Chapter 5

EVALUATING FINANCIAL PERFORMANCE

FOCUS

In this chapter, we focus on identifying and understanding the financial ratios used to evaluate the
venture’s financial performance over time. Venture performance and efficiency is important to a variety
of constituencies including lenders and creditors, equity investors, and the entrepreneur. Lenders and
creditors want to be repaid in full and on time; investors want a sufficient return on their investments as
compensation for the risks they are taking; the entrepreneur initially wants to survive and then build value
in the venture.

LEARNING OBJECTIVES

1. Understand important financial performance measures and their users, by life cycle stage
2. Describe how financial ratios are used to monitor a venture’s performance
3. Identify specific cash burn rate measures and liquidity ratios and explain how they are calculated and
used by the entrepreneur
4. Identify and describe the use and value of conversion period ratios to the entrepreneur
5. Identify specific leverage ratios and explain their usage by lenders and creditors
6. Identify and describe measures of profitability and efficiency that are important to the entrepreneur
and equity investors
7. Describe limitations when using financial ratios

CHAPTER OUTLINE

5.1 USERS OF FINANCIAL PERFORMANCE MEASURES BY LIFE CYCLE STAGE

5.2 USING FINANCIAL RATIOS
5.3 CASH BURN RATES AND LIQUIDITY RATIOS
A. Measuring Venture Cash Burn and Build Amounts and Rates
B. Beyond Burn: Traditional Measures of Liquidity
C. Interpreting Cash-Related and Liquidity-Related Trends
5.4 CONVERSION PERIOD RATIOS
A. Measuring Conversion Times
B. Interpreting Changes in Conversion Times
5.5 LEVERAGE RATIOS
A. Measuring Financial Leverage
B. Interpreting Changes in Financial Leverage
5.6 PROFITABILITY AND EFFICIENCY RATIOS
A. Income Statement Measures of Profitability
B. Efficiency and Return Measures
C. Operating Return on Assets
D. Interpreting Changes in Profitability and Efficiency
5.7 INDUSTRY COMPARABLE RATIO ANALYSIS
5.8 A HITCHHIKER’S GUIDE TO FINANCIAL ANALYSIS
SUMMARY

71
72 Chapter 5: Evaluating Financial Performance

DISCUSSION QUESTIONS AND ANSWERS

1. Describe the types of financial ratios and other financial performance measures that are used
during a venture’s successful life cycle. Who are the users of financial performance measures?

Refer to Figure 5.1.

Development and Startup Stages:
Type of Financing:
Seed and startup financing
Financial Ratios and Measures:
Cash burn rates and liquidity ratios
Conversion period ratios
Users of Financial Ratios and Measures:
Entrepreneur
Business angels
Venture capitalists (VCs)

Survival Stage:
Type of Financing:
First-round financing
Financial Ratios and Measures:
Cash burn, liquidity, and conversion ratios
Leverage ratios
Profitability and efficiency ratios
Users of Financial Ratios and Measures:
Entrepreneur, angels, and VCs
Commercial banks

Rapid-Growth Stage:
Type of Financing:
Second-round, mezzanine, and liquidity-stage
Financial Ratios and Measures:
Leverage ratios
Profitability and efficiency ratios
Users of Financial Ratios and Measures:
Entrepreneur, angels, and VCs
Commercial banks
Investment bankers

2. What are financial ratios and why are they useful?

Financial ratios are measurements that show relationships between two or more financial variables.

3. What are the three types of comparisons that can be made when conducting ratio analyses?

The three types of comparison that can be made with ratio analysis are trend analysis, cross-sectional
analysis, and industry comparables (benchmark) analysis.

4. What are the meanings of the terms “cash build” and “cash burn”? How do we calculate net
cash burn rates?
 Chapter 5: Evaluating Financial Performance 73

Cash build is the amount the firm receives on its sales calculated by net sales less the change in
receivables. Cash burn is the amount of cash a firm uses on its operating and financing expenses and
on its investments in assets.

5. How is the current ratio calculated and what does it measure? How does the quick ratio differ
from the current ratio?

The firm’s current ratio is calculated by dividing the current assets by the current liabilities. This
ratio measures the firm’s ability to pay off their short term debt in the near term. The quick ratio
differs in that it leaves out inventory in calibrating current assets.

6. Describe how a firm’s net working capital (NWC) is measured and how the NWC-to-total- assets
ratio is calculated. What does this ratio measure?

Net working capital is measured by subtracting current liabilities from current assets. NWC-to-total-
assets ratio is calculated by dividing NWC by the firm’s total assets (or average total assets). This
calculation measures liquidity of the firm with a higher percentage indicating a greater liquidity.

7. What is meant by a venture’s operating cycle? Also, describe the cash conversion cycle.

A venture’s operating cycle is the time it takes to purchase raw materials, assemble a product, book a
sale, and collect on it. The cash conversion cycle is the operating cycle less the days of short-term
credit extended by suppliers, employees and government (the purchase-to-payment cycle).

8. What are the three components of the cash conversion cycle? How is each component
calculated?

The three components of the cash conversion cycle are inventory-to-sale conversion period, sales-to-
cash conversion period, and purchase-to-payment conversion period. The inventory-to-sale
conversion period is calculated by dividing average inventories by the venture’s average daily cost of
goods sold. The sale-to-cash conversion period is calculated by dividing the average receivables by
the net sales per day. The purchase-to-payment conversion period is calculated by dividing the sum of
average payables and accrued liabilities by the venture’s cost of goods sold per day.

9. Briefly explain how changes in the conversion times of the components of the cash conversion
cycle can be interpreted.

A lengthening of the inventory-to-sale conversion period indicates less efficient inventory

management. A lengthening of the sale-to-cash conversion period indicates less efficient collections
or management of receivables. A decrease in the purchase-to-payment period indicates a less
efficient use of the credit provided by suppliers, employees and the government.

10. What is the meaning of leverage ratios? What are typical ratios used for relating total debt to a
venture’s assets and/or its equity?

