Evaluating a Firm's Financial Performance

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Evaluating a Firm's Financial Performance

  1. 1. Evaluating a Firm’s Financial Performance <ul><li>Goals of evaluating firm performance: </li></ul><ul><li>Are our decisions maximizing shareholder wealth? </li></ul><ul><li>We will want to answer questions about the firm’s </li></ul><ul><ul><li>Liquidity </li></ul></ul><ul><ul><li>Efficient use of Assets </li></ul></ul><ul><ul><li>Leverage (financing) </li></ul></ul><ul><ul><li>Profitability </li></ul></ul>
  2. 2. 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 </li></ul>
  3. 3. <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>Dragon’s Balance Sheet
  4. 4. <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) 8,360 </li></ul><ul><li>Taxes (assume 40%) (3,344) </li></ul><ul><li>Net Income 5,016 </li></ul>Dragon’s Income Statement
  5. 5. <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>Dragon (Other Information)
  6. 6. 1. Liquidity Ratios <ul><li>What is the firm’s Current Ratio? </li></ul><ul><li>Do we have enough liquid assets to meet approaching obligations? </li></ul><ul><li>If the average current ratio for the industry is 2.4 , is this good or not? </li></ul>
  7. 7. 1. Liquidity Ratios (Continued) <ul><li>What is the firm’s Acid-Test Ratio (Quick Ratio)? </li></ul><ul><li>Suppose the industry average is 0.92 . What does this tell us? </li></ul>
  8. 8. 1. Liquidity Ratios (Continued) <ul><li>What is the firm’s Average Collection Period (ACP)? </li></ul><ul><li>If the industry average is 47 days , what does this tell us? </li></ul><ul><li>Alternatively, we can calculate Average Collection Turnover (Accounts Receivable Turnover (ART)) first as: (Industry average is 8.2 times) </li></ul><ul><li>Second, we convert the turnover into a period using 365 day/year: </li></ul>
  9. 9. <ul><li>What is the firm’s Accounts Payable Turnover (APT)? </li></ul><ul><li>Accounts Payable Period (APP) </li></ul>1. Liquidity Ratios (Continued)
  10. 10. <ul><li>Measure how efficiently the firm’s assets generate operating profits </li></ul><ul><li>What is the firm’s Operating Income Return on Investment (OIROI)? </li></ul>2. Operating Efficiency Ratios <ul><li>Slightly below the industry average of 15% . The OIROI reflects product pricing and the firm’s ability to keep costs down </li></ul><ul><li>Note: EBIT is Operating Income </li></ul>
  11. 11. <ul><li>What is the firm’s Operating Profit Margin (OPM)? </li></ul><ul><li>Below the industry average of 12% </li></ul>2. Operating Efficiency Ratios (Continued)
  12. 12. <ul><li>What is the firm’s Total Asset Turnover (TAT)? </li></ul><ul><li>The industry average is 1.82 times </li></ul><ul><li>Total Asset Period (TAP): </li></ul><ul><li>The firm needs to figure out how to squeeze more sales dollars out of its assets </li></ul>2. Operating Efficiency Ratios (Continued)
  13. 13. <ul><li>What is the firm’s Inventory Turnover? </li></ul><ul><li>Dragon turns their inventory over 3.1 times per year. </li></ul><ul><li>The industry average is 3.9 times. Is this efficient? </li></ul><ul><li>Inventory Period (IP) for the firm is: </li></ul>2. Operating Efficiency Ratios (Continued)
  14. 14. <ul><li>Low Inventory Turnover </li></ul><ul><li>The firm may have too much inventory, which is expensive because: </li></ul><ul><ul><li>Inventory takes up costly warehouse space </li></ul></ul><ul><ul><li>Some items may become spoiled or obsolete </li></ul></ul>2. Operating Efficiency Ratios (Continued)
  15. 15. <ul><li>Cash Cycle = (Inventory Period + Receivables Period) – Payables Period </li></ul><ul><li>Cash Cycle = (117.74 + 59.30) – 41.57 = 135.47 </li></ul>2. Operating Efficiency Ratios (Continued)
  16. 16. <ul><li>What is the firm’s Fixed Asset Turnover (FAT)? </li></ul><ul><li>If the industry average is 4.6 times, what does this tell us about the firm? </li></ul><ul><li>Fixed Asset Period (FAP) for the firm is </li></ul>2. Operating Efficiency Ratios (Continued)
  17. 17. <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><ul><li>How does Leverage work? </li></ul><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 = 15,000 / 100,000 = 15% </li></ul><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 = (15,000 – 4,000) / 50,000 = 22% </li></ul>3. Leverage Ratios (Financing Decisions)
  18. 18. <ul><li>If the industry average is 47%, what does this tell us? </li></ul><ul><li>Can leverage make the firm more profitable ? </li></ul><ul><li>Can leverage make the firm riskier ? </li></ul><ul><li>What is Dragon’s Debt Ratio? </li></ul>3. Leverage Ratios (Financing Decisions) (Continued)
  19. 19. <ul><li>The industry average is 6.7 times. This is further evidence that the firm uses more debt financing than average </li></ul><ul><li>What is Dragon’s Times Interest Earned Ratio (TIER)? </li></ul>3. Leverage Ratios (Financing Decisions) (Continued)
  20. 20. <ul><li>The industry average is 17.54%. Is this what we would expect, given the firm’s leverage? </li></ul><ul><li>How well are the firm’s managers maximizing shareholder wealth? </li></ul>4. Return on Equity (ROE)
  21. 21. <ul><li>Even though Dragon has higher leverage than the industry average, they are much less efficient, and therefore, less profitable </li></ul>Conclusion
  22. 22. <ul><li>Brings together: </li></ul><ul><li>Profitability – measured by the Net Profit Margin (NPM) </li></ul><ul><li>Efficiency – measured by Total Asset Turnover (TAT) </li></ul><ul><li>Leverage – measured by Debt Ratio </li></ul>The DuPont Model
  23. 23. The DuPont Model

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