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.