Leverage ratios indicate the extent to which the venture is in debt and its ability to repay its debt
obligations. Typical ratios used are the total-debt-to-total-assets-ratio, debt-to-equity-ratio, and the
equity multiplier.
74 Chapter 5: Evaluating Financial Performance

11. What is the importance of the relationship between a venture’s current liabilities and its total
debt?

The portion of total debt that is “current” represents those liabilities that will come due within the
next year. The percentage of debt held in current liabilities is a reasonable glimpse of the venture’s
reliance on debt soon requiring an outlay of cash. Ventures with higher percentages are more likely
to need to restructure their liabilities in the near future.

12. Describe the two types of “coverage” ratios that are typically calculated when trying to assess a
venture’s ability to meet its interest payments and other financing-related obligations?

The two types of coverage ratios used are the interest coverage ratio and the fixed charges coverage
ratio. The interest coverage ratio measures the venture’s ability to pay its annual interest liability and
is calculated by dividing EBITDA by the annual interest payment. The fixed charges ratio measures
the venture’s ability to cover interest and fixed charges. It is calculated by dividing the sum of the
venture’s EBITDA and lease payments divided by the sum of interest payments, rental or
lease payments, and the before-tax cost of debt repayments.

13. What are four measures used to indicate how efficiently the venture is in generating profits on its
sales? Describe how each measure is calculated.

The four ratios used are gross profit margin, operating profit margin, net profit margin, and NOPAT
margin. Gross profit margin is calculated by dividing the gross profit by the venture’s net sales.
Operating profit margin is calculated by dividing earnings before interest and taxes (EBIT), by the
venture’s net sales. Net profit margin is calculated by dividing net income by net sales. NOPAT
margin is calculated by: (EBIT x (1 minus the tax rate))/net sales.

14. Identify and describe four efficiency/return ratios that combine data from both the income
statement and the balance sheet.

The four ratios are sales-to-total-assets, operating return on assets, return on assets, and return on
equity. Sales-to-total-assets is net sales divided by average total assets. Operating return on assets is
EBIT divided by average total assets. Return on assets is net profit divided by average total assets.
Return on equity is net profit divided by average owners’ equity.

15. Identify and describe the two components of the ROA model both in terms of what financial
dimensions they measure and how they are calculated.

The two components of the ROA model are the net profit margin and the sales-to-total-assets ratio.
Net profit margin measures the amount of sales that become net profit and is calculated by dividing
net income by sales. Sales-to-total-assets measures the how much the firm generates in sales with
one dollar of assets. It is calculated by dividing net sales by the firm’s average assets.

16. What are the three ratio components of the ROE model? How is each calculated and what
financial dimensions do they measure?

The three ratio components of the ROE model are the net profit margin (net income/sales), asset
turnover (net sales/average total assets), and the equity multiplier (average total assets/average
equity). Net profit margin measures profitability of sales. Asset turnover measures how well asset
 Chapter 5: Evaluating Financial Performance 75

are utilized in the production of sales. The equity multiplier measures how the firm scales its assets
on a base of equity (through liabilities and debt).

17. Indicate some of the concerns or cautions that need to be considered when conducting ratio
analysis.
.
When conducting ratio analysis, it is important to compare “apples to apples” by consistent use of the
same inputs to the ratios (e.g. annual sales or quarterly sales). It is also important to understand that
certain ratios may simultaneously indicate undesirable and desirable aspects of the venture’s strategy
and risk position. For example, an efficient use of trade credit can be interpreted as advantageous use
of inexpensive credit or as the assumption of a large amount of short-term financial risk (low current
and quick ratios).

INTERNET ACTIVITIES

1. Go to the Hoovers business online Web site at http://www.hoovers.com and click on

“Companies A-Z.” Identify a firm such as Google, Inc. (ticker symbol: GOOG) or
Applebee’s International, Inc. (ticker symbol: APPB).

A. Obtain the most recent three years of income statements and balance sheets. Analyze the
changes in operating and financial performance, if any, by applying the ratio analyses
covered in the chapter.

Web-researched results vary due to constant updating of the related web sits.

B. Estimate the length of the cash conversion over the two most recent years of available
data. What changes have occurred, if any?

Web-researched results vary due to constant updating of the related web sits.

C. Identify the industry that firm being studied resides in and the major competitors. Obtain
financial statement information for one or more competitors and conduct a ratios
analysis of each competitor analyzed.

Web-researched results vary due to constant updating of the related web sits.

EXERCISES/PROBLEMS AND ANSWERS

76 Chapter 5: Evaluating Financial Performance

1. Bike-With-Us Corporation, a specialty bicycle parts replacement venture, was started

last year by two former professional bicycle riders who had substantial competitive racing
experience including competing in the Tour de France. The two entrepreneurs borrowed
$50,000 from members of their families and each put up $30,000 in equity capital. Retail
space was rented and $60,000 was spent for fixtures and store equipment. Following are
the abbreviated income statement and balance sheet information for the Bike-With-Us
Corporation after one complete year of operation.

BIKE-WITH-US CORPORATION

Sales $325,000
Operating Costs 285,000
Depreciation 10,000
Interest 5,000
Taxes 6,000
Cash $1,000
Receivables 30,000
Inventories 50,000
Fixed Assets, Net 50,000
Payables 11,000
Accruals 10,000
Long-Term Loan 50,000
Common Equity 60,000

A. Prepare an income statement and a balance sheet for the Bike-With-Us Corporation
using only the information provided above.

