Evaluating a Firm’s Financial

Performance
 Objectives

 Financial Ratio Analysis

 Dupont Analysis
 Limitations of Ratio Analysis
 Firm Performance and Shareholder Value
 Financial Ratios

 Accounting data stated in relative terms

 Financial Ratios

 Help identify financial strengths and

weaknesses of a company by examining:
– Trends across time
– Comparisons with other firms’ ratios
 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?
 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
 Measuring Liquidity:
Approach 1

 Compare a firm’s current assets with

current liabilities
– Current Ratio
– Acid Test or Quick Ratio
 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

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

 How many times accounts receivable are

“rolled over” during a year
 Credit Sales / Accounts Receivable
 Inventory Turnover

 How many times is inventory rolled over

during the year?
 Cost of Goods Sold / Inventory
 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
 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
 Days of Sales Outstanding

 Average Collection Period

 Accounts Receivable / (Sales / 365)
 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)

Days of Payables Outstanding

 Average age in days of the firm’s accounts

payable

 Accounts Payable / (Cost of Goods Sold /365)

 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
 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
 Operating Income Return on
Investment
 Level of profits relative to the assets
or
 Income generated per $1 of assets

 OIROI = Operating Income/Total Assets

or
 OIROI = Operating Profit Margin
X
Total Asset Turnover
 Operating Profit Margin

 Examines operating profitability

 Operating Income / Sales
 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

 Fixed Asset Turnover

 Examines investment in fixed assets for

sales being produced
 Measures the dollar sales per $1 of fixed
assets

 Sales / Fixed Assets

 Alternate OIROI
 OIROI = Operating Profit Margin X
Total Asset Turnover

OIROI = Operating Income Sales

Sales X Total Assets
 Return on Assets

 ROA = Net Income / Total Assets

 X Company Ratio Analysis

 OIROI 650 / 1500 = .433

 Operating Profit Margin 650 / 2000 = .3250
 Total Asset Turnover 2000 / 1500 = 1.333
 Fixed Asset Turnover 2000 / 1100 = 1.82
 Alternate OIROI 650 X 2000 = .433
2000 1500
 ROA 500 / 1500 = .333
 How is the Firm Financing Its
Assets?

 Does the firm finance assets more by debt

or equity?
 Debt Ratio
 Times Interest Earned
 Debt Ratio

 What percentage of the firm’s assets are

financed by debt?

 Total Debt / Total Assets

 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
 X Company Ratio Analysis

 Debt Ratio 1100 / 1500 = 73.33%

 Times Interest Earned

650 / 50 = 13
 Is Management Providing a
Good Return on the Capital
Provided by the
Shareholders?

 Return on Common Equity

 Return on Common Equity

 Accounting Return on the common

stockholders’ investment

 Net Income / Common Equity

 X Company Ratio Analysis

 Return on common equity

Net Income / Common Equity

500 / 400 = 1.25 or 125%
 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
 ROA
Alternative Calculation
 ROA = Net Income / Total Assets
or
Net Profit Margin X Total Asset
Turnover
(Net Income X (Sales
Sales) Total Assets)
 DuPont Equation
 Net Income X Sales / Cmn Eqty
Sales Ttl Asts Ttl Asts

500/2000 X 2000/1500 / 400/1500

( .25 X 1.33 ) / .267 = 1.245

 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
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
 Starbucks-(2003)
Balance Sheet-(millions)
Assets Liabilities and O.E.
 Cash $350
 Accounts Pay $552
 Accounts Rec. $114
 S-Term Notes $1
 Inventory $342
 L-Term Debt $38
 Other C.A. $116  Total Liabilities $591
 Gross Fixed $2,669 Owner’s Equity
 Acc Dep <$919>  Common Stk $1,017
 Total Assets $2,672  Retained Earn. $1,064
 Total O.E. $2,081
 Total L + OE $2,672
 Starbucks-(2003)
Income Statement
 Sales $4,076
 Cost of Goods Sold $3,207
 Gross Profits $869
 Marketing and Admin $227
 Depreciation $206
 Total Operating Exp $433
 Operating Profits $436
(EBIT or Operating Income)
 Interest Expense $3
 Income Before Taxes $433
 Taxes $165
 Net Income $268
 Starbucks-(2003)
Peer Group Ratios
 current ratio 2.02
 acid-test ratio 1.44
 average collection period 93 days
 accounts receivable turnover 3.9x
 inventory turnover 8.5x
 OROA 14.9%
 operating profit margin 11.8%
 total asset turnover 1.26x
 fixed asset turnover 2.75x
 debt ratio 25%
 times interest earned 46.0x
 ROE 12.0%
 S&P500 Index P/E ratio 24x