FINANCIAL MANAGEMENT Financial ratios and firm performance

Introduction Managers need to be able to measure past performance and predict future performance if they want to deliver positive results; No one financial statement tells the complete story, but used together they can help us analyze a company’s performance over time and help predict future performance; Although they contain much useful information, we need to know the limitations of that information so that we do not fall into the trap of relying on numbers without informed analysis; We will learn how to conduct ratio analysis, a series of financial measurements that help us piece together the story behind the numbers and point us in the right direction to discover more information about specific areas of a company’s performance; Finding warning flags or unearth some gold nuggets is often an associated results of the analysis.

Financial statements Statement of financial position (balance sheet): listing of all assets and all claims against the assets of a company; “assets = liabilities + owner’s equity ” Income statement: the recording of the business activities over the past business cycle. Benchmarking compares a company’s current performance against its own previous performance or that of its competitors; Analyze trends over time for a good performance analysis: Increasing sales or net income usually reflect an improvement of the market position respectively a better management; Analyze trends of different elements for at least 5 years of quarterly data and, if possible, one business cycle included.

Financial statements Balance sheet

Financial statements Income statement (simplified)

Financial statements Based on the 2004-2008 period we can estimate geometric growth rates for sales or COGS element; [How ?] We use then the growth rates to extrapolate future evolutions of the main items: Net income in 2009: NI (2008) x 1.026 = 3,400 $; In this easy way we just use one variable: the net income;

Financial statements On the other hand, we have the alternative to use all the main variables involved in the net income equation; We then analyze each item trend perspective: Sales (+8%); COGS (+10%); SG&A (+12%); depreciation (-3.8%); interest (const); taxes (31.92% x taxable income). We get the following prediction for 2009: We get an estimate of 3,318 thou $ for the net income less than the first estimation 3,400 thou $; Using all the variables’ trends we see an erosion of the profit by the rising production costs (COGS) and support costs (SG&A). This is a warning flag -> investigate why costs are growing faster than production;

Financial statements When comparing companies with different sizes it is necessary to use the common-size financial statements in which each line are expressed as percentages of a common base figure (for income statements is usually sales); Explanation of the table above: comparison of two different size companies;

Financial statements Explanations of the balance sheet in a comparative way;

Financial Ratios Financial ratios: relationship between different accounts from financial statements [usually income statement and the balance sheet] that serve as a performance indicators; The trend analysis also works well on the financial ratios; Framework of financial ratios and what they serve for: ================================================= (1) Liquidity ratios: meet obligations over short-term; (2) Solvency ratios: meet obligations over long-term; (3) Asset management ratios: managing of assets for profit; (4) Profitability ratios: overall performance of the company; (5) Market value ratios: How does the market (investors) view the company’s financial prospects?

Financial Ratios Short-term solvency: liquidity ratios; (1) Current ratio: (2) Quick/Acid ratio: (3) Cash ratio: 2008 Liquidity Ratio Formula Cogswell Cola Spacely Spritzers Current ratio Current assets/ current liabilities 1.0596 1.0286 Quick or acid ratio test (current assets - inventories ) / current liabilities 0.8379 0.5465 Cash ratio Cash / current liabilities 0.2707 0.2147

Financial Ratios Long-term solvency: Solvency or financial leverage ratios; (1): Debt ratio: the amount in debt for every dollar of assets; (2): Times interest earned: the number of times over a company has its interest obligation covered by its EBIT; (3): Cash coverage ratio: indicates a company’s ability to generate cash from operations to meet its financial obligations [ why EBITDA and not EBIT on the numerator ?]; 2008 Financial Leverage Ratios Formulas Cogswell Cola Spacely Spritzers Debt ratio Total liabilities/ Total assets 0.6042 0.6398 Times interest earned EBIT/ interest expense 28.3483 6.8879 Cash coverage (EBIT+ depreciation)/ interest expense 34.5955 9.7757

Financial Ratios – Asset management ratios (1): Inventory turnover: no of times inventory is sold/restocked; (2): Days’ sales in inventory: days in which inventory is on the shelf before is sold; (3): Receivables turnover: no of times payment is collected; (4): Days’ sales in receivables: days in which receivable is collected; (5): Total asset turnover: management efficiency ratio; Asset management ratios Formulas Cogswell Cola Spacely Spritzers Inventory turnover COGS/inventory 8.5671 4.7733 Days’ sales in inventory 365/ inventory turnover 42.6050 76.4677 Receivables turnover {Credit} Sales/ acc receivable 9.9218 18.3873 Days’ sales in receivables 365/receivables turnover 36.7878 19.8506 Total asset turnover Sales/Total assets 1.0698 1.1305

Financial Ratios – Profitability ratios (1): Profit margin: % from sales generated as profit; (2): Return on assets: How well the assets (investment in plant, property, equipment etc) are generating income; (3): Return on equity:; Key ratio for the owners of the company. How much profit is being generated for the owners based on their ownership claim. Asset management ratios Formulas Cogswell Cola Spacely Spritzers Profit margin Net income / sales 0.1319 0.1020 Return on assets (ROA) Net income / total assets 0.1411 0.1153 Return on equity (ROE) Net income / total owner’s equity 0.3566 0.3201

Financial Ratios – Market value ratios Measure the performance of the firm against the perceived value of the firm from the trading value of the shares or number f shares; The earnings per share (EPS) are included usually in the IS; The market price can be observed on the organized stock exchanges – use annual average or just one day’s closing price; Market value ratios Formulas Cogswell Cola Spacely Spritzers Earnings per share (EPS) Net income / number of outstanding shares 1.85 1.46 Price to earnings ratio (P/E) Price per share / earnings per share 15.4054 13.0137 Price/earnings to growth ratio (PEG) (Price/earnings per share)/(earnings growth rate x 100) 1.2838 0.8676 Market to book value (MTB) Market value per share/book value per share 5.4913 4.1667

Financial Ratios – DuPont Analysis Breaking down ROE into three components of the firm; (1) Operating efficiency: profit margin; (2) Asset management efficiency: asset turnover; (3) Financial leverage: equity multiplier; The DuPont analysis allows the identification of the causes in the dynamic of the return on equity; ROE [Cogswell] = 0.1319 x 1.0698 x 2.5246 = 0.3566 [35,66%]; ROE [Spacely] = 0.1020 x 1.1305 x 2.7766 = 0.3201 [32,01%]; Ratios may not provide all the answers but they can point in the right direction for further investigation.

External use of financial statements, industry averages A firm that is considered a bad investment will have trouble raising capital from banks and bond holders as well as raising new equity capital. If you just analyze one year image of two companies it might be insufficient for a through analysis. Some key ratios are better for PepsiCo than for Coca Cola but also the price is higher reflecting these aspects.

External use of financial statements, industry averages Trend analysis for the main ratios: Explanations p. 432;

External use of financial statements, industry averages Financial ratios can vary across the industries; Always consider the benchmarking relative to the same industry