SOLUTION: FIN 500 Saudi Electronic University Principles of Finance Ratios Discussion

Chapter 4
Evaluating
a Firm’s Financial
Performance
Learning Objectives
• Explain the purpose and importance of
financial analysis.
• Calculate and use a comprehensive set of
measurements to evaluate a company’s
performance.
• Describe the limitations of financial ratio
analysis.
4-2
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THE PURPOSE OF
FINANCIAL ANALYSIS
4-3
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The Purpose of
Financial Analysis
Financial Analysis using Ratios
• A popular way to analyze the financial statements is
by computing ratios. A ratio is a relationship
between two numbers, e.g., a given ratio of A:B =
30:10 means A is 3 times B.
• A ratio by itself may have no meaning. Hence, a
given ratio is compared to:
– ratios from previous years
– ratios of other firms and/or leaders in the same industry
4-4
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Uses of Financial Ratios:
Within the Firm
• Identify deficiencies in a firm’s performance
and take corrective action.
• Evaluate employee performance and
determine incentive compensation.
• Compare the financial performance of the
firm’s different divisions.
4-5
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Uses of Financial Ratios:
Within the Firm
• Prepare, at both firm and division levels,
financial projections.
• Understand the financial performance of the
firm’s competitors.
• Evaluate the financial condition of a major
supplier.
4-6
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Uses of Financial Ratios:
Outside the Firm
Financial ratios are used by:
• Lenders in deciding whether or not to lend to a
company.
• Credit-rating agencies in determining a firm’s credit
worthiness.
• Investors (shareholders and bondholders) in
deciding whether or not to invest in a company.
• Major suppliers in deciding to whether or not to
extend credit to a company and/or in designing the
specific credit terms.
4-7
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MEASURING KEY
FINANCIAL
RELATIONSHIPS
4-8
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Question 1
How Liquid Is the Firm? Can It Pay Its Bills?
• A liquid asset is one that can be converted
quickly and routinely into cash at the
current market price.
• Liquidity measures the firm’s ability to pay
its bills on time. It indicates the ease with
which non-cash assets can be converted to
cash to meet the financial obligations.
4-9
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How Liquid Is the Firm?
Liquidity is measured by two approaches:
– Comparing the firm’s current assets and current
liabilities
– Examining the firm’s ability to convert accounts
receivables and inventory into cash on a timely
basis
4-10
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Measuring Liquidity:
Perspective 1
Compare a firm’s current assets with current
liabilities using:
– Current Ratio
– Acid Test or Quick Ratio
4-11
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4-12
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4-13
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Current Ratio
• Current ratio compares a firm’s current assets to its
current liabilities.
Coca-Cola = $32,986M ÷ $32,274M = 1.02
• Coca-Cola has only $1.02 in current assets for
every $1 in current liabilities. Coca-Cola’s liquidity
is lower than that of PepsiCo, which has a current
ratio of 1.14.
4-14
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Acid Test or Quick Ratio
• Quick ratio compares cash and current assets (minus
inventory) that can be converted into cash during the
year with the liabilities that should be paid within the
year.
Coca-Cola = ($21,675+ $4,466M) ÷ ($32,374M) = 0.81
• Coca-Cola has 81 cents in quick assets for every $1
in current debt. Coca-Cola is slightly less liquid than
PepsiCo, which has 85 cents for every $1 in current
debt.
4-15
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Measuring Liquidity:
Perspective 2
• Measures a firm’s ability to convert accounts
receivable and inventory into cash:
– Days in Receivables or Average Collection Period
– Inventory Turnover
4-16
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Days in Receivables
(Average Collection Period)
• How long does it take to collect the firm’s
receivables?
Coca-Cola = ($4,466M) ÷ ($45,998M/365) = 35.44 days
• Coca-Cola (at 35.44 days) is slightly faster than
PepsiCo (at 36.41 days) in collecting accounts
receivable.
4-17
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Accounts Receivable Turnover
• How many times are the accounts
receivable “rolled-over” each year?
Coca-Cola = $45,998M ÷ $4,466M = 10.30X
• The conclusion is the same—Coca-Cola
(10.30X) is slightly faster than PepsiCo
(10.33X) in collecting accounts receivable.
4-18
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Days in Inventory
• How long is the inventory held before being sold?
Coca-Cola = ($3,100M) ÷ ($17,889M ÷ 365)= 63.25 days
• Coca-Cola carries inventory for a longer time than
PepsiCo (37.15 days).
4-19
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Inventory Turnover
• How many times are the firm’s inventories
sold and replaced during the year?
Coca-Cola = $17,889M ÷ $3,100M= 5.77X
• The conclusion is the same—Coca-Cola
moves inventory much slower than PepsiCo
(9.83X).
4-20
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Question 2: Are the Firm’s Managers
Generating Adequate Operating Profits from
the Company’s Assets?
• This question focuses on the profitability of
the assets in which the firm has invested.
We consider the following ratios to answer
the question:
– Operating Return on Assets
– Operating Profit Margin
– Total Asset Turnover
– Fixed Assets Turnover
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4-22
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Operating Return on Assets
(ORA)
• ORA indicates the level of operating profits relative
to the firm’s total assets.
Coca-Cola = $9,707M ÷ $92,023M = 0.105 or 10.5%
• Thus managers are generating 10.5 cents of
operating profit for every $1 of assets which is
quite a bit less than PepsiCo (13.7%)
4-23
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Disaggregation of
Operating Return on Assets
4-24
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Managing Operations:
Operating Profit Margin (OPM)
• OPM examines how effective the company is in
