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Tools and Techniques of Financial Performance Evaluation

Apply horizontal analysis, trend analysis, and vertical analysis to financial statements. Horizontal Analysis It begins with the computation of changes from the previous year to the current year. The base year is the first year considered. Horizontal analysis uses both dollar amounts and percentages. Percentage Change = 100 x(Amount of Change / Base Year Amount) Trend Analysis Changes are calculated for several successive years instead of for two years. Trend analysis is important because it may point to basic changes in the nature of a business. Trend analysis uses an index number to show changes in related items over a period of time. Index = 100 x(Index Year Amount / Base Year Amount) Vertical Analysis Percentages are used to show the relationship of the different parts to a total in a single statement. The analyst sets a total figure in the statement equal to 100% and computes each components percentage of that total. The statement of percentages is called a common-size statement. Vertical analysis is useful for comparing the importance of specific components in the operation of a business and changes in the components from one year to the next.

Ratio Analysis Ratios identify meaningful relationships between the components of the financial statements. They are useful in: Evaluating a companys financial position and operations. Making comparisons with results in previous years or with other companies. The primary purpose of ratios is to point out areas needing further investigation.

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Tools and Techniques of Financial Performance Evaluation


Evaluating Liquidity Liquidity is a company's ability to pay bills when they are due and to meet unexpected needs for cash. All ratios that relate to liquidity involve working capital or some part of it. Current ratio: measures short-term debt-paying ability. Current Ratio = Current Assets / Current Liabilities Quick ratio: also measures short-term debt-paying ability. Quick Ratio = (Cash + Marketable Securities + Receivables) / Current Liabilities Receivable turnover: measures relative size of receivables and effectiveness of credit policies. Receivable Turnover = Net Sales / Average Accounts Receivable Average days sales uncollected: measures average days taken to collect receivables. Inventory turnover: measures relative size of inventory. Inventory Turnover = Cost of Goods Sold / Average Inventory Average days inventory on hand: measures average days taken to sell inventory. Average Days Inventory on Hand = Days in Year / Inventory Turnover Payables turnover: measures relative size of accounts payable. Payables Turnover = (Cost of Goods Sold +/- Change in Inventory) / Average Accounts Payable Average days payable: measures average days taken to pay accounts payables. Average days payable = Days in Year / Payables Turnover

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Tools and Techniques of Financial Performance Evaluation


Evaluating Profitability Profitability reflects a company's ability to earn a satisfactory income. A company's profitability is closely linked to its liquidity because earnings ultimately produce cash flow. Profitability ratios include: Profit margin: measures net income produced by each sales dollar. Profit Margin = Net Income / Net Sales Asset turnover: measures how efficiently assets are used to produce sales. Asset Turnover = Net Sales / Average Total Assets Return on assets: measures overall earning power. Return on Assets (ROA) = Net Income / Average Total Assets Return on equity: measures profitability of stockholders investments. Return on equity (ROE) = Net Income / Average Stockholders Equity

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Tools and Techniques of Financial Performance Evaluation


Evaluating Long-Term Solvency Long-term solvency has to do with a company's ability to survive for many years. The aim of long-term solvency analysis is to detect early signs that a company is headed for financial difficulty. Early signs that a company is on the road to bankruptcy include: Declining profitability and liquidity ratios. Unfavorable debt to equity ratio. Unfavorable interest coverage ratio. Debt to Equity Ratio Measures capital structure and leverage. Failure to honor debt can result in bankruptcy, so debt is risky. BUT debt provides flexible financing: It can be temporary. Interest is tax deductible. It leverages stockholders investments if the company earns a return on assets greater than the cost of interest. Debt to Equity Ratio = Total Liabilities / Stockholders Equity Interest Coverage Ratio Measures creditors protection from default on interest payments. Interest Coverage Ratio = (Income before Taxes + Interest Expense) / Interest Expense

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Tools and Techniques of Financial Performance Evaluation


Evaluating Cash Flow Adequacy Because cash flows are needed to pay debts when they are due, cash flow measures are closely related to the objectives of liquidity and long-term solvency. Cash flow adequacy ratios include: Cash flow yield: measures overall ability to generate operating cash flows in relation to net income. Cash flow yield = Net Cash Flows from Operating Activities / Net Income Cash flows to sales: measures ability of sales to generate operating cash flows. Cash Flows to Sales = Net Cash Flows from Operating Activities / Net Sales Cash flows to assets: measures ability of assets to generate operating cash flows. Cash Flows to Assets = Net Cash Flows from Operating Activities / Average Total Assets Free cash flow: measures cash generated or cash deficiency after providing for commitments. Free Cash Flow = NCF from OA Dividends Net Capital Expenditures

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Tools and Techniques of Financial Performance Evaluation


Evaluating Market Strength Market price is the price at which people are willing to buy or sell the stock. Market price provides information about how investors view the potential return and risk connected with owning the company's stock. Market price by itself is not very informative. Market price must be related to earnings by considering the price/earnings ratio and the dividends yield. Price/earnings ratio: Measures investor confidence in a company. It is useful for comparing the value placed on a companys shares in relation to the overall market. Price / Earnings Ratio = Market Price per Share / Earnings per Share Dividends yield: Measures a stocks current return to an investor. Dividends yield = Dividends per Share / Market Price per Share

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Tools and Techniques of Financial Performance Evaluation


Ratio Analysis Current Ratio Quick Ratio Days of Inventory (DI) Days Sales Outstanding (DSO) Fixed Assets Turnover Total Assets Turnover Debt/Assets Profit Margin ROA ROE

Du Pont equation ROE ROA K Profit Margin ROA: TAT FAT DSO DI

= ROE / ROA

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