-Chapter Four

Evaluating a Firm’s Financial Performance

Chapter 4

Keown, Martin, Petty - Chapter 44 - 2

Chapter Objectives

Why Financial Ratio AnalysisWhy Financial Ratio Analysis What are the Five CategoriesWhat are the Five Categories How to computeHow to compute LimitationsLimitations

Are (should) our decisions (be) Are (should) our decisions (be) maximizing shareholder wealth?maximizing shareholder wealth?

Financial Ratios

Tools that help us determine the Tools that help us determine the financial health of a company.financial health of a company.

We can compare a company’s We can compare a company’s financial ratios with its ratios in financial ratios with its ratios in previous years previous years (trend analysis).(trend analysis).

We can compare a company’s We can compare a company’s financial ratios with those of its financial ratios with those of its industry industry (benchmarks).(benchmarks).

Uses of Financial Ratios within the Firm

Identify deficiencies in a firm’s performance and Identify deficiencies in a firm’s performance and take corrective actions.take corrective actions.

Evaluate employees’ performance and determine Evaluate employees’ performance and determine incentive compensation.incentive compensation.

Compare the financial performance of different Compare the financial performance of different divisions within the firmdivisions within the firm

Uses of Financial Ratios within the Firm

Prepare financial projections, both at the Prepare financial projections, both at the firm and division levels.firm and division levels.

Understand the financial performance of Understand the financial performance of competitorscompetitors

Evaluate the financial condition of a major Evaluate the financial condition of a major supplier.supplier.

Uses of Financial Ratios Outside the Firm

Lenders in deciding whether or not to make a loan Lenders in deciding whether or not to make a loan to a company.to a company.

Credit-rating agencies in determining a firm’s Credit-rating agencies in determining a firm’s credit worthiness.credit worthiness.

Investors in deciding whether or not to invest in a Investors in deciding whether or not to invest in a company.company.

Major suppliers in deciding to sell and grant credit Major suppliers in deciding to sell and grant credit terms to a company.terms to a company.

We will want to answer We will want to answer questions about the firm’squestions about the firm’s

1. Liquidity1. Liquidity 2. Efficient use of Assets2. Efficient use of Assets 3. Leverage (financing)3. Leverage (financing) 4. Profitability/Returns4. Profitability/Returns 5. Shareholder Wealth5. Shareholder Wealth

Example:CyberDragon Corporation

CyberDragon’s Balance Sheet ($000)

Assets:Assets: Liabilities & Equity:Liabilities & Equity: CashCash $2,540$2,540 Accounts payableAccounts payable 9,7219,721

Marketable securitiesMarketable securities 1,8001,800 Notes payable Notes payable 8,5008,500

Accounts receivableAccounts receivable 18,32018,320 Accrued taxes payableAccrued taxes payable 3,2003,200

InventoriesInventories 27,53027,530 Other current liabilitiesOther current liabilities 4,1024,102

Total current assetsTotal current assets 50,19050,190 Total current liabilitiesTotal current liabilities 25,52325,523

Plant and equipmentPlant and equipment 43,10043,100 Long-term debt (bonds)Long-term debt (bonds) 22,00022,000

less accum deprec.less accum deprec. 11,40011,400 Total liabilitiesTotal liabilities 47,52347,523

Net plant & equip.Net plant & equip. 31,70031,700 Common stock ($10 par)Common stock ($10 par) 13,00013,000

Total assetsTotal assets 81,89081,890 Paid in capital Paid in capital 10,00010,000

Retained earningsRetained earnings 11,36711,367

Total stockholders' equity Total stockholders' equity 34,36734,367

Total liabilities & equityTotal liabilities & equity 81,89081,890

Sales (all credit)Sales (all credit) $112,760$112,760

Cost of Goods SoldCost of Goods Sold (85,300)(85,300)

Gross ProfitGross Profit 27,46027,460

Operating Expenses:Operating Expenses:

SellingSelling (6,540)(6,540)

General & AdministrativeGeneral & Administrative (9,400)(9,400)

Total Operating ExpensesTotal Operating Expenses (15,940)(15,940)

Earnings before interest and taxes (EBIT)Earnings before interest and taxes (EBIT) 11,52011,520

Interest charges:Interest charges:

Interest on bank notes:Interest on bank notes: (850)(850)

Interest on bonds:Interest on bonds: (2,310)(2,310)

Total Interest chargesTotal Interest charges ((3,160)3,160)

Earnings before taxes (EBT)Earnings before taxes (EBT) 8,6008,600

TaxesTaxes (3,344) (3,344)

Net IncomeNet Income 5,0165,016

CyberDragon’s Income Statement

CyberDragonOther Information

Dividends paid on common stockDividends paid on common stock$2,800$2,800

Earnings retained in the firmEarnings retained in the firm 2,2162,216

Shares outstanding (000)Shares outstanding (000) 1,3001,300

Market price per shareMarket price per share 2020

Book value per shareBook value per share 26.4426.44

Earnings per shareEarnings per share 3.863.86

Dividends per shareDividends per share 2.152.15

1. Liquidity Ratios

Do we have enough liquid assets Do we have enough liquid assets to meet approaching obligations?to meet approaching obligations?

