Predicting and Evaluating

a Firm’s Performance

E
V E R Y T H I N G I N T H E W O R L D is based on expectations about future
events and their results. The bridge between the uncertainty of the
future and the certainty of the past is a set of estimates generated
from past information and futuristic assumptions. Most business decisions
are based on this bridge, known as forecasting. The strength of this bridge is
dependent on the estimates made about future events, associated returns,
and risks. Past information that is available in annual reports, financial infor-
mation websites, media reports, statistical services, customers, and manage-
ment serves as the starting point for such analysis and interpretation. The
ability and capacity of a CFO to determine his future course of action and his
realistic goals are largely dependent on this assessment. In assessing the per-
formance of a firm or predicting its future, we need to make comparisons. Our
choice of actions would then be guided by what the firm perceives and what
it can achieve. In this chapter, we discuss the statements given in annual
reports and their evaluation techniques to develop and identify a firm’s goals
and constraints.
A firm’s and its CFO’s ability and capacity to undertake operational and
financial obligations that magnify the returns to achieve a strategic competitive
advantage can be realised once the relationship between futuristic goals and
constraints is established, using present and past financial and nonfinancial

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 2 ■ Predicting and Evaluating a Firm’s Performance

information. Outsiders can determine a firm’s long-term, strategic goals eas-

ily through annual reports. Tactical and operational goals are mentioned in
specific statements and in discussion with the respective heads of operational
wings. Firm-specific constraints and goals can be estimated by studying the
following statements:

■ Chairman’s statement
■ Director’s statement
■ CFO’s statement
■ Income statement
■ Balance sheet
■ Cash flow statement and funds flow statement
■ Significant accounting policies and notes to accounts

The rst three statements are forward-looking statements of the top man-
agement of a rm, namely, the chairman’s, director’s, and CFO’s statements.
This group strategically determines a rm’s future course of actions, which
in uences its operational and nancial capability. The strategic intent and
mission of a rm are known through its operational and nancial commit-
ments. Each statement highlights the rm’s achievements in the passing year,
its present commitments, its challenges, and also its future obligations. The
other three statements are the quantitative measure of the rm’s performance
in accounting terms. The notes to accounts is not a statement but informa-
tion on signi cant accounting policies that are followed by a rm to formu-
late the nancial statements. While we assess the accounting statements and
compare them with other statements over a period of time or inter- rm or
inter-industry, it is essential to understand these notes to account. Most off–
balance sheet entries and other window-dressing techniques used by manage-
ment are mentioned in this statement, which appear as an appendix to the
nancial statements. Among the window-dressing techniques, differences in a
rm’s statements from one period to another may be observed in depreciation
accounting, inventory valuation, risk hedging instrument valuation and use,
asset valuation, and estimations of translation loss or gain. Capital needs can
be easily identi ed and de ned by the strategic and accounting statements of
the rm. The rm’s prospects, the use of internal accruals, the issue of new
shares, bonus issues, stock splits, buybacks, the issue or redemption of any
loan, or any other source of funding that is used are all mentioned in statements
given by the top management. This qualitative information should be neither
ignored nor underestimated.
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 3 ■ Predicting and Evaluating a Firm’s Performance

An assessment of the three statements in this chapter yields the following

four items:

1. Strategic mission and vision of a firm.

2. Strategic intent and action of a firm.
3. Financial robustness indicators important to the firm and its decision
makers.
4. Firm’s focus areas to maintain strategic competitiveness.

For performance evaluation, the financial statements, such as the income

statement and the balance sheet, need to be assessed. They quantify the present
system of the financial workings of a firm; the past trends establish the support
and resistance levels for various items in the statement, and, furthermore, they
also establish the internal constraints of a firm.

INCOME STATEMENT

The analysis of the income statement should have the following four objectives:

1. Identification and knowledge of the trends in income.

2. Assessment of the factors that contribute to the revenue and expenses of a
firm.
3. Identification and selection of sensitivity variables.
4. Identification of the variable probability distributions and their impact in
generating different scenarios.