Income Statement
Sales $325,000
Less: Opr. Costs 285,000
EBITDA 40,000
Less: Depreciation 10,000
EBIT 30,000
Less: Interest 5,000
EBT 25,000
Less: Taxes 6,000
Net Income 19,000

Balance Sheet
Cash $1,000
Receivables 30,000
Inventories 50,000
Total Cur. Assets 81,000
Fixed Assets, Net 50,000
Total Assets $131,000
 Chapter 5: Evaluating Financial Performance 77

Payables 11,000
Accruals 10,000
Total Cur. Liab. 21,000
Long-Term Loan 50,000
Common Equity 60,000
Total Liab. & Eq. $131,000

B. Calculate the current ratio, quick ratio, and NWC-to-total-assets ratio.

Current Ratio = Current Asset/Current Liabilities = $81,000/$21,000 = 3.86

Quick Ratio = (CA - Inventories)/CL = ($81,000 - $50,000)/$21,000 = 1.48
NWC to Total Assets Ratio = (CA - CL)/Assets = ($81,000 - $21,000)/$131,000 = .458

C. Calculate the total-debt-to-total-assets ratio, debt-to-equity ratio, and interest coverage

Total Debt to Total Assets Ratio = Debt/Assets = $71,000/$131,000 = .542

Debt to Equity Ratio = Debt/Equity = $71,000/$60,000 = 1.183
Interest Coverage Ratio = EBITDA/Interest = $40,000/$5,000 = 8.00

D. Calculate the net profit margin, sales-to-total-assets ratio, and the return on total assets.

Net Profit Margin = Net Profit/Revenues = $19,000/$325,000 = 5.85%

Sales to Total Assets Ratio = Sales/Assets = $325,000/$131,000 = 2.48
Return on Total Assets = Net Profit/Assets = $19,000/$131,000 = 14.50%

E. Calculate the equity multiplier. Combine this calculation with the calculations in Part D
to show the ROE model with its three components.

Equity Multiplier = Assets/Equity = $131,000/$60,000 = 2.183

ROE = Net Profit Margin x Asset Turnover x Equity Multiplier
= 5.85% x 2.48 x 2.183 = 31.67%

2. Use the financial statements data for the Bike-With-Us Corporation provided in Problem 1
to make the following calculations.

A. Calculate the operating return on assets.

Operating return on assets = EBIT/Assets = $30,000/$131,000 = 22.90%

B. Determine the effective interest rate paid on the long-term debt.

Effective interest rate = Interest/Long-term debt = $5,000/$50,000 = 10.00%

C. Calculate the NOPAT margin. How does this compare with the results for the net profit
margin? Did the owners benefit from the use of interest-bearing long-term debt?
78 Chapter 5: Evaluating Financial Performance

Tax Rate = Taxes/EBT = $6,000/$25,000 = 24.00%

NOPAT Margin = [(EBIT)(1 – tax rate)]/Net Sales = [$30,000(1 - .24)]/$325,000 =
$22,800/$325,000 = 7.02%
The Net Profit Margin was lower at 5.85%
Since the Operating Return on Assets (22.90%) was higher than the Effective Interest
Rate (10.00%), the firm benefited from having interest-bearing long-term debt.

3. Following are two years of income statements and balance sheets for the Munich Exports
Corporation.

MUNICH EXPORTS CORPORATION

2007 2008
Cash $50,000 $50,000
Accounts Receivables 200,000 300,000
Inventories 450,000 570,000
Total Current Assets 700,000 920,000
Fixed Assets, Net 300,000 380,000
Total Assets $1,000,000 $1,300,000

Accounts Payable 130,000 $180,000

Accruals 50,000 70,000
Bank Loan 90,000 90,000
Total Current Liabilities 270,000 340,000
Long-Term Debt 400,000 550,000
Common Stock ($1 par) 50,000 50,000
Paid-in-Capital 200,000 200,000
Retained Earnings 80,000 160,000
Total Liab. & Equity $1,000,000 $1,300,000

2007 2008
Net Sales $1,300,000 $1,600,000
Cost of Goods Sold 780,000 960,000
Gross Profit 520,000 640,000
Marketing 130,000 160,000
General & Administrative 150,000 150,000
Depreciation 40,000 55,000
EBIT 200,000 275,000
Interest 45,000 55,000
Earnings Before Taxes 155,000 220,000
Income Taxes (40% rate) 62,000 88,000
Net Income $93,000 $132,000

A. Calculate the cash build, cash burn, and net cash burn or build for Munich Exports in
 Chapter 5: Evaluating Financial Performance 79

2008.

Cash Build = Net Sales – Increase in Receivables = $1,600,000 – ($300,000 - $200,000)

= $1,500,000

Cash Burn = Income Statement-Based Operating, Interest, and Tax Expenses + Increase
in Inventories – (Changes in Payables + Accrued Liabilities) + Capital Expenditures

Operating Expenses = Cost of Goods Sold + Marketing + General and Administrative =

$960,000 + $160,000 + $150,000 = $1,270,000
Other Cash Expenses = Interest + Taxes = $55,000 + $88,000 = $143,000
Increase in Inventories = ($570,000 - $450,000) = $120,000
Changes in Payables and Accrued Liabilities = [($180,000 - $130,000) + ($70,000 -
$50,000)] = $70,000

Capital Expenditures or Change in Gross Fixed Assets = Change in Net Fixed Assets plus
Depreciation = ($380,000 - $300,000) + $55,000 = $135,000

Cash Burn = $1,270,000 + $143,000 + $120,000 - $70,000 + $135,000 = $1,598,000

Net Cash Burn = Cash Burn – Cash Build = $1,598,000 - $1,500,000 = $98,000

B. Assume that 2009 will be a repeat of 2008. If your answer in Part A resulted in a net
cash burn position, calculate the net cash burn monthly rate and indicate the number of
months remaining “until out of cash.” If your answer in Part A resulted in a net cash
build position, calculate the net cash build monthly rate and indicate the expected cash
balance at the end of 2009.

$98,000/12 = $8,166.67
Cash balance at end of 2008 = $50,000
$50,000/$8,166.67 = 6.12 months remaining “until out of cash.”

4. Two years of financial statement data for the Munich Export Corporation are shown in
Problem 3.

A. Calculate the inventory-to-sale, sale-to-cash, and purchase-to-payment conversion

periods for Munich Exports for 2008.

