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Ch. 4 - Evaluating a Firm’s Financial Performance
, Prentice Hall, Inc.
Financial Statement Analysis
Are our decisions maximizing Are our decisions maximizing shareholder wealth?shareholder 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
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 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:CyberDragon Corporation
CyberDragon’s Balance Sheet ($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 31,50031,500
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) 8,6008,600
TaxesTaxes (3,344) (3,344)
Net IncomeNet Income 5,0165,016
CyberDragon’s Income Statement
CyberDragonOther 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 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 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 If the average current ratio for the industry is industry is 2.42.4, is this good or not?, 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 Suppose the industry average is .92.92..What does this tell us?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 If the industry average is 47 days47 days, , what does this tell us?what does this tell us?
18,320112,760/365 = 59.3 days
2. 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 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 Slightly below the industry average of average of 15%15%. .
What is the firm’s Operating Income Return on Investment (OIROI)?
11,52081,890
= 14.07%
•Slightly below the industry Slightly below the industry average of average of 15%15%. .
•The OIROI reflects product The OIROI reflects product pricing and the firm’s ability to pricing and the firm’s ability to
keep costs down.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 This is below the industry average of 12%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 The industry average is 1.82 times1.82 times. . The firm needs to figure out how to The firm needs to figure out how to squeeze more sales dollars out of its squeeze more sales dollars out of its
assets.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 CyberDragon turns their A/R over 6.166.16 times per year. The industry averagetimes per year. The industry average
is is 8.28.2 times. Is this efficient? 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 CyberDragon turns their inventory over 3.1 times per year. over 3.1 times per year.
The industry average is The industry average is 3.93.9 times. times. Is this efficient?Is this efficient?
85,30027,530 = 3.10 times
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 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 If the industry average is 4.64.6 times, what times, whatdoes this tell us about CyberDragon?does this tell us about CyberDragon?
112,76031,700 = 3.56 times
3. Leverage Ratios(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?
Suppose we have an all equity-Suppose we have an all equity-financed firm worth $100,000. Its financed firm worth $100,000. Its earnings this year total $15,000.earnings this year total $15,000.
ROE =ROE =
(ignore taxes for this example)(ignore taxes for this example)
How does Leverage work?
Suppose we have an all equity-Suppose we have an all equity-financed firm worth $100,000. Its financed firm worth $100,000. Its earnings this year total $15,000.earnings this year total $15,000.
ROE = = 15%ROE = = 15%15,000100,000
How does Leverage work?
Suppose the same $100,000 firm is Suppose the same $100,000 firm is financed with half equity, and half financed with half equity, and half 8% debt (bonds). Earnings are still 8% debt (bonds). Earnings are still $15,000.$15,000.
ROE =ROE =
How does Leverage work?
Suppose the same $100,000 firm is Suppose the same $100,000 firm is financed with half equity, and half financed with half equity, and half 8% debt (bonds). Earnings are still 8% debt (bonds). Earnings are still $15,000.$15,000.
ROE =ROE = ==15,000 - 4,00050,000
How does Leverage work?
Suppose the same $100,000 firm is Suppose the same $100,000 firm is financed with half equity, and half financed with half equity, and half 8% debt (bonds). Earnings are still 8% debt (bonds). Earnings are still $15,000.$15,000.
ROE =ROE = = = 22%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 If the industry average is 47%47%, what, whatdoes this tell us?does this tell us?
47,52381,890 = 58%
What is CyberDragon’s Debt Ratio?
47,52381,890 = 58%
If the industry average is If the industry average is 47%47%, what, whatdoes this tell us?does this tell us?
Can leverage make the firm Can leverage make the firm more more profitableprofitable??
Can leverage make the firm Can leverage make the firm riskierriskier??
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 The industry average is 6.76.7 times. This times. This is further evidence that the firm usesis further evidence that the firm uses
more debt financing than average.more debt financing than average.
11,5203,160 = 3.65 times
4. 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’sReturn on Equity (ROE)?
What is CyberDragon’sReturn on Equity (ROE)?
5,01534,367 = 14.6%
What is CyberDragon’sReturn on Equity (ROE)?
The industry average is The industry average is 17.54%17.54%..
5,01534,367 = 14.6%
What is CyberDragon’sReturn on Equity (ROE)?
5,01534,367 = 14.6%
The industry average is The industry average is 17.54%17.54%..Is this what we would expect, Is this what we would expect,
given the firm’s leverage?given the firm’s leverage?
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 Model
Brings together:Brings together:
ProfitabilityProfitability EfficiencyEfficiency LeverageLeverage
The DuPont Model
Net ProfitNet Profit Total AssetTotal Asset DebtDebt Margin Turnover RatioMargin Turnover Ratio
ROEROE = x = x / (1- )/ (1- )
The DuPont Model
Net ProfitNet Profit Total AssetTotal Asset DebtDebt Margin Turnover RatioMargin Turnover Ratio
Net IncomeNet Income SalesSales Total DebtTotal Debt Sales Total Assets Total AssetsSales Total Assets Total Assets
ROEROE = x = x / (1- )/ (1- )
= x = x /(1- )/(1- )
The DuPont Model
Net ProfitNet Profit Total AssetTotal Asset DebtDebt 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
ROEROE = x = x / (1- )/ (1- )
= x = x /(1- )/(1- )
= x = x / (1 - )/ (1 - )
The DuPont Model
Net ProfitNet Profit Total AssetTotal Asset DebtDebt 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
ROEROE = x = x / (1- )/ (1- )
= x = x /(1- )/(1- )
= x = x / (1 - )/ (1 - )
= = 14.6%14.6%