Wednesday, June 29, 2011

Financial Ratio Tutorial: What finance ratios can tell you about a company’s performance and how that information would influence investing decisions?? Which financial-based guidelines that you should follow when selecting some companies to invest in?? (based on the annual report of Coca- Cola Enterprise and PepsiCo)

After analyzing the annual report of Coca- Cola Enterprise and PepsiCo I believe that both are able to pay their liabilities, however, the company better placed to pay the current liabilities is PepsiCo. After determining the current ratio, which is the short-term assets versus the short-term liabilities available on the balance sheet of both companies, I found the current ratio of 1,12 for Coca Cola in 2009 and 1,43 for PepsiCo (appendix 1). In theory the higher current ratio is the better positioned to pay current liabilities. In this case PepsiCo shows the higher ratio as you can see below:
However the current ratio is a function of many variables which affect liquidity differently for an accurate analysis of current liabilities it is important to consider the timing of both cash received and cash paid out (Walsh, 2010). A comparison of the long term liabilities shows that Coca Cola is also much more compromised for the future as you see at figure 1.2:


Coca-Cola Enterprise
Long-Term Debt Obligations 7,400
Debt, less current portion 7,891
Other Liabilities 5,591
Other long-term obligations 1,796
Deferred Income Taxes 659
Deferred cash receipts from the Coca-Cola Company 35
Total Liabilities 22,406
Noncurrent deferred income tax liabilities 1,224

total liabilities 15,534


We cannot ignore the effect of the inventory on the current assets, you can't pay bills with inventories; you pay bills with cash!( Then when you calculate the current ratio of both companies without the inventories (Figure 1.3) PepsiCo’s seemingly tight current position is, in effect, much more liquid because the other assets have quicker cash conversion.

We cannot
Coca-Cola Enterprise
Inventories 2,618
inventories 874
Total Current Assets 12,571
total current assets 5,170
Total current assets without inventories 9,953
total current assets without inventories 4,296
Total Current Liabilities 8,756
total current liabilities 4,588

*The numbers are expressed in millions.
            Cash held for short-term purposes comprise an ''inventory “of liquid funds, which, like a commodity inventory, is held to satisfy demands made on the firm in the normal course of business (Lemke, 1970). Since cash is the most liquid asset, we also should compare how much the cash represents of the total asset and in doing this we found that the PepsiCo, again has better conditions whereby 31% of all the current assets are money alternatively Coca-Cola holds only 20%, as you can see below:

Coca-Cola Enterprise
Cash and cash equivalents $3,943
Cash and cash equivalents $ 1,036
Total Current Assets 12,571

total current assets 5,170

*The numbers are expressed in millions.

The profitability ratios evaluate the ability of the company to generate revenues in excess of operating costs and other expenses, some accounts compare firm’s earnings with total sales or investments that might reveal the effectiveness of management in operating the business. (Kurtz, 2010). For example, we had calculated the return of assets and the return of equity of Coca-Cola and PepsiCo as you can see at appendix 1. The return of assets indicates how profitable a company is relative to its total assets. A company such as Coca Cola Enterprise might require big, expensive machinery or equipment to generate  profit because their return of asset is 4.5%. PepsiCo, on the other hand, seems to be very asset-light with the ROA about 15% (Appendix 1). In this case the Coca Cola ROA means that the company earned $ 0.045 for each asset and PepsiCo $0.15. According to Kennon (2011) as a general rule, anything below 5% is very asset-heavy (manufacturing, railroads), anything above 20% is asset-light (advertising firms, software companies), however in this comparison both companies are in the same business this difference in ROA appears to be a result of PepsiCo’s management doing a much better job than that of Coca-Cola. This should be welcome news to PepsiCo’s investors because it provides good earnings in relation to all of the resources it had at its disposal (the shareholders’ capital plus short and long-term borrowed funds). The ROA is one of the most stringent and demanding test of return which would influence shareholders investing decisions.
            The return on equity ratio (ROE) is another profitability ratio which is very important in measuring how much the shareholders have earned from their investment in the company. Basically, the equation divides the net income by the average shareholders' equity, the ROE tells common shareholders how effectively their money is being employed. ( While the higher ROE indicates a good investment it is important to be carefully with the number that has been used, a small equity base or small net income could produce a high ROE, the figure 2.1 illustrates this circumstance because the ROE of Coca- Cola is much better than the ROE of PepsiCo but the shareowners equity and the net income is much smaller than PepsiCo. The investing decision need to be interpreted in different contexts of the company's performance and some specific averages to enhance the interpretation of results more accurately.
Coca-Cola Enterprise
Average Shareholders’ Equity $14555.5
Average shareowners’ equity $414
Net income attributable $5,946
Net income $ 731

