Finance KEOWN CH4 Notes

8/3/2019 Finance KEOWN CH4 Notes

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Chapter 4 Evaluating a Firms FinancialPerformance

Chapter Objectives

Financial Ratio Analysis

Dupont Analysis

Limitations of Ratio Analysis

Firm Performance and Shareholder Value

Financial Ratios

Accounting data stated in relative terms

Financial Ratios

Help identify financial strengths and

weaknesses of a company byexamining:

Trends across time

Comparisons with other firms 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 onthe capital provided by the shareholder?


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How liquid is a firm?

Liquidity is the ability to meet maturingdebt obligations

Measured by two approaches:

Comparing cash and assets that can beconverted into cash within the year with

liabilities that are coming due within theyear

Examines the firms ability to convert

accounts receivables and inventory intocash on a timely basis

Measuring Liquidity:Approach 1

Compare a firms current assets withcurrent liabilities

Current Ratio

Acid Test or Quick Ratio

Current Ratio

Compares cash and current assets thatshould be converted into cash during theyear with the liabilities that should be paidwithin the year

Current Assets / Current liabilities

Acid Test or Quick Ratio

Compares cash and current assets (minusinventory) that should be converted intocash during the year with the liabilities thatshould be paid within the year.

More restrictive than the current ratiobecause it eliminates inventories

(Current assets inventory) / Currentliabilities

X CompanyBalance Sheet

Assets

Cash $75

Accounts Rec.$150

Inventory $175 Equip/Bldg$1,200

Acc Dep

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

X CompanyIncome Statement

Sales (All Credit) $2,000

Cost of Goods Sold $1,200

Gross Profits $800

Marketing and Admin $80

Depreciation $70

Total Operating Exp $150

Operating Profits $650(EBIT or Operating Income)

Interest Expense $50

Income Before Taxes $600

Taxes $100

Net Income $500


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X Company Ratio Analysis

Current Ratiocurrent assets/current liabilities

400/600 = .667

Acid-Test Ratio

(Current assets inventory) / currentliabilities

(400 150) / 600 = .416

Measuring Liquidity:Approach 2

Measures a firms ability to convertaccounts receivable and inventory intocash

Average Collection Period

Accounts Receivable Turnover

Inventory Turnover

Cash Conversion Cycle


The conversion of accounts receivableinto cash, is measured by calculatinghow long it takes to collect the firmsreceivables

Accounts Receivable / Daily CreditSales



150 / (2,000 / 365) = 27.38


2,000 / 150 = 13.33

Inventory Turnover

1,200 / 175 = 6.86


How many times accounts receivable are

rolled over during a year Credit Sales / Accounts Receivable

Inventory Turnover

How many times is inventory rolled overduring the year?

Cost of Goods Sold / Inventory


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Cash Conversion Cycle

Sum of the days of sales outstanding (averagecollection period) and days of sales in inventoryless the days of payables outstanding.

Cash Days of Days of Days of

Conversion = Sales + Sales in -Payables

Cycle Outstanding Inventory Outstanding

Days of Sales Outstanding


Accounts Receivable / (Sales / 365)

Days of Sales In Inventory

Average age of the inventory or averagenumber of days that a dollar of inventoryis held by the firm

Inventory / (Cost of Goods Sold / 365)

Days of Payables Outstanding

Average age in days of the firmsaccounts payable

Accounts Payable / (Cost of Goods Sold/365)

Cash Conversion Cyclefor X Company

Days of Accts Rec 150

Sales = (Sales/365) = (2000/365) =

Outstanding

27.37

Days of Inventory 175

Sales In = (Cost of Goods Sold/ = (1200/365)

=

Inventory 365)

53.23

Days of

Payables = Accts Payable 600

Outstanding (Cost of Goods Sold/ = (1200/365) =

365)

182.50

Is Management GeneratingAdequate Operating Profits on

the Firms Assets?

Operating Income Return on Investment

(OIROIO) Operating Profit Margin

Total Asset Turnover

Fixed Asset Turnover

Return on Assets


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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 ItsAssets?

Does the firm finance assets more by debtof equity?

Debt Ratio

Times Interest Earned

Debt Ratio

What percentage of the firms assetsare financed by debt?

Total Debt / Total Assets


Examines the amount of operatingincome available to service interestpayments

or

The number of times the firm is earningor covering its interest payments

Operating Income / Interest


Debt Ratio 1100 / 1500 = 73.33%


650 / 50 = 13

Is Management Providing aGood Return on the Capital

Provided by theShareholders?

Return on Common Equity


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Return on Common Equity

Accounting Return on the commonstockholders investment

Net Income / Common Equity


Return on common equity

Net Income / Common Equity

500 / 400 = 1.25 or 125%

DuPont Analysis

An alternative method to analyze afirms profitability and return on equity

Allows management to see more clearlywhat drives return on equity and theinter-relationships among: net profitmargin, asset turnover, and commonequity ratio.

Return onCommon = ROA / Common Equity

Equity Total Assets

ROAAlternative 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 Sales / CmnEqty

Sales Ttl Asts Ttl Asts

500/2000 X 2000/1500 / 400/1500

( .25 X 1.33 ) / .267 = 1.245

Limitations of Ratio Analysis

Difficulty in identifying industry categories orfinding peers

Published peer group or industry averages areonly approximations

Accounting practices differ among firms Financial ratios can be too high or too low

Industry averages may not provide a desirabletarget ratio or norm

Use of average account balances to offseteffects of seasonality


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Economic Value Added (EVA)

Measures a firms economic profit, ratherthan accounting profit

Recognizes a cost of equity and a cost ofdebt

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 inthe firm

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Finance KEOWN CH4 Notes