Chapter 3 - Evaluation of Financial Performance PDF

Chapter 3 - Evaluation of Financial Performance FIN 3110 – Financial Management 1 Prepared by Dr. Harrison Ham ©2024 Clemson University. All rights reserved. No reproduction of further distributi...

Chapter 3 - Evaluation of Financial Performance FIN 3110 – Financial Management 1 Prepared by Dr. Harrison Ham ©2024 Clemson University. All rights reserved. No reproduction of further distribution 2/2/2025 permitted without prior written consent of Clemson University FIN 3110 (1)  Overview of Financial Analysis  Goal is to identify the major strengths and weaknesses of a business Why is Financial Analysis  Assess firms viability Important? Who uses it?  Assess firm health  Analyze problem areas  Credit managers use it to decide whether to extend credit  Security analysts use it to assess whether to invest  Bankers use for deciding to grant loans FIN 3110 (2)  Overview of Financial Analysis  3 Main financial statements  Balance Sheet  What does a firm own? How was it acquired? How do we analyze?  Income Statement What do we even look  How does the firm turn revenues into income? at?  Statement of cash flows  Where does cash come from/go?  Subdivided into cash from  Operations  Financing Activities  Investing Activities  Can convert to “common size” statements by dividing by sales (Income statement) or assets (Balance Sheet) FIN 3110 (3)  Overview of Financial Analysis  Need to have a benchmark How do we know what  Can compare firms to other firms numbers are good and  Can compare a firm to itself across time bad?  Need to make numbers comparable  Use financial ratios to make things more comparable across companies  Ex: $10m in income for TTT’s would be a good year, but for Walmart it would be terrible  Need to scale to make things “common size” FIN 3110 (4)  Financial Statements A snapshot of a firm’s assets and liabilities  Assets=Liabilities+Equity  Assets: What a firm owns  Liabilities: sourced funds through debt  Equity: sourced funds Balance Sheet through stock/reinvesting earnings  Higher up assets/liabilities are more liquid FIN 3110 (5)  Financial Statements A rolling tally of how a firm performed  Starts with sales  Each line takes out different expenses until net income Income  Expenses organized by how related they are to Statement operations  Finishes with how income is retained vs distributed to shareholders FIN 3110 (6) Ratio analysis Goal: Want to compare two companies Metric Home Depot Lowes Market Cap $352.7B $135.4B Net Income $14.77B $7.3B Assets $76.53B $43.36B Liabilities $75.49 $58.41B Issues Theyre different sizes They have different capital structures How do we make it so that we can tell if numbers are good or bad? FIN 3110 (7)  Ratio analysis Goal: Want to compare two companies Metric Home Depot Lowes Market Cap $352.7B $135.4B Net Income $14.77B $7.3B Assets $76.53B $43.36B Liabilities $75.49 $58.41B Need to make the two comparable through ratio analysis Scale metrics by other accounting metrics in the same firm Ratio Home Depot Lowes Net Income/Market Cap 4.2% 5.44% Assets/Liabilities 1.01 0.74 FIN 3110 (8)  Types of Ratios - Preview Ratio Type What do they tell us? Examples Liquidity How well can a firm handle short term Current, Quick, Cash financial obligations? Asset Management How well does the firm use its assets to Avg. Collection Period, Inventory Turnover, Fixed generate sales? Asset Turnover, Total Asset Turnover Financial Leverage How much does a company use debt? Debt, Equity, Debt to Equity, Equity Multiplier, TIE, Fixed Charge Coverage Profitability How well does a firm generate income? Gross profit, Net Profit Margin, ROI, ROE Valuation How expensive is the stock priced PE ratio, Price to book ratio, EV/EBITDA relative to the value it generates? Dividend Policy How much of income is returned to the Dividend Yield, Payout Ratio shareholders? FIN 3110 (9)  Types of Ratios - Preview Mistakes commonly made in ratio analysis Ratios are only warning signs, they aren’t necessarily the ground truth Need to dig in to find out what is really going on Banks can have insanely high debt ratios, but that’s ok because that’s how they operate for example Ratios need to be compared to something. By themselves they are hard to interpret Compare to the industry, other firms, or the same firm over time Can set goals for ratios and see how company is performing in comparison For example “We aim to have a gross profit margin of 10%” Different accounting methods can drastically change some ratios So need to keep in mind how the ratio inputs are calculated Ratios can get weird when the denominator is near zero The PE ratio is undefined for firms with zero income One ratio can tell a very different story than another even if they are similar ratios Knowing what drives the differences is key Some accounts like