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
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