Current RatioCurrent Ratio

sLiabilitieCurrent

AssetsCurrentRatioCurrent

What is CyberDragon’s Current Ratio?

If the average current ratio for the If the average current ratio for the industry is industry is 2.42.4, is this good or not?, is this good or not?

50,19025,523 = 1.97

Acid Test RatioAcid Test Ratio

sLiabilitieCurrent

sInventorieAssetsCurrent

RatioQuickRatioTestAcid

What is the firm’s Acid Test Ratio?

Suppose the industry average is Suppose the industry average is .92.92..What does this tell us?What does this tell us?

50,190 - 27,53025,523 = .89

Average Collection PeriodAverage Collection Period

SalesCreditDaily

ivableAccounts

PeriodCollectionAverage

What is the firm’s Average Collection Period?

If the industry average is If the industry average is 47 days47 days, , what does this tell us?what does this tell us?

18,320112,760/365 = 59.3 days

Accounts Receivable TurnoverAccounts Receivable Turnover

RecievableAccounts

SalesCredit

rTurnoveReceivableAccounts

What is the firm’s Accounts Receivable Turnover?

CyberDragon turns their A/R over CyberDragon turns their A/R over 6.166.16 times per year. The industry averagetimes per year. The industry average

is is 8.28.2 times. Is this efficient? times. Is this efficient?

112,76018,320 = 6.16 times

Inventory TurnoverInventory Turnover

Inventory

SoldGoodsofCost

TurnoverInventory

What is the firm’s Inventory Turnover?

CyberDragon turns their inventory CyberDragon turns their inventory over 3.1 times per year. over 3.1 times per year.

The industry average is The industry average is 3.93.9 times. times. Is this efficient?Is this efficient?

85,30027,530 = 3.10 times

Also … What is the firm’s “Inventory Holding Period” or “Days Sales In Inventory”

2. Operating Efficiency Ratios

Is management generating Is management generating adequate operating profits on the adequate operating profits on the firm’s assets?firm’s assets?

Operating Income Return on Operating Income Return on Investment (OIROI) … also known Investment (OIROI) … also known as Operating Return on Assets as Operating Return on Assets (OROA)(OROA)

AssetsTotal

IncomeOperatingOIROI

•Slightly below the industry Slightly below the industry average of average of 15%15%. .

•The OIROI reflects product The OIROI reflects product pricing and the firm’s ability to pricing and the firm’s ability to

keep costs down.keep costs down.

What is the firm’s Operating Income Return on Investment (OIROI)?

11,52081,890

= 14.07%

Operating Profit MarginOperating Profit Margin

IncomeOperating

nMargiProfitOperating

What is their Operating Profit Margin?

•This is below the industry average of This is below the industry average of 12%12%..

11,520112,760 = 10.22%

Total Asset TurnoverTotal Asset Turnover

AssetsTotal

TurnoverAssetTotal

What is their Total Asset Turnover?

The industry average is The industry average is 1.82 times1.82 times. . The firm needs to figure out how to The firm needs to figure out how to squeeze more sales dollars out of its squeeze more sales dollars out of its

assets.assets.

112,76081,890 = 1.38 times

Fixed Asset TurnoverFixed Asset Turnover

AssetsFixedNet

SalesTurnoverAssetFixed

What is the firm’s Fixed Asset Turnover?

If the industry average is If the industry average is 4.64.6 times, what times, whatdoes this tell us about CyberDragon?does this tell us about CyberDragon?

112,76031,700 = 3.56 times

Also consider:

A/R Ratios

Inventory Ratios

3. Leverage Ratios/How Financing Assets?

Measure the Measure the impact of using debt impact of using debt capitalcapital to finance assets. to finance assets.

Firms use debt to lever (increase) Firms use debt to lever (increase) returns on common equity.returns on common equity.

How does Leverage work?

Suppose we have an all equity-Suppose we have an all equity-financed firm worth $100,000. Its financed firm worth $100,000. Its earnings this year total $15,000.earnings this year total $15,000.

ROE =ROE =

(ignore taxes for this example)(ignore taxes for this example)

Suppose we have an all equity-Suppose we have an all equity-financed firm worth $100,000. Its financed firm worth $100,000. Its earnings this year total $15,000.earnings this year total $15,000.

ROE = = 15%ROE = = 15%15,000100,000

Suppose the same $100,000 firm is Suppose the same $100,000 firm is financed with half equity, and half financed with half equity, and half 8% debt (bonds). Earnings are still 8% debt (bonds). Earnings are still $15,000 … $15,000 … less interestless interest..

ROE =ROE =

Suppose the same $100,000 firm is Suppose the same $100,000 firm is financed with half equity, and half financed with half equity, and half 8% debt (bonds). Earnings are still 8% debt (bonds). Earnings are still $15,000.$15,000.

