Finance 206 Evaluating a firm’s Financial Performance

Finance 206 Evaluating a firm’s Financial Performance How Liquid is the Firm? Are the firm’s managers generating adequate operating profits on the firm’s assets? How is the firm financing its assets? Are the firm’s managers creating shareholders value?

Table 4-1 Income Statement for Davies Inc. Ending Dec 31, 2007 ($ millions)) Sales 600 Cost of Goods Sold460 Gross Profit140 Operating expenses Selling expenses $ 20 General and administrative exp 15 Depreciation exp. 30 Total operating expenses $ 65 Operating Income (EBIT) 75 Interest 15 Earnings before Taxes 60 Income Taxes 18 Net Income 42 Number of Common Shares outstanding 20 Earnings per share (EPS) 2.10 Dividends per share (EPS) 0.50

Table 4-1 Balance Sheet for Davies Inc. Ending Dec 31, 2007 ($ millions) ASSETS _____________________________________________ Cash$ 20 Accounts receivable 36 Inventories 84 Other Current Assets 3 Total Current Assets 143 Gross Fixed Assets$ 410 Accumulated depreciation (115) Net Fixed Assets 295 Total Assets 438 DEBT AND EQUITY ______________________________________________ Accounts Payable 42 Accrued Expenses 10 Short-term notes 12 Total current liabilities 64 Long-term debt 171 Total Liabilities 235 EQUITY ______________________________________________ Common Stockholder’s Equity Common-Stock per value 11 Paid-in Capital 75 Retained earnings 117 Total Common Equity 203 Total Liabilities and Equity 438

Let us look at the balance sheet and compare the firm’s “liquid“ assets (current assets) to short-term) liabilities. CURRENT RATIO: Current assets Current ratio = ____________ Current Liabilities 143 M Current ratio = ____________ = M Based on the current ratio, Davies, Inc. is more liquid than the average firm in the peer group. The company has $2.23 in current assets for every $1 in short-term debt, compared to a peer-group ratio of $1.80 The measurement of liquidity is a measurement for the future. The best numbers are between 1.5 and 2. When the number is too much above the value of 2 it indicates the firm may be holding on two much cash. If less than 1.5 it may not be able to pay its upcoming bills in the next 12 months. Table 4-1 Balance Sheet for Davies Inc. Ending Dec 31, 2007 ($ millions) ASSETS _____________________________________________ Cash$ 20 Accounts receivable 36 Inventories 84 Other Current Assets 3 Total Current Assets 143 Gross Fixed Assets$ 410 Accumulated depreciation (115) Net Fixed Assets 295 Total Assets 438 DEBT AND EQUITY ______________________________________________ Accounts Payable 42 Accrued Expenses 10 Short-term notes 12 Total current liabilities 64 Long-term debt 171 Total Liabilities 235 EQUITY ______________________________________________ Common Stockholder’s Equity Common-Stock per value 11 Paid-in Capital 75 Retained earnings 117 Total Common Equity 203 Total Liabilities and Equity 438

Cash + Accounts Receivable Acid-test ratio = ________________________ Current Liabilities 20 M + 36 M acid-test ratio = ____________ = M Peer group acid-test ratio 0.94 Based on the acid-test, Davies Inc. appears to be slightly less liquid. It has $0.88 in cash and accounts receivable per $1 in current debt, compared to $0.94 for the average company in the peer group. This value should be about the number 1 range, otherwise a cash flow problem could arise. Table 4-1 Balance Sheet for Davies Inc. Ending Dec 31, 2007 ($ millions) ASSETS _____________________________________________ Cash$ 20 Accounts receivable 36 Inventories 84 Other Current Assets 3 Total Current Assets 143 Gross Fixed Assets$ 410 Accumulated depreciation (115) Net Fixed Assets 295 Total Assets 438 DEBT AND EQUITY ______________________________________________ Accounts Payable 42 Accrued Expenses 10 Short-term notes 12 Total current liabilities 64 Long-term debt 171 Total Liabilities 235 EQUITY ______________________________________________ Common Stockholder’s Equity Common-Stock per value 11 Paid-in Capital 75 Retained earnings 117 Total Common Equity 203 Total Liabilities and Equity 438

How long does it take to convert the firm’s receivables into cash? We can answer this by computing a firm’s sales outstanding, or its average collection period. Average Collection period = Accounts receiable _________________ annual credit sales/365 Average Collection period = 36 M _________________ 600 M/365 Average Collection period = 36 M __________________ 1.64M/day = Days days Davies Inc. collects accounts receiable compared to 25 days for the peer group,, which suggests the firm’s is more liquid than those of competing firms. Table 4-1 Balance Sheet for Davies Inc. Ending Dec 31, 2007 ($ millions) ASSETS _____________________________________________ Cash$ 20 Accounts receivable 36 Inventories 84 Other Current Assets 3 Total Current Assets 143 Gross Fixed Assets$ 410 Accumulated depreciation (115) Net Fixed Assets 295 Total Assets 438 INCOME STATEMENT Table 4-1 Income Statement for Davies Inc. Ending Dec 31, 2007 Sales 600 Cost of Goods Sold460 Gross Profit140

How many times are Account Receivable are “rolled over” during the year, using the account receivable turnover ratio. Average receiable turnover = Annual credit sales _________________ Accounts receivable Average receiable turnover = 600 M _________________ 36 M = Days Peer group accounts receivable turnover X Davies Inc, collects accounts receivable more quickly than its competing firms. [This ratio depends on the type of business is being measured. It is best to compare the inventory turnover for several years and it will be best to see this number increase each year.] Table 4-1 Balance Sheet for Davies Inc. Ending Dec 31, 2007 ($ millions) ASSETS _____________________________________________ Cash$ 20 Accounts receivable 36 Inventories 84 Other Current Assets 3 Total Current Assets 143 Gross Fixed Assets$ 410 Accumulated depreciation (115) Net Fixed Assets 295 Total Assets 438 INCOME STATEMENT Table 4-1 Income Statement for Davies Inc. Ending Dec 31, 2007 Sales 600 Cost of Goods Sold460 Gross Profit140

Operating profits is the income generated from the firm’s assets without regard to how they the assets are financed. Lets examine level of operating profits relative to the firm’s total assets we use the operating return on assets (OROA). Operating return on assets = Operating Profits _________________ total assets Operating return on assets = 75 M _________________ 438 M = = 17.1 % Peer group operating return on assets 17.8% Davies Inc. is earning a slightly lower return on the assets relative to the peer group of 17.8 %. This value indicates that Davis Inc. earned 17.1 cents per $1 dollar of assets. Income Statement Table 4-1 Davies Inc. Operating Income (EBIT) 75 M Table 4-2 Balance Sheet Davies Inc. Total Assets 438 M