Analyzing Financial Performance

1. Analyzing Financial Performance Chapter 7

2. Terms to Know • Debt • Financial Efficiency • Liquidity • Profitability • Repayment Capacity • Revenue • Solvency

3. Five Key Areas of Financial Analysis • 1. Liquidity – ability to meet obligations • 2. Solvency – borrowed capital in relation to owner equity invested in business • 3. Profitability – profit from use of labor, management, and capital • 4. Repayment Capacity – ability to repay debts • 5. Financial Efficiency – efficient use of labor, management, and capital

4. 16 main measures are used to evaluate the five areas of financial analysis.

6. I. Five financial criteria for complete business analysis are calculated by 16 measures / ratios • A. Liquidity (1st criteria) • 1. Ability to meet financial obligations, without disrupting normal ongoing operations • 2. Working capital (measure #1) • a. Calculated from the balance sheet information • b. total current assets - total current liabilities working capital

7. I. Five financial criteria for complete business analysis are calculated by 16 measures / ratios • A. Liquidity (1st criteria) • 3. Current ratio (measure #2) • a. Indicates the extent to which current assets would cover current liabilities • b. Total current assets ÷ Total current liabilities • c. Usually expressed as XX:1 • (1) if the ratio is greater than 1:1, the business is considered “liquid” • (2) if the ratio is less than 1:1, the business is considered “not liquid” reflecting a high degree of short-term cash flow risks • (3) the higher the ratio, the more liquid the business • (4) as a ratio it is not dependent on the size of a business and comparisons to other businesses can be made

8. I. Five financial criteria for complete business analysis are calculated by 16 measures / ratios • A. Liquidity (1st criteria) • 4. Cash flow coverage ratio (measure #3) • a. From statement of cash flows beginning cash + cash received from operating activities + cash received from investing activities + proceeds from term loans + cash received from equity contributions cash paid for operating activities + cash paid for investing activities + principal paid on term loans and capital leases + cash equity distribution

9. I. Five financial criteria for complete business analysis are calculated by 16 measures / ratios • A. Liquidity (1st criteria) • 4. Cash flow coverage ratio (measure #3) • b. From cash flow budget total cash available ÷ total cash required • (1) most relevant and useful • (2) assess ability to meet cash obligations • (3) the higher the ratio, the greater the liquidity • (4) limitations • (5) test the sensitivity to different prices and major input costs, including interest rates

10. I. Five financial criteria for complete business analysis are calculated by 16 measures / ratios • B. Solvency (2nd criteria) • 1. Amount of borrowed capital used, relative to the amount of owner’s equity capital • 2. Indication of a business’ debt repayment capacity if all assets liquidated • 3. Ability to continue as a viable business after financial adversity (i.e. withstand risk) • 4. Uses total assets and liabilities • 5. Net worth or owner equity are most straightforward measure of solvency • a. Include deferred taxes among liabilities

11. I. Five financial criteria for complete business analysis are calculated by 16 measures / ratios • B. Solvency (2nd criteria) • 6. Debt-to-asset ratio (measure #4) • a. Measures the proportion of total assets owed to creditors • b. Total liabilities ÷ total assets • c. Expresses risk of business debt repayment capacity (the higher the ratio the greater the risk exposure) • d. Use cost basis approach to value assets and deferred taxes included as liabilities

12. I. Five financial criteria for complete business analysis are calculated by 16 measures / ratios • B. Solvency (2nd criteria) • 7. Equity-to-asset ratio (measure #5) • a. Total equity ÷ total assets • b. The lower the ratio, then creditors have more money in the business than the owner does • c. Measures the proportion of assets financed by owner equity capital

13. I. Five financial criteria for complete business analysis are calculated by 16 measures / ratios • B. Solvency (2nd criteria) • 8. Debt-to-equity ratio (measure #6) • a. Total liabilities ÷ total equity • b. The lower the ratio, then creditors have less money in the business than the owner does • c. Measures the extent of combination of debt capital and equity capital

14. I. Five financial criteria for complete business analysis are calculated by 16 measures / ratios • C. Profitability (3rd criteria) • 1. Measures the extent to which a business generates a profit from the use of labor, management and capital. • 2. The analytical focus is on the relationship between revenues and expenses • 3. Return on assets (measure #7) • a. Net income from operations + interest expense - value of unpaid operator and family labor, and management = average of total assets • b. Overall profitability index • c. The higher the ratio, the more profitable the business • d. This is the most meaningful measure for business to business comparisons when the market-value approach is used to value assets.

