Evaluating a Firm’s Financial Performance Chapter 4
Chapter Objectives <ul><li>Why Financial Ratio Analysis </li></ul><ul><li>What are the Five Categories </li></ul><ul><li>H...
Why? <ul><li>Are (should) our decisions (be) maximizing shareholder wealth? </li></ul>
Financial Ratios <ul><li>Tools that help us determine the financial health of a company. </li></ul><ul><li>We can compare ...
Uses of Financial Ratios within the Firm <ul><li>Identify deficiencies in a firm’s performance and take corrective actions...
Uses of Financial Ratios within the Firm <ul><li>Prepare financial projections, both at the firm and division levels. </li...
Uses of Financial Ratios Outside the Firm <ul><li>Lenders in deciding whether or not to make a loan to a company. </li></u...
<ul><li>We will want to answer questions about the firm’s </li></ul><ul><li>1. Liquidity </li></ul><ul><li>2. Efficient us...
Example: CyberDragon Corporation
CyberDragon’s Balance Sheet  ($000) <ul><li>Assets: Liabilities & Equity: </li></ul><ul><li>Cash $2,540 Accounts payable  ...
<ul><li>Sales (all credit) $112,760 </li></ul><ul><li>Cost of Goods Sold   (85,300) </li></ul><ul><li>Gross Profit   27,46...
CyberDragon Other Information <ul><li>Dividends paid on common stock $2,800 </li></ul><ul><li>Earnings retained in the fir...
1.  Liquidity Ratios <ul><li>Do we have enough liquid assets to meet approaching obligations? </li></ul>
Current Ratio
What is CyberDragon’s  Current Ratio ? If the average current ratio for the  industry is  2.4 ,  is this good or not? 50,1...
Acid Test Ratio
What is the firm’s  Acid Test Ratio ? Suppose the industry average is  .92 . What does this tell us? 50,190 - 27,530 25,52...
Average Collection Period
What is the firm’s  Average Collection Period ? If the industry average is  47 days , what does this tell us? 18,320 112,7...
Accounts Receivable Turnover
What is the firm’s  Accounts Receivable Turnover ? CyberDragon turns their A/R over  6.16   times per year.  The industry ...
Inventory Turnover
What is the firm’s  Inventory Turnover ? CyberDragon turns their inventory over 3.1 times per year.  The industry average ...
Also … What is the firm’s “Inventory Holding Period” or “Days Sales In Inventory”
2. Operating Efficiency Ratios <ul><li>Is management generating adequate operating profits on the firm’s assets? </li></ul>
Operating Income Return on Investment (OIROI) … also known as Operating Return on Assets (OROA)
What is the firm’s  Operating Income Return on Investment  (OIROI)? <ul><li>Slightly below the industry average of  15% . ...
Operating Profit Margin
What is their  Operating Profit Margin ? <ul><li>This is below the industry average of  </li></ul><ul><li>12% . </li></ul>...
Total Asset Turnover
What is their  Total Asset Turnover ? The industry average is  1.82 times .  The firm needs to figure out how to squeeze m...
Fixed Asset Turnover
What is the firm’s  Fixed Asset Turnover ? If the industry average is  4.6  times, what does this tell us about CyberDrago...
Also consider: A/R Ratios Inventory Ratios
3.  Leverage Ratios/How Financing Assets? <ul><li>Measure the  impact of using debt capital  to finance assets. </li></ul>...
How does Leverage work? <ul><li>Suppose we have an all equity-financed firm worth $100,000.  Its earnings this year total ...
How does Leverage work? <ul><li>Suppose we have an all equity-financed firm worth $100,000.  Its earnings this year total ...
How does Leverage work? <ul><li>Suppose the same $100,000 firm is financed with half equity, and half 8% debt (bonds).  Ea...
How does Leverage work? <ul><li>Suppose the same $100,000 firm is financed with half equity, and half 8% debt (bonds).  Ea...
How does Leverage work? <ul><li>Suppose the same $100,000 firm is financed with half equity, and half 8% debt (bonds).  Ea...
Debt Ratio
What is CyberDragon’s  Debt Ratio ? If the industry average is  47% , what does this tell us? Can leverage make the firm  ...
Times Interest Earned Ratio
What is the firm’s  Times Interest Earned  Ratio? The industry average is  6.7  times.  This  is further evidence that the...
4. Return on (Common) Equity … also, Profitability <ul><li>Is management providing a good return on the capital provided b...