Inventory-to-Sale Conversion Period = Average Inventories / (Cost of Goods Sold/365) =

[($450,000 + $670,000)/2]/$960,000/365 = $560,000/$2,630.14 = 212.92 days

Sale-to-Cash Conversion Period = Average Receivables / (Net Sales/365) = [($200,000 +

$300,000)/2]/ ($1,600,000/365) = $250,000/$4,383.56 = 57.03 days

Purchase-to-Payment Conversion Period = (Average Payables + Average Accrued

Liabilities) / (Cost of Goods Sold/365) = [(($130,000 + $180,000)/2) + (($50,000 +
$70,000)/2) / ($960,000/365) = ($155,000 + $60,000)/$2,630.14 = $215,000/$2,630.14 =
80 Chapter 5: Evaluating Financial Performance

81.74 days

B. Calculate the length of Munich Exports’ cash conversion cycle for 2008.

Cash Conversion Cycle = Inventory-to-Sale Conversion Period + Sale-to-Cash

Conversion Period – Purchase-to-Payment Conversion Period

Cash Conversion Cycle = 212.92 days + 57.03 days – 81.74 days = 188.21 days

5. The Castillo Products Company was started in 2006. The company manufactures
components for personal decision assistant (PDA) products and for other hand-held
electronic products. A difficult operating year 2007 was followed by a profitable 2008.
However, the founders (Cindy and Rob Castillo) are still concerned about the venture’s
liquidity position and the amount of cash being used to operate the firm. Following are
income statements and balance sheets for the Castillo Products Company for 2007 and 2008.

CASTILLO PRODUCTS COMPANY

2007 2008
Net Sales $900,000 $1,500,000
Cost of Goods Sold 540,000 900,000
Gross Profit 360,000 600,000
Marketing 90,000 150,000
General & Administrative 250,000 250,000
Depreciation 40,000 40,000
EBIT (20,000) 160,000
Interest 45,000 60,000
Earnings Before Taxes (65,000) 100,000
Income Taxes 0 25,000
Net Income (Loss) ($65,000) $75,000

2007 2008
Cash $50,000 $20,000
Accounts Receivables 200,000 280,000
Inventories 400,000 500,000
Total Current Assets 650,000 800,000
Gross Fixed Assets 450,000 540,000
Accumulated Depreciation -100,000 -140,000
Net Fixed Assets 350,000 400,000
Total Assets $1,000,000 $1,200,000

Accounts Payable $130,000 $160,000

Accruals 50,000 70,000
Bank Loan 90,000 100,000
Total Current Liabilities 270,000 330,000
Long-Term Debt 300,000 400,000
 Chapter 5: Evaluating Financial Performance 81

Common Stock 150,000 150,000

Paid-in-Capital 200,000 200,000
Retained Earnings 80,000 120,000
Total Liab. & Equity $1,000,000 $1,200,000

A. Use year-end data to calculate the current ratio, the quick ratio, and the net working
capital (NWC) to total assets ratio for 2007 and 2008 for the Castillo Company. What
changes occurred?

Current Ratio = Current Asset/Current Liabilities

Year 2007: $650,000/$270,000 = 2.41
Year 2008: $800,000/$330,000 = 2.42

Quick Ratio = (CA - Inventories)/CL

Year 2007: ($650,000 - $400,000)/$270,000 = 0.93
Year 2008: ($800,000 - $500,000)/$330,000 = 0.91

NWC to Total Assets Ratio = (CA - CL)/Assets

Year 2007: ($650,000 - $270,000)/$1,000,000 = 0.38
Year 2008: ($800,000 - $330,000)/$1,200,000 = 0.39

B. Use Castillo’s complete income statement data and the changes in balance sheet items
between 2007 and 2008 to determine the firm’s cash build and cash burn for 2008. Did
Castillo have a net cash build or net cash burn for 2008?

Cash Build = Sales – Change in Accounts Receivable

= $1,500,000 - $80,000 = $1,420,000
Cash Burn = Inventory-Related Purchases + Administrative Expenses + Marketing
Expenses + Interest Expense - (Change in Accrued Liabilities +
Change in Payables) + Capital Investments + Taxes
= ($900,000 +$100,000) + $250,000 + $150,000 + $60,000 - ($20,000
+ $30,000) + $90,000 + $25,000 = $1,525,000
Net Cash Burn or Build = Cash Build – Cash Burn
= $1,420,000 - $1,525,000
= -$105,000 = $105,000 Cash Burn

C. Convert the annual cash build and cash burn amounts calculated in Part B to monthly
cash build and cash burn rates. Also indicate the amount of the net monthly cash build
or cash burn rate.

Monthly Cash Burn Rate $1,525,000 12 $127,083.33

Less: Monthly Cash Build Rate -$1,420,000 12 -$118,333.33
Monthly Net Cash Burn Rate $105,000 12 $8,750.00

6. Castillo Products Company, described in Problem 5, improved its operations from a net loss
in 2007 to a net profit in 2008. While the founders, Cindy and Rob Castillo, are happy about
82 Chapter 5: Evaluating Financial Performance

these developments, they are concerned with trying to understand how long the firm takes to
complete its cash conversion cycle in 2008. Use the financial statements from Problem 5 to
make your calculations. Balance sheet items should reflect the averages of the 2007 and
2008 accounts.

A. Calculate the inventory-to-sale conversion period for 2008.

Inventory-to-Sale Conversion Period = Avg. Inventory/Avg. Daily COGS

= (($400,000 + $500,000)/2)/($900,000/365) = 182.50 days

B. Calculate the sale-to-cash conversion period for 2008.

Sale-to-Cash Conversion Period = Avg. Receivables/Avg. Daily Sales

= (($200,000 + $280,000)/2)/($1,500,000/365) = 58.40 days

C. Calculate the purchase-to-payment conversion period for 2008.

Purchase-to-Payment Conversion Period

= (Avg. Payables + Avg. Accruals)/Avg. Daily CGS
= (($130,000 + $160,000)/2 + ($50,000 + $70,000)/2)/($900,000/365) = 83.14 days

D. Determine the length of the Castillo Product’s cash conversion cycle for 2008.

Length of the Cash Conversion Cycle = (Inventory-to-Sale Conversion Period) + (Sales-

to-cash Conversion Period) – (Purchase-to-Payment Conversion Period)
= 182.50 days + 58.40 days – 83.14 days = 157.76 days

7. Use the financial statements data for the Castillo Products presented in Problem 5.

A. Calculate the net profit margin in 2007 and 2008 and the sales-to-total-assets ratio using
yearend data for each of the two years.

