Finance Chapter 4: Evaluating a Firm's Financial Performance

Measuring Key Financial Relationships

• Five questions can be answered by using ratios:
  • How liquid is the firm?
  • Are the firm’s managers generating adequate operating profits on the company’s assets?
  • How is the firm financing its assets?
  • Are the firm’s managers providing a good return on the capital provided by the shareholders?
  • Are the firm’s managers creating shareholder value?

Liquidity Measures

• A liquid asset can be converted quickly 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 financial obligations.

Financial Analysis

• Financial analysis using ratios is a popular way to analyze financial statements.
• A ratio is a relationship between two numbers (e.g., A:B = 30:10 means A is 3 times B).
• Financial ratios provide two ways of making meaningful comparisons of a firm's financial data:
  • Ratios examined over time (comparing previous years to the current year).
  • Ratios compared to that of other firms or leaders in the same industry.

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.
  • Prepare financial projections at both firm and division levels.
  • Understand the financial performance of the firm’s competitors.
  • Evaluate the financial condition of a major supplier.
• Some users of financial ratios:
  • Lenders in deciding whether to lend to a company.
  • Credit-rating agencies in determining a firm’s creditworthiness.
  • Investors (shareholders and bondholders) in deciding whether to invest in a company.

Market-Value Ratios

• Market-value ratios indicate what investors think of management’s past performance and prospects.
• Price/Earnings (P/E) Ratio:
  • Measures how much investors are willing to pay for $1 of reported earnings.
  • Example: investors are willing to pay more for Walmart for every dollar of earnings per share compared to Target ($26.22 for Walmart versus $14.07 for Target).
• 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.
  • A ratio greater than 1 indicates that the shares are more valuable than what the shareholders originally paid.
  • Example: Walmart ratio of 3.27X is lower than Target ratio of 3.53X, suggesting that Target is perceived as having better growth prospects relative to its risk.

Limitations of Financial Ratio Analysis

• It is sometimes difficult to identify the industry to which a firm belongs or determine comparable peers.
• The published peer group or industry averages are only approximations.