While evaluating the income statement, the following eight items are of
prime concern:

1. Turnover of a firm, gross and net sales, contributions of various products

and markets on sales, and identification of the areas of growth and develop-
ment or saturation.
2. Breakup of the cost structures, identifying what can be outsourced for
reduced cost advantage, hedging the risk against variable and volatile input
costs, and predicting the behaviour of costs.
3. Amounts spent on research and development, training personnel, and cor-
porate social responsibility measures.

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 Balance Sheet ■ 4

4. Depreciation and its accounting policies.

5. Inventory and its valuation policies.
6. Scope for improvement in margins.
7. Identification of non-normal costs or losses or gains.
8. Quality of earning with respect to stability and its origin.

BALANCE SHEET

An analysis of the balance sheet should focus on the following four items:

1. Capital structure. The level of debt in the capital structure and its impact
on the profitability of the firm. Retained earnings of the firm that support
the firm’s operational and financial obligations. Is there any redemption on
debt at the time of evaluation of a balance sheet? Are there any contingent
claims on the capital structure, such as convertibles, warrants, employee
stock option schemes, or bonus schemes, that can change the debt-to-
equity levels in the firm? How much do the contingent liabilities influence
or dilute the earnings of the firm?
2. Fixed assets. Changes in fixed asset levels that may increase the productive
capacity of the firm. Are there any changes in the fixed assets due to mere
revaluation of the asset values? Is there any capital work in progress that
should be converted into fixed assets in the future?
3. Working capital. Changes in the current assets, especially cash, debtors,
and inventory levels.
4. Investments. Liquidity and return on investments.

Balance sheets and income statements must be read with their respec-
tive schedules for further analysis and to break down the different items
that are present in the statement. A balance sheet would present only the
gross block, depreciation, and net block of assets. The schedule of fixed assets
would tell us about the purchase and sale of assets, the type of deprecia-
tion policy that is followed, and what the real change is in the net assets.
Similarly, the schedule of investments would guide us to determine whether
the firm was making speculative or long-term investments. Furthermore, the
schedule of current assets, especially investments and receivables, would
suggest whether changes in valuation or provisioning have had an effect
on profits.

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 5 ■ Predicting and Evaluating a Firm’s Performance

CASH FLOW STATEMENT

A cash flow statement bridges the gap between the income statement and
the balance sheet. The adequacy, sources, and use of cash by a firm can be
detected through this statement. The statement is divided into three parts:
cash from operating activities, cash from investing activities, and cash from
financing activities. The statement clearly shows how the previous year’s cash
balances changed this year by movement in any of the three activities. It is
a statement of liquidity that easily traces whether cash flow offers short- or
long-term stability.

FUNDS FLOW STATEMENT

A funds flow statement is divided into three parts: a change in working capital
statement, a profit-and-loss appropriation account, and a source and applica-
tion of funds statement. Long-term liabilities should fund fixed assets and the
permanent capital of the firm. Current liabilities should under normal circum-
stances fund current assets. Under no circumstances should long-term liabilities
be used to fund current liabilities. Fixed assets should not be sold to redeem
current or long-term liabilities. Trends in this statement would indicate the
movement in working capital levels, fixed asset acquisitions, and dividend
payments. They would also reflect how a firm intends to use its present profits.

SIGNIFICANT ACCOUNTING POLICIES

AND NOTES TO ACCOUNT

This is an important annexure that explains the balance sheet and the profit-
and-loss account. It can provide an explanation for the following eleven
items:

1. Employee benefits: Defined contribution plans, other long-term benefit

plans, short-term employee benefit plans.
2. Taxes on income: Current and deferred tax liabilities.
3. Information on operating leases, financial leases, and other derivative
instruments.
4. Capital commitments, provisions, contingent liabilities, and contingent
assets.

