Evaluating Firm Performance_2

8/8/2019 Evaluating Firm Performance_2

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Evaluating a Firms FinancialEvaluating a Firms FinancialPerformancePerformance


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Obj ectivesObj ectives

Financial Ratio AnalysisDupont AnalysisLimitations of Ratio AnalysisFirm Performance and Shareholder Value


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Financial RatiosFinancial Ratios

Accounting data stated in relative terms


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Financial RatiosFinancial Ratios

H elp identify financial strengths andweaknesses of a company by examining: Trends across time

Comparisons with other firms ratios


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Financial RatiosFinancial RatiosE xamine:

H ow liquid is a firm?Is management generating adequateoperating profits on the firms assets?H ow is the firm financing its assets?Is management providing a good return onthe capital provided by the shareholder?


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How liquid is a firm?

How liquid is a firm?

Liquidity is the ability to meet maturingdebt obligationsMeasured 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 E xamines the firms ability to convert accounts

receivables and inventory into cash on a timely basis


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M easuring Liquidity:M easuring Liquidity: Approach 1 Approach 1

Compare a firms current assets withcurrent liabilities Current Ratio Acid Test or Quick Ratio


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Current Ratio

Current Ratio

Compares cash and current assets thatshould be converted into cash during theyear with the liabilities that should be paidwithin the year

Current Assets / Current liabilities


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Acid Test or Quick Ratio Acid Test or Quick RatioCompares cash and current assets (minusinventory) that should be converted intocash during the year with the liabilities thatshould be paid within the year.More restrictive than the current ratio

because it eliminates inventories(Current assets inventory) / Currentliabilities


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X C ompanyX C ompanyIncome StatementIncome Statement

Sales (All Credit) $2,000Cost of Goods Sold $1,200Gross Profits $800Marketing and Admin $80Depreciation $70Total Operating E xp $150Operating Profits $650(E BIT or Operating Income)

Interest E xpense $50Income Before Taxes $600Taxes $100

Net Income $500


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X C

ompany Ratio AnalysisX

C

ompany Ratio AnalysisCurrent Ratiocurrent assets/current liabilities400/600 = .667Acid-Test Ratio

(Current assets inventory) / currentliabilities(400 150) / 600 = .416


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M easuring Liquidity:M easuring Liquidity: Approach 2 Approach 2

Measures a firms ability to convertaccounts receivable and inventory into cash

Average Collection Period

Accounts Receivable Turnover Inventory Turnover Cash Conversion Cycle


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AverageC

ollection Period AverageC

ollection Period

The conversion of accounts receivable intocash, is measured by calculating how long ittakes to collect the firms receivables

Accounts Receivable / Daily Credit Sales


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Accounts Receiva ble Accounts Receiva bleTurnover Turnover

H ow many times accounts receivable arerolled over during a year Credit Sales / Accounts Receivable


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Inventory Turnover Inventory Turnover

H ow many times is inventory rolled over during the year?Cost of Goods Sold / Inventory


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X C

ompany Ratio AnalysisX

C

ompany Ratio AnalysisAverage Collection Period150 / (2,000 / 365) = 27.38Accounts Receivable Turnover 2,000 / 150 = 13.33

Inventory Turnover 1,200 / 175 = 6.86


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Cash

Conversion

Cycle

Cash

Conversion

Cycle

Sum of the days of sales outstanding (average

collection period) and days of sales in inventory lessthe days of payables outstanding.

Cash Days of Days of Days of Conversion = Sales + Sales in - PayablesCycle Outstanding Inventory Outstanding


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Days of Sales Outstanding

Days of Sales Outstanding

Average Collection PeriodAccounts Receivable / (Sales / 365)


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Days of Sales In Inventory

Days of Sales In Inventory

Average age of the inventory or average

number of days that a dollar of inventory isheld by the firm

Inventory / (Cost of Goods Sold / 365)


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Days of Paya bles Outstanding

Days of Paya bles Outstanding

Average age in days of the firms accounts payable

Accounts Payable / (Cost of Goods Sold /365)


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C ash C onversion C ycleC ash C onversion C yclefor X C ompanyfor X C ompany

Days of Accts Rec 150Sales = (Sales/365) = (2000/365) =Outstanding

27.37Days of Inventory 175Sales In = (Cost of Goods Sold/ = (1200/365) =Inventory 365)

53.23Days of Payables = Accts Payable 600Outstanding (Cost of Goods Sold/ = (1200/365) =

365)

182.50


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Is M anagement GeneratingIs M anagement Generating

Adequate Operating Profits on Adequate Operating Profits onthe Firms Assets?the Firms Assets?

