CHAPTER-3
THEORETICAL FRAMEWORK
Financial performance:
Financial performance is a gauge of how effectively a company can utilize
resources from its main line of business and generate income. The phrase is
also used as a broad indicator of a company's long-term financial stability.
Financial performance is compared by analysts and investors between similar
companies in the same industry or between industries or sectors as a whole.
For internal users, financial performance is examined to determine their
respective companies' well-being and standing, among other benchmarks. For
external users, financial performance is analyzed to dictate potential
investment opportunities and to determine if a company is worth its while.
Financial statement analysis:
Financial statement analysis is a process conducted on organizations by
internal and external parties to gain a better understanding of how a company
is performing. The process consists of analyzing four critical financial
statements in a business.
1. Balance Sheet: In financial statement analysis, an organization's balance
sheet is looked at to determine the operational efficiency of a business.
2. Income Statement: In financial statement analysis, a business's income
statement is investigated to determine overall present and future profitability.
3. Cash Flow Statement: A cash flow statement is critical in a financial
statement analysis to identify where the money is generated and spent by the
organization.
4. Annual Report: The last statement, the annual report, provides qualitative
information which is useful to further analyze a company's overall operational
and financing activities.
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Measuring Financial Performance:
Through a financial performance analysis, specific financial formulas and
ratios are calculated, which, when compared to historical and industry
metrics, provide insight into a company's financial condition and
performance.
Financial ratio:
Financial ratios are basic calculations using quantitative data from a
company's financial statements. They are used to get insights and important
information on the company's performance, profitability, and financial health.
Common financial ratios come from a company's balance sheet, income
statement, and cash flow statement.
Businesses use financial ratios to determine liquidity, debt concentration,
growth, profitability, and market value.
Importance of financial ratio:
To measure return on capital investments.
To calculate profit margins.
To assess a company's efficiency and how costs are allocated.
To determine how much debt is used to finance operations.
To identify trends in profitability.
To manage working capital and short-term funding requirements.
• To identify operating bottlenecks and assess inventory management
systems.
To measure a company's ability to settle debt and liabilities.
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Essential financial ratio:
The common financial ratios every business should track are:
1. Liquidity ratio
2. Profitability ratio
3. Solvency ratio
4. Efficiency ratio
5. Debt coverage ratio
1. Liquidity ratio:
Companies use liquidity ratios to measure working capital performance -the
money available to meet your current, short-term obligations. Simply put,
companies need liquidity to pay their bills. Liquidity ratios measure a
company's capacity to meet its short-term obligations and are a vital indicator
of its financial health.
There are different forms of liquidity ratios.
Current ratio: Current Assets / Current Liabilities: The current ratio
measures how a business's current assets, such as cash, cash equivalents,
accounts receivable, and inventories, are used to settle current liabilities such
as accounts payable.
Quick ratio: current assets inventories/ current liabilities: Also known as the
acid-test ratio, the quick ratio measures how a business's more liquid assets,
such as cash, cash equivalents, and accounts receivable can cover current
liabilities. This ratio excludes inventories from current assets. A quick ratio
of 1 is considered the industry average.
2. Profitability ratio:
A business's profit is calculated as net sales and fewer expenses. Profitability
ratios measure how a company generates profits using available resources
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over a given period. Higher ratio results are often more favorable, but these
ratios provide much more information when compared to the results of similar
companies.
Some of the most common profitability ratios are:
Return on equity (ROE): Net income / Total equity: Shareholders' equity is
capital investments. The return on equity measures how much profit a
business generates from shareholders' equity.
Return on capital employed: Net operating profit/total assets-current
liability 100: A financial ratio that can be used to assess a company's
profitability and capital efficiency.
Net profit margin: Net profit / net sales 100: Profit margin is a measure of
profitability. It is calculated by finding the profit as a percentage of the
revenue.
3. Solvency ratio/leverage ratio;
Companies often use short and long-term debt to finance business
operations. Leverage ratios measure how much debt a company has. The
types of the leverage ratio to consider are:
Debt to equity ratio: Total Debt / Total Equity: The debt-to-equity ratio
measures a company's debt liability compared to shareholders' equity. This
ratio is important for investors because debt obligations are often prioritized
if a company goes bankrupt.
4. Efficiency ratio:
Efficiency ratios show how effectively a company uses working capital to
generate sales.
There are several ways to analyze efficiency ratios:
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Asset turnover ratio: Net sales / Average total assets: Companies use assets
to generate sales. The asset turnover ratio measures how much net sales are
made from average assets.
5. Debt coverage ratio
The debt service coverage ratio (DSCR) measures a company's ability to pay
its debts using its cash flow. It's calculated by dividing the company's net
operating income by its total debt service. The debt-service coverage ratio
(DSCR) measures a firm's available cash flow to pay its current debt
obligations. The DSCR shows investors and lenders whether a company has
enough income to pay its debts. The ratio is calculated by dividing net
operating income by debt service, including principal and interest.
Interest coverage ratio:-
The interest coverage ratio (ICR) is a financial metric that measures how well
a company can pay interest on its debt. It's also known as the "times
interest earned" ratio. It is a financial ratio that is used to determine how well
a company can pay the interest on its outstanding debts. The ICR is
commonly used by lenders, creditors, and investors to determine the
riskiness of lending capital to a company.
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