. Financial analysts outside of the firm who have an interest in its economic well-being also use financial ratios. An example of this group would be a loan officer of a commercial bank who wishes to determine the creditworthiness of a loan applicant and its ability to pay the interest and principal associated with the loan request.
Financial Ratios
Accounting data restated in relative terms in order to help people identify some of the financial strengths and weaknesses of a company.
Use of Financial Ratios
Financial ratios are the principal tool of financial analysis. Sometimes referred to simply as benchmarks, ratios standardize the financial information of firms so that comparisons can be made between firms of varying sizes.
Which questions can financial ratios be used to answer?
- How liquid is the company
- Are the company’s managers effectively generating profits on the firm’s assets
- How is the firm financed
- Are the firm’s managers providing a good return on the capital provided by the shareholders
- Are the firm’s managers creating or destroying shareholder value
What are the two methods that can be used to analyze a firm’s financial ratios?
- We can examine the firm’s ratios across time (say, for the past 5 years) to compare its current and past performance
- We can compare the firm’s ratios with those of other firms. For example, Lowe’s was chosen as a comparison firm for analyzing the financial position of Home Depot.
Financial Ratios Info
Financial ratios provide a popular way to evaluate a firm’s financial performance. However, when evaluating a company’s use of its assets (capital) to create firm value, a financial ratio analysis based entirely on the firm’s financial statements may not be enough. If we want to understand how the market assesses the performance of a company’s managers, we can use the market price of the firm’s stock relative to its accounting earnings and equity book value.
Economic Value Added (EVA)
Economic Value Added provides another approach for evaluating a firm’s performance in terms of shareholder value creation. EVA is equal to the difference between the return on a company’s invested capital and the investors’ opportunity cost of the funds times the total amount of the capital invested.
Liquidity
A firm’s ability to pay its bills on time. Liquidity is related to the ease and speed with which a firm can convert its noncash assets into cash, as well as to the size of the firm’s investment in noncash assets relative to its short-term liabilities.
Current Ratio
A firm’s current assets divided by its current liabilities. This ratio indicates the firm’s degree of liquidity by comparing its current assets to its current liabilities.
Acid-Test (Quick) Ratio
The sum of a firm’s cash, marketable securities, and accounts receivable divided by its current liabilities. This ratio is a more stringent measure of liquidity than the current ratio because it excludes inventories and other current assets (those that are least liquid) from the numerator.
Days in Receivables (Average Collection Period)
A firm’s accounts receivable divided by the company’s average daily credit sales (annual credit sales/365). This ratio expresses how many days on average it takes to collect receivables.
Accounts Receivable Turnover Ratio
A firm’s credit sales divided by its accounts receivable. This ratio expresses how often accounts receivable are “rolled over” during a year.
Days in Inventory
Inventory divided by daily cost of goods sold. This ratio measures the number of days a firm’s inventories are held on average before being sold; it also indicates the quality of the inventory.
Inventory Turnover
A firm’s cost of goods sold divided by its inventory. This ratio measures the number of times a firm’s inventories are sold and replaced during the year (that is, the relative liquidity of the inventories).
Operating Return on Assets (OROA)
The ratio of a firm’s operating profits divided by its total assets. This ratio indicates the rate of return being earned on the firm’s assets.
Operations Management
How effectively management is performing in the day-to-day operations in terms of how well management is generating revenues and controlling costs and expenses; in other words, how well is the firm managing the activities that directly affect the income statement?
Asset Management
How efficiently management is using the firm’s assets to generate sales.
Operating Profit Margin
A firm’s operating profits divided by sales. this ratio serves as an overall measure of operating effectiveness.
Total Asset Turnover
A firm’s sales divided by its total assets. This ratio is an overall measure of asset efficiency based on the relation between a firm’s sales and the total assets.
Fixed Asset Turnover
A firm’s sales divided by its net fixed assets. This ratio indicates how efficiently the firm is using its fixed assets.
Debt Ratio
A firm’s total liabilities divided by its total assets. this ration measures the extent to which a firm has been financed with debt.
Times Interest Earned
A firm’s operating profits divided by interest expense. This ratio measures a firm’s ability to meet its interest payments from its annual operating earnings.
Return on Equity
A firm’s net income divided by its total common book equity. The ratio is the accounting rate of return earned on the common stockholders’ investment.
Price/Earnings Ratio
The price the market places on $1 of a firm’s earnings. For example, if a firm has an earnings per share of $2, and a stock price of $30 per share, its price/earnings ratio is 15. ($30/$2).
