1. Chapter 3 - Evaluating a Firm’s Financial Performance

2. Financial Ratio Analysis
Are our decisions maximizing shareholder wealth?

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

4. 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.

5. CyberDragon’s Balance Sheet ($000)
Example: Cyber Dragon Corporation
Assets: Liabilities & Equity:
Cash $2,540 Accounts payable ,721
Marketable securities 1,800 Notes payable ,500
Accounts receivable 18,320 Accrued taxes payable ,200
Inventories 27,530 Other current liabilities ,102
Total current assets ,190 Total current liabilities ,523
Plant and equipment 43,100 Long-term debt (bonds) ,000
less accum deprec. 11,400 Total liabilities ,523
Net plant & equip ,700 Common stock ($10 par) ,000
Total assets ,890 Paid in capital ,000
Retained earnings ,367
Total stockholders' equity ,367
Total liabilities & equity ,890

6. CyberDragon’s Income Statement
Sales (all credit) $112,760
Cost of Goods Sold (85,300)
Gross Profit ,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) ,360
Taxes (assume 40%) (3,344)
Net Income ,016

7. 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 Earnings per share 3.86 Dividends per share 2.15

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

9. What is CyberDragon’s Current Ratio?
current assets
current liabilities

10. 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?

11. What is the firm’s Acid Test Ratio?
current assets - inventories
current liabilities

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

13. What is the firm’s Average Collection Period?
accounts receivable
daily credit sales

14. What is the firm’s Average Collection Period?
18,320
112,760/365
= days
If the industry average is 47 days, what does this tell us?

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

16. What is the firm’s Operating Income Return on Investment (OIROI)?
total assets

17. What is the firm’s Operating Income Return on Investment (OIROI)?
11,520
81,890
= %
Slightly below the industry average of 15%.
The OIROI reflects product pricing and the firm’s ability to keep costs down.

18. What is their Operating Profit Margin?
operating income
sales

19. What is their Operating Profit Margin?
11,520
112,760
= %
This is below the industry average of
12%.

20. What is their Total Asset Turnover?
sales
total assets

21. What is their Total Asset Turnover?
112,760
81,890
= times
The industry average is 1.82 times.
The firm needs to figure out how to squeeze more sales dollars out of its assets.

22. What is the firm’s Accounts Receivable Turnover?
credit sales
accounts receivable

23. What is the firm’s Accounts Receivable Turnover?
112,760
18,320
= times
CyberDragon turns their A/R over 6.16
times per year. The industry average
is 8.2 times. Is this efficient?

24. What is the firm’s Inventory Turnover?
cost of goods sold
inventory

25. What is the firm’s Inventory Turnover?
85,300
27,530
= times
CyberDragon turns their inventory over 3.1 times per year.
The industry average is 3.9 times. Is this efficient?

26. 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.

27. What is the firm’s Fixed Asset Turnover?
sales
fixed assets

28. What is the firm’s Fixed Asset Turnover?
112,760
31,700
= times
If the industry average is 4.6 times, what
does this tell us about CyberDragon?

29. 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.

30. 15,000 100,000 How does Leverage work? ROE = = 15%
Suppose we have an all equity-financed firm worth $100,000. Its earnings this year total $15,000.
ROE = = 15%
(ignore taxes for this example)
15,000
100,000

31. How does Leverage work? ROE = = 22% 15,000 - 4,000 50,000
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

32. What is CyberDragon’s Debt Ratio?
total debt
total assets

33. 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?

34. What is the firm’s Times Interest Earned Ratio?
operating income
interest expense

35. What is the firm’s Times Interest Earned Ratio?
11,520
3,160
= times
The industry average is 6.7 times. This
is further evidence that the firm uses
more debt financing than average.

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

37. What is CyberDragon’s Return on Equity (ROE)?
net income
common equity

38. 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?

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

40. The DuPont Model
Brings together:
Profitability
Efficiency
Leverage

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