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faculty.winthrop.edu

  1. 1. TOPIC 4 <ul><li>EVALUATING FINANCIAL </li></ul><ul><li>PERFORMANCE </li></ul>
  2. 2. <ul><li>How easy is it for us to </li></ul><ul><li>pay our bills? </li></ul><ul><li>How easy is it for us to </li></ul><ul><li>pay our bills if our inventory </li></ul><ul><li>is not very liquid? </li></ul><ul><li>Are we carrying the right </li></ul><ul><li>amount of inventory? </li></ul><ul><li>Are we collecting our accounts </li></ul><ul><li>receivable as fast as we should? </li></ul><ul><li>Do we have the right amount of debt? </li></ul><ul><li>Are we earning enough profit? </li></ul><ul><li>How is our stock price? </li></ul>
  3. 3. What are the five major categories of ratios, and what questions do they answer? <ul><li>Liquidity: Can we make required payments? </li></ul><ul><li>Asset management: right amount of assets vs. sales? </li></ul><ul><li>Debt management: Right mix of debt and equity? </li></ul><ul><li>Profitability: Do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA? </li></ul><ul><li>Market value: Do investors like what they see as reflected in P/E and M/B ratios? </li></ul>
  4. 4. FOR EACH RATIO YOU SHOULD KNOW: <ul><li>THE “PROBLEM” </li></ul><ul><li>DEFINITION OF THE RATIO </li></ul><ul><li>RATIONALE FOR THE RATIO </li></ul><ul><li>HOW TO EVALUATE </li></ul>
  5. 5. LIQUIDITY RATIOS <ul><li>CURRENT RATIO </li></ul><ul><li>Current assets / current liabilities </li></ul><ul><li>QUICK RATIO </li></ul><ul><li>Current assets – inventory / current liabilities </li></ul>When would this ratio be used?
  6. 6. Comments on current ratio <ul><li>Expected to improve but still below the industry average. </li></ul><ul><li>Liquidity position is weak. </li></ul>2004 2003 2002 Ind. Current ratio 2.34x 1.20x 2.30x 2.70x
  7. 7. ASSET MANAGEMENT RATIOS <ul><li>INVENTORY TURNOVER </li></ul><ul><li> Sales / Inventory </li></ul><ul><li>Do we want this ratio to be as high as </li></ul><ul><li>possible? </li></ul><ul><li>AR TURNOVER (DAYS SALES </li></ul><ul><li>OUTSTANDING) </li></ul><ul><li> Accounts receivable / sales per day </li></ul><ul><li>Do we want this ratio to be as low as </li></ul><ul><li>possible? </li></ul>
  8. 8. Fixed asset and total asset turnover <ul><li>FA turnover = Sales / Net fixed assets </li></ul><ul><li>TA turnover = Sales / Total assets </li></ul>
  9. 9. What is the inventory turnover vs. the industry average? Inv. turnover = Sales / Inventories = $7,036 / $1,716 = 4.10x 2004 2003 2002 Ind. Inventory Turnover 4.1x 4.70x 4.8x 6.1x
  10. 10. Appraisal of DSO <ul><li>The company collects on sales too slowly, and is getting worse. </li></ul><ul><li>The company has a poor credit policy. </li></ul>2004 2003 2002 Ind. DSO 45.6 38.2 37.4 32.0
  11. 11. DEBT RATIOS <ul><li>THE DEBT RATIO (amount of debt) </li></ul><ul><li>Total debt / Total assets </li></ul><ul><li>TIMES INTEREST EARNED (ability to </li></ul><ul><li>service the debt) </li></ul><ul><li>EBIT / Annual Interest </li></ul>
  12. 12. PROFITABILITY RATIOS <ul><li>PROFIT MARGIN </li></ul><ul><li>Net Income / Sales </li></ul><ul><li>2. RETURN ON ASSETS </li></ul><ul><li>Net Income / assets </li></ul><ul><li>3. RETURN ON EQUITY </li></ul><ul><li>Net Income / equity </li></ul>
  13. 13. MARKET VALUE RATIOS <ul><li>P/E RATIO </li></ul><ul><li>MARKET/BOOK RATIO </li></ul><ul><li>Market value of the stock per share </li></ul><ul><li>divided by </li></ul><ul><li>book value of the stock per share </li></ul><ul><li>Book value is total equity on the balance </li></ul><ul><li>sheet divided by the number of shares </li></ul><ul><li>outstanding </li></ul>
  14. 14. DUPONT ANALYSIS RETURN PROFIT ASSET ON ASSETS = MARGIN X TURNOVER ROA = NI/S X S/A
  15. 15. The Du Pont system <ul><li>Also can be expressed as: </li></ul><ul><li>ROE = (NI/Sales) x (Sales/TA) x (TA/Equity) </li></ul><ul><li>Focuses on: </li></ul><ul><ul><li>Expense control (PM) </li></ul></ul><ul><ul><li>Asset utilization (TATO) </li></ul></ul><ul><ul><li>Debt utilization (Eq. Mult.) </li></ul></ul><ul><li>Shows how these factors combine to determine ROE. </li></ul>
  16. 16. EXTENDED DUPONT EQUATION RETURN RETURN EQUITY ON EQUITY = ON ASSETS X MULTIPLIER NI/E = NI/S X S/A X A/E
  17. 17. Extended DuPont equation: Breaking down Return on equity <ul><li>ROE = (Profit margin) x (TA turnover) x (Equity multiplier) </li></ul><ul><li>= 3.6% x 2 x 1.8 </li></ul><ul><li>= 13.0% </li></ul>PM TA TO EM ROE 2001 2.6% 2.3 2.2 13.3% 2002 -2.7% 2.1 5.8 -32.5% 2003E 3.6% 2.0 1.8 13.0% Ind. 3.5% 2.6 2.0 18.2%
  18. 18. Appraising profitability with the return on assets and return on equity <ul><li>Both ratios rebounded from the previous year, but are still below the industry average. More improvement is needed. </li></ul><ul><li>Wide variations in ROE illustrate the effect that leverage can have on profitability. </li></ul>2004 2003 2002 Ind. ROA 7.3% -5.6% 6.0% 9.1% ROE 13.0% -32.5% 13.3% 18.2%
  19. 19. Why are ratios useful? <ul><li>Ratios standardize numbers and facilitate comparisons. </li></ul><ul><li>Ratios are used to highlight weaknesses and strengths. </li></ul>
  20. 20. NON-FINANCIAL ASPECTS OF COMPANY EVALUATION <ul><li>Number of customers, suppliers, products </li></ul><ul><li>Amount of oversees business </li></ul><ul><li>Competition </li></ul><ul><li>Laws and regulations </li></ul><ul><li>Management </li></ul>(Possible problem of “double counting.”
  21. 21. PROBLEMS OR LIMITATIONS OF RATIO ANALYSIS <ul><li>Determining the industry. </li></ul><ul><li>Accounting practices differ. </li></ul><ul><li>Industry average may not be appropriate. </li></ul><ul><li>Ratios may be misleading (for example, high current ratio) </li></ul><ul><li>Seasonal changes </li></ul>

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