Evaluating a Firm’s Financial Performance

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

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

3. Dragon’s Balance Sheet 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 11,367 Total stockholders' equity 34,367 Total liabilities & equity 81,890

4. Dragon’s Income Statement 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

5. Dragon (Other 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

6. 1. Liquidity Ratios • 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?

7. 1. Liquidity Ratios (Continued) • What is the firm’s Acid-Test Ratio (Quick Ratio)? • Suppose the industry average is 0.92. What does this tell us?

8. 1. Liquidity Ratios (Continued) • 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:

9. 1. Liquidity Ratios (Continued) • What is the firm’s Accounts Payable Turnover (APT)? • Accounts Payable Period (APP)

10. 2. Operating Efficiency Ratios • 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

11. 2. Operating Efficiency Ratios (Continued) • What is the firm’s Operating Profit Margin (OPM)? • Below the industry average of 12%

12. 2. Operating Efficiency Ratios (Continued) • 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

13. 2. Operating Efficiency Ratios (Continued) • 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:

14. 2. Operating Efficiency Ratios (Continued) • 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

15. 2. Operating Efficiency Ratios (Continued) • Cash Cycle = (Inventory Period + Receivables Period) – Payables Period • Cash Cycle = (117.74 + 59.30) – 41.57 = 135.47

16. 2. Operating Efficiency Ratios (Continued) • 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

17. 3. Leverage Ratios (Financing Decisions) • 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%

18. 3. Leverage Ratios (Financing Decisions) (Continued) • What is Dragon’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?

19. 3. Leverage Ratios (Financing Decisions) (Continued) • What is Dragon’s Times Interest Earned Ratio (TIER)? • The industry average is 6.7 times. This is further evidence that the firm uses more debt financing than average

20. 4. Return on Equity (ROE) • How well are the firm’s managers maximizing shareholder wealth? • The industry average is 17.54%. Is this what we would expect, given the firm’s leverage?

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

22. The DuPont Model Brings together: • Profitability – measured by the Net Profit Margin (NPM) • Efficiency – measured by Total Asset Turnover (TAT) • Leverage – measured by Debt Ratio

23. The DuPont Model