Return on (Common) Equity (ROE)
What is CyberDragon’s Return on Equity  (ROE)? The industry average is  17.54% . 5,016 34,367 =  14.6%
What is CyberDragon’s Return on Equity  (ROE)? The industry average is  17.54% . Is this what we would expect, given the f...
5. Is Management Creating Shareholder Value? <ul><li>These ratios indicate what investors think of management’s past perfo...
What is CyberDragon’s Price/Earnings (P/E) Ratio ? 20 3.86 =  5.18
What is CyberDragon’s Price/Book Ratio ? 20 26.44 =  .76
5. Is Management Creating Shareholder Value? … Cont. <ul><li>Economic Value Added (EVA) … Based on “economic profit”  not ...
Economic Value Added (EVA) <ul><li>How is shareholder value created?  </li></ul><ul><ul><li>If the firm earns a return on ...
EVA: Formula <ul><li>EVA = (r-k) X A </li></ul><ul><li>where:  </li></ul><ul><li>r = Operating return on assets </li></ul>...
EVA Example <ul><li>A firm has total assets of $5,000 and has raised money from both debt and equity in equal proportion. ...
Conclusion: <ul><li>Even though CyberDragon has higher leverage than the industry average, they are  much less efficient ,...
Limitations of Ratio Analysis <ul><li>It is difficult to tell whether company is, on balance, in a strong or weak position...
 
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-Chapter Four

  1. 1. Evaluating a Firm’s Financial Performance Chapter 4
  2. 2. Chapter Objectives <ul><li>Why Financial Ratio Analysis </li></ul><ul><li>What are the Five Categories </li></ul><ul><li>How to compute </li></ul><ul><li>Limitations </li></ul>
  3. 3. Why? <ul><li>Are (should) our decisions (be) maximizing shareholder wealth? </li></ul>
  4. 4. Financial Ratios <ul><li>Tools that help us determine the financial health of a company. </li></ul><ul><li>We can compare a company’s financial ratios with its ratios in previous years (trend analysis). </li></ul><ul><li>We can compare a company’s financial ratios with those of its industry (benchmarks). </li></ul>
  5. 5. Uses of Financial Ratios within the Firm <ul><li>Identify deficiencies in a firm’s performance and take corrective actions. </li></ul><ul><li>Evaluate employees’ performance and determine incentive compensation. </li></ul><ul><li>Compare the financial performance of different divisions within the firm </li></ul>
  6. 6. Uses of Financial Ratios within the Firm <ul><li>Prepare financial projections, both at the firm and division levels. </li></ul><ul><li>Understand the financial performance of competitors </li></ul><ul><li>Evaluate the financial condition of a major supplier. </li></ul>
  7. 7. Uses of Financial Ratios Outside the Firm <ul><li>Lenders in deciding whether or not to make a loan to a company. </li></ul><ul><li>Credit-rating agencies in determining a firm’s credit worthiness. </li></ul><ul><li>Investors in deciding whether or not to invest in a company. </li></ul><ul><li>Major suppliers in deciding to sell and grant credit terms to a company. </li></ul>
  8. 8. <ul><li>We will want to answer questions about the firm’s </li></ul><ul><li>1. Liquidity </li></ul><ul><li>2. Efficient use of Assets </li></ul><ul><li>3. Leverage (financing) </li></ul><ul><li>4. Profitability/Returns </li></ul><ul><li>5. Shareholder Wealth </li></ul>
  9. 9. Example: CyberDragon Corporation
  10. 10. CyberDragon’s Balance Sheet ($000) <ul><li>Assets: Liabilities & Equity: </li></ul><ul><li>Cash $2,540 Accounts payable 9,721 </li></ul><ul><li>Marketable securities 1,800 Notes payable 8,500 </li></ul><ul><li>Accounts receivable 18,320 Accrued taxes payable 3,200 </li></ul><ul><li>Inventories 27,530 Other current liabilities 4,102 </li></ul><ul><li>Total current assets 50,190 Total current liabilities 25,523 </li></ul><ul><li>Plant and equipment 43,100 Long-term debt (bonds) 22,000 </li></ul><ul><li>less accum deprec. 11,400 Total liabilities 47,523 </li></ul><ul><li>Net plant & equip. 31,700 Common stock ($10 par) 13,000 </li></ul><ul><li>Total assets 81,890 Paid in capital 10,000 </li></ul><ul><li>Retained earnings 11,367 </li></ul><ul><li>Total stockholders' equity 34,367 </li></ul><ul><li>Total liabilities & equity 81,890 </li></ul>
