Financial Analysis and Performance Evaluation

Evaluating Firm Performance

• Financial Analysis is used in the strategic management process to compare desired and actual performance
• Financial analysis can help assess firm performance, compare performance over time, with industry norms, and with competitors
• It can also determine if a firm's strategy is working and identify problems

Financial Ratio Analysis

• Financial analysis helps you understand what to look for in financial statements, how to perform basic ratio analysis, how to interpret financial statements data strategically, and what financial forecasting entails

Assessing the Balance Sheet

• The basic accounting equation states: Assets = Liabilities + Equity
• Any increase in assets must be associated with an equal increase in liabilities or equity
• When reviewing a balance sheet, you can determine if the firm is large or small by examining the Total Assets
• Look at the biggest items on the balance sheet and identify any significant changes (increases/decreases)
• A significant amount of debt relative to equity may indicate financial risk

Interpreting the Income Statement

• The income statement, also known as the "Profit and Loss Statement", tracks sales, expenses, and profit/loss of a business during a given period.
• Net Sales - The total sales made after taking into account discounts and allowances.
• Gross Margin - Sales revenue minus the cost of goods sold.
• EBITDA - Earnings Before Interest, Taxes, Depreciation, and Amortization

Interpreting Income Statements Strategically

• Examine sales growth to see if it is slow or fast by comparing it to previous growth, industry average, and main competitors
• Analyze Net Income/Loss to identify if sales and profits are changing at the same rate and identify the potential reasons for discrepancies

Cash Flow Statement

• A company with too little cash cannot pay employees, debts, or suppliers.
• Too much cash signifies lost investment opportunities.
• Cash is particularly important in countries with poor access to credit.

Financial Ratio Analysis

• Five types of financial ratios:
  • Short-term solvency or liquidity
  • Long-term solvency measures
  • Asset management or turnover
  • Profitability
  • Market value
• Meaningful ratio analysis involves analysis of how ratios change over time, comparison with industry norms, and comparison with key competitors

Liquidity Ratios

• Measure the ability to pay short-term obligations
• Current Ratio (CR) - Current Assets / Current Liabilities. A ratio of 1-2 is considered safe (rule of thumb).
• Quick Ratio (QR) - (Current Assets - Inventory) / Current Liabilities, A ratio above 1 is considered safe (rule of thumb).
• Cash Ratio - Cash / Current Liabilities

Leverage/Solvency Ratios

• Measure ability to meet long-term obligations
• Debt to Asset Ratio - Total Debt / Total Assets. A ratio of .5 or less is considered safe (rule of thumb).
• Debt to Equity Ratio - Total Debt / Shareholders' Equity. Evaluates whether a lot of debt is being used to finance growth.
• Return on Assets (ROA) - Net Profit / Total Assets. A measure of management efficiency.
• Return on Invested Capital (ROIC) - Net Operating Profit after Taxes / Invested Capital. A measure of the efficiency of using capital.
• Return on Equity (ROE) - Net Profit/ Stockholders' Equity. Rate of return on shareholders' investment.
• Gross Margin Gross Profit / Net Sales

Shareholder Ratios

• Earnings per share (EPS) - (Net Profit - Preferred Stock Dividend) / Common Shares Outstanding.
• Price to Earnings (PE) Ratio - Share Price / Earnings per Share.
• Total Shareholder Return (TSR) - (Dividends + Share Price at the end of the period (adjusted for splits)) / Share Price at the beginning of the period

Sources of Financial Information

• Company websites (Investor Information, Corporate Sections, Earnings reports, Annual reports)
• Financial Websites (Yahoo Finance, The Wall Street Journal, Fortune.com, SEC)
• Databases (Compustat)

The Balanced Scorecard

• An integration of many issues that come into evaluating performance
• Four Key Perspectives:
  • Customer Perspective
  • Internal Perspective
  • Innovation & Learning Perspective
  • Financial Perspective

Internal Business Perspective

• Managers should focus on critical internal operations that enable the firm to satisfy customer needs.
• Business processes - Cycle time, quality, employee skills, productivity.
• Decisions, coordinated actions, and key resources and capabilities

Innovation and Learning Perspective

• Managers must frequently introduce new products as well as adapt existing products and services
• This requires human capital (skills, talent, knowledge), information capital (information systems, networks), and organizational capital (culture, leadership).

Financial Perspective

• Managers measure how the firm’s strategy, implementation, and execution are contributing to bottom line improvement
  • Financial Goals: Profitability, growth, shareholder value
  • Desired Outcomes: Improved Sales, Increased Market Share, reduced operating expenses, higher asset turnover

Limitations of the Balanced Scorecard

• Not a "quick fix" - needs proper execution
• Requires a commitment to learning
• Needs employee involvement
• Needs cultural change
• Needs a focus on nonfinancial measures
• Requires data on actual performance

This quiz focuses on evaluating firm performance through financial analysis, including ratio analysis and balance sheet assessment. Understand how to interpret financial statements and what factors can indicate a firm's strategic effectiveness. Test your knowledge on key financial concepts and principles.