Chapter 3 - Evaluating a Firm’s Financial Performance  2005, Pearson Prentice Hall

Financial Ratio Analysis  Are our decisions maximizing shareholder wealth?  Identify some of the financial strengths and weaknesses of a company.

We will want to answer questions about the firm’s  Liquidity  Efficient use of Assets  Leverage (financing)  Profitability

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.

Example: CyberDragon Corporation

CyberDragon’s Balance Sheet ($000) Assets:Liabilities & Equity: Assets:Liabilities & Equity: Cash$2,540Accounts payable 9,721 Cash$2,540Accounts payable 9,721 Marketable securities 1,800Notes payable 8,500 Marketable securities 1,800Notes payable 8,500 Accounts receivable18,320Accrued taxes payable 3,200 Accounts receivable18,320Accrued taxes payable 3,200 Inventories27,530Other current liabilities 4,102 Inventories27,530Other current liabilities 4,102 Total current assets 50,190Total current liabilities 25,523 Total current assets 50,190Total current liabilities 25,523 Plant and equipment43,100Long-term debt (bonds) 22,000 Plant and equipment43,100Long-term debt (bonds) 22,000 less accum deprec.11,400Total liabilities 47,523 less accum deprec.11,400Total liabilities 47,523 Net plant & equip. 31,700Common stock ($10 par) 13,000 Net plant & equip. 31,700Common stock ($10 par) 13,000 Total assets 81,890Paid in capital 10,000 Total assets 81,890Paid in capital 10,000 Retained earnings 11,367 Total stockholders' equity 34,367 Total liabilities & equity 81,890

Sales (all credit)$112,760 Sales (all credit)$112,760 Cost of Goods Sold (85,300) Cost of Goods Sold (85,300) Gross Profit 27,460 Gross Profit 27,460 Operating Expenses: Operating Expenses: Selling (6,540) Selling (6,540) General & Administrative (9,400) General & Administrative (9,400) Total Operating Expenses (15,940) Total Operating Expenses (15,940) Earnings before interest and taxes (EBIT) 11,520 Earnings before interest and taxes (EBIT) 11,520 Interest charges: Interest charges: Interest on bank notes: (850) Interest on bank notes: (850) Interest on bonds: (2,310) Interest on bonds: (2,310) Total Interest charges (3,160) Total Interest charges (3,160) Earnings before taxes (EBT) 8,360 Earnings before taxes (EBT) 8,360 Taxes (assume 40%) (3,344) Taxes (assume 40%) (3,344) Net Income 5,016 Net Income 5,016 CyberDragon’s Income Statement

CyberDragon Other Information Dividends paid on common stock$2,800 Dividends paid on common stock$2,800 Earnings retained in the firm 2,216 Earnings retained in the firm 2,216 Shares outstanding (000) 1,300 Shares outstanding (000) 1,300 Market price per share 20 Market price per share 20 Book value per share Book value per share Earnings per share 3.86 Earnings per share 3.86 Dividends per share 2.15 Dividends per share 2.15

1. Liquidity Ratios  Do we have enough liquid assets to meet approaching obligations?

What is CyberDragon’s Current Ratio? current assets current liabilities Indicates a firm’s liquidity, as measured by its liquid assets (current assets) relative to its liquid debt (short-term or current liabilities).

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

What is the firm’s Acid Test (Quick) Ratio? current assets - inventories current liabilities Indicates a firm’s liquidity, as measured by its liquid assets, excluding inventories, relative to its current liabilities.

What is the firm’s Acid Test Ratio? Suppose the industry average is.92. What does this tell us? 50, ,530 25,523 =.89

What is the firm’s Average Collection Period? accounts receivable daily credit sales Indicates how rapidly a firm is collecting its credit, as measured by the average number of days it takes to collect its accounts receivable.

What is the firm’s Average Collection Period? If the industry average is 47 days, what does this tell us? 18, ,760/365 = 59.3 days

2. Operating Efficiency Ratios  Measure how efficiently the firm’s assets generate operating profits.

What is the firm’s Operating Income Return on Investment (OIROI)? operating income total assets Indicates the effectiveness of management at generating operating profits on the firm’s assets, as measured by operating profits relative to the total assets.

