Financial Performance Ratios

A Sun Tzu Moment

 “Those adept in waging war do not require a second levy of conscripts nor more than one provisioning”.[1]

Introduction

Many of you undertaking case study financial performance analysis will find the exercise challenging.  However, the rewards are great.  Understanding the efficiency and effectiveness of the expenditure of a firm’s financial resources will provide you with a competitive advantage over those within your organization who have not taken the time to acquire these valuable skills.

First, two caveats: This high-level overview of key financial performance ratios is offered only to supplement the materials you will cover with your instructors during your program.  This listing is not exhaustive, so do not be surprised if your instructors introduce further ratios for consideration when undertaking case study analyses. Second, in undertaking an analysis of financial statements, be aware that you view the statements through the interpretive lens you have acquired.  For example, those of you involved – or wishing to be involved – in the banking industry may place greater weight on ratios supporting whether to give a young entrepreneur a loan, while those of you with a marketing background might be more interested in gross margins.  Nevertheless, whichever lenses you view the ratios through and however you apply the weighting, there are generally four questions that must be addressed. Does the company have the capacity to meet its short-term (one-year) financial commitments? Are the operating profits adequate relative to the assets? How is the company financing its assets? Are the stockholders satisfied with their return on investment? To answer these questions, we need to extract the data available from the company’s income statements and balance sheets and convert the numbers to financial performance ratios.

Strategists understand that, to measure the success of a firm’s current strategy, a good starting point is to ascertain whether the firm is meeting its financial and strategic objectives. If the firm is substantially meeting these objectives, then only small changes are warranted; however, if the firm is significantly and consistently falling short of its objectives, then major changes are needed and a new strategy needs to be implemented.   An examination of the financial performance data provides concrete evidence as to the success or failure of the firm’s management and assists in validating recommendations when writing up a case study. Sun Tzu’s wise counsel, highlighting the importance of ensuring the effective and efficient use of financial resources, must be kept uppermost in management’s mind.

Reflectively thinking about the financial ratios will permit us to better understand how the organization has been performing internally year-over-year as well as enable us to compare our firm with other firms’ and industry averages.  Statistics Canada, the Canadian Institute of Chartered Accountants, and firms such as Dun & Bradstreet publish industry data that permit this type of comparison. Visit Power’s Student Case Study Analysis and Writers’ Handbook text site at (link) www.Power.Nelson.com for an extensive list of financial e-research URLs that form part of this text.

No doubt, on occasion you will find significant deviations in the ratios you examine.  Ensure you understand the reason for these deviations. While they may be an indicator of something serious, they may not be troubling – there may be a very reasonable explanation.

Financial Performance Ratio Classifications[2]

Financial performance ratios can be classified into five different clusters: profitability, liquidity, efficiency, financial leverage, and shareholder-return ratios.

Profitability Ratios

By calculating profitability ratios, we can determine the effectiveness of how management has spent the firm’s scarce resources. Clearly, the more efficiently a firm consumes its resources, the greater its profitability. Calculating these ratios permits us to first evaluate the firm’s profitability performance against similar firms in the industry; and second, the ratios provide us with the perspective necessary to judge the historical trend of a firm’s profitability performance – whether the performance is improving or declining over time.

There are a variety of different profit ratios that can be determined from the financial data. Each of these ratios highlights and measures a different aspect of the company’s performance.  The most common profit ratios used in case study analysis are gross profit margin, net profit margin, return on total assets, and return on investment.

• Gross profit margin. Gross profit margin indicates the percentage of sales available to cover general and administrative expenses and other operating costs.

      Gross profit margin % = (sales revenue – cost of goods sold) / sales revenue

• Net profit margin. Net profit margin is the percentage of profit earned on sales. This ratio is important because, for long-term survival, businesses need to make a profit.         Net profit margin % = net income /sales revenue

• Return on assets. ROA measures how efficiently the firm’s assets generate earnings. This ratio measures the profit earned on the employment of assets.

      Return on assets = net income / total assets

Note: Net income is the profit after preferred dividends (provided for in the contract) have been paid. Total assets include both current and fixed assets.

• Return on investment. This ratio measures, in the broadest sense, the profitability of an investment. It is not uncommon for accountants to use entirely different ROI computations. Watch for manipulation here. In this formula, the ratio measures the firm’s after-tax net income against the total assets invested to achieve that level of income.

Return on Investment = after-tax net income / total assets

Liquidity Ratios

A company’s liquidity is a measure of its ability to meet maturing debt obligations by having adequate working capital available. Does the firm now have, or will it have when needed, sufficient working capital to pay its creditors? An asset is deemed liquid if it can be readily converted to cash. Liquid assets are current assets such as cash, marketable securities, accounts receivable, and the like. Generally, the higher the value of the ratio, the larger the safety margin the company has to meet its short-term debt obligations. Two commonly used liquidity ratios are the current and quick ratios.

• Current ratio. The current ratio measures the extent to which the claims of short-term creditors are covered by assets that can be quickly converted into cash. Because failure to meet commitments can lead to bankruptcy, most companies should have a current ratio of at least 1.

