Question

Some of the factors we look for when evaluating competitive advantage is the financial performance of the firm. Most of the time, the focus is on stock price. That doesn’t tell much of a story about the performance of the firm. Instead, we need to examine Accounting Profitability. What are the ratios that need to be examined? What story do they tell us?

Answer 1

The focus on stock price for evaluating financial performance of a firm is not completely justified and stock price does not give a true picture. Stock prices are based on market sentiment and expected future performance of the company and overall performance of the sector in which the company operates. Along with stock price, accounting profitability must be studied.

Accounting profit = Total revenue - (Total fixed and variable costs + taxes)

Total revenue indicates the money earned, and costs and taxes indicate the money spent.

The various accounting ratios that need to be examined are:

• Liquidity ratios such as current ratio (Current assets/Current liabilities), Quick ratio (Quick assets/Current liablities), and Cash ratio ((Cash + marketable securities)/Current liabilities)
• Profitability ratios such as Gross profit margin ((Revenue – Cost of Goods Sold)/Revenue), Operating margin ((Gross Profits- Operating Expense)/Revenue), Profit margin ((Revenue – Operating expense + non-operating income-Interest Expense- Income taxes)/Revenue), and Earnings per share ((Net Income – Preferred Dividend)/Weighted Average Outstanding Shares).
• Leverage ratios such as Debt to equity ratio (Total debt/total equity), Debt to asset ratio (Total debt/total assets), and Interest coverage ratio (Earnings before interest and taxes/Interest Expense).
• Activity ratios such as Receivable ratio (Annual Sales Credit/Accounts Receivable), Inventory Turnover Ratio (Cost of Goods Sold/Average Inventory), and Asset turnover ratio (Net revenue/assets).

These ratios are calculated by taking values of different parameters directly from Balance sheet, Profit & Loss statement and Cash flow statement. Hence, these ratios give a detailed financial performance analysis and areas of shortfall of a company.