ANALYZING

FINANCIAL
PERFORMANCE
Reading: Cornett, Chapter 3
 Content
• Liquidity ratios
• Asset management ratios
• Debt ratios
• Profitability ratios
• Market value ratios
• Dupont Analysis
• Time Series and Cross-Sectional Analysis
• Cautions in using ratios to evaluate firm
performance

Module 3: Analyzing Financial Performance 2

 Financial ratios
• Financial ratios are usually easy to calculate.
• That’s the good news.
• The bad news is that there are so many of
them.

Module 3: Analyzing Financial Performance 3

Financial ratios

Module 3: Analyzing Financial Performance 4

 Liquidity ratios
• Liquidity ratios measure how easily the firm
can lay its hands on cash.
• Liquidity ratios measure the relationship
between a firm’s current assets and its
current liabilities.

Module 3: Analyzing Financial Performance 5

Liquidity ratios

Module 3: Analyzing Financial Performance 6

 Exercise
Calculating Liquidity Ratios for DPH Tree Farm, Inc.

Liquidity ratio DPH Tree Fam, Inc. Industry average

‘2012

Current ratio 1.5

Quick ratio 0.5

Cash ratio 0.15

Module 3: Analyzing Financial Performance 7

 Liquidity ratios
• Liquidity ratios also have some less desirable
characteristics.
• Measures of liquidity can rapidly become
out of date.

Module 3: Analyzing Financial Performance 8

 Asset Management Ratios
• Asset management ratios measure how
efficiently a firm uses its assets (inventory,
account receivable and fixed assets) as well
as how efficiently the firm manages its
account payable.

Module 3: Analyzing Financial Performance 9

 Inventory Management
• Inventory Turnover
 the rate at which companies turn over their
inventories

Inventory turnover =

• Days’ sales in inventory

 Number of days that inventory is held before the final
products is sold.

Days’ sales in inventory=

Module 3: Analyzing Financial Performance 10

 Accounts Receivable Management
• Accounts receivables turnover
 Number of dollars for sales produced per
dollar of accounts receivable.
Accounts receivable turnover =

• Average collection period

 how quickly customers pay their bills.
ACP=

Module 3: Analyzing Financial Performance 11

 Accounts Payable Management
• Accounts payable turnover
 dollar cost of good sold produced per dollar
of accounts payable.
Accounts payable turnover =

• Average accounts payable period

 how quickly customers pay their bills.
ACP=

Module 3: Analyzing Financial Performance 12

 Fixed Assets and
Working Capital Management
• Fix asset turnover

• Fixed asset turnover =

• Sales to net working capital

 how hard working capital has been put to use.

• Sales to NWC=

Module 3: Analyzing Financial Performance 13

 Total Asset Management
• Sales to Total Assets
 how hard the firm’s assets are being put to
use:=

 A high ratio could indicate that the firm is

working close to capacity.

Module 3: Analyzing Financial Performance 14

 Calculating Asset Management Ratios
Inventory Days Average AR Average Accounts Fixed Sales to Total
turnover sales in collection turnover payment payable assets NWC Assets
inventory period period turnover turnover Turnover

2.15 170 95 3.84 102 3.55 0.85 3.2 0.4

days days days

Module 3: Analyzing Financial Performance 15

 Debt Management Ratios
• Because shareholders gets only what is left
after the debtholders have been paid, debt is
said to create financial leverage.

Module 3: Analyzing Financial Performance 16

 Leverage Ratios
 show how heavily the company is in debt.

• Debt ratio =
with Total capitalization = Long-term debt + other liabilities + equity

• Debt to equity ratio =

Module 3: Analyzing Financial Performance 17

 Coverage Ratios
• Times interest earned
=

• Fix-charge coverage

• Cash coverage
=

Module 3: Analyzing Financial Performance 18

 Profitability Ratios
• used to judge how efficiently the firm is using
its assets.
• Return on total assets (ROA)
=

Module 3: Analyzing Financial Performance 19

 ROA and ROE
• A more common measurement of ROA and ROE

• ROA =

• ROE =

Module 3: Analyzing Financial Performance 20

 Payout Ratio
• measures the proportion of earnings that is
paid out as dividends.
• Payout ratio =

Module 3: Analyzing Financial Performance 21

 Market Value Ratios
• show how the firm is valued by investors
• Price-Earning Ratio
P/E ratio =

-----------------------------------------------
• Dividend Yield =

---------------------------------------------------
• Market to Book Ratio

Module 3: Analyzing Financial Performance 22

Dupont Analysis

Module 3: Analyzing Financial Performance 23

 Time Series and
Cross Sectional Analysis
1. Time Series Analysis

Performance of firm over the time

2. Cross-sectional Analysis

Performance of the firm against one or more

companies in the same industry

Module 3: Analyzing Financial Performance 24

 Median financial ratios

Median financial ratios for publicly traded North American companies, December 2015

Module 3: Analyzing Financial Performance 25

 Cautions in Using Ratios
• Financial statement data are historical.
• Financial ratios seldom provide answers, but
they do help you ask the right questions.
• There is no international standard for
financial ratios.
• Be selective in your choice of ratios. Different
ratios often tell you similar things.
• Be careful not to extrapolate past rate of
earnings growth – earnings follow
approximately a random walk.

Module 3: Analyzing Financial Performance 26

 Applications of
Financial Analysis

W.H.Beaver, 1966, ‘Financial

Ratios and Predictors of
Failure”, Empirical Research
in Accounting
• Healthy firms have
different financial ratios
than firms that are
heading for insolvency.
• Financial ratios provide
valuable clues about a
firm’s market risk.

Module 3: Analyzing Financial Performance 27

Applications of Financial Analysis
BOND RATINGS

Module 3: Analyzing Financial Performance 28