Current ratio = current assets / current liabilities

• Quick ratio. The quick ratio, also called the acid test ratio, measures a company’s ability to pay off the claims of short-term creditors without relying on the sale of its inventories. This is a valuable measure since in practice the immediate sale of inventories is often difficult.

Quick ratio = (current assets – inventory) / current liabilities

Efficiency Ratios  

Efficiency ratios, also known as activity ratios, provide insight into the effectiveness of companies’ asset management. Inventory turnover and average collection period ratios are the most common and useful.

• Inventory turnover. This measures the number of times inventory is turned over in a fixed period of time. It is useful in determining whether a firm is carrying excess inventory. Because the costs of goods sold reflect the company’s cost rather than the full market value of the goods when sold, COGS is a better measure of turnover than sales.  Inventory is taken at the balance sheet date. On occasion firms will choose to compute the inventory average (beginning – ending) but for case study analyses, use the inventory at the balance sheet date unless you are advised by your instructor to do otherwise.

Inventory turnover = cost of goods sold / inventory

• Average collection period. Also referred to as day’s sales outstanding, this ratio is the average time a company has to wait to receive payment (collect its receivables) after making a sale. It measures the effectiveness of the company’s credit, billing, and collection procedures. Note:  accounts receivable is divided by average daily sales. The use of 360 days is the standard for most financial analyses.

Average collection period = accounts receivable / (total sales / 360)

Financial Leverage Ratios

Firms must maintain their balance between debt and equity.  We refer to this balance as the capital structure.  The appropriate balance between debt and equity (stock, retained earnings) is determined by management.  Debt generally has a lower cost than capitalization (selling more stock) because creditors have less risk exposure.  By the terms of the debt instrument, investors are promised interest and the return of principle.  Of course, there is some risk: the firm might make insufficient profit to meet the covenants of the debt instrument, and bankruptcy is always a possibility. The three most widely used leverage ratios include debt-to-assets, debt-to-equity, and times-covered.

• Debt-to-assets ratio. The debt-to-asset ratio is the clearest measure of the extent of external financing undertaken by the firm to acquire its investments. This ratio provides a sense of the leverage the company has accepted and as a result provides an indication of the company’s level of potential risk in terms of its debt load. Total debt is the sum of a company’s current liabilities and its long-term debt.  Total assets are the sum of fixed assets and current assets.

      Debt-to-assets = total debt / total assets

• Debt-to-equity ratio. The Debt-to-equity ratio is perhaps the most widely used measure of financial leverage.  The ratio provides insight into the balance between debt and equity in the firm’s capital structure.

Debt-to-equity = total debt / total equity

• Times-covered ratio. This ratio provides an indication as to whether a company’s gross profits are sufficient to meet its annual interest payments. If the ratio declines to less than 1, then the company will be unable to meet its interest costs and can be deemed technically insolvent.

Times covered = profit before interest and taxes / total interest charges

Shareholder Return Ratios

Most business strategists would agree that the first duties of senior management are to maximize shareholder wealth and ensure the firm’s survival.   Accordingly, your case study financial performance analysis must include an examination of the returns shareholders receive on their investment. Senior managers are well aware that in today’s global markets, the purchase and retention of shares are subject to the whim of the marketplace, which demands an adequate return on investment for shareholders. CEOs that fail to monitor the firm’s share price do so at their own peril.  As we have noted before, these ratios can also be compared internally year-over-year as well as to the industry’s average to ensure the firm remains attractive enough to investors to maintain a continuing flow of investment.  The most common ratios are: return on equity, price/earnings, market to book value, and dividend yield.

• Return on equity. ROE measures whether the firm’s earnings are attractive to stockholders when compared to stockholders’ returns on investments in similar companies in the same industry.

      Return on equity = net income / total shareholder equity

• Price/earnings. The P/E ratio reflects the relationship between the stock price and the company’s earnings.  It is a ratio that investors most often solely rely upon to justify whether the stock is attractive. However, having undertaken your financial courses, you understand the fallacy of this perspective!

      Price-earnings ratio = market price per share / earnings per share

• Market to book value. A useful ratio that, when greater than 1, indicates the stock is undervalued.  If less than 1, the stock is overvalued.  You will find this ratio useful in your case study analysis to provide a measure of the company’s expected future growth prospects.

      Market to book value = book value of firm / market value of firm

• Dividend yield. This ratio tells investors how much ‘bang for their buck’ they are receiving from dividends.  For example, it indicates how much cash flow investors are receiving for each dollar invested in equity.  The dividend yield equals return on investment for a stock.

      Dividend yield = annual dividends per share / price per share

You should commit to memory at least a half dozen of these most common performance ratios. It is anticipated that you will have a command of these ratios by the time you have completed your program.

[1] Mark McNeilly, Sun Tzu and the Art of Business: Six Strategic Principles for Managers (New York: Oxford University Press, 1996), p178.

[2] The financial data in Chapter 2 – the Cobbler Case ( add link) demonstrates how to apply these ratios.