ROE =ROE = ==15,000 - 4,00050,000

Suppose the same $100,000 firm is Suppose the same $100,000 firm is financed with half equity, and half financed with half equity, and half 8% debt (bonds). Earnings are still 8% debt (bonds). Earnings are still $15,000.$15,000.

ROE =ROE = = = 22%22%

15,000 - 4,00050,000

Debt RatioDebt Ratio

AssetsTotal

DebtTotalRatioDebt

What is CyberDragon’s Debt Ratio?

47,52381,890 = 58%

If the industry average is If the industry average is 47%47%, what, whatdoes this tell us?does this tell us?

Can leverage make the firm Can leverage make the firm more more profitableprofitable??

Can leverage make the firm Can leverage make the firm riskierriskier??

Times Interest Earned RatioTimes Interest Earned Ratio

Interest

IncomeOperating

EarnedInterestTimes

What is the firm’s Times Interest Earned Ratio?

The industry average is The industry average is 6.76.7 times. This times. This is further evidence that the firm usesis further evidence that the firm uses

more debt financing than average.more debt financing than average.

11,5203,160 = 3.65 times

4. Return on (Common) Equity … also, Profitability

Is management providing a good Is management providing a good return on the capital provided by the return on the capital provided by the shareholders?shareholders?

Return on (Common) Equity (ROE)Return on (Common) Equity (ROE)

EquityCommon

IncomeNetROE

What is CyberDragon’sReturn on Equity (ROE)?

The industry average is The industry average is 17.54%17.54%..

5,01634,367 = 14.6%

What is CyberDragon’sReturn on Equity (ROE)?

5,01634,367 = 14.6%

The industry average is The industry average is 17.54%17.54%..Is this what we would expect, Is this what we would expect,

given the firm’s leverage?given the firm’s leverage?

5. Is Management Creating Shareholder Value?

These ratios indicate what investors think of These ratios indicate what investors think of management’s past performance and future management’s past performance and future prospects.prospects.

Price/Earnings ratioPrice/Earnings ratio Price/Book ratioPrice/Book ratio

What is CyberDragon’sPrice/Earnings (P/E) Ratio?

203.86 = 5.18

What is CyberDragon’sPrice/Book Ratio?

2026.44 = .76

5. Is Management Creating Shareholder Value? … Cont.

Economic Value Added (EVA) … Based on Economic Value Added (EVA) … Based on “economic profit” “economic profit” notnot “accounting profit” “accounting profit”

Economic Value Added (EVA)

How is shareholder value created? How is shareholder value created?

If the firm earns a return on capital that is greater than the investors’ If the firm earns a return on capital that is greater than the investors’ required rate of return.required rate of return.

EVA attempts to measure a firm’s economic profit, rather than EVA attempts to measure a firm’s economic profit, rather than accounting profit.accounting profit.

EVA recognizes a cost of equity in addition to the cost of debt EVA recognizes a cost of equity in addition to the cost of debt (interest expense).(interest expense).

EVA: Formula

EVA = (r-k) X AEVA = (r-k) X A

where: where:

r = Operating return on assetsr = Operating return on assets

k = Total cost of capitalk = Total cost of capital

A = Amount of capital (or Total Assets)A = Amount of capital (or Total Assets)

EVA Example

A firm has total assets of $5,000 and has raised money A firm has total assets of $5,000 and has raised money from both debt and equity in equal proportion. Further, from both debt and equity in equal proportion. Further, assume that cost of debt is 8% and the cost of equity is assume that cost of debt is 8% and the cost of equity is 16%. Assume the firm earns 17% operating income on its 16%. Assume the firm earns 17% operating income on its investments.investments.

EVA = (17%-12%)* $5,000 = EVA = (17%-12%)* $5,000 = $250$250

Where, cost of capital Where, cost of capital

= .5*(8%) + .5*(16%) = 12%= .5*(8%) + .5*(16%) = 12%

Conclusion:

Even though CyberDragon has Even though CyberDragon has higher leverage than the industry higher leverage than the industry

average, they are average, they are much less much less efficientefficient, and therefore, less , and therefore, less

profitable.profitable.

Limitations of Ratio Analysis

It is difficult to tell whether company is, on balance, in a strong or It is difficult to tell whether company is, on balance, in a strong or weak position.weak position.

Inflation and seasonal factors may distort ratios.Inflation and seasonal factors may distort ratios. Different operating and accounting practices may distort Different operating and accounting practices may distort

comparisons.comparisons. ““Window dressing” techniques can make ratios look better than Window dressing” techniques can make ratios look better than

they actually are.they actually are. ““Average” performance is not necessarily good.Average” performance is not necessarily good. Sometimes it is hard to tell if a ratio is “good” or “bad”.Sometimes it is hard to tell if a ratio is “good” or “bad”. Difficulty in identifying industry categories or finding peers.Difficulty in identifying industry categories or finding peers. Published peer group or industry averages are only Published peer group or industry averages are only

approximations.approximations.

-Chapter Four

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