Slide 1 Evaluating a Firm’s Financial Performance Goals of evaluating firm performance: Are our decisions maximizing shareholder wealth? We will want to answer questions about the firm’s Liquidity Efficient use of Assets Leverage (financing) Profitability

Slide 2 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

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

Slide 4 Sales (all credit)$112,760 Cost of Goods Sold (85,300) Gross Profit 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) 8,360 Taxes (assume 40%) (3,344) Net Income 5,016 Dragon’s Income Statement

Slide 5 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 Earnings per share 3.86 Dividends per share 2.15 Dragon (Other Information)

Slide 6 What is the firm’s Current Ratio? Do we have enough liquid assets to meet approaching obligations? If the average current ratio for the industry is 2.4, is this good or not? 1. Liquidity Ratios

Slide 7 What is the firm’s Acid-Test Ratio (Quick Ratio)? Suppose the industry average is What does this tell us? 1. Liquidity Ratios (Continued)

Slide 8 What is the firm’s Average Collection Period (ACP)? If the industry average is 47 days, what does this tell us? Alternatively, we can calculate Average Collection Turnover (Accounts Receivable Turnover (ART)) first as: (Industry average is 8.2 times) Second, we convert the turnover into a period using 365 day/year: 1. Liquidity Ratios (Continued)

Slide 9 What is the firm’s Accounts Payable Turnover (APT)? Accounts Payable Period (APP) 1. Liquidity Ratios (Continued)

Slide 10 Measure how efficiently the firm’s assets generate operating profits What is the firm’s Operating Income Return on Investment (OIROI)? Slightly below the industry average of 15%. The OIROI reflects product pricing and the firm’s ability to keep costs down Note: EBIT is Operating Income 2. Operating Efficiency Ratios

Slide 11 What is the firm’s Operating Profit Margin (OPM)? Below the industry average of 12% 2. Operating Efficiency Ratios (Continued)

Slide 12 What is the firm’s Total Asset Turnover (TAT)? The industry average is 1.82 times Total Asset Period (TAP): The firm needs to figure out how to squeeze more sales dollars out of its assets 2. Operating Efficiency Ratios (Continued)

Slide 13 What is the firm’s Inventory Turnover? Dragon turns their inventory over 3.1 times per year. The industry average is 3.9 times. Is this efficient? Inventory Period (IP) for the firm is: 2. Operating Efficiency Ratios (Continued)

Slide 14 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 2. Operating Efficiency Ratios (Continued)

Slide 15 Cash Cycle = (Inventory Period + Receivables Period) – Payables Period Cash Cycle = ( ) – = Operating Efficiency Ratios (Continued)

Slide 16 What is the firm’s Fixed Asset Turnover (FAT)? If the industry average is 4.6 times, what does this tell us about the firm? Fixed Asset Period (FAP) for the firm is 2. Operating Efficiency Ratios (Continued)

Slide 17 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 = 15,000 / 100,000 = 15% 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 = 22% 3. Leverage Ratios (Financing Decisions)

Slide 18 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 Dragon’s Debt Ratio? 3. Leverage Ratios (Financing Decisions) (Continued)

Slide 19 The industry average is 6.7 times. This is further evidence that the firm uses more debt financing than average What is Dragon’s Times Interest Earned Ratio (TIER)? 3. Leverage Ratios (Financing Decisions) (Continued)

Slide 20 The industry average is 17.54%. Is this what we would expect, given the firm’s leverage? How well are the firm’s managers maximizing shareholder wealth? 4. Return on Equity (ROE)

Slide 21 Even though Dragon has higher leverage than the industry average, they are much less efficient, and therefore, less profitable Conclusion

Slide 22 Brings together: Profitability – measured by the Net Profit Margin (NPM) Efficiency – measured by Total Asset Turnover (TAT) Leverage – measured by Debt Ratio The DuPont Model

Slide 23 The DuPont Model