managing its cost of goods sold and operating
expenses that determine the operating profit.
Coca-Cola = $9,707M ÷ $45,998M = 0.211 or 21.1%
• Coca-Cola managers are better than PepsiCo in
managing the cost of goods sold and operating
expenses, as the Operating Profit Margin for
PepsiCo is only 14.5%.
4-25
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Managing Assets:
Total Asset Turnover
• This ratio measures how efficiently a firm is using
its assets in generating sales.
Coca-Cola = $45,998M ÷ $92,023M = .50X
• Coca-Cola is generating 50 cents in sales for every
$1 invested in assets, which is much lower than
PepsiCo (.95X).
4-26
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Managing Assets:
Fixed Asset Turnover
• Examines efficiency in generating sales from
investment in “fixed assets”
Coca-Cola = $45,998M ÷ $14,633M = 3.14X
• Coca-Cola generates $3.14 in sales for every $1
invested in fixed assets, which is lower than
PepsiCo (3.87X)
4-27
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4-28
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Question 3: How Is the Firm
Financing Its Assets?
• Here we examine the question: Does the
firm finance its assets by debt or equity or
both? We use the following two ratios to
answer the question:
– Debt Ratio
– Times Interest Earned
4-29
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Debt Ratio
• This ratio indicates the percentage of the firm’s
assets that are financed by debt (implying that the
balance is financed by equity).
Coca-Cola = $61,703M ÷ $92,023M = 0.671 or 67.1%
• Coca-Cola finances 67% of its assets by debt and
33% by equity compared to PepsiCo financing 75%
of its assets by debt.
4-30
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Times Interest Earned
• This ratio indicates the amount of operating income
available to service interest payments.
Coca-Cola = $9,707M ÷ $483M = 20.1X
• Coca-Cola’s operating income is 20 times the
annual interest expense and higher than PepsiCo
(10.63X) due to its relatively higher operating
profits.
4-31
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Times Interest Earned
Note:
• Interest is not paid with income but with
cash.
• Oftentimes, firms are required to repay part
of the principal annually.
• Thus, times interest earned is only a crude
measure of the firm’s capacity to service its
debt.
4-32
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Question 4: Are the Firm’s Managers
Providing a Good Return on the Capital
Provided by the Company’s Shareholders?
• This is analyzed by computing the firm’s
accounting return on common stockholder’s
investment or return on equity (ROE).
• Note: Common equity includes both
common stock and retained earnings.
4-33
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ROE
Coca-Cola =
$7,098M ÷ $30,320M = 0.234 or 23.4%
• Owners of Coca-Cola are receiving a lower return
(23.4%) compared to PepsiCo (37.1%).
• One of the reasons for lower ROE is the lower
operating return on assets generated by Coca-Cola
(10.5% for Coca-Cola v. 13.7% for Pepsi-Co). A
lower return on the firm’s assets will always result
in a lower return on equity and vise versa.
• Also, Coca-Cola uses less debt (67% for Coca-Cola
v. 75% for Pepsi-Co). Higher debt translates to
higher ROE under favorable business conditions.
4-34
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4-35
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Question 5: Are the Firm’s Managers
Creating Shareholder Value?
• We can use two approaches to answer this
question:
– Market value ratios (P/E)
– Economic Value Added (EVA)
• These ratios indicate what investors think of
management’s past performance and future
prospects.
4-36
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Price/Earnings Ratio
• Measures how much investors are willing to pay for
$1 of reported earnings.
Coca-Cola = $42.00 ÷ $1.60 = 26.25X
• Investors are willing pay more for Coca-Cola for
every dollar of earnings per share compared to
PepsiCo ($26.25 for Coca-Cola versus $22.09 for
PepsiCo).
4-37
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Price/Book Ratio
• Compares the market value of a share of stock to the book
value per share of the reported equity on the balance sheet.
Coca-Cola = $42.00 ÷ $6.81 = 6.17X
• A ratio greater than 1 indicates that the shares are more
valuable than what the shareholders originally paid. The ratio
is lower than PepsiCo ratio of 8.19X suggesting that PepsiCo is
perceived as having better growth prospects relative to its
risk.
4-38
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Economic Value Added (EVATM)
• Shareholder value is created if the firm earns a return on
capital that is greater than the investors’ required rate of
return.
• EVA attempts to measure a firm’s economic profit, rather than
accounting profit. EVA recognizes the cost of equity in
addition to the cost of debt (interest expense).
4-39
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EVA for Coca-Cola
• Operating return on assets = 10.5%
• Total assets = $92.023 billion
• Assume cost of capital = 10%
EVA = (.105% – .10)* $92.023B = $460.115M
4-40
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SUMMARY OF RATIOS
4-41
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THE LIMITATIONS OF
FINANCIAL RATIO
ANALYSIS
4-45
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The Limitations of
Financial Ratio Analysis
1. It is sometimes difficult to identify industry
categories or comparable peers.
2. The published peer group or industry averages are
only approximations.
3. Industry averages may not provide a desirable
target ratio.
4. Accounting practices differ widely among firms.
5. A high or low ratio does not automatically lead to a
specific conclusion.
6. Seasons may bias the numbers in the financial
statements.
4-46

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Key Terms
• Accounts receivable turnover
ratio
• Acid-test (quick) ratio
• Asset efficiency
• Current ratio
• Days in inventory
• Days in receivables (average
collection period)
• Debt ratio
• Economic value added
• Financial ratios
• Fixed-asset turnover
4-47
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Inventory turnover
Liquidity
Operating profit margin
Operating return on assets
(OROA)
Price/book ratio
Price/earnings ratio
Return on equity
Times interest earned
Total asset turnover

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