Net profit margin 2007: -$65,000/$900,000 = -7.22%

Net profit margin 2008: $75,000/$1,500,000 = 5.00%
Sales-to-total-assets 2007: $900,000/$1,000,000 = .900
Sales-to-total-assets 2008: $1,500,000/$1,200,000 = 1.250

B. Use your calculations from Part A to determine the rate of return on assets in each of the
two years for the Castillo Products.

Rate of return on assets 2007: -7.22% x .900 = -6.50%

Rate of return on assets 2008: 5.00% x 1.250 = 6.25%

C. Calculate the percentage growth in net sales from 2007 to 2008. Compare this with the
percentage change in total assets for the same period.

Percentage growth in net sales: ($1,500,000 - $900,000)/$900,000 = 66.67%

 Chapter 5: Evaluating Financial Performance 83

Percentage change in total assets: ($1,200,000 - $1,000,000)/$1,000,000 = 20.00%

D. Express each expense item as a percentage of net sales for both 2007 and 2008. Describe
what happened that allowed Castillo Products to move from a loss to a profit between
the two years.

2007 2008
Net sales 100.00% 100.00%
Cost of goods sold 60.00 60.00
Gross profit 40.00 40.00
Marketing 10.00 10.00
General & administrative 27.78 16.67
Depreciation 4.44 2.67
EBIT -2.22 10.67
Interest 5.00 4.00
Earnings before taxes -7.22 6.67
Income taxes 0.00 1.67
Net income (loss) -7.22% 5.00%

The decline in general and administrative expenses as a percentage of sales (i.e., the
spreading of fixed costs) was the major contributor to Castillo becoming profitable. The
decline in depreciation expenses and in interest expenses as percentages of sales also
contributed to the move to profitability. However, increased taxes on profits reduced some
of the profitability gains.

8. Safety-First, Inc. makes portable ladders that can be used to exit second floor levels of
homes in the event of fire. Each ladder consists of fire resistant rope and high strength
plastic steps. A lightweight fire resistant cape with a smoke filter is included with Safety-
First ladder. Each ladder and cape, when not in use, are rolled up and stored in a pouch the
size of a back pack and can easily be taken on trips and vacations.
Jan Smithson founded Safety-First as soon as she graduated from a private liberal arts
college in the northwest three years ago. After struggling for the first year, the venture
seemed to be growing and producing profits. Following are the two most recent years of
financial statements, expressed in thousands of dollars, for the Safety-First, Inc.

SAFETY-FIRST, INC.

Income Statements (in $ Thousands)

2007 2008
Net sales 3,750 4,500
Cost of goods sold 2,250 2,700
Gross profit 1,500 1,800
Operating expenses 670 860
Interest 30 40
Income before taxes 800 900
Income taxes 250 300
Net income 550 600
84 Chapter 5: Evaluating Financial Performance

Balance Sheets (in $ Thousands)

2007 2008
Cash 400 150
Accounts receivable 500 800
Inventories 1,450 2,000
Total current assets 2,350 2,950
Gross fixed assets 2,000 2,800
Less accumulated depreciation (950) (1,250)
Net fixed assets 1,050 1,550
Total assets 3,400 4,500

Accounts payable 300 400

Bank loan 150 250
Accrued liabilities 100 150
Total current liabilities 550 800
Long-term debt 150 150
Common stock 850 1,100
Retained earnings 1,850 2,450
Total liabilities and equity 3,400 4,500

A. Using yearend data for, calculate the inventory-to-sale conversion period, the sale-to-
cash conversion period, and the purchase-to-payment conversion period for 2007 and
2008.

Note: because inventories, accounts receivable, accounts payable, and accrued liabilities
are not available for 2006, averages of these accounts cannot be calculated for 2007. So
for 2007 versus 2008 comparative purposes, we use yearend data for these accounts.

Inventory-to-Sale Conversion Period = (Yearend Inventories) / (COGS / 365)

2007: 1450 / (2250 / 365) = 1450/6.1644 = 235.22
2008: 2000 / (2700 / 365) = 2000/7.3973 = 270.37

Note: the calculation for 2008 using average inventories would be:
Inventory-to-Sale Conversion Period = (Average Inventories) / (COGS / 365)
2008: ((1450 + 2000) / 2) / (2700 / 365) = 1725/7.3973 = 233.19

Sale-to-Cash Conversion Period = (Yearend Receivables) / (Net Sales / 365)

2007: 500 / (3750 / 365) = 500/10.2740 = 48.67
2008: 800 / (4500 / 365) = 800/12,3288 = 64.89

Note: the calculation for 2008 using average receivables would be:
Sale-to-Cash Conversion Period = (Average Receivables) / (Net Sales / 365)
2008: [(500 + 800) / 2] / (4500 / 365) = 650/12.3288 = 52.72
 Chapter 5: Evaluating Financial Performance 85

Purchase-to-Payment Conversion Period = (Yearend Payables + Yearend Accrued

Liabilities) / (COGS / 365)
2007 (300 + 100) / (2250 / 365) = 400/6.1644 = 64.89
2008: (400 + 150) / (2700 / 365) = 550/7.3973 = 74.35

Note: the calculation for 2008 using average payables and average accruals would be:
Purchase-to-Payment Conversion Period = (Average Payables + Average Accrued
Liabilities) / (COGS / 365)
2008: ((300 + 400)/2) + ((100 + 150)/2) = 350 + 125 = 475
475 / (2700 / 365) = 475/7.3973 = 64.21

B. Determine the cash conversion cycle for each year and discuss the changes, if any that
took place.

Cash Conversion Cycle = Inventory-to-Sale Conversion Period + Sale-to-Cash

Conversion Period – Purchase-to-Payment Conversion Period

2007: 235.22 + 48.67 – 64.89 = 219.00

2008: 270.37 + 64.89 – 74.35 = 260.91

Note: using average (2007 and 2008) balance sheet accounts for 2008 results in the
following cash conversion cycle:
2008: 233.19 + 52.72 – 64.21 = 221.70

9. Return to the financial statements data provided in Problem 8 for the Safety-First
Corporation.

A. Calculate the net profit margin, the sales-to-total-assets ratio, and the equity multiplier for
both 2007 and 2008 using year-end (rather than average) balance sheet data.

