Financial Indicators That Can Be essay

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According to these analysts, "The implicit assumption underlying the price-to-earnings method is that the fair market value of the closely held business can be approximated from the market value of comparable publicly traded businesses. To implement this method, the valuator must be able to identify a set of presumed-to-be comparable publicly traded companies and obtain sufficient information on each to verify the extent of comparability from an economic, management, and financial perspective. No publicly traded company will be precisely comparable to the closely held business being valued, so informed judgment must be exercised" (p. 81). As a general rule, the smaller in size and the more limited the scope of activities of the business being valued, the less likely there will be a set of publicly traded companies that are comparable, or even a single comparable publicly traded company. Publicly traded companies are for the most part large, measured in terms of revenues or assets, and they are diversified across product lines (Link & Boger 1999).

Share price performance

This is a fundamental financial metric that is used in virtually any analysis of how well a company is performing in terms of producing value for its stakeholders. Normally, share price performance is evaluated over the course of one- or three-year periods (Dobbs & Koller 2000). In this regard, Dobbs and Koller (1998) report that, "Any performance measure must incorporate a company's share price performance. If they do nothing else, investors will look at how well a stock has performed for them" (p. 32). These analysts, though, also emphasize that it is foolhardy to take a single metric such as share price performance in isolation from other financial indicators in measuring a company's overall performance in the market in which it competes (Dobbs & Koller 1998). According to Dobbs and Koller, "A performance measure must do more than simply record how much a stock goes up (or down). It must cut through the noise of the market and provide an accurate picture of exactly how and why managers are creating value" (1998 p. 33). Despite these constraints, share price performance represents a useful gauge of a company's ability to provide returns to its investors. In this regard, Cheffins (1997) points out that, "The pay-offs associated with good share price performance are more complex with institutional investors than they are for private investors, but higher prices are good news for all concerned" (p. 630).

Section Two: Specific Financial Indicators Connected with Corporate Liquidity that are the Most Important Indicators for Surviving Financial Crises

Earnings before interest, taxes, depreciation, and amortization (EBITDA)

The usefulness of the EBITDA in gauging a company's performance and fiscal health depends on a number of factors, including who is conducting the analysis and for what purpose (Fields, 2002). The guidance provided by Fields (2002) indicates that, "The board of directors of the company, as well as security analysts and credit analysts, are concerned with the performance of the company as a whole. Therefore, the measure they use to evaluate company-wide performance will probably be net income. Increasingly, however, security analysts, who are concerned with the company's performance within the context of the stock market, are using EBITDA" (p. 94).

The reasons cited by many authorities for this increased emphasis on EBITDA relates to its ability to be combined with other financial indicators to produce insights that might not be otherwise possible (Hardwood et al. 1999). Indeed, according to Penman (2003), the EBITDA is "the premiere pro forma number" but it carries a number of inherent flaws that require care in its interpretation. For instance, Penman notes that, "EBITDA ignores depreciation in addition. Investment bankers like this number for their comparable analysis in IPOs, for they like to create IPO bubbles. EBITDA ignores a real cost. Factories rust and become obsolescent. Overcapacity in telecom networks is a cost" (p. 78). Moreover, there are some other constraints to the use of the EBITDA that must be taken into account. For example, Penwood emphasizes that the EBITDA was used by WorldCom with some infamous results:

EBITDA promotes substitution of capital for labor, creating excess capacity. EBITDA also provides incentives to capitalize expenses. WorldCom, while promoting EBITDA as the 'gauge of vigorous growth,' capitalized operating expenses in a $3.8 billion fraud exposed in 2002. By shifting the expenses to depreciation, these operating costs never affected the EBITDA on which we were asked to focus. Combine EBITDA with revenues recognized from (excess) capacity swaps and one has a telecom bubble going. But the bubble bursts" (p. 78).

Generally speaking, though, when used with care, there are some valuable applications for the EBITDA. For instance, according to Harwood et al. (1999), "Low ratios of EBITDA to interest payments indicate firms with high financial risk" (p. 104).

Gross profit margin (GPM)

A company's profit is expressed in terms of either the gross profit margin or the gross profit markup. According to McCalley (1992), "The gross profit margin (GPM) is derived by dividing the dollars ($) of gross profit (GP) per unit of sale by the unit of selling price (SP). GPM = GP $/unit + SP" (p. 40). In addition, the GPM for most products tend to vary over time such as from year to year or even from sale to sale (McCalley, 1992). The significance of the GPM will also be different for different types of products, but these differences are relative; for instance, a company may realize high profit on products such as heavy equipment while other companies such as pharmaceuticals will realize smaller profits on individual sales with the volume of sales therefore representing a key element in this analysis (McCalley, 1992).

Operating cash flow (also termed cash flow from operating activities)

Cash-flow statements differ from company to company, but most follow some standard practices that can be used to identify how much money is coming in and going out. According to Kremer and his associates (2000), not all of the cash inflows are traditionally located at the top of a cash-flow statement, but the statement is rather separated into three categories, each with its related inflows and outflows. As to operating cash flow, Kremer et al. report, "The first several lines on the statement reflect cash related to a business's operations. Collections is the top line and in ordinary circumstances represents a company's biggest inflow of cash. It is all the cash a business collects from outstanding receivables or from cash sales" (p. 43). These authors also note that, "Although the cash-flow statement has three categories, it really has only one bottom line, operating cash flow. Cash flow from operating activities, or operating cash flow, shows how much cash the company generated from operations" (Kremer et al. 2000, p. 44).

The importance and relevance of the operating cash flow will differ for creditors, potential investors and existing stakeholders, though. In this regard, Allen and Cote (2005) report that, "Investors' and creditors' differing goals offer initial clues to differences in their decision-making behavior. Investors are the residual owners and their returns are limited only by the opportunity set and managerial motivations. Thus, they place primary emphasis on profitability to signal whether their return expectations will be met. Operating cash flow and solvency are secondary concerns to investors" (p. 198). In addition, investors will look to the operating cash flow for corroboration with earnings predictions by companies they may be interested in as a potential investment. According to Quirin, O'Bryan and Wilcox (1999), "As discretionary accruals can be used to manipulate earnings information, investor reaction to the earnings signal may be dependent on the operating cash flow signal" (p. 3). By contrast, creditors analyze a company's operating cash flow to determine the company's ability to consistently generate cash flow from their ongoing business activities (Allen & Cote 2005). In this regard, these authors add that, "Creditors have a specific interest in operating cash flows because of the need to determine a firm's ability to repay loans. Given the risks they assume and the nature of their relationship with the firm, creditors are expected to incorporate cash flow information into their assessments of a borrower's creditworthiness" (Allen & Cote 2005, p. 199). In sum, the financial indicator represented by operating cash flow is a measure that can be used to analyze the consequences of a company's performance volatility (Sorensen 2002).

Interrelationship between financial indicators

Unfortunately for managers, it is impossible for even the savviest analyst to make any intelligent and informed decisions concerning a company's fiscal health and performance based on a single metric taken in isolation of a number of other financial indicators. In this regard, Dobbs and Koller (1998) emphasize that, "The analysis of corporate performance cannot be boiled down to a single number, although it can be a systematic and rigorous process. It should consider the financial market's assessment of a company, the company's underlying performance, and its expected future performance as reflected in its market value" (p. 33). According to Jablonsky and Barsky (2001), it is important to begin…[continue]

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