15. I. Five financial criteria for complete business analysis are calculated by 16 measures / ratios • C. Profitability (3rd criteria) • 4. Return to equity (measure #8) • a. Net income from operation - value of unpaid operator and family labor and management average total equity • b. Measures rate of return on owner equity capital employed in the business • c. The higher the ratio, the more profitable the business

16. I. Five financial criteria for complete business analysis are calculated by 16 measures / ratios • C. Profitability (3rd criteria) • 5. Operating profit margin ration (measure #9) • a. Net income from operation + interest expense - Value of unpaid operator and family labor and management = gross revenue • b. Measures the return to capital per dollar of gross revenue • c. Must use accrual income measures • d. May use value of production or gross revenue

17. I. Five financial criteria for complete business analysis are calculated by 16 measures / ratios D. Repayment capacity (4th criteria) 1. Measures the ability to repay debt (term debt and capital lease payments) from both business and non-business income 2. Can a business service additional debt or invest in additional capital after meeting all other cash commitments? 3. Measures are derived from accrual net income figures. 4. Long term viability requires that a business be profitable

18. I. Five financial criteria for complete business analysis are calculated by 16 measures / ratios D. Repayment capacity (4th criteria) 5. Term debt and capital lease coverage ratio (measure #10) a. Net income from operation + total non-business related income + depreciation / amortization expense + interest on term debt + interest on capital leases - total income tax expense - withdrawals for family living annual scheduled principal & interest payments on term debt + annual scheduled principal & interest payment on capital leases

19. I. Five financial criteria for complete business analysis are calculated by 16 measures / ratios D. Repayment capacity (4th criteria) 5. Term debt and capital lease coverage ratio (measure #10) b. Measures ability to cover term debt and capital lease payments c. The higher the ratio, the greater the margin to cover payments and greater the flexibility to withstand adversity

20. I. Five financial criteria for complete business analysis are calculated by 16 measures / ratios D. Repayment capacity (4th criteria) 6. Capital replacement and term debt repayment margin(measure #11) a. Net income from operation + total non-business related income + depreciation/amortization expense + interest on term debt + interest on capital leases - total income tax expense - withdrawals for family living annual scheduled principal & interest payments on term debt + annual scheduled principal & interest payment on capital leases - payments on unpaid operating debt from prior period - principal payments on current portions of term debt - principal payment on current portions of capital leases - total annual payments on personal liabilities not included in withdrawals = capital replacement and term debt repayment margin

21. I. Five financial criteria for complete business analysis are calculated by 16 measures / ratios D. Repayment capacity (4th criteria) 6. Capital replacement and term debt repayment margin (measure #11) b. Evaluates the ability to service existing term debt and replace capital assets c. Evaluates risk management

22. I. Five financial criteria for complete business analysis are calculated by 16 measures / ratios E. Financial Efficiency (5th criteria) 1. Measures the degree of efficiency in using labor, management and capital 2. Financial efficiency analysis deals with the relationships between inputs and outputs 3. Can be measured in physical as well as dollar terms 4. Techniques of analysis: how is information gathered in order to make accurate and appropriate decisions?

23. I. Five financial criteria for complete business analysis are calculated by 16 measures / ratios E. Financial Efficiency (5th criteria) 5. Asset turnover ratio (measure #12) a. Gross revenues ÷ average total assets b. Measures how effective assets generate revenue c. The higher the ratio, the more efficiently assets are being used to generate revenue

24. I. Five financial criteria for complete business analysis are calculated by 16 measures / ratios E. Financial Efficiency (5th criteria) The next four operating ratios (measures #13-16) represents the total composition of gross revenue. That is, in percentage terms the four ratios reflect the allocation of 100% of a business’ gross revenues.

25. I. Five financial criteria for complete business analysis are calculated by 16 measures / ratios E. Financial Efficiency (5th criteria) 6. Operating ratio (measure #13) a. Total operating expenses – depreciation expense gross revenues

26. I. Five financial criteria for complete business analysis are calculated by 16 measures / ratios E. Financial Efficiency (5th criteria) 7. Depreciation expense ratio (measure #14) a. depreciation expense gross revenues

27. I. Five financial criteria for complete business analysis are calculated by 16 measures / ratios E. Financial Efficiency (5th criteria) 8. Interest expense ratio (measure #15) a. Total interest expense gross revenues

28. I. Five financial criteria for complete business analysis are calculated by 16 measures / ratios E. Financial Efficiency (5th criteria) 9. Net income from operations ratio (measure #16) a. Net income from operations gross revenues

29. Guidelines for Applying the Use of Financial Measures • 1. Historical information • 2. Current information • 3. Projected information

30. Guidelines for Applying the Use of Financial Measures • Measures assessed by: • 1. other measures • 2. same measure over time • 3. same measure for similar business • 4. same measures for dissimilar business • 5. a known benchmark

31. II. Calculate financial measures as ratios A. Utilize ratios and measures 1. Ratios are simply one number divided by another to express a relationship a. Bushels per acre ; b. Blossoms per flower ; c. Lambs per ewe B. Value of ratios 1. Assess measures individually and in relation to others 2. Compare measures with known benchmark 3. Calculate measures using good information 4. Use measures to evaluate past, present, and future

32. III. Measure against standards A. Compare business against itself for a general trend of the business 1. Compare past performance with present performance 2. Trend analysis over time 3. Compare present information with budgeted information

33. III. Measure against standards B. Compare business against benchmark 1. If business ratios are above or below the benchmark figures then it could indicate a problem C. Compare business against industry average 1. Comparisons should be made with businesses of similar size and type D. Keep in mind that financial measures (ie, ratios) are not a substitute for informed judgement and common sense. They enhance decision-making ability and they offer a means to assess the status of an individual business.