Net Profit Margin = Net Profit / Net Sales

2007: 550/3,750 = 14.67%
2008: 600/4,500 = 13.33%

Sales-to-Total Assets = Net Sales / Total Assets

2007: 3,750/3,400 = 1.1029
2008: 4,500/4,500 = 1.0000

Equity Multiplier = Total Assets / Common Equity

2007: 3,400/(850 + 1850) = 3,400/2,700 = 1.2593
2008: 4,500/(1,100 +2,450) = 4,500/3,550 = 1.2676

B. Use the results from Part A to calculate the venture’s return on equity in each year.

Return on Equity = Net Profit Margin x Asset Turnover x Equity Multiplier

2007: 14.67% x 1.1029 x 1.2593 = 20.37%
2008: 13.33% x 1.0000 x 1.2676 = 16.90%
 86 Chapter 5: Evaluating Financial Performance

C. Describe what happened in terms of the financial performance of the Safety-First

Corporation between 2007 and 2008.

The net profit margin declined as did the asset turnover causing the return on assets
(ROA) to decline:
2007: ROA = 14.67% x 1.2593 = 18.47%
2008: ROA = 13.33% x 1.0000 = 13.33%

The equity multiplier increased slightly from 1.2593 to 1.2676. The net result was a
decline in ROE from 20.37% in 2007 to 16.90% in 2008.

10. Make use of the financial statements data provided in Problem 8 for the Safety-First
Corporation.

A. Calculate the operating profit margins and the NOPAT margins in 2007 and 2008 for the
Safety-First Corporation. What changes occurred?

Operating Profit Margin = EBIT / Net Sales

2007: (800 + 30)/3,750 = 22.13%
2008: (900 + 40)/4,500 = 20.89%

NOPAT Margin = (EBIT(1 – Tax Rate) / Net Sales

2007: [(800 + 30)(1- 250/800)]/3,750 = (830(1 -.3125))/3,750 = 570.63/3,750 = 15.22%
2008: [(900 + 40)(1- 300/900)]/4,500 = (940(1 - .3333))/4,500 = 626.70/4,500 = 13.93%

Both profit margin measures declined indicated less efficient control of expenses.

B. Calculate the operating return on assets (or the venture’s basic earning power) using year-
end balance sheet information for both 2007 and 2008. Describe what happened in terms
of operating return performance?

Operating Return on Assets = EBIT / Total Assets

2007: (800 + 30)/3,400 = 24.41%
2008: (900 + 40)/4,500 = 20.89%

The operating return on assets declined as did the operating profit margin calculated in
Part A.

C. Did the venture benefit from using interest-bearing debt in the form of bank loans and
long-term debt in 2007 and 2008?

Bank loans increased from $150,000 in 2007 to $250,000 in 2008 while long-term debt
remained constant at $150,000 over both years. The net result was an increase in total
interest-bearing debt of $100,000 between 2007 and 2008. At the same time, the amount
of interest increased from $30,000 to $40,000.
 Chapter 5: Evaluating Financial Performance 87

Effective Interest Rate = Interest / Amount of Interest-Bearing Debt

2007: 30/300 = 10.00%
2008: 40/400 = 10.00%

Since the effective interest rate was lower that the operating return on assets (see Part B),
the venture benefited from the use of interest-bearing debt in both years. Since the
operating return on assets was higher in 2007 and the effective interest rate was 10.00%
in both years, the venture benefited relatively more from having interest-bearing debt in
2007.

MINI CASE: SCANDI HOME FURNISHINGS, INC.

Kaj Rasmussen founded Scandi Home Furnishings as a corporation during mid-2005. Sales
during the first full year (2006) of operation reached $1.3 million. Sales increased by 15
percent in 2007 and another 20 percent in 2008. However, profits after increasing in 2007 over
2006 fell sharply in 2008 causing Kaj to wonder what was happening to his “pride and joy”
business venture. After all, Kaj has continued to work as close as possible to a 24/7 pace
beginning with the startup of Scandi and through the first three full years of operation.
Scandi Home Furnishings, located in eastern North Carolina, designs, manufactures,
and sells to home furnishings retailers Scandinavian-designed furniture and accessories. The
modern Scandinavian design has a streamlined and uncluttered look. While this furniture style
is primarily associated with Denmark, both Norway and Sweden designers have contributed to
the allure of Scandinavian home furnishings. Some say that the inspiration for the Scandinavian
design can be traced to the “elegant curves” of art nouveau from which designers were able to
produce aesthetically pleasing, structurally strong modern furniture. Danish, and the home
furnishings produced by the other Scandinavian countries—Sweden, Norway, and Finland, are
made using wood (primarily oak, maple, and ash), aluminum, steel, and high-grade plastics.
Kaj grew up in Copenhagen, Denmark and received a college degree from a technical
university in Sweden. As is typically in Europe, Kaj began his business career as an apprentice
at a major home furnishings manufacturer in Copenhagen. After “learning the trade,” he
quickly moved into a management position in the firm. However, after a few years, Kaj realized
that what he really wanted to do was to start and operate his own Scandinavian home
furnishings business. At the same time, after traveling throughout the world including the U.S.,
he was sure that he wanted to be an entrepreneur in the United States. Thus, while it was hard
to give up the Tivoli Gardens with its many entertainment and dining activities, as well as the
other attractions in Copenhagen, Kaj moved to the U.S. in early 2005. With $140,000 of his
personal assets, and $210,000 from venture investors, he began operations in mid-2005. Kaj,
with a 40 percent ownership interest and industry-related management expertise, was allowed to
operate the venture in a way that he thought was best for Scandi. Four years later, Kaj is sure
he did the right thing.
Following are the three years of income statements and balance sheets for the Scandi
Home Furnishings Corporation. Kaj has felt that in order to maintain a competitive advantage
that he would need to continue to expand sales. After first concentrating on selling
Scandinavian home furnishings in the northeast in 2006 and 2007, he decided to enter the west
88 Chapter 5: Evaluating Financial Performance

