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Chapter 4 - Evaluating Financial Performance

Chapter 4 - Evaluating Financial Performance. Financial Analysis – process of assessing financial condition of a firm Principal analytic tool is the financial ratio Understand ratios and what they mean. Ratio Analysis. Identify firm’s strengths and weaknesses

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Chapter 4 - Evaluating Financial Performance

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  1. Chapter 4 - Evaluating Financial Performance • Financial Analysis – process of assessing financial condition of a firm • Principal analytic tool is the financial ratio • Understand ratios and what they mean

  2. Ratio Analysis • Identify firm’s strengths and weaknesses • Comparison of the firm over time or with other firms • Industry averages – benchmarks • Robert Morris Associates, Dun & Bradstreet • Four types of ratios: liquidity, efficiency, leverage and profitability

  3. Ratios and Major Questions • How liquid is the firm? • Are adequate operating profits being generated? • How is the firm financing its assets? • Are shareholders receiving an adequate return?

  4. How Liquid is the Firm? • Liquidity – ability to meet maturing obligations • Enough resources to pay when due? • How do liquid assets compare with debt? • Compare cash and assets to be converted to cash with debt due in same period • Can firm convert receivables/inventories to cash on timely basis? How quick or long?

  5. Liquidity • Current ratio – conventional wisdom says 2:1 but there is “the lettuce problem”. • Acid test or quick ratio – (CA - Inv)/ CL • Collection period – how many days to collect receivables = AR / DCrS = say 20 • Turnover – how many times are AR rolled over during a year? = CS/AR = say 18 X • By most of these measures, McD less liquid

  6. Collection Period & Turnover Measure the same thing – are reciprocals 365 days = 17.9 X 365 Days = 20.4days 20.4 days 17.9 X McD not good at collections (20 days vs. 7) Are longer credit terms good or bad? Competitive necessity or weak management ? Receivables aging – good footnote

  7. Inventory Turnover • Turnover Ratio = Cost of Goods Sold (Times per year) Inventory • Why COGS? Need cost-based numbers in numerator and denominator • If less liquid, greater chance to be unable to pay on time. • McD – excellent inventory management (87 times a year versus 35)

  8. Cash Conversion Cycle • To reduce working capital, speed up collections, turn inventory faster, slow disbursements • Sum of days required to collect + days in inventory - Days of Payable Outstanding • DPO = Accounts Payable = say 29 COGS / 365

  9. Operating Profits – Adequate? • Text tells us to use operating profits • GP ignores marketing exp; NP includes financing effects • OIROI – Operating Income Return on Investment – op profits relative to assets OIROI = Operating Income Total Assets McD generates more income per $ of assets

  10. OIROI • Separate OIROI into its two pieces: OIROI = OPM * TAT 15.4% = 23.4% * .66 • Operating Profit Margin = Op. Income Sales • Management’s effectiveness in keeping costs in line with sales; McD = very good

  11. Total Asset Turnover • TAT = Sales = .66 Total Assets • Amount of sales generated by $1 of assets • Higher turnover better; good use of asset • McD – weak $0.66 in sales per $ of assets • Where’s the problem? Check components

  12. Total Asset Turnover • McD very weak. But why? • TurnoverMcDonalds Peers • Receivables 17.9 X = Bad 56 • Inventory 87 Good 35 • Fixed Assets .84 Bad 3.2

  13. OIROI Summary • OIROI = Operating Inc. * Sales Sales Total Assets • McD effectively keeps costs and operating expenses low, but is not particularly good in managing its assets Overall, they are doing better than the competitors – OIROI = 15. 4% versus 11.6%

  14. How Does Firm Finance Assets? • What percentage of assets are financed by debt and how much by equity? • Debt includes all liabilities, both short and long-term Debt Ratio = Total Debt Total Assets • McD uses significantly less debt (54 vs 69%)

  15. Times Interest Earned • TIE – how much operating income is available to meet interest expense? Or, how many times is it covering annual interest? • TIE = Operating Income = 7.5 Times Interest Expense McD – no problem in paying int. Op. Inc. could fall to 1/7th of current level and still pay (1/7.5)

  16. Adequate Returns? • Are stockholders receiving an adequate return on their investment? Is it attractive compared to other companies? Return on Com Equity = Net Income Common Equity Equity = PV+ P-I + RE but no preferred stock McD – profitability fully offsets low leverage

  17. What Can We Say About McD • Its liquidity is average even with low receivable turnover; good on inventory • OIROI is good;good profitability offsets low asset turnover • Uses less debt than competitors • Good Return on Equity; uses less debt but this offset by greater profitability.

  18. Limitations With Ratios • Difficult to identify industry categories • No exact peers • Averages are only approximates • Accounting principles differ • Ratios can be too high or too low • Industry averages include “stars and dogs” • However, ratios are still useful tools

  19. Unmentioned Problems • Old firm versus new • Have assets been depreciated? • Window dressing • Actions to make good at year end • Role of “revolvers” • Some ratios make you look good, others make look bad • Overall – look at several combinations

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