Slide 1

Evaluating a Firm’s Financial Performance Goals of evaluating firm performance: Are our decisions maximizing shareholder

wealth? We will want to answer questions about the firm’s

Liquidity Efficient use of Assets Leverage (financing) Profitability

Slide 2

Financial Ratios Tools that help us determine the financial health

of a company We can compare a company’s financial ratios

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

with those of its industry

Slide 3

Assets: Liabilities & Equity: Cash $2,540 Accounts payable 9,721 Marketable securities 1,800 Notes payable 8,500 Accounts receivable 18,320 Accrued taxes payable 3,200 Inventories 27,530 Other current liabilities 4,102 Total current assets 50,190 Total current liabilities 25,523 Plant and equipment 43,100 Long-term debt (bonds) 22,000 less accum deprec. 11,400 Total liabilities 47,523 Net plant & equip. 31,700 Common stock ($10 par) 13,000 Total assets 81,890 Paid in capital 10,000

Retained earnings 11,367Total stockholders' equity

34,367Total liabilities & equity 81,890

Dragon’s Balance Sheet

Slide 4

Sales (all credit) $112,760 Cost of Goods Sold (85,300) Gross Profit 27,460 Operating Expenses:

Selling (6,540) General & Administrative (9,400) Total Operating Expenses (15,940)

Earnings before interest and taxes (EBIT) 11,520 Interest charges:

Interest on bank notes: (850) Interest on bonds: (2,310) Total Interest charges (3,160)

Earnings before taxes (EBT) 8,360 Taxes (assume 40%) (3,344) Net Income 5,016

Dragon’s Income Statement

Slide 5

Dividends paid on common stock $2,800

Earnings retained in the firm 2,216

Shares outstanding (000) 1,300

Market price per share 20

Book value per share 26.44

Earnings per share 3.86

Dividends per share 2.15

Dragon (Other Information)

Slide 6

What is the firm’s Current Ratio? Do we have enough liquid assets to meet approaching

obligations?

If the average current ratio for the industry is 2.4, is this good or not?

97.1523,25

190,50

sLiabilitie Current

Assets CurrentRatio Current ===

1. Liquidity Ratios

Slide 7

What is the firm’s Acid-Test Ratio (Quick Ratio)?

Suppose the industry average is 0.92. What does this tell us?

89.0523,25

27,530-190,50Ratio (Quick)Test -Acid

sLiabilitieCurrent

sInventorie - AssetsCurrent Ratio (Quick)Test -Acid

1. Liquidity Ratios (Continued)

Slide 8

What is the firm’s Average Collection Period (ACP)?

If the industry average is 47 days, what does this tell us? Alternatively, we can calculate Average Collection Turnover

(Accounts Receivable Turnover (ART)) first as: (Industry average is 8.2 times)

Second, we convert the turnover into a period using 365 day/year:

days 3.59365/760,112

320,18

SalesCredit Daily

Receivable AccountsA CP

times 115.6320,18

760,112

Receivable Accounts

SalesTRA ===

days 3.59155.6

365

Turnover Receivable Accounts

365RPA ===

1. Liquidity Ratios (Continued)

Slide 9

What is the firm’s Accounts Payable Turnover (APT)?

Accounts Payable Period (APP)

times 78.8271,9

300,85

Payable Accounts

SoldGoods of CostPTA ===

days 57.4178.8

365

Turnover Payable Accounts

365PPA ===

1. Liquidity Ratios (Continued)

Slide 10

Measure how efficiently the firm’s assets generate operating profits

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

Slightly below the industry average of 15%. The OIROI reflects product pricing and the firm’s ability to keep costs down

Note: EBIT is Operating Income

%07.14100890,81

520,11

Assets Total

EBITOIROI =×==

2. Operating Efficiency Ratios

Slide 11

What is the firm’s Operating Profit Margin (OPM)?

Below the industry average of 12%

%22.10100760,112

520,11

Sales

(EBIT) Income OperatingOPM =×==

2. Operating Efficiency Ratios (Continued)

Slide 12

What is the firm’s Total Asset Turnover (TAT)?

