Chapter 4

1. Chapter 4

2. Evaluating a Firm’s Financial Performance

3. Chapter Objectives • Financial Ratio Analysis • Dupont Analysis • Limitations of Ratio Analysis • Firm Performance and Shareholder Value

4. Financial Ratios • Accounting data stated in relative terms

5. Financial Ratios • Help identify financial strengths and weaknesses of a company by examining: • Trends across time • Comparisons with other firms’ ratios

6. Financial 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?

7. 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

8. Measuring Liquidity: Approach 1 • Compare a firm’s current assets with current liabilities • Current Ratio • Acid Test or Quick Ratio

9. Current 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

10. Acid 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

11. 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 CompanyBalance Sheet

12. X CompanyIncome 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

13. X Company Ratio Analysis • Current Ratio current assets/current liabilities 400/600 = .667 • Acid-Test Ratio (Current assets – inventory) / current liabilities (400 – 150) / 600 = .416

14. Measuring Liquidity:Approach 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

15. Average 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

16. X Company Ratio Analysis • Average Collection Period • 150 / (2,000 / 365) = 27.38 • Accounts Receivable Turnover • 2,000 / 150 = 13.33 • Inventory Turnover • 1,200 / 175 = 6.86

17. Accounts Receivable Turnover • How many times accounts receivable are “rolled over” during a year • Credit Sales / Accounts Receivable

18. Inventory Turnover • How many times is inventory rolled over during the year? • Cost of Goods Sold / Inventory

19. Cash 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 Inventory Outstanding

20. Days of Sales Outstanding • Average Collection Period • Accounts Receivable / (Sales / 365)

21. Days 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)

22. Days of Payables Outstanding • Average age in days of the firm’s accounts payable • Accounts Payable / (Cost of Goods Sold /365)

23. Cash Conversion Cycle for X Company Days of Accts Rec150 Sales = (Sales/365) = (2000/365) = Outstanding 27.37 Days of Inventory175 Sales In = (Cost of Goods Sold/ = (1200/365) = Inventory 365) 53.23 Days of Payables = Accts Payable600 Outstanding (Cost of Goods Sold/ = (1200/365) = 365) 182.50

24. Is Management Generating Adequate Operating Profits on the Firm’s Assets? • Operating Income Return on Investment (OIROIO) • Operating Profit Margin • Total Asset Turnover • Fixed Asset Turnover • Return on Assets

25. Operating Income Return on Investment • Level of profits relative to the assets or • Income generated per $1 of assets • OIROI = Operating Income/Total Assets or • OIROI = Operating Profit Margin X Total Asset Turnover

26. Operating Profit Margin • Examines operating profitability • Operating Income / Sales

27. Total Asset Turnover • How efficiently a firm is using its assets in generating sales • Measures the dollar sales per $1 of Assets • Sales / Total Assets

28. Fixed Asset Turnover • Examines investment in fixed assets for sales being produced • Measures the dollar sales per $1 of fixed assets • Sales / Fixed Assets

29. Alternate OIROI • OIROI = Operating Profit Margin X Total Asset Turnover OIROI = Operating IncomeSales Sales X Total Assets

30. Return on Assets • ROA = Net Income / Total Assets

31. X Company Ratio Analysis • OIROI 650 / 1500 = .433 • Operating Profit Margin 650 / 2000 = .3250 • Total Asset Turnover 2000 / 1500 = 1.333 • Fixed Asset Turnover 2000 / 1100 = 1.82 • Alternate OIROI 650 X 2000 = .433 2000 1500 • ROA 500 / 1500 = .333

32. How is the Firm Financing Its Assets? • Does the firm finance assets more by debt of equity? • Debt Ratio • Times Interest Earned

33. Debt Ratio • What percentage of the firm’s assets are financed by debt? • Total Debt / Total Assets

34. Times Interest Earned • Examines the amount of operating income available to service interest payments or • The number of times the firm is earning or covering its interest payments • Operating Income / Interest

35. X Company Ratio Analysis • Debt Ratio 1100 / 1500 = 73.33% • Times Interest Earned 650 / 50 = 13

36. Is Management Providing a Good Return on the Capital Provided by the Shareholders? • Return on Common Equity

37. Return on Common Equity • Accounting Return on the common stockholders’ investment • Net Income / Common Equity

38. X Company Ratio Analysis • Return on common equity Net Income / Common Equity 500 / 400 = 1.25 or 125%

39. DuPont Analysis • An 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 on Common = ROA / Common Equity Equity Total Assets

40. ROAAlternative Calculation • ROA = Net Income / Total Assets or Net Profit Margin X Total Asset Turnover (Net Income X (Sales Sales) Total Assets)

41. DuPont 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

42. Limitations 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

43. 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