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 Ratio Analysis ■ 6

5. Borrowing costs for the acquisition of assets.

6. Stock-based compensation.
7. Government grants.
8. Research and development expenditure details.
9. Any impairment of assets.
10. Transactions with key management personnel and related party transac-
tions, especially subsidiaries.
11. Significant accounting changes or polices for valuing fixed and current assets,
investments, and inventories; any excess provisions made for bad debts. A
change in the valuation of the assets can be detected using the schedules and
the notes to account, to gain an understanding of the operations of the firm.

Once the firm is assessed in isolation for its qualitative and quantitative
goals, a decision maker must also attempt to review its performance with its
peers. Goals created in isolation, without keeping peer evaluations in mind,
can be highly unrealistic. Furthermore, increasingly conclusive goals can be
created with objective comparisons. A common technique for such an objective
and relative comparison is known as ratio analysis.

RATIO ANALYSIS

The ratio analysis can be grouped into five main types of ratios:

1. Profitability ratio.
2. Solvency ratio or debt management ratio.
3. Liquidity or working capital management ratio.
4. Activity or asset management ratio.
5. Market or security ratios.

The different ratios are given in Exhibit 3.3.

While analysing the statements and the ratios, one must also consider the
following five factors before using the trend analysis for forecasting:

1. Economic conditions within the economy and the industry.

2. Competitive and technological changes in the industry and the company.
3. Regulatory changes in the economy, in the industry, and, if any, specific to
the company.
4. Investment capacity and growing capacity of a firm.
5. Manpower conditions of a firm at all levels.

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 7 ■ Predicting and Evaluating a Firm’s Performance

EXHIBIT 3.3 Ratio Analysis

Ratio Formula for Calculation Remarks

Profitability Ratios

Gross Profit Margin Gross Profit/Net Sales Profit margin of a firm

before indirect expenses,
such as interest, other
administrative expenses,
depreciation, and taxes, are
provided for.
Net Profit Margin Earnings after Tax/Net Operating profit of a firm
Sales after providing for all
expenses.
Basic Earning Earnings before Interest Firm’s ability to earn profits
Power and Tax (EBIT)/Total before it provides for
Assets the financial charges and

Compare with Previous Years’ Ratios

government taxes.

Compare with Industry Average

Return on Total Earnings after Taxes/Total Firm’s return to the use of
Assets (ROA) Assets its assets.
Return on Common Earnings after Taxes/ Firm’s return to the use of its
Equity (ROE) Common Equity common equity.
Solvency or Debt Management Ratio

Debt-to-Equity Long-Term Debt/Total The use of loan funds

Ratio Equity against the firm’s own funds.
Times Interest EBIT/Interest Charges Number of times the
Earned Ratio earnings cover the interest
obligation.
Fixed Charge (EBIT + Lease Payment)/ Number of times the total
Coverage Ratio (Interest Charges + Lease earnings provide for the
Payments + Sinking Fund fixed obligations in the form
Payments/[1-Taxes]) of lease payments, debt
repayments, and interest
charges.
Liquidity or Working Capital Management Ratio

Current Ratio Current Asset/Current Ability of the organisation

Liabilities to meet its short-term
obligations.
Quick or Acid Test Current Asset-Inventories/ Highly liquid assets used to
Ratio Current Liabilities determine the ability of a
firm to meet its short-term
obligations.

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 Ratio Analysis ■ 8

EXHIBIT 3.3

Ratio Formula for Calculation Remarks

Activity or Asset Management Ratio

Inventory Turnover Sales/Average Inventory Average number of times a

Compare with Previous Years’ Ratios

Ratio year the stock changes.

Compare with Industry Average

Day Sales Receivables/(Annual Average number of days’
Outstanding Ratio Sales/360) credit is given to debtors.
(DSO)
Fixed Asset Sales/Net Fixed Assets Ability of a firm to generate
Turnover Ratio sales from its fixed assets.
Total Asset Sales/Total Assets Ability of a firm to generate
Turnover Ratio sales from its total assets.
Market or Security Ratio

Price/Earning Ratio Price per Share/Earnings Market price of a firm’s

per Share share to its given level of
earnings.
Market/Book Ratio Market Price per Share/ Confidence the public has in
Book Value per Share the firm’s earning capacity.

