Chapter 14

Financial Ratios
and Firm
Performance
 Learning Objectives

1. Create, understand, and interpret

common-size financial statements.
2. Calculate and interpret financial ratios.
3. Compare different company performances
using financial ratios, historical financial
ratio trends, and industry ratios.

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 Ratios and their Classification

A. Profitability ratios
1. Profit margin
2. Return on assets (investment)
3. Return on equity
B. Asset utilization ratios
4. Receivable turnover
5. Average collection period
6. Inventory turnover
7. Fixed asset turnover
8. Total asset turnover

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1-3
 Ratios and their Classification
(cont’d)
C. Liquidity ratios
9. Current ratio
10. Quick ratio
11. Cash Ratio = Cash / CL
12. NWC to Total Assets = NWC / TA
D. Debt utilization ratios
13. Debt to total assets
14. Times interest earned
15. Fixed charge coverage
E. Market value ratios
16. Earnings per share (EPS)
17. Price/Earnings (P/E) ratio
18. Book value per share
19. Market/Book (M/B) ratio
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1-4
 14.1 Financial Statements

Just like a doctor takes a look at a patient’s x-rays or

cat-scan when diagnosing health problems, a
manager or analyst can take a look at a firm’s primary
financial statements i. e. the income statement and
the balance sheet, when trying to gauge the status or
performance of a firm.
Income statement: periodic recording of the
sources of revenue and expenses of a firm,
Balance sheet: provides a point in time snap shot of
the firm’s assets, liabilities and owner’s equity.

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 14.1 (A) Benchmarking

• The financial statements constitute fairly complex

documents involving a whole bunch of numbers.
• Absolute values
– tell us something about the amount of assets, liabilities,
equity, revenues, expenses, and taxes of a firm,
– difficult to really gauge what’s going on, primarily because
of size and maturity differences among firms.
– requires “benchmarking” against some standard.
• One common method of benchmarking a is to
compare a firm’s current performance against that of
its own performance over a 3-5 year period (trend
analysis), by looking at the growth rate in various
key items such as sales, costs, and profits.

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 14.1 (A) Benchmarking
(continued)
Table 14.1 Cogswell Cola’s Abbreviated Income Statements
($ in thousands)

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 14.1 (A) Benchmarking
(continued)

• Another useful way to make some sense

out of this mess of numbers, is to re-cast
the income statement and the balance
sheet into common size statements, by
expressing each income statement item
as a percent of sales and each balance
sheet item as a percent of total assets.

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 14.1 (A) Benchmarking
(continued)
Figure 14.3

11,497 \25,112 x 100

7,457 \25,112 x 100

1,112 \25,112 x 100

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 14.1 (A) Benchmarking
(continued)
Figure 14.4

1,638\23,474x100 =

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 14.1 (A) Benchmarking
(continued)
• Benchmarking is a good starting point to
detect trends (if any) in a firm’s
performance and to make quick
comparisons of key financial statement
values with competitors on a relative basis.

• More in-depth diagnosis requires individual

item analyses and comparisons which are
best done by conducting ratio analysis.

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 14.2 Financial Ratios

• Financial ratios are relationships between

different accounts from financial statements—
usually the income statement and the
balance sheet—that serve as performance
indicators

• Being relative values, financial ratios allow for

meaningful comparisons across time,
between competitors, and with industry
averages.

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 14.2 Financial Ratios
(continued)
5 key areas of a firm’s performance can be analyzed using
financial ratios:
1. Liquidity ratios: Can the company meet its obligations over the
short term?
2. Solvency ratios: (also known as financial leverage ratios): Can
the company meet its obligations over the long term?
3. Asset management ratios: How efficiently is the company
managing its assets to generate sales?
4. Profitability ratios: How well has the company performed overall?
5. Market value ratios: How does the market (investors) view the
company’s financial prospects?
Can also conduct a Du Pont analysis which involves a breakdown of the
return on equity into its three components, i.e. profit margin, turnover,
and leverage.