  11. 11. <ul><li>Sales (all credit) $112,760 </li></ul><ul><li>Cost of Goods Sold (85,300) </li></ul><ul><li>Gross Profit 27,460 </li></ul><ul><li>Operating Expenses: </li></ul><ul><li> Selling (6,540) </li></ul><ul><li> General & Administrative (9,400) </li></ul><ul><li> Total Operating Expenses (15,940) </li></ul><ul><li>Earnings before interest and taxes (EBIT) 11,520 </li></ul><ul><li>Interest charges: </li></ul><ul><li> Interest on bank notes: (850) </li></ul><ul><li> Interest on bonds: (2,310) </li></ul><ul><li> Total Interest charges ( 3,160) </li></ul><ul><li>Earnings before taxes (EBT) 8,600 </li></ul><ul><li>Taxes (3,344) </li></ul><ul><li>Net Income 5,016 </li></ul>CyberDragon’s Income Statement
  12. 12. CyberDragon Other Information <ul><li>Dividends paid on common stock $2,800 </li></ul><ul><li>Earnings retained in the firm 2,216 </li></ul><ul><li>Shares outstanding (000) 1,300 </li></ul><ul><li>Market price per share 20 </li></ul><ul><li>Book value per share 26.44 </li></ul><ul><li>Earnings per share 3.86 </li></ul><ul><li>Dividends per share 2.15 </li></ul>
  13. 13. 1. Liquidity Ratios <ul><li>Do we have enough liquid assets to meet approaching obligations? </li></ul>
  14. 14. Current Ratio
  15. 15. What is CyberDragon’s Current Ratio ? If the average current ratio for the industry is 2.4 , is this good or not? 50,190 25,523 = 1.97
  16. 16. Acid Test Ratio
  17. 17. What is the firm’s Acid Test Ratio ? Suppose the industry average is .92 . What does this tell us? 50,190 - 27,530 25,523 = .89
  18. 18. Average Collection Period
  19. 19. What is the firm’s Average Collection Period ? If the industry average is 47 days , what does this tell us? 18,320 112,760/365 = 59.3 days
  20. 20. Accounts Receivable Turnover
  21. 21. What is the firm’s Accounts Receivable Turnover ? CyberDragon turns their A/R over 6.16 times per year. The industry average is 8.2 times. Is this efficient? 112,760 18,320 = 6.16 times
  22. 22. Inventory Turnover
  23. 23. What is the firm’s Inventory Turnover ? CyberDragon turns their inventory over 3.1 times per year. The industry average is 3.9 times. Is this efficient? 85,300 27,530 = 3.10 times
  24. 24. Also … What is the firm’s “Inventory Holding Period” or “Days Sales In Inventory”
  25. 25. 2. Operating Efficiency Ratios <ul><li>Is management generating adequate operating profits on the firm’s assets? </li></ul>
  26. 26. Operating Income Return on Investment (OIROI) … also known as Operating Return on Assets (OROA)
  27. 27. What is the firm’s Operating Income Return on Investment (OIROI)? <ul><li>Slightly below the industry average of 15% . </li></ul><ul><li>The OIROI reflects product pricing and the firm’s ability to keep costs down. </li></ul>11,520 81,890 = 14.07%
  28. 28. Operating Profit Margin
  29. 29. What is their Operating Profit Margin ? <ul><li>This is below the industry average of </li></ul><ul><li>12% . </li></ul>11,520 112,760 = 10.22%
  30. 30. Total Asset Turnover
  31. 31. What is their Total 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. 112,760 81,890 = 1.38 times
  32. 32. Fixed Asset Turnover
  33. 33. What is the firm’s Fixed Asset Turnover ? If the industry average is 4.6 times, what does this tell us about CyberDragon? 112,760 31,700 = 3.56 times
  34. 34. Also consider: A/R Ratios Inventory Ratios
  35. 35. 3. Leverage Ratios/How Financing Assets? <ul><li>Measure the impact of using debt capital to finance assets. </li></ul><ul><li>Firms use debt to lever (increase) returns on common equity. </li></ul>
  36. 36. How does Leverage work? <ul><li>Suppose we have an all equity-financed firm worth $100,000. Its earnings this year total $15,000. </li></ul><ul><li>ROE = </li></ul><ul><li>(ignore taxes for this example) </li></ul>
  37. 37. How does Leverage work? <ul><li>Suppose we have an all equity-financed firm worth $100,000. Its earnings this year total $15,000. </li></ul><ul><li>ROE = = 15% </li></ul>15,000 100,000
