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Evaluating a Firm’s Financial Performance

Evaluating a Firm’s Financial Performance. Objectives. Why Financial Ratio Analysis What are the Five Categories How to compute Limitations. Why?. Are (should) our decisions (be) maximizing shareholder wealth?. Financial Ratios.

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Evaluating a Firm’s Financial Performance

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  1. Evaluating a Firm’s Financial Performance

  2. Objectives • Why Financial Ratio Analysis • What are the Five Categories • How to compute • Limitations

  3. Why? • Are (should) our decisions (be) maximizing shareholder wealth?

  4. 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 (benchmarks).

  5. Uses of Financial Ratios within the Firm • Identify deficiencies in a firm’s performance and take corrective actions. • Evaluate employees’ performance and determine incentive compensation. • Compare the financial performance of different divisions within the firm

  6. Uses of Financial Ratios within the Firm • Prepare financial projections, both at the firm and division levels. • Understand the financial performance of competitors • Evaluate the financial condition of a major supplier.

  7. Uses of Financial Ratios Outside the Firm • Lenders in deciding whether or not to make a loan to a company. • Credit-rating agencies in determining a firm’s credit worthiness. • Investors in deciding whether or not to invest in a company. • Major suppliers in deciding to sell and grant credit terms to a company.

  8. We will want to answer questions about the firm’s • 1. Liquidity • 2. Efficient use of Assets • 3. Leverage (financing) • 4. Profitability/Returns • 5. Shareholder Wealth

  9. Example:CyberDragon Corporation

  10. CyberDragon’s Balance Sheet ($000) 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 50,190Total current liabilities 25,523 Plant and equipment 43,100Long-term debt (bonds) 22,000 less accum deprec. 11,400Total 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 11,367 Total stockholders' equity 34,367 Total liabilities & equity 81,890

  11. JOIN KHALID AZIZ • ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. • FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. • COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. CONTACT: 0322-3385752 R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.

  12. CyberDragon’s Income Statement Sales (all credit)$112,760 Cost of Goods Sold (85,300) Gross Profit27,460 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)8,600 Taxes (3,344) Net Income5,016

  13. CyberDragonOther Information 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

  14. 1. Liquidity Ratios • Do we have enough liquid assets to meet approaching obligations?

  15. Current Ratio

  16. 50,190 25,523 = 1.97 What is CyberDragon’s Current Ratio? If the average current ratio for the industry is 2.4, is this good or not?

  17. Acid Test Ratio

  18. 50,190 - 27,530 25,523 = .89 What is the firm’s Acid Test Ratio? Suppose the industry average is .92. What does this tell us?

  19. Average Collection Period

  20. 18,320 112,760/365 = 59.3 days What is the firm’s Average Collection Period? If the industry average is 47 days, what does this tell us?

  21. Accounts Receivable Turnover

  22. 112,760 18,320 = 6.16 times What is the firm’s Accounts Receivable Turnover? CyberDragon turns their A/R over 6.16 times per year. The industry average is 8.2 times. Is this efficient?

  23. Inventory Turnover

  24. 85,300 27,530 = 3.10 times What is the firm’s Inventory Turnover? CyberDragon turns their inventory over 3.1 times per year. The industry average is 3.9 times. Is this efficient?

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

  26. 2. Operating Efficiency Ratios • Is management generating adequate operating profits on the firm’s assets?

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

  28. 11,520 81,890 = 14.07% 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.

  29. Operating Profit Margin

  30. 11,520 112,760 = 10.22% What is their Operating Profit Margin? • This is below the industry average of • 12%.

  31. Total Asset Turnover

  32. JOIN KHALID AZIZ • ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. • FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. • COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. CONTACT: 0322-3385752 R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.

  33. 112,760 81,890 = 1.38 times What is their Total Asset Turnover? The industry average is 1.82 times. The firm needs to figure out how to squeeze more sales dollars out of its assets.

  34. Fixed Asset Turnover

  35. 112,760 31,700 = 3.56 times What is the firm’s Fixed Asset Turnover? If the industry average is 4.6 times, what does this tell us about CyberDragon?

  36. Also consider:A/R RatiosInventory Ratios

  37. 3. Leverage Ratios/How Financing Assets? • Measure the impact of using debt capital to finance assets. • Firms use debt to lever (increase) returns on common equity.

  38. How does Leverage work? • Suppose we have an all equity-financed firm worth $100,000. Its earnings this year total $15,000. ROE = (ignore taxes for this example)

  39. How does Leverage work? • Suppose we have an all equity-financed firm worth $100,000. Its earnings this year total $15,000. ROE = = 15% 15,000 100,000

  40. How does Leverage work? • Suppose the same $100,000 firm is financed with half equity, and half 8% debt (bonds). Earnings are still $15,000 … less interest. ROE =

  41. How does Leverage work? • 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

  42. How does Leverage work? • Suppose the same $100,000 firm is financed with half equity, and half 8% debt (bonds). Earnings are still $15,000. ROE = = 22% 15,000 - 4,000 50,000

  43. Debt Ratio

  44. 47,523 81,890 = 58% What is CyberDragon’s Debt Ratio? If the industry average is 47%, what does this tell us? Can leverage make the firm more profitable? Can leverage make the firm riskier?

  45. Times Interest Earned Ratio

  46. 11,520 3,160 = 3.65 times What is the firm’s Times Interest Earned Ratio? The industry average is 6.7 times. This is further evidence that the firm uses more debt financing than average.

  47. 4. Return on (Common) Equity … also, Profitability Is management providing a good return on the capital provided by the shareholders?

  48. Return on (Common) Equity (ROE)

  49. 5,016 34,367 = 14.6% What is CyberDragon’sReturn on Equity (ROE)? The industry average is 17.54%.

  50. 5,016 34,367 = 14.6% What is CyberDragon’sReturn on Equity (ROE)? The industry average is 17.54%. Is this what we would expect, given the firm’s leverage?

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