Firm Performance Ratios Analysis Resources & Criteria
This assignment--Part 9--will allow you to take a close look at your firm's financial performance via various financial ratios. From your Competing for Advantage text (Hoskisson et al., 2013), on p. 129, you will see that Table 4.6 lists several financial ratios as well as on the Financial Ratios page. Here are two excellent pages that will provide you with more assistance in calculating and understanding financial ratios:
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o My Accounting Course Website (Links to an external site.)
o Workful Blog (Links to an external site.)
Financial ratios are ways to measure firm performance. You can benchmark your firm's ratios to those of its competitors; or, you can compute your firm's ratios over a series of years to looks at its trends. For this assignment, you will be calculating them over a span of 5 years.
Sometimes you can find financial ratios already computed for your firm on the Mergent Database (Links to an external site.) found at the PSU library, which is fine. If you have data on your firm found there, then you can use the ratio report generated by Mergent instead. Or you may find this resource to be handy: Current Ratio Calculator (Links to an external site.)
Please be sure to denote where you have found these statistics, or you calculated them. Calculations should be attached--extra credit will be given for calculations shown with work, even if it is done with Excel.
Profitability Ratios
- Asset Turnover
- Profit Margin
- Return on Assets (ROA)
- Return on Equity (ROE)
- Return on Sales (ROS)
Liquidity Ratios - Current Ratio
- Quick Ratio
Debt Ratios - Debt-to-Equity Ratio
- Interest Coverage Ratio
Efficiency Ratios - Asset Turnover Ratio
- Inventory Turnover Ratio
Market Ratios - Earnings per Share (EPS)
- Price to Earnings (P to E) Ratio
- Dividend Yield
Financial Ratios
One way to measure whether you are operating a sustainable and profitable company is to keep a close eye on measures called financial ratios. These are terms you may have heard during discussions about business and include:
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o Return on Equity (ROE)
o Return on Assets (ROA)
o Return on Sales (ROS)
o Asset Turnover
The ratios mentioned above are all “profitability ratios” because they compare various numbers (e.g., sales or assets) with the profit the company is generating. However, you can also measure success using “market ratios” such as overall market share or market capitalization that demonstrate how well the company is performing in the marketplace compared with its competitors.
Profitability Ratios
We know that a business exists to make a profit; so, profit is a very clear measure of success. However, what represents a “good” profit result or a “bad” profit result is a function of the type of business you are in. We balance other elements—such as sales or assets—against the profit number to give more information about the quality of the result for the business we are measuring.
In accounting, the word “return” means the company’s profit compared with another element of the company’s financial results. Below are the key profitability ratios and how to read them.
Return on Equity (ROE)
Profits ÷ Equity
Return on equity (ROE) compares the equity that the owners of the business have tied up in the business with its profit.
You’ll remember from our focus on the balance sheet that owners’ equity or net worth is common stock plus retained earnings—the accumulation of net profits over the years that were not paid back to the owners in dividends. To assess the return on that equity, we take net profit for the year and divide it by shareholders’ equity to get return on equity.
Return on Assets (ROA)
Profits ÷ Assets
Return on assets (ROA) gives us a different perspective on the company’s returns in relation to its assets. ROA is a way of looking at the stewardship of the company. It compares profit with the total assets of the business. We have a value for our assets—that is, how much we have tied up in the business. ROA tells us how much profit the managers of the business—the stewards of those assets—are able to make on those assets.
We calculate ROA by taking net profit and dividing it by the assets on the balance sheet. ROA is a vital measure for assessing the health of asset-heavy businesses with lots of money tied up in plant and equipment, raw materials, and inventory.
ROA is an excellent measure of both the effectiveness and efficiency of the operations side of the business. A high ratio indicates good utilization of company resources.
Return on Sales (ROS)
Profits ÷ Sales
Return on sales (ROS) compares profit with sales. ROS looks at the revenue or the sales dollars we’ve generated from our products and services to see what percentage of that goes all the way to the bottom line into net profit.
Think of ROS as an efficiency measure. It answers this question: Of every dollar that comes into the business, how many cents does the business get to keep? What percentage of your sales ends up in net profit?
For example, if the total sales for a business is $2 million and the profit is $200,000, we divide $200,000 into $2 million for an ROS of 10%, meaning 10 cents in every dollar is profit.
Is 10% ROS a good result or a poor result? That all depends on the type of industry and the type of company we are looking at. In a commodity business—like a supermarket, for example—ROS will be low because only a few cents from each item makes it into profit. These businesses focus on large volume sales, not profits on individual items to drive their profits. A 4% ROS for a supermarket, then, would be excellent. However, for a company in high tech electronics where volumes are low but the company makes a high margin on every sale, 4% would be a dismal ROS.
Asset Turnover
Sales ÷ Assets
Asset turnover compares sales with the company’s assets. Asset turnover doesn’t look directly at profit, but it implies something about profit. It is a measure of how effectively we’ve used our assets in generating revenue.
Asset turnover is calculated by taking sales for a given period divided by the asset base on the balance sheet. How often can your sales match the value of your assets in that period? How often can you make your assets earn their keep or how often have you “turned over” the value of your assets?
If, for example, you have assets of $1 million and your sales during the year are $1.5 million, then your asset turnover is 1.5, $1.5 million divided by $1 million.
Market Ratios
Market ratios assess a company’s health according to its stock price and other relationships in the stock market. These ratios, of course, are only relevant for publicly traded corporations, such as your Simulation company.
Earnings Per Share
Let’s start with earnings per share (EPS). EPS is reported for a publicly traded corporation every quarter and is viewed as a critical number in terms of assessing the value of a company’s stock.
EPS is calculated by taking net profit for the quarter or year in question and dividing it by the number of shares outstanding—or the number of shares held in the marketplace. Predictions over whether EPS will be up or down—higher or lower than estimated—have a great deal of immediate impact on stock price.
In some ways, that impact is misleading. Companies that show a profit can still become bankrupt if they don’t manage their cash flow, and EPS ignores how much cash a company has, or does not have, to run its operations.
As a qualifier, then, analysts and businesspeople will often discuss the “quality of earnings” to suggest their confidence that the profits reflected in the EPS will turn into cash. In this way, they are of higher quality than virtual or imagined profits created by accounting tricks.
Price to Earnings Ratio
The next market ratio is the price to earnings (P to E) ratio. P to E is calculated by taking the stock price at a given point in time and dividing it by earnings per share. This usually results in a large positive number. For example, the stock price might be 10 times the earnings per share or 20 times the earnings per share. This number is often referred to as the “multiple” instead of the P to E ratio—simply because it’s a multiple of EPS.
Managers will often discuss the relative size of their P to E ratio, at times bemoaning the fact that it’s too low: “Our stock price should be worth more than 10 times our earnings per share!” Unfortunately, while that may be the managers’ assessment, it’s not the market’s assessment.
On the other hand, sometimes you’ll hear analysts say that the P to E multiple is too high, suggesting overvaluation of stock on the market. A correction usually follows.
Dividend Yield
When a company pays a dividend, that dividend is often compared to the trading value of the stock price in the stock market in a ratio called the dividend yield. Dividend yield is calculated as the dividend divided by the stock price.
The dividend yield is the percentage of returns generated compared with the stock price. This is similar to the interest on your bank account. When you assess that interest, you compare it with the capital tied up in the account. The dividend yield tells you what your “interest” is on the money you have tied up in a stock.
Excerpt from pages 55-57 of Guest, W. (Ed.). (2019). Comprehensive Business Review: Concepts and Cases with Capstone® Business Simulation. Chicago, IL: Capsim Management Simulations, Inc.