Operating Income Return on Investment(OIROIO)Operating Profit Margin

Total Asset Turnover Fixed Asset Turnover Return on Assets


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Operating Income Return onOperating Income Return onInvestmentInvestment

Level of profits relative to the assetsor

Income generated per $1 of assets

OIROI = Operating Income/Total Assetsor

OIROI = Operating Profit MarginX

Total Asset Turnover


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Operating ProfitM

arginOperating ProfitM

argin

E xamines operating profitabilityOperating Income / Sales


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Total Asset Turnover Total Asset Turnover

H ow efficiently a firm is using its assets ingenerating salesMeasures the dollar sales per $1 of Assets

Sales / Total Assets


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Fixed Asset Turnover Fixed Asset Turnover E xamines investment in fixed assets for

sales being producedMeasures the dollar sales per $1 of fixedassets

Sales / Fixed Assets


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Alternate OIROI Alternate OIROIOIROI = Operating Profit Margin X

Total Asset Turnover

OIROI = Operating Income SalesSales X Total Assets


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Return on AssetsReturn on Assets

ROA = Net Income / Total Assets


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X C ompany Ratio AnalysisX C ompany Ratio Analysis

OIROI 650 / 1500 = .433

Operating Profit Margin 650 / 2000 = .3250Total Asset Turnover 2000 / 1500 = 1.333Fixed Asset Turnover 2000 / 1100 = 1.82

Alternate OIROI 650 X 2000 = .4332000 1500

ROA 500 / 1500 = .333


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H ow is the Firm Financing ItsH ow is the Firm Financing Its Assets? Assets?

Does the firm finance assets more by debtor equity?Debt Ratio

Times Interest E arned


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De bt Ratio

De bt Ratio

W hat percentage of the firms assets arefinanced by debt?

Total Debt / Total Assets


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Times Interest EarnedTimes Interest Earned

E xamines the amount of operating incomeavailable to service interest payments

or The number of times the firm is earning or covering its interest paymentsOperating Income / Interest


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Is M anagement Providing aIs M anagement Providing a

Good Return on the C apitalGood Return on the C apitalProvided by theProvided by theShareholders?Shareholders?

Return on Common E quity


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Return onC

ommon EquityReturn onC

ommon Equity

Accounting Return on the commonstockholders investment

Net Income / Common E quity


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D uPont AnalysisD uPont AnalysisAn alternative method to analyze a firms

profitability and return on equity

Allows management to see more clearlywhat drives return on equity and the inter-relationships among: net profit margin,asset turnover, and common equity ratio.

Return onCommon = ROA / Common E quityE quity Total Assets


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RO ARO A Alternative C alculation Alternative C alculation

ROA = Net Income / Total Assetsor

Net Profit Margin X Total AssetTurnover

(Net Income X (SalesSales) Total Assets)


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DuPont Equation

DuPont Equation

Net Income X Sales / Cmn E qtySales Ttl Asts Ttl Asts

500/2000 X 2000/1500 / 400/1500

( .25 X 1.33 ) / .267 = 1.245


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Limitations of Ratio AnalysisLimitations of Ratio AnalysisDifficulty in identifying industry categories or finding peers

Published peer group or industry averages are onlyapproximationsAccounting practices differ among firmsFinancial ratios can be too high or too low

Industry averages may not provide a desirabletarget ratio or normUse of average account balances to offset effectsof seasonality


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Economic Value Added (EVA)Economic Value Added (EVA)Measures a firms economic profit, rather thanaccounting profit

Recognizes a cost of equity and a cost of debtE VA = (r-k) X C

where:

r = Operating income return on invested capitalk = Total cost of capitalC = Amount of capital (Total Assets) invested in the

firm


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Star bucksStar bucks--(2003)(2003)Balance SheetBalance Sheet --(millions)(millions)

AssetsCash $350Accounts Rec. $114Inventory $342Other C.A. $116Gross Fixed $2,669

Acc Dep Total Assets $2,672

Liabilities and O. E .Accounts Pay $552S-Term Notes $1

L-Term Debt $38Total Liabilities $591

Owners E quity

Common Stk $1,017Retained E arn. $1,064Total O. E . $2,081Total L + O E $2,672


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Star bucksStar bucks--(2003)(2003)Income StatementIncome Statement

Sales $4,076Cost of Goods Sold $3,207Gross Profits $869

Marketing and Admin $227Depreciation $206Total Operating E xp $433Operating Profits $436(E BIT or Operating Income)

InterestE

xpense $3Income Before Taxes $433Taxes $165

Net Income $268


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Star bucksStar bucks--(2003)(2003)Peer Group RatiosPeer Group Ratios

current ratio 2.02acid-test ratio 1.44average collection period 93 daysaccounts receivable turnover 3.9xinventory turnover 8.5xOROA 14.9%operating profit margin 11.8%total asset turnover 1.26xfixed asset turnover 2.75xdebt ratio 25%times interest earned 46.0xROE 12.0%S&P500 Index P/ E ratio 24x

Evaluating Firm Performance_2

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