Another powerful tool that is used to assess a firm’s performance is the

Du Pont Chart Analysis or the Du Pont equation, which demonstrates the
relationship of how different assets are used to create value for the equity
shareholders in the form of return on equity. Exhibit 3.4 shows how the
current fixed assets, sales, and expenses contribute to the ROA and the ROE
of a firm. The chart also helps identify which factors would contribute at
what level.

Du Pont Equation

ROE = ROA × Equity multiplier

Net income/Common equity = Net income/Total assets
× Total assets/Common equity
The traditional ratio analysis mentioned above suffers from six problems.
They are:

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 9 ■ Predicting and Evaluating a Firm’s Performance

ROE

Equity Multiplier !
ROA Total Asset/
Common equity

Asset Turnover=
Net Profit Margin !
Sales/Total
Net Profit/ Sales
Assets

Sales Fixed Assets Current Assets

Net Incomes Cash Inventories Debtors

Total Sales-Total
Cost

EXHIBIT 3.4 Du Pont Chart Analysis

1. Ratio comparison between industries that are very different is not useful,
because the values generated do not convey meaningful results.
2. A balance sheet’s value on which ratio analysis is based prepared on a
historical cost basis and may not be a true presentation of the total assets
because of inflation.

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 Predicting Bankruptcy ■ 10

3. Seasonal factors may distort the ratio analysis, because the income state-
ment may not represent the holistic picture at different time periods.
4. Firms use window-dressing techniques of changing depreciation policies,
inventory valuations, and off–balance sheet items that distort the values in
the financial statements, making the ratio analysis less relevant.
5. Firms in different geographical regions may follow different accounting
policies, which makes them not comparable.
6. It is also difficult to estimate which ratio is good to predict the performance
of a firm, what weight should be assigned to each ratio for an evalua-
tor to see their overall impact on the performance evaluation, and how
this weight should be decided. Furthermore, traditional ratio analysis is
a univariate analysis that lacks the ability to predict the future of a com-
pany more objectively, because it identifies separate ratios and not their
interrelationships.

A firm’s overall performance and prediction of its financial strength can be

made using the Altman Z score, given next.

PREDICTING BANKRUPTCY

One of the most well-known models for predicting bankruptcies was given by
Edward I. Altman (1968), who developed the Z score to predict the performance
of a firm signaled out by four balance sheet and income statement ratios. The
Altman Z score could predict a firm’s performance with respect to bankruptcy.
In his original work on the model in 1968, he used 66 corporations, with a prior
grouping of 33 firms in each of the two groups: bankrupt and nonbankrupt.
The study covered the period from 1946 to 1965 (a twenty-year-period sample)
and examined a list of ratios in time period t in order to predict bankruptcy in
the other firms in the following period (t + 1). The firms were stratified on the
basis of industry and by size, with asset sizes that ranged between $1 million
and $25 million. A multidiscriminant function analysis was then used to reduce
the list of 22 potential variables to 5 that had the ability to predict corporate
bankruptcy. The model developed was as follows:

Z-Score Model
Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5

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 11 ■ Predicting and Evaluating a Firm’s Performance

Where
X1 = Working capital/total assets.
X2 = Retained earnings/total assets.
X3 = Earnings before interest and taxes/total assets.
X4 = Market value equity/book value of total liabilities.
X5 = Sales/total assets.
Z = Overall index or score.

Companies listed in the stock exchanges with a Z score of less than 1.81
were highly risky and likely to go bankrupt, companies with a score of more
than 2.99 were healthy, and scores between 1.81 and 2.99 were in a grey area
with uncertain results.
Used as a warning device, rather than a predictive tool, the model was
found to be descriptive, comparative, and not probabilistic.*
Altman revised his model in 1983, 1995, and 2002, to accommodate
privately listed firms, nonmanufacturing firms, and manufacturing firms in
developing countries.