coast market. An increase in expenses associated with identifying, contacting, and selling to
home furnishings retailers in California, Oregon, and Washington. Kaj Rasmussen was hoping
that you could help him better understand what has been happening to Scandi Home
Furnishings both from operating and financial standpoints.

SCANDI HOME FURNISHINGS, INC.

Income Statements
2006 2007 2008
Net Sales $1,300,000 $1,500,000 $1,800,000
Cost of Goods Sold 780,000 900,000 1,260,000
Gross Profit 520,000 600,000 540,000
Marketing 130,000 150,000 200,000
General & Administrative 150,000 150,000 200,000
Depreciation 40,000 53,000 60,000
EBIT 200,000 247,000 80,000
Interest 45,000 57,000 70,000
Earnings Before Taxes 155,000 190,000 10,000
Income Taxes (40%) 62,000 76,000 4,000
Net Income $93,000 $114,000 $6,000

SCANDI HOME FURNISHINGS, INC.

Balance Sheets
2006 2007 2008
Cash $50,000 $40,000 $10,000
Accounts Receivables 200,000 260,000 360,000
Inventories 450,000 500,000 600,000
Total Current Assets 700,000 800,000 970,000
Fixed Assets, Net 300,000 400,000 500,000
Total Assets $1,000,000 $1,200,000 $1,470,000

Accounts Payable $130,000 $170,000 $180,000

Accruals 50,000 70,000 80,000
Bank Loan 90,000 90,000 184,000
Total Current Liabilities 270,000 330,000 444,000
Long-Term Debt 300,000 400,000 550,000
Common Stock ($10 par)* 300,000 300,000 300,000
Capital Surplus 50,000 50,000 50,000
Retained Earnings 80,000 120,000 126,000
Total Liab. & Equity $1,000,000 $1,200,000 $1,470,000

Note: 30,000 shares of common stock were issued to Kaj Rasmussen and the venture investors
when Scandi Home Furnishings was incorporated in mid-2005.
 Chapter 5: Evaluating Financial Performance 89

A. Kaj was particularly concerned by the drop in cash from $50,000 in 2006 to $10,000 in
2008. Calculate the average current ratio, the quick ratio, and the networking capital to
total assets ratio for 2006-2007 and 2007-2008. What has happened to Scandi’s
liquidity position?

Note: ratio calculations involving asset items on the balance sheet are averages of the
prior and current years. For example, the ratios for 2007 use average balance sheet
account amounts for 2006 and 2007. Likewise, ratios for 2008 use average balance sheet
account amounts for 2007 and 2008.

Liquidity Ratios:
2007 2008 Change
Current Ratio 2.500 2.287 Lower
Quick Ratio 0.917 0.866 Lower
NWC-to-Total-Assets 0.409 0.373 Lower

All three liquidity ratios declined.

B. An analysis of the cash conversion cycle should also help Kaj understand what has been
happening to the operations of Scandi. Prepare an analysis of the average conversion
periods for the three components of the cash conversion cycle for 2006-2007 and 2007-
2008. Explain was has happened in terms of each component of the cycle.

Ratios are based on the current year’s income statement amounts and average amounts
(past year and current year) for balance sheet items.

Cash Conversion Cycle (in Days):

2007 2008 Change
Inventory-to-Sale 192.64 159.33 Better
Sale-to-Cash 55.97 62.89 Worse
Purchase-to-Payment (85.17) (72.42) Worse
Cash Conversion Cycle 163.44 149.77 Better

The cash conversion cycle declined from 163.44 days in 2007 to 149.77 days in 2008 due
to a sharp decline in the inventory-to-sale conversion period which more than offset an
increase in the sale-to-cash conversion period and a decrease in the purchase-to-payment
conversion period.

C. Kaj should be interested in knowing whether Scandi has been building or burning cash.
Compare the cash build, cash burn, and the net cash build/burn positions for 2007 and
2008. What, if any, changes have occurred?

Cash Build Versus Cash Burn:

2007 2008
Cash Build:
Net Sales $1,500,000 $1,800,000
90 Chapter 5: Evaluating Financial Performance

Increase in Receivables -60,000 -100,000

Cash Build 1,440,000 1,700,000

Cash Burn:
Cost of Goods Sold -$900,000 -$1,260,000
Marketing -150,000 -200,000
General & Admin. -150,000 -200,000
Interest -57,000 -70,000
Income Taxes -76,000 -4,000
Cash Burn from Inc. Stmt. -1,333,000 -1,734,000
Increase in Inventories -50,000 -100,000
Change in Payables 40,000 10,000
Change in Accrued Liab. 20,000 10,000

Increase in Fixed Assets, Net -100,000 -100,000

Depreciation -53,000 -60,000
Inc. in Gross Fixed Assets -153,000 -160,000

Cash Burn -$1,476,000 -$1,974,000

Net Cash Build (Burn) -$36,000 -$274,000

The venture had a $36,000 net cash burn in 2007 and a larger $274,000 net cash burn in
2008. Operating expenses and interest expenses increased resulting in lower cash from
operations. The net cash burn also increased due to the increase in accounts receivable
and in inventories.

