Chapter 4Chapter 4

Evaluating a Firm’s Financial Evaluating a Firm’s Financial PerformancePerformance

Chapter ObjectivesChapter Objectives

Financial Ratio AnalysisDupont AnalysisLimitations of Ratio AnalysisFirm Performance and Shareholder Value

Financial RatiosFinancial Ratios

Accounting data stated in relative terms

Financial RatiosFinancial Ratios

Help identify financial strengths and weaknesses of a company by examining:– Trends across time– Comparisons with other firms’ ratios

Financial RatiosFinancial Ratios

Examine:How liquid is a firm?Is management generating adequate

operating profits on the firm’s assets?How is the firm financing its assets?Is management providing a good return on

the capital provided by the shareholder?

How liquid is a firm?How liquid is a firm?

Liquidity is the ability to meet maturing debt obligations

Measured by two approaches:– Comparing cash and assets that can be

converted into cash within the year with liabilities that are coming due within the year

– Examines the firm’s ability to convert accounts receivables and inventory into cash on a timely basis

Measuring Liquidity: Measuring Liquidity: Approach 1Approach 1

Compare a firm’s current assets with current liabilities– Current Ratio– Acid Test or Quick Ratio

Current RatioCurrent Ratio

Compares cash and current assets that should be converted into cash during the year with the liabilities that should be paid within the year

Current Assets / Current liabilities

Acid Test or Quick RatioAcid Test or Quick Ratio

Compares cash and current assets (minus inventory) that should be converted into cash during the year with the liabilities that should be paid within the year.

More restrictive than the current ratio because it eliminates inventories

(Current assets – inventory) / Current liabilities

X CompanyX CompanyBalance SheetBalance Sheet

Assets Cash $75 Accounts Rec. $150 Inventory $175 Equip/Bldg $1,200 Acc Dep <$100> Total Assets $1,500

Liabilities and O.E. Accounts Pay $600 L-Term Debt $500 Total Liabilities $1100

Owner’s Equity Common Stk $200 Retained Earn. $200 Total O.E. $400 Total L + OE $1,500

X CompanyX CompanyIncome StatementIncome Statement

Sales (All Credit) $2,000 Cost of Goods Sold $1,200 Gross Profits $800 Marketing and Admin $80 Depreciation $70 Total Operating Exp $150 Operating Profits $650

(EBIT or Operating Income) Interest Expense $50 Income Before Taxes $600 Taxes $100 Net Income $500

X Company Ratio AnalysisX Company Ratio Analysis

Current Ratio

current assets/current liabilities

400/600 = .667Acid-Test Ratio

(Current assets – inventory) / current liabilities

(400 – 150) / 600 = .416

Measuring Liquidity:Measuring Liquidity:Approach 2Approach 2

Measures a firm’s ability to convert accounts receivable and inventory into cash

Average Collection Period

Accounts Receivable Turnover

Inventory Turnover

Cash Conversion Cycle

Average Collection PeriodAverage Collection Period

The conversion of accounts receivable into cash, is measured by calculating how long it takes to collect the firm’s receivables

Accounts Receivable / Daily Credit Sales

X Company Ratio AnalysisX Company Ratio Analysis

Average Collection Period150 / (2,000 / 365) = 27.38Accounts Receivable Turnover2,000 / 150 = 13.33Inventory Turnover1,200 / 175 = 6.86

Accounts Receivable Accounts Receivable TurnoverTurnover

How many times accounts receivable are “rolled over” during a year

Credit Sales / Accounts Receivable

Inventory TurnoverInventory Turnover

How many times is inventory rolled over during the year?

Cost of Goods Sold / Inventory

Cash Conversion CycleCash Conversion Cycle

Sum of the days of sales outstanding (average collection period) and days of sales in inventory less the days of payables outstanding.

Cash Days of Days of Days of

Conversion = Sales + Sales in - Payables

Cycle Outstanding InventoryOutstanding

Days of Sales OutstandingDays of Sales Outstanding

Average Collection PeriodAccounts Receivable / (Sales / 365)

Days of Sales In InventoryDays of Sales In Inventory

Average age of the inventory or average number of days that a dollar of inventory is held by the firm

Inventory / (Cost of Goods Sold / 365)

Days of Payables OutstandingDays of Payables Outstanding

Average age in days of the firm’s accounts payable

Accounts Payable / (Cost of Goods Sold /365)

Cash Conversion CycleCash Conversion Cycle for X Company for X Company

Days of Accts Rec 150

Sales = (Sales/365) = (2000/365) =

Outstanding

27.37

Days of Inventory 175

Sales In = (Cost of Goods Sold/ = (1200/365)=

Inventory 365)

53.23

Days of

Payables = Accts Payable 600

Outstanding (Cost of Goods Sold/ = (1200/365) =

365)

182.50

Is Management Generating Is Management Generating Adequate Operating Profits on Adequate Operating Profits on

the Firm’s Assets?the Firm’s Assets?

