Chapter 3 - Evaluating a Chapter 3 - Evaluating a Firm’s Financial PerformanceFirm’s Financial Performance

2005, Pearson Prentice Hall

Financial Ratio AnalysisFinancial Ratio Analysis

Are our decisions Are our decisions maximizing maximizing shareholder shareholder wealth?wealth?

We will want to answer We will want to answer questions about the firm’squestions about the firm’s

LiquidityLiquidity Efficient use of AssetsEfficient use of Assets Leverage (financing)Leverage (financing) ProfitabilityProfitability

Financial RatiosFinancial Ratios

Tools that help us determine the Tools that help us determine the financial health of a company.financial health of a company.

We can compare a company’s We can compare a company’s financial ratios with its ratios in financial ratios with its ratios in previous years previous years (trend analysis)(trend analysis)..

We can compare a company’s We can compare a company’s financial ratios with those of its financial ratios with those of its industry.industry.

Example:Example:CyberDragon CorporationCyberDragon Corporation

CyberDragon’s Balance CyberDragon’s Balance Sheet Sheet ($000)($000)

Assets:Assets: Liabilities & Equity:Liabilities & Equity: CashCash $2,540$2,540 Accounts payableAccounts payable 9,7219,721

Marketable securitiesMarketable securities 1,8001,800 Notes payable Notes payable 8,5008,500

Accounts receivableAccounts receivable 18,32018,320 Accrued taxes payableAccrued taxes payable 3,2003,200

InventoriesInventories 27,53027,530 Other current liabilitiesOther current liabilities 4,1024,102

Total current assetsTotal current assets 50,19050,190 Total current liabilitiesTotal current liabilities 25,52325,523

Plant and equipmentPlant and equipment 43,10043,100 Long-term debt (bonds)Long-term debt (bonds) 22,00022,000

less accum deprec.less accum deprec. 11,40011,400 Total liabilitiesTotal liabilities 47,52347,523

Net plant & equip.Net plant & equip. 31,70031,700 Common stock ($10 par)Common stock ($10 par) 13,00013,000

Total assetsTotal assets 81,89081,890 Paid in capital Paid in capital 10,00010,000

Retained earningsRetained earnings 11,36711,367

Total stockholders' equity Total stockholders' equity 34,36734,367

Total liabilities & equityTotal liabilities & equity 81,89081,890

Sales (all credit)Sales (all credit) $112,760$112,760

Cost of Goods SoldCost of Goods Sold (85,300) (85,300)

Gross ProfitGross Profit 27,46027,460

Operating Expenses:Operating Expenses:

SellingSelling (6,540)(6,540)

General & AdministrativeGeneral & Administrative (9,400)(9,400)

Total Operating ExpensesTotal Operating Expenses (15,940)(15,940)

Earnings before interest and taxes (EBIT)Earnings before interest and taxes (EBIT) 11,52011,520

Interest charges:Interest charges:

Interest on bank notes:Interest on bank notes: (850)(850)

Interest on bonds:Interest on bonds: (2,310)(2,310)

Total Interest chargesTotal Interest charges ((3,160)3,160)

Earnings before taxes (EBT)Earnings before taxes (EBT) 8,3608,360

TaxesTaxes (assume 40%) (assume 40%) (3,344) (3,344)

Net IncomeNet Income 5,0165,016

CyberDragon’s CyberDragon’s Income StatementIncome Statement

CyberDragonCyberDragonOther InformationOther Information

Dividends paid on common stockDividends paid on common stock $2,800$2,800

Earnings retained in the firmEarnings retained in the firm 2,2162,216

Shares outstanding (000)Shares outstanding (000) 1,3001,300

Market price per shareMarket price per share 2020

Book value per shareBook value per share 26.4426.44

Earnings per shareEarnings per share 3.863.86

Dividends per shareDividends per share 2.152.15

1. Liquidity Ratios1. Liquidity Ratios

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

What is CyberDragon’s What is CyberDragon’s Current Current RatioRatio??

current assetscurrent liabilities

What is CyberDragon’s What is CyberDragon’s Current Current RatioRatio??

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 What is the firm’s Acid Test RatioAcid Test Ratio??

current assets - inventoriescurrent liabilities

What is the firm’s What is the firm’s Acid Test RatioAcid Test Ratio??

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

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

What is the firm’s What is the firm’s Average Collection Average Collection PeriodPeriod??

accounts receivabledaily credit sales

What is the firm’s What is the firm’s Average Collection Average Collection PeriodPeriod??

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

18,320112,760/365 = 59.3 days

2. Operating Efficiency Ratios2. Operating Efficiency Ratios

Measure how efficiently the Measure how efficiently the firm’s assets generate operating firm’s assets generate operating profits.profits.