The industry average is 1.82 times Total Asset Period (TAP):

The firm needs to figure out how to squeeze more sales dollars out of its assets

times 38.1890,81

760,112

Assets Total

SalesTAT ===

days 50.26438.1

365

Turnover Asset Total

365TAP ===

2. Operating Efficiency Ratios (Continued)

Slide 13

What is the firm’s Inventory Turnover?

Dragon turns their inventory over 3.1 times per year. The industry average is 3.9 times. Is this efficient? Inventory Period (IP) for the firm is:

times 10.3530,27

300,85

sInventorie

SoldGoods of CostTI ===

days 74.11710.3

365

TurnoverInventory

365PI ===

2. Operating Efficiency Ratios (Continued)

Slide 14

Low Inventory Turnover The firm may have too much inventory, which is

expensive because:

Inventory takes up costly warehouse space

Some items may become spoiled or obsolete

2. Operating Efficiency Ratios (Continued)

Slide 15

Cash Cycle = (Inventory Period + Receivables Period) – Payables Period

Cash Cycle = (117.74 + 59.30) – 41.57 = 135.47

2. Operating Efficiency Ratios (Continued)

Slide 16

What is the firm’s Fixed Asset Turnover (FAT)?

If the industry average is 4.6 times, what does this tell us about the firm?

Fixed Asset Period (FAP) for the firm is

times 56.3700,31

760,112

Assets Fixed Net

SalesFAT ===

days 53.10256.3

365

Turnover Asset Fixed

365PFA ===

2. Operating Efficiency Ratios (Continued)

Slide 17

Measure the impact of using debt capital to finance assets Firms use debt to lever (increase) returns on common equity How does Leverage work? Suppose we have an all equity-financed firm worth $100,000. Its

earnings this year total $15,000 ROE = 15,000 / 100,000 = 15% Suppose the same $100,000 firm is financed with half equity, and

half 8% debt (bonds). Earnings are still $15,000 ROE = (15,000 – 4,000) / 50,000 = 22%

3. Leverage Ratios (Financing Decisions)

Slide 18

If the industry average is 47%, what does this tell us? Can leverage make the firm more profitable? Can leverage make the firm riskier?

What is Dragon’s Debt Ratio?

%58100890,81

523,47

Assets Total

Debt TotalRatio Debt =×==

3. Leverage Ratios (Financing Decisions) (Continued)

Slide 19

The industry average is 6.7 times. This is further evidence that the firm uses more debt financing than average

What is Dragon’s Times Interest Earned Ratio (TIER)?

times 65.3160,3

520,11

Expense Interest

Income) (Operating EBITTIER ===

3. Leverage Ratios (Financing Decisions) (Continued)

Slide 20

The industry average is 17.54%. Is this what we would expect, given the firm’s leverage?

How well are the firm’s managers maximizing shareholder wealth?

%6.14100367,34

016,5

Equity Total

Income NetROE =×==

4. Return on Equity (ROE)

Slide 21

Even though Dragon has higher leverage than the industry average, they are much less efficient, and therefore, less profitable

Conclusion

Slide 22

Brings together: Profitability – measured by the Net Profit Margin (NPM)

Efficiency – measured by Total Asset Turnover (TAT)

Leverage – measured by Debt Ratio

%45.4100760,112

016,5

Sales

Income NetNPM =×==

times 38.1890,81

760,112

Assets Total

SalesTAT ===

%58100890,81

523,47

Assets Total

Debt TotalRatio Debt =×==

The DuPont Model

Slide 23Assets Total

Income NetAssets on Return

Assets Total

Sales

Sales

Income NetAssets on ReturnTATNPM

58%-1

4Equity on Return

Assets Total

Debt Total-1

Assets Total

Sales

Sales

Income Net

Equity on Return

DR-1

TATNPMEquity on Return

%6.1438.1%45.

The DuPont Model