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 14.2 (A) Short-Term Solvency:
Liquidity Ratios
• Measure a company’s ability to cover its
short-term debt obligations in a timely
manner:
• 3 key liquidity ratios include: The current
ratio, quick ratio, and cash ratio.

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 14.2 (A) Short-Term Solvency:
Liquidity Ratios
Table 14.2 Liquidity Ratios 2011 for Cogswell Cola and
Spacely Spritzers

Cogswell has better liquidity and short-term solvency than Spacely, but,
higher investment in current assets also means that lower yields are
being realized since current assets are typically low yielding.
So, we need to look at the other areas and inter-related effects of the
firm’s various accounting items.

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 14.2 (B) Long-Term Solvency:
Solvency or Financial Leverage Ratios

• Measure a company’s ability to meet its

long-term debt obligations based on its
overall debt level and earnings capacity.
• Failure to meet its interest obligation could
put a firm into bankruptcy.
• Equations 14.4, 14.5, and 14.6 can be used
to calculate 3 key financial leverage ratios:
the debt ratio, times interest earned ratio,
and cash coverage ratio.

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 14.2 (B) Long-Term Solvency: Long-Term
Solvency: Solvency or Financial Leverage
Ratios

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 14.2 (B) Long-Term Solvency: Long-
Term Solvency: Solvency or Financial
Leverage Ratios
Table 14.3 Financial Leverage Ratios 2011 for Cogswell
Cola and Spacely Spritzers

Cogswell Cola has relatively less debt and a significantly greater ability to cover its
interest obligations by using either its EBIT (times interest earned ratio) or its net
cash flow (cash coverage ratio) than Spacely Spritzers.

Leverage must be analyzed as a combination of debt level and coverage. If a firm is

heavily leveraged but has good interest coverage, it is using the interest
deductibility feature of taxes to its benefit. Having a high leverage with low
coverage could put the firm into a risk of bankruptcy.

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 14.2 (C) Asset Management
Ratios
• Measure how efficiently a firm is using its assets to generate
revenues or how much cash is being tied up in other assets
such as receivables and inventory.
• Equations 14.7 – 14.11 can be used to calculate 5 key asset
management ratios.

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 14.2 (C) Asset Management
Ratios
Table 14.4 Asset Management Ratios 2011 for Cogswell
Cola and Spacely Spritzers

While Cogswell is more efficient at managing its

inventory, Spacely seems to be doing a better job
of collecting its receivables and utilizing its total
assets in generating revenues

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 14.2 (D) Profitability Ratios

Profitability ratios such as net profit margin, returns on

assets, and return on equity, measure a firm’s
effectiveness in turning sales or assets into profits.

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 14.2 (D) Profitability Ratios
(continued)
Table 14.5 Profitability Ratios 2011 for Cogswell Cola and
Spacely Spritzers

As far as profitability is concerned, Cogswell is

outperforming Spacely by about 3%.

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 14.2 (E) Market Value Ratios

Used to gauge how attractive or reasonable a firm’s

current price is relative to its earnings, growth rate, and
book value.

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 14.2 (E) Market Value Ratios
(continued)

• Potential investors and analysts often use these

ratios as part of their valuation analysis.
• Typically, if a firm has a high price to earnings and
a high market to book value ratio, it is an indication
that investors have a good perception about the
firm’s performance.
• However, if these ratios are very high it could also
mean that a firm is over-valued.
• With the price/earnings to growth ratio (PEG ratio),
the lower it is, the more of a bargain it seems to be
trading at, vis-à-vis its growth expectation.
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 14.2 (E) Market Value Ratios
(continued)

Ratio Cogswell Cola Spacely Spritzers

P/E 15.41 13.01

PEG 1.28 0.86
P/B 5.49 4.17

The ratios seem to indicate that investors in both firms

seem to have good expectations about their performance
and are therefore paying fairly high prices relative to their
earnings book values.

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 14.2 (F) DuPont analysis

Involves breaking down ROE into three components

of the firm:
1) operating efficiency, as measured by the profit
margin (net income/sales);
2) asset management efficiency, as measured by
asset turnover (sales/total assets); and
3) financial leverage, as measured by the equity
multiplier (total assets/total equity).