  38. 38. How does Leverage work? <ul><li>Suppose the same $100,000 firm is financed with half equity, and half 8% debt (bonds). Earnings are still $15,000 … less interest . </li></ul><ul><li>ROE = </li></ul>
  39. 39. How does Leverage work? <ul><li>Suppose the same $100,000 firm is financed with half equity, and half 8% debt (bonds). Earnings are still $15,000. </li></ul><ul><li>ROE = = </li></ul>15,000 - 4,000 50,000
  40. 40. How does Leverage work? <ul><li>Suppose the same $100,000 firm is financed with half equity, and half 8% debt (bonds). Earnings are still $15,000. </li></ul><ul><li>ROE = = 22% </li></ul>15,000 - 4,000 50,000
  41. 41. Debt Ratio
  42. 42. What is CyberDragon’s Debt Ratio ? If the industry average is 47% , what does this tell us? Can leverage make the firm more profitable ? Can leverage make the firm riskier ? 47,523 81,890 = 58%
  43. 43. Times Interest Earned Ratio
  44. 44. What is the firm’s Times Interest Earned Ratio? The industry average is 6.7 times. This is further evidence that the firm uses more debt financing than average. 11,520 3,160 = 3.65 times
  45. 45. 4. Return on (Common) Equity … also, Profitability <ul><li>Is management providing a good return on the capital provided by the shareholders? </li></ul>
  46. 46. Return on (Common) Equity (ROE)
  47. 47. What is CyberDragon’s Return on Equity (ROE)? The industry average is 17.54% . 5,016 34,367 = 14.6%
  48. 48. What is CyberDragon’s Return on Equity (ROE)? The industry average is 17.54% . Is this what we would expect, given the firm’s leverage? 5,016 34,367 = 14.6%
  49. 49. 5. Is Management Creating Shareholder Value? <ul><li>These ratios indicate what investors think of management’s past performance and future prospects. </li></ul><ul><ul><li>Price/Earnings ratio </li></ul></ul><ul><ul><li>Price/Book ratio </li></ul></ul>
  50. 50. What is CyberDragon’s Price/Earnings (P/E) Ratio ? 20 3.86 = 5.18
  51. 51. What is CyberDragon’s Price/Book Ratio ? 20 26.44 = .76
  52. 52. 5. Is Management Creating Shareholder Value? … Cont. <ul><li>Economic Value Added (EVA) … Based on “economic profit” not “accounting profit” </li></ul>
  53. 53. Economic Value Added (EVA) <ul><li>How is shareholder value created? </li></ul><ul><ul><li>If the firm earns a return on capital that is greater than the investors’ required rate of return. </li></ul></ul><ul><li>EVA attempts to measure a firm’s economic profit, rather than accounting profit. </li></ul><ul><li>EVA recognizes a cost of equity in addition to the cost of debt (interest expense). </li></ul>
  54. 54. EVA: Formula <ul><li>EVA = (r-k) X A </li></ul><ul><li>where: </li></ul><ul><li>r = Operating return on assets </li></ul><ul><li>k = Total cost of capital </li></ul><ul><li>A = Amount of capital (or Total Assets) </li></ul>
  55. 55. EVA Example <ul><li>A firm has total assets of $5,000 and has raised money from both debt and equity in equal proportion. Further, assume that cost of debt is 8% and the cost of equity is 16%. Assume the firm earns 17% operating income on its investments. </li></ul><ul><li>EVA = (17%-12%)* $5,000 = $250 </li></ul><ul><li>Where, cost of capital </li></ul><ul><li>= .5*(8%) + .5*(16%) = 12% </li></ul>
  56. 56. Conclusion: <ul><li>Even though CyberDragon has higher leverage than the industry average, they are much less efficient , and therefore, less profitable. </li></ul>
  57. 57. Limitations of Ratio Analysis <ul><li>It is difficult to tell whether company is, on balance, in a strong or weak position. </li></ul><ul><li>Inflation and seasonal factors may distort ratios. </li></ul><ul><li>Different operating and accounting practices may distort comparisons. </li></ul><ul><li>“ Window dressing” techniques can make ratios look better than they actually are. </li></ul><ul><li>“ Average” performance is not necessarily good. </li></ul><ul><li>Sometimes it is hard to tell if a ratio is “good” or “bad”. </li></ul><ul><li>Difficulty in identifying industry categories or finding peers. </li></ul><ul><li>Published peer group or industry averages are only approximations. </li></ul>

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