BUS601: Financial Management

2a. Calculate financial ratios given a company's financial package

• What is common sizing, and how is it used in financial analysis?
• What are profitability, liquidity, and operating ratios, and what is the purpose of each?
• How can calculating the various financial ratios help executives to manage the business?

Imagine you are the firm's executive, and you have received this month's financial report for review. You appreciate the importance of understanding the financial position of your business and the need to evaluate its performance. Where is a reasonable starting point for your analysis as you look at the income statement, statement of retained earnings, balance sheet, and statement of cash flows?

A good initial step is to common-size the statements: restate the numbers as a percentage of a common value such as sales. Using percentages makes it easier to evaluate the performance of a specific item over time or when compared with the prior period or the current budget. This facilitates the identification of positive or negative trends in performance.

Financial ratios are a category of measures used to evaluate various financial performance measures to analyze and evaluate the health of the firm's financial position. While numerous financial ratios can be calculated, common ones include profitability ratios, liquidity ratios, and operating ratios. Profitability ratios help evaluate how well the firm is doing at generating a profit on the sales of its products and services. This ratio can include items like the gross margin, operating margin, and net profit margin. Gross margin is the firm's revenue minus the cost of goods sold (COGS), and the gross margin ratio is determined by dividing the gross profit by revenue. This is one method for evaluating the impact on profitability as the cost of goods increases or decreases. The operating margin compares how the firm manages operating costs such as salaries, selling expenses, marketing costs, etc., and is calculated by dividing the operating income by the revenue. Finally, the net profit margin analyzes the 'bottom line', or the profit that remains after all expenses and taxes have been paid.

Liquidity ratios allow management to evaluate the firm's ability to service its short-term debt, or debt that the company must repay in twelve months or less. Liquidity represents the amount of cash the firm can have available to meet these short-term debt obligations. Two common liquidity ratios are the current ratio and the quick ratio. The current ratio considers the difference between current assets (which are the most liquid) and current liabilities. The quick ratio is similar to the current ratio, except that it requires that the value of inventory be eliminated from current assets. This addresses the potential concerns of having obsolete inventory and could have a value of less than is currently reported.

For an overview of business performance and a measure of how well the decisions made are helping the firm meet its goals, operating ratios are quite helpful. Two standard and widely used measures are the return on assets (ROA) and the return on equity (ROE). Return on assets is a measure of the return that the business is generating from the assets that have been acquired and/or invested in. Return on equity is used to show the shareholders what return is being earned from the investments that they have made in the firm.

To review, see:

• Classification
• Profitability Ratios
• Liquidity Ratios

 

2b. Evaluate a firm's performance over time

• What is the price/earnings ratio (P/E), and why is it important to shareholders?
• What is the market/book ratio, and what information does it provide to a firm?

Executives are focused on increasing the value of their firms, which provides the basis for generating the returns expected by their shareholders and investors. With their acquisition of stock in a firm, investors expect that there will be returns on this investment equal to or greater than their potential returns from other investment opportunities. Two very common ratios are evaluated to determine the firm's success in increasing its value: the price/earnings ratio (P/E) and the market/book ratio.

As a firm's value increases, one would expect the price of a share of stock to be worth more. Consider the differences between a firm that has demonstrated a record of strong financial performance over time and has a positive forecast that shows a reasonable opportunity for the firm to maintain or even increase its performance. The stock for this firm will be trading at a premium, and one measure of this can be seen in the price/earnings ratio, which is equal to the market price per share divided by the annual company earnings per share. (Total earnings divided by the number of shares outstanding). Consider that a share of stock is selling for $40.00. The earnings per share over the last twelve months is 5. This stock has a P/E ratio of 8.

The market/book ratio looks at the current book value of the firm (balance sheet) compared to what the market says the firm is worth. Remember that the book value of the firm considers assets at their acquisition value less depreciation and does not consider what those assets might be worth at current market prices. If the market price per share is higher than the book price per share, it signals that the market expects the firm to be able to generate more value from their assets than the assets are worth.

To review, see Market Value Ratios.

 

2c. Compare a firm's performance to other companies in the same industry segment

• What is the value to a firm to compare their financial performance with competitors or other companies in the industry?
• What is benchmarking, and how can it be used by a company when reviewing its financial performance?

It is certainly useful to perform a detailed financial analysis of how well our firm is performing. It is an opportunity to compare our current results with prior periods. For example, consider comparing this month's revenue and expenses with the same month's activity from a year ago. If the firm has prepared a budget as part of its strategic plan, there can also be a comparison of the company's actual results for the month when measured against what was budgeted. As we have seen, various financial ratios are an essential component of this analysis.

However, it is not enough to only engage in an internal review. A major advantage of using financial ratios is conducting a comparative financial analysis or comparing our firm with other competitors in the market or our industry. For example, suppose that our firm is showing profit margins increasing each year from 4.6%, to 5.1%, to the current rate of 5.4%. This indicates that the decisions that have been made on salaries, material costs, inventories, etc., are being controlled and have resulted in increased profits. But a further analysis of the profit margins from our main competitor over the same period show results of 5.3%, 5.9%, and 6.2%. How does this additional information affect your analysis?

To review, see The DuPont Equation.

 

2d. Recognize areas where financial performance can be improved

• How is benchmarking the financial performance of a firm different from conducting an industry comparison?
• What is trend analysis, and why is it important?

One requirement for managing a successful enterprise, whether large, small, public, or private, is to spend sufficient time analyzing the business's financial performance. Throughout this course, you have been introduced to several methods of evaluating performance, and we will end this section with a brief review of an internal process and an external one.
 
Internally, the use of trend analysis is quite helpful in evaluating overall performance and identifying areas that may need some management intervention. Trend analysis considers historical performance, usually over several periods, and charts the recorded trends. A simple example can be the generation of revenue. Let's say that over the last three years, revenue has increased by 2.0%, 4.1%, and 1.5%. We can also chart key financial ratios such as return on equity, which was 5.3%, 3.6%, and 3.0% over the same period. The challenge is, of course, not in just charting the numbers but in investigating and understanding the 'story' behind the numbers. Even though sales did show an increase last year, it was less than the increase from the year before. What were the causes for this decrease? There may have been changes in competition, new products, etc. A trend analysis is important because it can identify areas for review and be the starting point for future forecasts.
 
While it is helpful to look internally and evaluate the firm's performance, it is equally important to look externally and compare our performance with our industry or the overall marketplace. One way to conduct this analysis is to research the key financial ratios that apply to our industry sector to compare the performance of our firm with the industry. Are we following the industry trend, or are we under- or over-performing in certain areas? Again, the need is to conduct research and understand what the comparisons can mean to our business and if there are decisions to be made.
 
Benchmarking takes the external analysis to a new level. When a firm identifies the top performer or competitor in its market and reviews its key financial ratios against those of that firm, the process is referred to as benchmarking. The value of this method is the focus on top performers and how well they are doing in the market. If our results are less than theirs, it can help identify opportunities, new goals, and objectives to improve our performance. Benchmarking data can also be used to demonstrate to investors and potential investors how well the firm is doing against other important companies in the market.
 
To review, see Profitability Ratios.

 

Unit 2 Vocabulary 

This vocabulary list includes terms you will need to know to successfully complete the final exam.

• benchmarking
• book value
• common size
• comparative financial analysis
• current ratio
• financial ratios
• gross margin
• liquidity ratios
• market/book ratio
• market price
• net profit margin
• operating margin
• operating ratios
• price/earnings ratio
• profitability ratios
• quick ratio
• return on assets
• return on equity
• short-term debt
• trend analysis