Ch. 3 - Evaluating a Firm’s Financial Performance

, Prentice Hall, Inc.

Financial Statement Analysis

• Are our decisions maximizing shareholder wealth?

We will want to answer questions about the firm’s

• Liquidity

• Efficient use of Assets

• Leverage (financing)

• Profitability

We will want to answer questions about the firm’s

• Liquidity

• Efficient use of Assets

• Leverage (financing)

• Profitability

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.

Example:CyberDragon Corporation

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 50,190 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

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

CyberDragon’s Income Statement

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

1. Liquidity Ratios

• Do we have enough liquid assets to meet approaching obligations?

What is CyberDragon’s Current Ratio?

What is CyberDragon’s Current Ratio?

50,19025,523 = 1.97

What is CyberDragon’s Current Ratio?

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

50,19025,523 = 1.97

What is the firm’s Acid Test Ratio?

What is the firm’s Acid Test Ratio?

50,190 - 27,53025,523 = .89

What is the firm’s Acid Test Ratio?

Suppose the industry average is .92.What does this tell us?

50,190 - 27,53025,523 = .89

What is the firm’s Average Collection Period?

What is the firm’s Average Collection Period?

18,320112,760/365 = 59.3 days

What is the firm’s Average Collection Period?

If the industry average is 47 days, what does this tell us?

18,320112,760/365 = 59.3 days

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)?

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

11,52081,890

= 14.07%

•Slightly below the industry average of 15%.

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

11,52081,890

= 14.07%

•Slightly below the industry average of 15%.

•The OIROI reflects product pricing and the firm’s ability to

keep costs down.

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

11,52081,890

= 14.07%

What is their Operating Profit Margin?

What is their Operating Profit Margin?

11,520112,760 = 10.22%

What is their Operating Profit Margin?

•This is below the industry average of 12%.

11,520112,760 = 10.22%

What is their Total Asset Turnover?

What is their Total Asset Turnover?

112,76081,890 = 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.

112,76081,890 = 1.38 times

What is the firm’s Accounts Receivable Turnover?

What is the firm’s Accounts Receivable Turnover?

112,76018,320 = 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?

112,76018,320 = 6.16 times

What is the firm’s Inventory Turnover?

What is the firm’s Inventory Turnover?

85,30027,530 = 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?

85,30027,530 = 3.10 times

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.

What is the firm’s Fixed Asset Turnover?

What is the firm’s Fixed Asset Turnover?

112,76031,700 = 3.56 times

What is the firm’s Fixed Asset Turnover?

If the industry average is 4.6 times, whatdoes this tell us about CyberDragon?

112,76031,700 = 3.56 times

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 =

(ignore taxes for this example)

How does Leverage work?

• Suppose we have an all equity-financed firm worth $100,000. Its earnings this year total $15,000.

ROE = = 15%15,000100,000

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 =

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 - 4,00050,000

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 - 4,00050,000

What is CyberDragon’s Debt Ratio?

What is CyberDragon’s Debt Ratio?

47,52381,890 = 58%

What is CyberDragon’s Debt Ratio?

If the industry average is 47%, whatdoes this tell us?

47,52381,890 = 58%

What is CyberDragon’s Debt Ratio?

47,52381,890 = 58%

If the industry average is 47%, whatdoes this tell us?

Can leverage make the firm more profitable?

Can leverage make the firm riskier?

What is the firm’s Times Interest Earned Ratio?

What is the firm’s Times Interest Earned Ratio?

11,5203,160 = 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.

11,5203,160 = 3.65 times

4. Return on Equity

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

What is CyberDragon’sReturn on Equity (ROE)?

What is CyberDragon’sReturn on Equity (ROE)?

5,01634,367 = 14.6%

What is CyberDragon’sReturn on Equity (ROE)?

The industry average is 17.54%.

5,01634,367 = 14.6%

What is CyberDragon’sReturn on Equity (ROE)?

5,01634,367 = 14.6%

The industry average is 17.54%.Is this what we would expect,

given the firm’s leverage?

Conclusion:

• Even though CyberDragon has higher leverage than the industry

average, they are much less efficient, and therefore, less

profitable.

The DuPont Model

Brings together:

• Profitability

• Efficiency

• Leverage

Net Profit Total Asset Debt Margin Turnover RatioROE = x / (1- )

The DuPont Model

Net Profit Total Asset Debt Margin Turnover Ratio

Net Income Sales Total Debt Sales Total Assets Total Assets

ROE = x / (1- )

= x /(1- )

The DuPont Model

Net Profit Total Asset Debt Margin Turnover Ratio

Net Income Sales Total Debt Sales Total Assets Total Assets

5,016 112,760 47,523 112,760 81,890 81,890

ROE = x / (1- )

= x /(1- )

= x / (1 - )

The DuPont Model

ROE = x / (1- )

= x /(1- )

= x / (1 - )

= 14.6%

Net Profit Total Asset Debt Margin Turnover Ratio

Net Income Sales Total Debt Sales Total Assets Total Assets

5,016 112,760 47,523 112,760 81,890 81,890

The DuPont Model