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Evaluating a Firm’s Financial

Performance
Objectives
■ Why Financial Ratio Analysis
■ What are the Five Categories
■ How to compute
■ Limitations
Why?

■ Are (should) our decisions (be)


maximizing shareholder wealth?
Financial Ratios
■ Tools that help us determine the
financial health of a company.
■ We can compare a company’s
financial ratios with its ratios in
previous years (trend analysis).
■ We can compare a company’s
financial ratios with those of its
industry (benchmarks).
Uses of Financial Ratios within
the Firm
■ Identify deficiencies in a firm’s performance and
take corrective actions.
■ Evaluate employees’ performance and determine
incentive compensation.
■ Compare the financial performance of different
divisions within the firm
Uses of Financial Ratios within
the Firm
■ Prepare financial projections, both at the
firm and division levels.
■ Understand the financial performance of
competitors
■ Evaluate the financial condition of a major
supplier.
Uses of Financial Ratios Outside
the Firm

■ Lenders in deciding whether or not to make a loan


to a company.
■ Credit-rating agencies in determining a firm’s
credit worthiness.
■ Investors in deciding whether or not to invest in a
company.
■ Major suppliers in deciding to sell and grant credit
terms to a company.
We will want to answer questions
about the firm’s

■ 1. Liquidity
■ 2. Efficient use of Assets
■ 3. Leverage (financing)
■ 4. Profitability/Returns
■ 5. Shareholder Wealth
Example:
CyberDragon Corporation
CyberDragon’s
Balance Sheet ($000)
Assets: Liabilities & Equity:
Cash $2,540 Accounts payable 9,721
Marketable securities 1,800 Notes payable 8,500
Accounts receivable 18,320 Accrued taxes payable 3,200
Inventories 27,530 Other current liabilities 4,102
Total current assets 50,190 Total current liabilities 25,523
Plant and equipment 43,100 Long-term debt (bonds) 22,000
less accum deprec. 11,400 Total liabilities 47,523
Net plant & equip. 31,700 Common stock ($10 par) 13,000
Total assets 81,890 Paid in capital 10,000
Retained earnings 11,367
Total stockholders' equity 34,367
Total liabilities & equity 81,890
Sales (all credit) $112,760
Cost of Goods Sold CyberDragon’s Income
(85,300)
Gross Profit Statement
27,460
Operating Expenses:
Selling (6,540)
General & Administrative (9,400)
Total Operating Expenses (15,940)
Earnings before interest and taxes (EBIT) 11,520
Interest charges:
Interest on bank notes: (850)
Interest on bonds: (2,310)
Total Interest charges (3,160)
Earnings before taxes (EBT) 8,600
Taxes (3,344)
Net Income 5,016
CyberDragon
Other Information

Dividends paid on common stock $2,800


Earnings retained in the firm 2,216
Shares outstanding (000) 1,300
Market price per share 20
Book value per share 26.44
Earnings per share 3.86
Dividends per share 2.15
1. Liquidity Ratios
■ Do we have enough liquid assets
to meet approaching obligations?
Current Ratio

Current Assets
Current Ratio =
Current Liabilities
What is CyberDragon’s Current
Ratio?

50,190
25,523 = 1.97

If the average current ratio for the


industry is 2.4, is this good or not?
Acid Test Ratio

Acid − Test Ratio (Quick Ratio)


Current Assets − Inventories
=
Current Liabilities
What is the firm’s Acid Test Ratio?

50,190 - 27,530 = .89


25,523

Suppose the industry average is .92.


What does this tell us?
Average Collection Period

Average Collection Period


Accounts Receivable
=
Daily Credit Sales
What is the firm’s Average Collection
Period?

18,320 = 59.3 days


112,760/365

If the industry average is 47 days,


what does this tell us?
Accounts Receivable Turnover

Accounts Receivable Turnover


Credit Sales
=
Accounts Recievable
What is the firm’s Accounts
Receivable Turnover?

112,760 = 6.16 times


18,320

CyberDragon turns their A/R over 6.16


times per year. The industry average
is 8.2 times. Is this efficient?
Inventory Turnover

Inventory Turnover
Cost of Goods Sold
=
Inventory
What is the firm’s Inventory
Turnover?

85,300
27,530 = 3.10 times

CyberDragon turns their inventory


over 3.1 times per year.
The industry average is 3.9 times.
Is this efficient?
Also … What is the firm’s “Inventory
Holding Period” or “Days Sales In
Inventory”
2. Operating Efficiency
Ratios
■ Is management generating
adequate operating profits on the
firm’s assets?
Operating Income Return on
Investment (OIROI) … also known
as Operating Return on Assets
(OROA)

Operating Income
OIROI =
Total Assets
What is the firm’s Operating Income
Return on Investment (OIROI)?