Equation 14.19 shows that if we multiply a firm’s

net profit margin by its total asset turnover ratio
and its equity multiplier, we will get its return on
equity.

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 14.2 (F) DuPont analysis
(continued)

Cogswell has better operational efficiency, i.e. it is better able to move sales
dollars into income, but Spritzer is more efficient at utilizing its assets, and since
it uses more debt, it is able to get more of its earnings to its shareholders.
Although these 14 ratios are not the only ones that can be used to assess a
firm’s performance, they are the most popular ones.
It is important to look at the overall picture of the firm in all 5 areas and
accordingly reach conclusions or make recommendations for changes.

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 14.3 External Uses of Financial
Statements and Industry Averages

Financial statements of publicly traded companies and

industry averages of key items provide the raw
material for analysts and investors to make
investment recommendations and decisions

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 14.3 (A) Cola Wars
Table 14.6 Key Financial Ratios and
Accounts for PepsiCo and Coca-Cola (as of
December 31, 2010)

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 14.3 (A) Cola Wars
Table 14.7 Some Key Ratios for PepsiCo and Coca-
Cola (Five-Year Period)

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 14.3 (A) Cola Wars (continued)

• One of the first things we notice in looking over the five years
of data is how similar many of the ratios are from year to
year, showing remarkable consistency for these two
companies.
• We also can see that the gross margin of Coca-Cola is
consistently higher than that of PepsiCo.
• The debt to equity ratio of both firms is mostly falling over the
five-year period.
• We also can see that ROE has been very good for both
companies, although slightly better for PepsiCo.
• Finally, PepsiCo has very strong and growing earnings per
share over this period, outperforming Coca-Cola’s EPS, but
PepsiCo is also more expensive (higher current price per
share).

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 14.3 (B) Industry ratios:
Table 14.8 Financial Ratios: Industry Averages

• Industry ratios are often used as benchmarks for financial

ratio analysis of individual firms.
• There can be significant differences in various key areas
across industries, which is why comparing company ratios
with industry averages can be very useful and more
informative.
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 Additional Problems with Answers
Problem 1
Constructing an Income Statement.
Using the income and expense account
information for Tri-Mark Products Inc.
listed below, construct an incomest
statement for the year ended 31
December, 2009.
Shares outstanding: 1,575,000
Tax rate: 35%
Interest expense: $3,540,000
Revenue: $950,500,000
Depreciation: $50,000,000
Selling, general, and administrative
expense: $85,000,000
Other income: $1,350,000
Research and development: $5,200,000
Cost of goods sold: $730,000,000

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 Additional Problems with Answers
Problem 1 (Answer)

Tri-mark Products Incorporated

Income Statement for the year ended 31st Dec. 2009 ('000s)
Revenue $ 950,500
Cost of goods sold $ 730,000
Gross Profit $ 220,500
Operating expenses
Selling, general and administrative
expenses $ 85,000
R&D $ 5,200
Depreciation $ 50,000
Operating Income $ 80,300
Other Income $ 1,350
EBIT $ 81,650
Interest Expense $ 3,540
Taxable Income $ 78,110
Taxes $ 27,339
Net Income $ 50,772
Shares Outstanding $ 16,740
EPS $ 3.03

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 Additional Problems with Answers
Problem 2
Constructing a Balance Sheet. Construct Tri-Mark Incorporated’s
2009 year-end Balance Sheet using the asset, liability, and equity
accounts listed below:
Retained Earnings $60,500,000
Accounts Payable $57,000,000
Accounts Receivable $43,000,000
Common Stock $89,676,000
Cash $6,336,000
Short Term Debt $1,500,000
Inventory $42,000,000
Goodwill $30,000,000
Long Term Debt $74,000,000
Other Non-Current Liabilities $15,000,000
PP&E $225,000,000
Other Non-Current Assets $14,000,000
Long-Term Investments $25,340,000
Other Current Assets $12,000,000