Z Model for Privately Held Firms (Altman, 1983)

Z′ = 0.717X1 + 0.814X2 + 3.107X3 + 0.420X4 + 0.998X5
X4: Book value of equity/book value of total debt
Z < 1.23: The firm is bankrupt, and there are no errors in classification.
Z > 2.90: The firm is nonbankrupt, and there are no errors in classification.
Gray area between 1.23 and 2.90

Z Model for Nonmanufacturing Firms and Manufacturing Firms in

Developing Countries (Altman, Hartzell, and Peck, 1995)
Z″ = 6.56X1 + 3.26X2 + 6.72X3 + 1.05X4
X4: Book value of equity/book value of total debt

*See the article by Edward I. Altman, Danovi Alessandro, and Alberto Falini on “Z-SCORE Model
Application: Italian Companies Subject to Extraordinary Administration,” available at http://
people.stern.nyu.edu/ealtman/papers.html, for more detailed explanation; Edward I. Altman,
“Predicting Financial Distress of Companies: Revisiting the Z-Score and Zeta Models” in Handbook
of Research Methods and Applications in Empirical Finance, eds. A. R. Bell, C. Brooks, and M. Prokop-
czuk (Edward Elgar Publishing: Cheltenham Glos, UK, 2013); and E. I. Altman, J. Hartzell, and
M. Peck (1995), “Emerging Markets Corporate Bonds: A Scoring System,” available at http://pages
.stern.nyu.edu/~ealtman/Emerg_Mkt_Corporate_Bonds.pdf.

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 Summary ■ 12

In calculating the Z score, he further added an intercept of +3.25, which

would make the score 0. A Z score of zero would indicate default. The Z score
has been tested for several companies over many years. The score was found to
have better predictive power than most rating agencies when it was tested for
companies such as Enron and WorldCom. In cases where rating agencies were
positive until the end about the firms, two years prior to bankruptcy the score
showed them in the grey zone.
Since the model was developed for U.S. corporations, it was adapted for
emerging nations by the development of an emerging market score. The Alt-
man Z Score model was revised to create the Emerging Market Score (EMS)
model. The score requires the calculation of an average Z″ score for a specific
U.S. rating for firms in that specific rating class, then calculating Z″ scores for
firms in emerging markets, and comparing them with the earlier Z″ scores of
U.S. corporations. Next would be adjusting the firm’s riskiness based on its
open position of foreign debt and volatility in currency; the overall riskiness
of the firm; the dominance of the firm’s position in the industry; a special fea-
ture of the emerging market firm’s bond, such as collateral and bond guaran-
tors; and, finally, substituting the market value for equity for the book value
of equity. The scores for the emerging market firm’s bonds are then used to
predict bankruptcy.
A rating on S&P from AAA to BBB- has a emerging market score of >8.15
to 5.35, which is a safe zone; from BB+ to B+, with a score of 5.65 to 4.75,
comes within the grey zone; and from B to D, with a score of 4.5 and less than
< 7.5, would be in the default zone.

SUMMARY

To predict and evaluate a firm’s performance, an in-depth analysis is required

of the following statements: the chairman’s statement, the director’s statement,
the CFO’s statement, the balance sheet, the income statement, the cash flow
statement, the funds flow statement, and information on significant accounting
policies with notes to accounts. The first three are forward-looking statements
provided by the top decision makers of the firm. Given the scale of operations of
the firm, the decision-making power may be held by an individual or a group.
With the first three statements, a firm’s vision, mission, strategic intent, and focus
on strategic competitive areas can be identified. The four financial statements—
income, balance sheet, cash flow, and funds flow statements—identify the

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 13 ■ Predicting and Evaluating a Firm’s Performance

financial strengths and weaknesses of the firm. Forecasting the future perfor-
mance level of a firm can be done by using traditional ratio analysis, the Du Pont
Chart. The Altman Z score, Z′ and Z″ scores, and Emerging Market Scores are
discussed as models that are competent to predict corporate bankruptcy. Such
techniques predict the level of a firm’s performance vis-à-vis its peer groups,
other industrial groups, over time, and globally.

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