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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
Average Collection Period
The conversion of accounts receivableinto cash, is measured by calculatinghow long it takes to collect the firmsreceivables
Accounts Receivable / Daily CreditSales
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
Accounts Receivable Turnover
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
Average Collection Period
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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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 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
Times Interest Earned
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
X Company Ratio Analysis
Debt Ratio 1100 / 1500 = 73.33%
Times Interest Earned
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
X Company Ratio Analysis
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