D. Creditors, as well as management, are also concerned about the ability of the venture to
meet its debt obligations as they come due, the proportion of current liabilities to total
debt, the availability of assets to meet debt obligations in the event of financial distress,
and the relative size of equity investments to debt levels. Calculate average ratios in each
of these areas for the 2006-2007 and 2007-2008 periods. Interpret your results and
explain what has happened to Scandi.

Financial Leverage:
2007 2008 Change
Total-Debt-to-Total-Assets 0.5909 0.6457 Higher
Equity Multiplier 2.444 2.822 Higher
Debt-to-Equity Ratio 1.444 1.822 Higher
Current-Liab.-to-Total Debt 0.4615 0.4490 Lower
Interest Coverage 5.263 2.000 Lower

Financial leverage (as measured by the total-debt-to-total-assets ratio, the equity

multiplier, and the debt-to-equity ratio) increased in 2008 versus 2007. This indicates
that financial risk also increased. The current-liabilities-to-total debt ratio improved (was
lower in 2008) indicating a more than proportional use of long-term debt relative to short-
 Chapter 5: Evaluating Financial Performance 91

term debt to meet financing needs in 2008. The interest coverage dropped substantially
due to an increase in the amount of interest and a drop in EBITDA.

E. Of importance to Kaj and the venture investors is the efficiency of the operations of the
venture. Several profit margin ratios relating to the income statement are available to
help analyze Scandi’s performance. Calculate average profit margin ratios for 2006-
2007 and 2007-2008 and describe what is happening to the profitability of Scandi Home
Furnishings.

Profitability Ratios:
2007 2008 Change
Gross Profit Margin 0.4000 0.3000 Lower
Operating Profit Margin 0.1647 0.0444 Lower
Net Profit Margin 0.0760 0.0033 Lower
NOPAT Margin 0.0988 0.0267 Lower

All profitability ratios decreased in 2008 versus 2007. For example, the gross profit
margin decreased from 40.00% to 30.00% and the net profit margin decreased from
7.60% to 0.33%.

F. Kaj and the venture investors are also interested in how efficiently Scandi is able to
convert their equity investment, as well as the venture’s total assets, into sales. Calculate
several ratios that combine data from the income statements and balance sheets and
compare what has happened between the 2006-2007 and 2007-2008 periods.

Efficiency and Return Ratios:

2007 2008 Change
Sales-to-Total-Assets 1.3636 1.3483 Same
Operating Return on Assets 0.2245 0.5993 Lower
Return on Assets (ROA) 0.1036 0.0045 Lower
Return on Equity (ROE) 0.2533 0.0127 Lower

The sales-to-total-assets ratio remained about the same at 1.3636 in 2007 to 1.3483 in
2008. Profitability was sharply lower in terms of the ROA results (from 10.36% to .45%)
and the ROE results (from 25.33% to 1.27%).

G. A ROA model consisting of the product of two ratios provides an overview of a venture’s
efficiency and profitability at the same time. A ROE model consists of the product of
three ratios and simultaneously shows an overview a venture’s efficiency, profitability,
and leverage performance. Calculate ROA and ROE models for the 2006-2007 and
2007-2008 periods. Provide an interpretation of your findings.

ROA 2007: 10.36% = 7.60% x 1.3636

ROA 2008: 0.45% = 0.33% x 1.3483
ROE 2007: 25.33% = 7.60% x 1.3636 x 2.444
ROE 2008: 1.27% = 0.33% x 1.3483 x 2.822
92 Chapter 5: Evaluating Financial Performance

Both the ROA and ROE model results show declining performance due to a large decline
in the net profit margin combined with a relatively unchanged (slight decline) sales-to-
assets ratio. The financial leverage (as measured by the equity multiplier) increased from
2007 to 2008 during this period of declining operating performance.

H. Kaj has been able to obtain some industry ratio data from the home furnishings industry
trade association of which he is a member. The industry association collects proprietary
financial information from members of the association, compiles averages to protect the
proprietary nature of the information, and provides averages for use by individual trade
association members. Over the 2006-2007 and 2007-2008 periods, the inventory-to-sale
conversion period has averaged 200 days, while the sale-to-cash conversion period (days
of sales outstanding) for the industry has average 60 days. How did Scandi’s operations
in terms of these two components of the cash conversion cycle compare with these
industry averages?

Scandi’s inventory-to-sale conversion period (192.64 days and 159.33 days) was lower
(and thus better) relative to the 200 day average for the industry. Thus, the firm was
turning over its inventories more quickly than the industry average. The firm’s sale-to-
cash conversion period decreased from being better than the 60-day industry average at
55.97 days to being worse than the industry average at 62.86 days.

I. Trade association data for the home furnishings industry shows an average net profit
margin of 6.5 percent, a sales-to-assets ratio of 1.3 times, and a total-debt-to-total-assets
ratio of 55 percent over the 2006-2007 and 2007-2008 time periods. Compare and
contrast to the industry average in terms of the ROA and ROE models. Make sure you
compare the components of each model as well as the product of the components.

If the total-debt-to-total-assets ratio is 55%, the equity-to-total-assets ratio is 45% (1 - .

55). If we calculate the inverse of this ratio (1/.45), we get an equity multiplier for the
industry of 2.222. Thus, the industry ROE model is:

ROE Industry: 18.78% = 6.50% x 1.300 x 2.222

From Part G:
ROA 2007: 10.36% = 7.60% x 1.3636
ROA 2008: 0.45% = 0.33% x 1.3483
ROE 2007: 25.33% = 7.60% x 1.3636 x 2.444
ROE 2008: 1.27% = 0.33% x 1.3483 x 2.822

Scandi’s ROE declined from above the industry average in 2007 to well below the
industry average in 2008. The firm’s net profit margin also declined from above the
industry average to below the industry average. Also, while the turnover of assets
declined slightly for the firm, the ratio remained above the industry average. Scandi’s
use of debt to finance its assets was above the industry average in 2007 and even more so
in 2008.
Chapter 5: Evaluating Financial Performance 93