Operating Income Return on Investment (OIROIO)

Operating Profit MarginTotal Asset TurnoverFixed Asset TurnoverReturn on Assets

Operating Income Return on Operating Income Return on InvestmentInvestment

Level of profits relative to the assets or

Income generated per $1 of assets

OIROI = Operating Income/Total Assetsor

OIROI = Operating Profit MarginX

Total Asset Turnover

Operating Profit MarginOperating Profit Margin

Examines operating profitability Operating Income / Sales

Total Asset TurnoverTotal Asset Turnover

How efficiently a firm is using its assets in generating sales

Measures the dollar sales per $1 of Assets

Sales / Total Assets

Fixed Asset TurnoverFixed Asset Turnover

Examines investment in fixed assets for sales being produced

Measures the dollar sales per $1 of fixed assets

Sales / Fixed Assets

Alternate OIROIAlternate OIROI

OIROI = Operating Profit Margin X

Total Asset Turnover

OIROI = Operating Income Sales

Sales X Total Assets

Return on AssetsReturn on Assets

ROA = Net Income / Total Assets

X Company Ratio AnalysisX Company Ratio Analysis

OIROI 650 / 1500 = .433Operating Profit Margin 650 / 2000 = .3250Total Asset Turnover 2000 / 1500 = 1.333Fixed Asset Turnover 2000 / 1100 = 1.82Alternate OIROI 650 X 2000 = .433

2000 1500

ROA 500 / 1500 = .333

How is the Firm Financing Its How is the Firm Financing Its Assets?Assets?

Does the firm finance assets more by debt of equity?

Debt RatioTimes Interest Earned

Debt RatioDebt Ratio

What percentage of the firm’s assets are financed by debt?

Total Debt / Total Assets

Times Interest EarnedTimes Interest Earned

Examines the amount of operating income available to service interest payments

orThe number of times the firm is earning or

covering its interest paymentsOperating Income / Interest

X Company Ratio AnalysisX Company Ratio Analysis

Debt Ratio 1100 / 1500 = 73.33%

Times Interest Earned

650 / 50 = 13

Is Management Providing a Is Management Providing a Good Return on the Capital Good Return on the Capital

Provided by the Provided by the Shareholders?Shareholders?

Return on Common Equity

Return on Common EquityReturn on Common Equity

Accounting Return on the common stockholders’ investment

Net Income / Common Equity

X Company Ratio AnalysisX Company Ratio Analysis

Return on common equity

Net Income / Common Equity

500 / 400 = 1.25 or 125%

DuPont AnalysisDuPont AnalysisAn alternative method to analyze a firm’s

profitability and return on equity

Allows management to see more clearly what drives return on equity and the inter-relationships among: net profit margin, asset turnover, and common equity ratio.

Return onCommon = ROA / Common Equity Equity Total Assets

ROAROAAlternative CalculationAlternative Calculation

ROA = Net Income / Total Assets

or

Net Profit Margin X Total Asset

Turnover

(Net Income X (Sales

Sales) Total Assets)

DuPont EquationDuPont Equation

Net Income X Sales / Cmn Eqty

Sales Ttl Asts Ttl Asts

500/2000 X 2000/1500 / 400/1500

( .25 X 1.33 ) / .267 = 1.245

Limitations of Ratio AnalysisLimitations of Ratio Analysis

Difficulty in identifying industry categories or finding peers

Published peer group or industry averages are only approximations

Accounting practices differ among firms Financial ratios can be too high or too low Industry averages may not provide a desirable target

ratio or norm Use of average account balances to offset effects of

seasonality

Economic Value Added (EVA)Economic Value Added (EVA)

Measures a firm’s economic profit, rather than accounting profit

Recognizes a cost of equity and a cost of debt EVA = (r-k) X C

where:

r = Operating income return on invested capital

k = Total cost of capital

C = Amount of capital (Total Assets) invested in the firm