Chapter 4

Evaluating a Firms Financial Performance

Chapter Objectives

Financial Ratios

Financial Ratio Analysis Dupont Analysis Limitations of Ratio Analysis Firm Performance and Shareholder Value

Accounting data stated in relative terms

Financial Ratios

Financial Ratios
Examine: How liquid is a firm? Is management generating adequate operating profits on the firms assets? How is the firm financing its assets? Is management providing a good return on the capital provided by the shareholder?

Help identify financial strengths and weaknesses of a company by examining:

Trends across time Comparisons with other firms ratios

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 firms ability to convert accounts receivables and inventory into cash on a timely basis

Measuring Liquidity: Approach 1

Compare a firms current assets with current liabilities

Current Ratio Acid Test or Quick Ratio

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

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

X Company Balance Sheet

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 Owners Equity Common Stk $200 Retained Earn.$200 Total O.E. $400 Total L + OE $1,500

X Company Income Statement

Sales (All Credit) Cost of Goods Sold Gross Profits Marketing and Admin $80 Depreciation $70 Total Operating Exp Operating Profits (EBIT or Operating Income) Interest Expense Income Before Taxes Taxes Net Income $2,000 $1,200 $800

$150 $650 $50 $600 $100 $500

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

Measuring Liquidity: Approach 2

Measures a firms ability to convert accounts receivable and inventory into cash Average Collection Period Accounts Receivable Turnover Inventory Turnover Cash Conversion Cycle

Average Collection Period

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

The conversion of accounts receivable into cash, is measured by calculating how long it takes to collect the firms receivables Accounts Receivable / Daily Credit Sales

Accounts Receivable Turnover

Inventory Turnover

How many times accounts receivable are rolled over during a year Credit Sales / Accounts Receivable

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

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 + Sales in Days of Outstanding

Days of Sales Outstanding

Average Collection Period Accounts Receivable / (Sales / 365)

Conversion = Sales Payables Cycle Outstanding

Inventory

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)

Days of Payables Outstanding

Average age in days of the firms accounts payable

Accounts Payable / (Cost of Goods Sold /365)

Cash Conversion Cycle for X Company

Days of Sales Outstanding = Accts Rec (Sales/365) = 150 (2000/365) =

Is Management Generating Adequate Operating Profits on the Firms Assets?

27.37

Days of Sales In = Inventory Days of Payables Outstanding

Inventory = (Cost of Goods Sold/ 365)

175 =

(1200/365)

53.23 = Accts Payable (Cost of Goods Sold/ = 365) 600 (1200/365)

= 182.50

Operating Income Return on Investment (OIROIO) Operating Profit Margin Total Asset Turnover Fixed Asset Turnover Return on Assets

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

Operating Profit Margin

Examines operating profitability Operating Income / Sales

Total Asset Turnover

Fixed Asset Turnover

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

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

Alternate OIROI
OIROI = Operating Profit Margin X Total Asset Turnover

Return on Assets

ROA = Net Income / Total Assets OIROI = Operating Income Sales Assets X Sales Total

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

How is the Firm Financing Its Assets?

Does the firm finance assets more by debt of equity? Debt Ratio Times Interest Earned

ROA

500 / 1500

Debt Ratio

Times Interest Earned

What percentage of the firms assets are financed by debt? Total Debt / Total Assets

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

X Company Ratio Analysis

Debt Ratio 1100 / 1500 Times Interest Earned 650 / 50

73.33%

Is Management Providing a Good Return on the Capital Provided by the Shareholders?

Return on Common Equity

13

Return on Common Equity

X Company Ratio Analysis

Return on common equity Accounting Return on the common stockholders investment Net Income / Common Equity Net Income / Common Equity 500 / 400 = 1.25 or 125%

DuPont Analysis
An alternative method to analyze a firms 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

ROA Alternative Calculation

ROA = Net Income / Total Assets or Net Profit Margin X Total Asset Turnover (Net Income X (Sales Sales) Total Assets)

DuPont Equation
Net Income X Eqty Sales Sales Ttl Asts / Cmn

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

Ttl Asts /

500/2000 X 2000/1500 400/1500 ( .25 X 1.33 ) /

.267 =

1.245

Economic Value Added (EVA)

Measures a firms 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