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 Additional Problems with Answers
Problem 2 (Answer)
Tri-mark Products Inc.
Balance Sheet as at year ended
31st December 2009 (‘000s)
Liabilities:
Current Assets Current Liabilities
Accounts
Cash $6,336 Payable $57,000
Accts.
Rec. $43,000 Short Term Debt $1,500
TOTAL Current
Inventory $42,000 Liabilities. $58,500
Other
Current $12,000 Long Term Debt $74,000
Total
Current $103,336 Other Liabilities $15,000
L- T Inv. $25,340 Total Liabilities $147,500
PP&E $225,000 Owner’s Equity
Goodwill $30,000 Common Stock $189,676
Other Retained
Assets $14,000 Earnings $60,500
Total OE $250,176
Total Total Liab. And
Assets $397,676 OE $397,676

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 Additional Problems with Answers
Problem 3

• Common size statements: Re-state Tri-

Mark Incorporated’s 2009 financial
statements as common-size statements and
comment on them

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 Additional Problems with Answers
Problem 3 (Answer)
% of % of
Total Total
Assets: Assets Liabilities: Assets
Current
Current Assets Liabilities
Accounts
Cash $6,336 0.02 Payable $57,000 0.14
Short
Accts. Term
Rec. $43,000 0.11 Debt $1,500 0.00
TOTAL
Inventory $42,000 0.11 Current Liab. $58,500 0.15
Long
Other Term
Current $12,000 0.03 Debt $74,000 0.19
Total Other
Current $103,336 0.26 Liabilities $15,000 0.04
Total
L- T Inv. $25,340 0.06 Liabilities $147,500 0.37
Owner’s
PP&E $225,000 0.57 Equity
Common
Goodwill $30,000 0.08 Stock $189,676 0.48
Other Retained
Assets $14,000 0.04 Earnings $60,500 0.15
Total Assets $397,676 1.00 Total OE $250,176 0.63
Total Liab.
And OE $397,676 1.00

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 Additional Problems with Answers
Problem 4

Compute and analyze financial ratios.

Using the 2009 income statement and
balance sheet of Trimark Products Inc., as
constructed in problems 1 and 2 above,
compute its financial ratios. How is the firm
doing relative to its industry in the areas of
liquidity, asset management, leverage, and
profitability?

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 Additional Problems with Answers
Problem 4 (continued)

Industry
Ratio Average
Current Ratio 2.200
Quick Ratio (or Acid
Test Ratio) 1.500
Cash Ratio 0.135
Debt Ratio 0.430
Cash Coverage 10.600
Day’s Sales in
Receivables 29.000
Total Asset Turnover 2.800
Inventory Turnover 20.100
Day’s Sales in
Inventory 11.500
Receivables Turnover 32.000
Profit Margin 0.045
Return on Assets 0.126
Return on Equity 0.221

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 Additional Problems with Answers
Problem 4 (Answer)

Industry
Trimark Average
Current Ratio 1.766 2.200
Quick Ratio (or Acid
Ratio Test) 1.048 1.500
Cash Ratio 0.108 0.135
Debt Ratio 0.371 0.430
Cash Coverage 37.189 10.600
Day’s Sales in
Receivables 16.512 12.000
Total Asset
Turnover 2.390 2.800
Inventory
Turnover 28.808 30.100
Day’s Sales in
Inventory 12.670 11.500
Receivables
Turnover 22.105 30.000
Profit Margin 0.053 0.045
Return on Assets 0.128 0.126
Return on Equity 0.203 0.221

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 Additional Problems with Answers
Problem 4 (Answer) (continued)
Analysis:
Liquidity: Trimark’s liquidity ratios are below the industry
average indicating that they might need to look into their
management of current assets and liabilities.
Leverage: Trimark’s debt ratio is much lower than the industry
average and its cash coverage is more than 3 time the average,
indicating that if it needs to borrow long-term debt it should
not have much of a problem.
Asset management: Trimark’s asset turnover ratios are all
below the average. It needs to tighten up collections, and
manage its inventory more efficiently.
Profitability: Trimark has a good control on cost of goods sold.
Its net profit margin is better than the industry and so is its
ROA. The industry, however, is returning a higher rate to the
shareholders on average, primarily due to the higher debt
levels.
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