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

operating incometotal assets

•Slightly below the industry average of 15%.

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

11,52081,890

= 14.07%

What is their What is their Operating Profit Operating Profit MarginMargin??

operating incomesales

What is their What is their Operating Profit Operating Profit MarginMargin??

•This is below the industry average of 12%.

11,520112,760 = 10.22%

What is their What is their Total Asset TurnoverTotal Asset Turnover??

salestotal assets

What is their What is their Total Asset TurnoverTotal Asset Turnover??

112,76081,890 = 1.38 times

What is their What is their Total Asset TurnoverTotal 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 What is the firm’s Accounts Accounts Receivable TurnoverReceivable Turnover??

credit salesaccounts receivable

What is the firm’s What is the firm’s Accounts Accounts Receivable TurnoverReceivable Turnover??

112,76018,320 = 6.16 times

What is the firm’s What is the firm’s Accounts Accounts Receivable TurnoverReceivable 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 What is the firm’s Inventory Inventory TurnoverTurnover??

cost of goods soldinventory

What is the firm’s What is the firm’s Inventory Inventory TurnoverTurnover??

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:Low inventory turnover:

The firm may have too much The firm may have too much

inventory, which is expensive inventory, which is expensive

because:because:

Inventory takes up costly Inventory takes up costly

warehouse space.warehouse space.

Some items may become spoiled Some items may become spoiled

or obsolete.or obsolete.

What is the firm’s What is the firm’s Fixed Asset Fixed Asset TurnoverTurnover??

salesfixed assets

What is the firm’s What is the firm’s Fixed Asset Fixed Asset TurnoverTurnover??

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

112,76031,700 = 3.56 times

3. Leverage Ratios3. Leverage Ratios(financing decisions)(financing decisions)

Measure the Measure the impact of using debt impact of using debt capitalcapital to finance assets. to finance assets.

Firms use debt to lever (increase) Firms use debt to lever (increase) returns on common equity.returns on common equity.

How does Leverage work?How does Leverage work?

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

ROE =ROE =

(ignore taxes for this example)(ignore taxes for this example)

How does Leverage work?How does Leverage work?

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

ROE = = 15%ROE = = 15%15,000

100,000

How does Leverage work?How does Leverage work?

Suppose the same $100,000 firm is Suppose the same $100,000 firm is financed with half equity, and half 8% financed with half equity, and half 8% debt (bonds). Earnings are still $15,000.debt (bonds). Earnings are still $15,000.

ROE =ROE =

How does Leverage work?How does Leverage work?

Suppose the same $100,000 firm is Suppose the same $100,000 firm is financed with half equity, and half 8% financed with half equity, and half 8% debt (bonds). Earnings are still $15,000.debt (bonds). Earnings are still $15,000.

ROE =ROE = = = 22%22%

15,000 - 4,00050,000

What is CyberDragon’s What is CyberDragon’s Debt RatioDebt Ratio??

total debttotal assets

What is CyberDragon’s What is CyberDragon’s Debt Debt RatioRatio??

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

47,52381,890 = 58%

What is CyberDragon’s What is CyberDragon’s Debt RatioDebt 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 What is the firm’s Times Interest Times Interest EarnedEarned Ratio? Ratio?

operating incomeinterest expense

What is the firm’s What is the firm’s Times Interest Times Interest EarnedEarned Ratio? 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 Equity4. Return on Equity

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

What is CyberDragon’sWhat is CyberDragon’sReturn on EquityReturn on Equity (ROE)? (ROE)?

net incomecommon equity

What is CyberDragon’sWhat is CyberDragon’sReturn on EquityReturn on Equity (ROE)? (ROE)?

5,01634,367 = 14.6%

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

given the firm’s leverage?

Conclusion:Conclusion:

Even though CyberDragon has Even though CyberDragon has higher leverage than the industry higher leverage than the industry

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

profitable.profitable.

The DuPont ModelThe DuPont Model

Brings together:Brings together:

ProfitabilityProfitability EfficiencyEfficiency LeverageLeverage

ROE = x / (1- )

= x /(1- )

= x / (1 - )

= 14.6%

Net Profit Total Asset DebtNet Profit Total Asset Debt Margin Turnover RatioMargin Turnover Ratio

Net IncomeNet Income SalesSales Total DebtTotal Debt Sales Total Assets Total AssetsSales Total Assets Total Assets

5,0165,016 112,760112,760 47,52347,523 112,760 81,890 81,890112,760 81,890 81,890

The DuPont ModelThe DuPont Model