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 Operating Income Return on Investment (OIROI)? 11,520 81,890 = 14.07%

What is their Operating Profit Margin? operating income sales Indicates management’s effectiveness in managing the firm’s income statement, as measured by operating profits relative to sales.

What is their Operating Profit Margin? This is below the industry average of 12%. 11, ,760 = 10.22%

What is their Total Asset Turnover? sales total assets Indicates management’s effectiveness in managing the firm’s balance sheet, its assets - as indicated by the amount of sales generated per one dollar of assets.

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

What is the firm’s Accounts Receivable Turnover? credit sales accounts receivable Indicates how rapidly the firm is collecting its credit, as measured by the number of times its accounts receivable are collected or “rolled over” during the year.

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

What is the firm’s Inventory Turnover? cost of goods sold inventory Indicates the relative liquidity of inventories, as measured by the number of times a firm’s inventories are replaced during the year.

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

Low inventory turnover: The firm may have too much inventory, which is expensive because:  Inventory takes up costly warehouse space.  Some items may become spoiled or obsolete.

What is the firm’s Fixed Asset Turnover? sales fixed assets Indicates the efficiency with which the firm use its fixed assets to generate sales.

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

3. Leverage Ratios (financing decisions)  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 = = 15% 15, ,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 == 22% 15, ,000 50,000

What is CyberDragon’s Debt Ratio? total debt total assets Indicates how much debt is used to finance a firm’s assets.

What is CyberDragon’s Debt Ratio? 47,523 81,890 = 58% If the industry average is 47%, what does this tell us? Can leverage make the firm more profitable? Can leverage make the firm riskier?

What is the firm’s Times Interest Earned Ratio? operating income interest expense Indicates a firm’s ability to cover its interest expense, as measured by its earnings before interest and taxes relative to its interest expense.

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

4. Return on Equity How well are the firm’s managers maximizing shareholder wealth?

What is CyberDragon’s Return on Equity (ROE)? net income common equity Indicates the accounting rate of return on the stockholders’ investment, as measured by net income relative to common equity.

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. Other Profitability Ratios  Gross Profit Margin  Net Profit Margin  Earnings per Share  Return on Assets

What is CyberDragon’s Gross Profit Margin (GPM)? gross profit sales Measures the percentage of each sales dollar remaining after the firm has paid for its goods.

What is CyberDragon’s Gross Profit Margin (GPM)? 27, ,760 = 24.4%

What is CyberDragon’s Net Profit Margin (NPM)? net income sales Measures the net income of a firm as a percent of sales.

What is CyberDragon’s Net Profit Margin (NPM)? 5, ,760 = 4.4%

What is CyberDragon’s Return on Assets (ROA)? net income total assets Determines the amount of net income produced on a firm’s assets by relating net income to total assets; also called the return on investment (ROI).

What is CyberDragon’s Return on Assets (ROA)? 5,016 81,890 = 6.1%

What is CyberDragon’s Eanings per Share (EPS)? earnings available for common stockholders number of shares of common stock outstanding Represents the dollar amount earned on behalf of each outstanding share of common stock.

What is CyberDragon’s Earnings per Share (EPS)? 5,016 1,300 = $3.86

Conclusion:  Even though CyberDragon has higher leverage than the industry average, they are much less efficient, and therefore, less profitable.

The DuPont Model Brings together:  Profitability  Efficiency  Leverage

Net Profit Total Asset Debt Net Profit Total Asset Debt Margin Turnover Ratio Margin Turnover Ratio Net Income Sales Total Debt Net Income Sales Total Debt Sales Total Assets Total Assets Sales Total Assets Total Assets 5, ,760 47,523 5, ,760 47, ,760 81,890 81, ,760 81,890 81,890 ROE = x / (1- ) = x /(1- ) The DuPont Model

ROE = x / (1- ) = x /(1- ) = 14.6% Net Profit Total Asset Debt Net Profit Total Asset Debt Margin Turnover Ratio Margin Turnover Ratio Net Income Sales Total Debt Net Income Sales Total Debt Sales Total Assets Total Assets Sales Total Assets Total Assets 5, ,760 47,523 5, ,760 47, ,760 81,890 81, ,760 81,890 81,890 The DuPont Model