To satisfy the stockholder the company should have a good enough income to distribute to shareholders in the form of cash dividends. The dividend payout ratio is one of the financial ratios that are used to identify the percentage of earnings (net income) per common share allocated to paying cash dividends to shareholders. To find the dividend payout ratio, it is necessary to divide the dividends per common share by earnings per share, those are the numbers the company declares in the annual report. For example Coca Cola pay $0.30 in dividend per share in annual dividends and have $1.49 earnings per share and their DPR is 20.13%. In other hand, PepsiCo pay $0.45 dividend per share and their EPS is $3.77 then their DPR is 11.93%. However, the DPR does not mean that PepsiCo does not have good dividend, actually their dividend per share is bigger than Coca Cola but their earnings per share is much bigger which could mean that the is using most of the earnings to other things which are better for the company such as investing in operating assets which will assist in continued growth. Alternatively, Coca Cola may be in mature stage where there is little room for growth and paying higher dividends is the best use of profits.
            However some companies do not pay dividends, therefore, it is necessary to find other financial ratios to determine which company has the most satisfied stockholders. According to Investopedia the price/earnings ratio (P/E) is the best known of the investment valuation indicators; because even with some imperfections it is the most widely reported and used valuation by investment professionals and the investing public. Basically you have to divide the stock price per share by the Earnings per share the result means how much the investors would be paying for every dollar of the company’s earnings. A high P/E ratio is required to satisfy stockholders as this suggests that investors are can expect higher earnings growth in the future compared to the overall market. A  low P/E ratio suggests that investors should have more modest expectations for future growth compared to the market as a whole. Because this ratio uses the stock price per share make this ratio is more accurate with the real expectations of the investors in the market, also since the stock market is public and free the stock price per share is more difficult to be manipulated by the company.
The list of financial ratios that are useful indicators of a firm's performance and financial situation should consider the liquidity of the Company in this case I would use the quick ratio as a way to measure the liquidity that does not include inventory in the current asset as, after all, only money can pay the bills. In figure 1.3, Coca Cola can pay all the liabilities but PepsiCo can afford only 93% if we don’t consider the inventory. If the investment is long term, it would be good to check the Financial, unlike liquidity ratios that are concerned with short-term assets and liabilities, financial leverage ratios measure the extent to which the firm is using long term debt. Shown in the Appendix 1 Coca Cola has the higher ratio that means the company is taking greater risk which can be a problem in the long term, in other hand PepsiCo is using the strong equity position which provides less risk.
            After defining if the investment is for long or short term I would check the profitability ratios but in this case it is good to look not only at the ratios but also the numbers that compose the ratio. For example in Return on Assets, PepsiCo presents a higher return (Appendix 1) but on Return on Equity Coca Cola seems much better that is because one of the numbers that compose the equation as Total shareowners’ equity is too low, affecting the overall result. In this case is important to look at other ratios to understand better the whole scenario. Since both companies pay dividends Cash Flow Indicator Ratio will provide insight into the dividend policy of the firm and the prospects for future growth. In this case Coca Cola seems more positive and as having the better ratio as we see at Appendix 1, but we have to consider that dividend payout ratios vary widely among companies and also the factors which determine what the company is paying in dividend may change and might not be the same in the future.
            Lastly, it is important to consider the stock market. Today, most companies in America are listed in the New York Stock Exchange which is one of the oldest stock markets in the world (Kurtz, 2010). Accompanying the price and the variations of the stock price per share of the company that you are going to invest in, the stock market provided results are very accurate because you can see exactly how the company is performing in the market as seen through the eyes of many investors. For example you can access the information about PepsiCo and Coca Cola, from the online in real time and they will give the information as shown in Figure 4.1. Then using some investment valuation ratios you can evaluate how much the investors are paying for the performance of the company.

After all….which single piece of non-financial data is the most important to consider when making decisions about whether or not to invest in a company??
            I believe that the core management staff is vital for the company, of course there are other factors which also impact the performance of a company but the single piece of non-financial data is the most important is the core management. In the core management each one of the people creates value by given the directions for the company.
            People not only create value quickly but also sustain that value over time. Many companies believe that they are already addressing the challenge by investing heavily in updated technology, process reinvention, and systems engineering. Each of these can be necessary and effective investments and can indeed contribute to the successful implementation of strategies. However, without equal or greater attention to the people factors, these efforts to improve processes and technologies are, at best, insufficient, and at worst detrimental. Particularly in this economy, the managers play an important role in a company whose strategies shift rapidly by necessity and whose implementation effectivness can be the difference between profit, loss and—in the most dramatic cases—survival (Boswell, 2010).

Appendix 1: Table 1.0

Coca-Cola Enterprise



Liquidity measurement ratio:

·        Current Ratio:


Profitability indicator ratios

·        Return on assets


·        Return on Equity


Debt ratio:

·        Debt ratio


Operating performance ratio:

·        Fixed asset turnover ratio


Cash flow indicator ratio:

·        Dividend payout ratio


Investment valuation ratio:

·        Price / Earnings ratio


*The numbers are expressed in millions.

Boswell, Ed. MWorld, Winter2010. STRATEGIC SPEED Execution, Success, and the Importance of People. Vol. 9 Issue 4, p18-21, 4p Subjects: EMPLOYEES;       STRATEGIC planning; LEADERSHIP; BUSINESS planning; CORPORATE profits
Gill, Amarjit; Biger, Nahum; Tibrewal, Rajendra, 2010. Determinants of Dividend Payout        Ratios: Evidence from United States. Open Business Journal, 2010, Vol. 4, p8-14, 7p,        3 Charts Subjects: DIVIDENDS; MANUFACTURING industries; SERVICE           industries; RATIO analysis; PROFIT margins; SALES management; DEBT-to-equity          ratio; CASH flow; UNITED States
Kennon, Joshua  (2011). Return on Assets (ROA) .Investing Lesson 4 - Analyzing an Income   Statement . Source:          income-statement.htm
Kurtz, D. (2010 Update). Contemporary business: 2011 custom edition (13th ed.). Hoboken,
NJ:         John Wiley & Sons.

Lemke, Kenneth W..(1970)  The Evaluation of Liquidity: An Analytical Study. Journal of         Accounting Research, Spring70, Vol. 8 Issue 1, p47-77, 31p, 3 Charts, 6 Graphs
Walsh, Ciaran (2010). Key Management Ratios. “The 100+ ratios every managers need to         know”. Financial Times Series (FT).
Additional Source:
New York Stock Exchange. Source:

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