In this video, we walk through 5 FAR practice questions teaching about calculating performance metrics. These questions are from FAR content area 1 on the AICPA CPA exam blueprints: Financial Reporting.
The best way to use this video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.
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Calculating Performance Metrics
Performance metrics are essential tools for evaluating a company’s financial health and operational efficiency. Four key metrics—EBITDA, price-to-earnings (P/E) ratio, dividend payout ratio, and asset turnover ratio—provide insights into profitability, valuation, investor returns, and operational efficiency. Below is a detailed explanation of how to calculate each of these metrics, their purposes, and examples for each.
EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization)
EBITDA is calculated by subtracting all operating expenses (up to depreciation and amortization) from revenue. The formula is as follows:
EBITDA = Revenue – COGS – SG&A (before depreciation, amortization, interest, and taxes)
Purpose:
EBITDA measures a company’s operational profitability, focusing only on earnings from core business activities. It excludes non-operational expenses like interest and taxes, as well as non-cash expenses like depreciation and amortization. This metric helps investors and analysts assess the company’s ability to generate earnings without the impact of financing and accounting decisions.
Example:
Let’s say ABC Corp. has the following financial data:
- Revenue: $20,000,000
- Cost of Goods Sold (COGS): $9,000,000
- SG&A Expenses (Salaries, Marketing, Rent): $5,000,000
- Depreciation: $1,000,000
- Amortization: $500,000
EBITDA = $20,000,000 – $9,000,000 – $5,000,000 = $6,000,000
Price-to-Earnings (P/E) Ratio
The P/E ratio is calculated by dividing the current stock price by the company’s earnings per share (EPS). The formula is:
P/E Ratio = Stock Price / Earnings Per Share (EPS)
Remember, Earnings Per Share (EPS) = Net Income / Shares Outstanding
Purpose:
The P/E ratio helps investors understand how much they are paying for each dollar of a company’s earnings. A higher P/E ratio may indicate growth expectations, while a lower P/E ratio can signal the stock is undervalued or that earnings are high relative to the stock price. It’s a widely used tool for comparing companies within the same industry.
Example:
Consider XYZ Corp. with the following data:
- Net Income: $1,500,000
- Shares Outstanding: 500,000
- Stock Price: $60
First, calculate the EPS:
EPS = $1,500,000 / 500,000 = $3.00
Then, calculate the P/E Ratio:
P/E Ratio = $60 / $3.00 = 20
This means investors are willing to pay 20 times the company’s earnings for each share.
Dividend Payout Ratio
The dividend payout ratio is calculated by dividing the total dividends paid by the net income, then multiplying by 100 to express it as a percentage. The formula is:
Dividend Payout Ratio = (Dividends Paid / Net Income) × 100
Purpose:
The dividend payout ratio shows how much of a company’s net income is distributed to shareholders as dividends. A higher ratio means more profits are being paid out to shareholders, while a lower ratio indicates the company is reinvesting more back into the business for growth.
Example:
Imagine DEF Inc. has the following information:
- Net Income: $2,000,000
- Dividends Paid: $400,000
Dividend Payout Ratio = ($400,000 / $2,000,000) × 100 = 20%
This means DEF Inc. distributes 20% of its earnings to shareholders and reinvests the remaining 80% back into the business.
Asset Turnover Ratio
The asset turnover ratio is calculated by dividing total revenue by the average total assets. The formula is:
Asset Turnover Ratio = Revenue / Average Total Assets
Average Total Assets = (Beginning Assets + Ending Assets) / 2
Purpose:
The asset turnover ratio measures how efficiently a company uses its assets to generate revenue. A higher ratio indicates that the company is generating more sales per dollar of assets, which reflects better operational efficiency. A lower ratio may signal inefficiency in asset utilization.
Example:
Let’s look at GHI Manufacturing, which has the following data:
- Revenue: $12,000,000
- Beginning Assets: $4,000,000
- Ending Assets: $5,000,000
First, calculate Average Total Assets:
Average Total Assets = ($4,000,000 + $5,000,000) / 2 = $4,500,000
Then, calculate the Asset Turnover Ratio:
Asset Turnover Ratio = $12,000,000 / $4,500,000 = 2.67
This means GHI Manufacturing generates $2.67 in revenue for every dollar of assets it holds.
Summary:
- EBITDA: Measures operational profitability by excluding non-operational and non-cash expenses.
- P/E Ratio: Evaluates how much investors are paying for each dollar of earnings.
- Dividend Payout Ratio: Shows what percentage of net income is returned to shareholders as dividends.
- Asset Turnover Ratio: Assesses how efficiently a company uses its assets to generate revenue.
These metrics offer crucial insights into different aspects of a company’s financial performance, helping stakeholders make informed decisions.
