1. Chapter 4

2. Evaluating a Firm’s Financial Performance

3. Chapter Objectives Financial Ratio Analysis Dupont Analysis
Limitations of Ratio Analysis
Firm Performance and Shareholder Value

4. Financial Ratios
Accounting data stated in relative terms

5. Financial Ratios
Help identify financial strengths and weaknesses of a company by examining:
Trends across time
Comparisons with other firms’ ratios

6. Financial Ratios Examine: How liquid is a firm?
Is management generating adequate operating profits on the firm’s assets?
How is the firm financing its assets?
Is management providing a good return on the capital provided by the shareholder?

7. How liquid is a firm?
Liquidity is the ability to meet maturing debt obligations
Measured by two approaches:
Comparing cash and assets that can be converted into cash within the year with liabilities that are coming due within the year
Examines the firm’s ability to convert accounts receivables and inventory into cash on a timely basis

8. Measuring Liquidity: Approach 1
Compare a firm’s current assets with current liabilities
Current Ratio
Acid Test or Quick Ratio

9. Current Ratio
Compares cash and current assets that should be converted into cash during the year with the liabilities that should be paid within the year
Current Assets / Current liabilities

10. Acid Test or Quick Ratio
Compares cash and current assets (minus inventory) that should be converted into cash during the year with the liabilities that should be paid within the year.
More restrictive than the current ratio because it eliminates inventories
(Current assets – inventory) / Current liabilities

11. X Company Balance Sheet
Assets
Cash $75
Accounts Rec. $150
Inventory $175
Equip/Bldg $1,200
Acc Dep <$100>
Total Assets $1,500
Liabilities and O.E.
Accounts Pay $600
L-Term Debt $500
Total Liabilities $1100
Owner’s Equity
Common Stk $200
Retained Earn. $200
Total O.E. $400
Total L + OE $1,500

12. X Company Income Statement
Sales (All Credit) $2,000
Cost of Goods Sold $1,200
Gross Profits $800
Marketing and Admin $80
Depreciation $70
Total Operating Exp $150
Operating Profits $650
(EBIT or Operating Income)
Interest Expense $50
Income Before Taxes $600
Taxes $100
Net Income $500

13. X Company Ratio Analysis
Current Ratio
current assets/current liabilities
400/600 = .667
Acid-Test Ratio
(Current assets – inventory) / current liabilities
(400 – 150) / 600 = .416

14. Measuring Liquidity: Approach 2
Measures a firm’s ability to convert accounts receivable and inventory into cash
Average Collection Period
Accounts Receivable Turnover
Inventory Turnover
Cash Conversion Cycle

15. Average Collection Period
The conversion of accounts receivable into cash, is measured by calculating how long it takes to collect the firm’s receivables
Accounts Receivable / Daily Credit Sales

16. X Company Ratio Analysis
Average Collection Period
150 / (2,000 / 365) = 27.38
Accounts Receivable Turnover
2,000 / 150 = 13.33
Inventory Turnover
1,200 / 175 = 6.86

17. Accounts Receivable Turnover
How many times accounts receivable are “rolled over” during a year
Credit Sales / Accounts Receivable

18. Inventory Turnover
How many times is inventory rolled over during the year?
Cost of Goods Sold / Inventory

19. Cash Conversion Cycle
Sum of the days of sales outstanding (average collection period) and days of sales in inventory less the days of payables outstanding.
Cash Days of Days of Days of
Conversion = Sales + Sales in - Payables
Cycle Outstanding Inventory Outstanding

20. Days of Sales Outstanding
Average Collection Period
Accounts Receivable / (Sales / 365)

21. Days of Sales In Inventory
Average age of the inventory or average number of days that a dollar of inventory is held by the firm
Inventory / (Cost of Goods Sold / 365)

22. Days of Payables Outstanding
Average age in days of the firm’s accounts payable
Accounts Payable / (Cost of Goods Sold /365)

23. Cash Conversion Cycle for X Company
Days of Accts Rec 150
Sales = (Sales/365) = (2000/365) =
Outstanding
27.37
Days of Inventory 175
Sales In = (Cost of Goods Sold/ = (1200/365) =
Inventory 365)
53.23
Days of
Payables = Accts Payable 600
Outstanding (Cost of Goods Sold/ = (1200/365) =
365)
182.50

24. Is Management Generating Adequate Operating Profits on the Firm’s Assets?
Operating Income Return on Investment (OIROIO)
Operating Profit Margin
Total Asset Turnover
Fixed Asset Turnover
Return on Assets

25. Operating Income Return on Investment
Level of profits relative to the assets or
Income generated per $1 of assets
OIROI = Operating Income/Total Assets
OIROI = Operating Profit Margin X
Total Asset Turnover

26. Operating Profit Margin
Examines operating profitability
Operating Income / Sales

27. Total Asset Turnover
How efficiently a firm is using its assets in generating sales
Measures the dollar sales per $1 of Assets
Sales / Total Assets

28. Fixed Asset Turnover
Examines investment in fixed assets for sales being produced
Measures the dollar sales per $1 of fixed assets
Sales / Fixed Assets

29. Alternate OIROI OIROI = Operating Profit Margin X Total Asset Turnover
OIROI = Operating Income Sales
Sales X Total Assets

30. Return on Assets
ROA = Net Income / Total Assets

31. X Company Ratio Analysis
OIROI / = .433
Operating Profit Margin 650 / =
Total Asset Turnover 2000 / =
Fixed Asset Turnover 2000 / 1100 = 1.82
Alternate OIROI 650 X =
ROA / =

32. How is the Firm Financing Its Assets?
Does the firm finance assets more by debt of equity?
Debt Ratio
Times Interest Earned

33. Debt Ratio What percentage of the firm’s assets are financed by debt?
Total Debt / Total Assets

34. Times Interest Earned
Examines the amount of operating income available to service interest payments or
The number of times the firm is earning or covering its interest payments
Operating Income / Interest

35. X Company Ratio Analysis
Debt Ratio 1100 / 1500 = 73.33%
Times Interest Earned
650 / 50 = 13

36. Is Management Providing a Good Return on the Capital Provided by the Shareholders?
Return on Common Equity

37. Return on Common Equity
Accounting Return on the common stockholders’ investment
Net Income / Common Equity

38. X Company Ratio Analysis
Return on common equity
Net Income / Common Equity
500 / 400 = 1.25 or 125%

39. DuPont Analysis
An alternative method to analyze a firm’s profitability and return on equity
Allows management to see more clearly what drives return on equity and the inter-relationships among: net profit margin, asset turnover, and common equity ratio.
Return on
Common = ROA / Common Equity
Equity Total Assets

40. ROA Alternative Calculation
ROA = Net Income / Total Assets or
Net Profit Margin X Total Asset
Turnover
(Net Income X (Sales
Sales) Total Assets)

41. DuPont Equation Net Income X Sales / Cmn Eqty Sales Ttl Asts Ttl Asts

42. Limitations of Ratio Analysis
Difficulty in identifying industry categories or finding peers
Published peer group or industry averages are only approximations
Accounting practices differ among firms
Financial ratios can be too high or too low
Industry averages may not provide a desirable target ratio or norm
Use of average account balances to offset effects of seasonality

43. Economic Value Added (EVA)
Measures a firm’s economic profit, rather than accounting profit
Recognizes a cost of equity and a cost of debt
EVA = (r-k) X C
where:
r = Operating income return on invested capital
k = Total cost of capital
C = Amount of capital (Total Assets) invested in the firm