earnings per share can be influenced by management through accounting tricks to make them misleading When this happens, we say that a company has “low earnings quality” -> Book has examples of this The first 5 students from each class to see this and email me get a bonus point! FIN 3110 (10)  Liquidity Ratios – Can they pay short term obligations? Current Ratio 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠  Current Assets  Cash + any assets that can be converted to cash in the next 12 months  Short term investments, Inventory, AR  Current Liabilities  Financial obligations due in the next 12 months  AP, Notes Payable, Current portion of LT debt, accruals…  How big are next twelve month sources of cash vs obligations?  Higher means you can pay obligations better  Issues  Large/slow moving inventory, and delinquent AR can make this look higher than it should be FIN 3110 (11)  Liquidity Ratios – Can they pay short term obligations? Quick Ratio 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠  Sometimes inventory moves very slow, so you may not get money back within the next 12 months  So we remove it from the current ratio to create quick ratio  Issues  Delinquent AR (Over 90 days due) may not be paid soon (or at all)  This could inflate the ratio so we can remove delinquent AR too: FIN 3110 (12)  Liquidity Ratios – Can they pay short term obligations? Cash Ratio 𝐶𝑎𝑠ℎ 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠  Most conservative liquidity ratio  Could you pay all of your obligations right now? FIN 3110 (13)  Liquidity Ratios – Can they pay short term obligations? Home Depot Vs. Lowes Metric Home Depot Lowes Current Ratio 1.34 1.17 Quick Ratio 0.42 0.23 Cash Ratio 0.18 0.18 Home Depot has slightly better current and quick ratio Cash ratio is the same Both companies have current ratios above 1 But when inventory is removed, the quick ratio shows both have large current liabilities FIN 3110 (14)  Asset Management – How Efficiently are Assets Used? Average Collection Period 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑟𝑒𝑑𝑖𝑡 𝑆𝑎𝑙𝑒𝑠 /365  How long do you take to collect your receivables?  Literally its how many days it takes on average to collect AR  Lower is generally better  Need to compare to credit terms  If you give clients 40 days to pay, and they take 90+ on average you have a problem FIN 3110 (15)  Asset Management – How Efficiently are Assets Used? Inventory Turnover 𝐶𝑂𝐺𝑆 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦  How many times per year do you sell through your inventory?  Use average of current inventory and last years inventory in denominator to make it more stable  Too high could mean you don’t hold enough inventory  Too low could mean you hold too much or don’t generate enough sales  Maybe get rid of slow moving products  Need to consider numerator and denominator in context FIN 3110 (16)  Asset Management – How Efficiently are Assets Used? Fixed Asset Turnover 𝑆𝑎𝑙𝑒𝑠 𝑁𝑒𝑡 𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠  Net Fixed Assets=Total Assets-Current Assets  How much revenue is generated out of Plant Property and Equipment?  How many dollars of sales per dollar of PPE?  Can be unreliable  Costs can change  Equipment can be very old  Depreciation policies can vary across firms  Could lease PPE instead of owning  Better to compare within firms than between firms FIN 3110 (17)  Asset Management – How Efficiently are Assets Used? Total Asset Turnover 𝑆𝑎𝑙𝑒𝑠 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠  How much revenue is generated out of all of the firms resources?  How many dollars of sales per dollar of assets?  Higher means firm is doing a better job with its resources FIN 3110 (18)  Asset Management – How Efficiently are Assets Used? Home Depot Vs. Lowes Metric Home Depot Lowes Average Collection Period 10 days 4.2 days Inventory Turnover 4.34x 3.11x Fixed Asset Turnover 3.2x 3.5x Total Asset Turnover 1.95x 1.87x Lowes collects receivables faster than Home Depot But both are fairly low Home depot sells through inventory more Is it because they have small inventory? Or because they sell more? Need to check inputs to ratio to be sure Both companies have similar turnover ratios FIN 3110 (19)  Leverage Ratios – How Much is Debt Used? Debt Ratio 𝐷𝑒𝑏𝑡 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠  The proportion of assets financed by debt  Debt includes all liabilities  Some people prefer to only use long term debt though  Too much debt could indicate risk of bankruptcy  Depends heavily on the industry to say what “too much” is  Make sure to have a benchmark! FIN 3110 (20)  Leverage Ratios – How Much is Debt Used? Debt to Equity 𝐷𝑒𝑏𝑡 𝐸𝑞𝑢𝑖𝑡𝑦  What proportion of a firms financing is supplied by debt?  Same information as debt ratio, just expressed a different way  Debt Ratio =Debt/Assets=Debt/(Debt+Equity)