11,520 = 14.07%
81,890
•Slightly below the industry
average of 15%.
•The OIROI reflects product
pricing and the firm’s ability to
keep costs down.
Operating Profit Margin

Operating Profit Margin


Operating Income
=
Sales
What is their Operating Profit
Margin?

11,520 = 10.22%
112,760

•This is below the industry average of


12%.
Total Asset Turnover

Total Asset Turnover


Sales
=
Total Assets
JOIN KHALID AZIZ
■ ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS,
B.COM.
■ FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4
ICAP MODULE B, B.COM, BBA, MBA & PIPFA.
■ COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP
MODULE D, BBA, MBA & PIPFA.

CONTACT:
0322-3385752
R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA,
KARACHI, PAKISTAN.
What is their Total Asset Turnover?

112,760 = 1.38 times


81,890

The industry average is 1.82 times.


The firm needs to figure out how to
squeeze more sales dollars out of its
assets.
Fixed Asset Turnover

Sales
Fixed Asset Turnover =
Net Fixed Assets
What is the firm’s Fixed Asset
Turnover?

112,760
31,700 = 3.56 times

If the industry average is 4.6 times, what


does this tell us about CyberDragon?
Also consider:

A/R Ratios

Inventory Ratios
3. Leverage Ratios/How
Financing Assets?
■ Measure the impact of using debt
capital to finance assets.
■ Firms use debt to lever (increase)
returns on common equity.
How does Leverage work?
■ Suppose we have an all equity-
financed firm worth $100,000. Its
earnings this year total $15,000.

ROE =

(ignore taxes for this example)


How does Leverage work?
■ Suppose we have an all equity-
financed firm worth $100,000. Its
earnings this year total $15,000.

15,000
ROE = = 15%
100,000
How does Leverage work?
■ Suppose the same $100,000 firm is
financed with half equity, and half
8% debt (bonds). Earnings are still
$15,000 … less interest.

ROE =
How does Leverage work?
■ Suppose the same $100,000 firm is
financed with half equity, and half
8% debt (bonds). Earnings are still
$15,000.

ROE = 15,000 - 4,000 =


50,000
How does Leverage work?
■ Suppose the same $100,000 firm is
financed with half equity, and half
8% debt (bonds). Earnings are still
$15,000.

ROE = 15,000 - 4,000 = 22%


50,000
Debt Ratio

Total Debt
Debt Ratio =
Total Assets
What is CyberDragon’s Debt Ratio?

47,523 = 58%
81,890
If the industry average is 47%, what
does this tell us?

Can leverage make the firm more


profitable?
Can leverage make the firm riskier?
Times Interest Earned Ratio

Times Interest Earned


Operating Income
=
Interest
What is the firm’s Times Interest
Earned Ratio?

11,520
3,160 = 3.65 times

The industry average is 6.7 times. This


is further evidence that the firm uses
more debt financing than average.
4. Return on (Common) Equity
… also, Profitability

Is management providing a good


return on the capital provided by the
shareholders?
Return on (Common) Equity (ROE)

Net Income
ROE =
Common Equity
What is CyberDragon’s
Return on Equity (ROE)?

5,016
34,367 = 14.6%

The industry average is 17.54%.


What is CyberDragon’s
Return on Equity (ROE)?

5,016
34,367 = 14.6%

The industry average is 17.54%.


Is this what we would expect,
given the firm’s leverage?
5. Is Management Creating
Shareholder Value?

■These ratios indicate what investors think of


management’s past performance and future
prospects.
◆ Price/Earnings ratio
◆ Price/Book ratio
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.

■Economic Value Added (EVA) … Based


on “economic profit” not “accounting
profit”
Economic Value Added (EVA)
■ How is shareholder value created?
◆ If the firm earns a return on capital that is greater than the investors’
required rate of return.

■ EVA attempts to measure a firm’s economic profit, rather


than accounting profit.
■ EVA recognizes a cost of equity in addition to the cost of debt
(interest expense).
EVA: Formula
■ EVA = (r-k) X A

where:
r = Operating return on assets
k = Total cost of capital
A = Amount of capital (or Total Assets)
EVA Example
■ 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.

■ EVA = (17%-12%)* $5,000 = $250

■ Where, cost of capital


= .5*(8%) + .5*(16%) = 12%
Conclusion:

■ Even though CyberDragon has


higher leverage than the industry
average, they are much less
efficient, and therefore, less
profitable.
Limitations of Ratio Analysis
■ It is difficult to tell whether company is, on balance, in a strong or
weak position.
■ Inflation and seasonal factors may distort ratios.
■ Different operating and accounting practices may distort
comparisons.
■ “Window dressing” techniques can make ratios look better than
they actually are.
■ “Average” performance is not necessarily good.
■ Sometimes it is hard to tell if a ratio is “good” or “bad”.
■ Difficulty in identifying industry categories or finding peers.
■ Published peer group or industry averages are only
approximations.