1. Evaluating a Firm’s Financial Performance

2. Objectives Why Financial Ratio Analysis What are the Five Categories
How to compute
Limitations

3. Why?
Are (should) our decisions (be) maximizing shareholder wealth?

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 (benchmarks).

5. Uses of Financial Ratios within the Firm
Identify deficiencies in a firm’s performance and take corrective actions.
Evaluate employees’ performance and determine incentive compensation.
Compare the financial performance of different divisions within the firm

6. Uses of Financial Ratios within the Firm
Prepare financial projections, both at the firm and division levels.
Understand the financial performance of competitors
Evaluate the financial condition of a major supplier.

7. Uses of Financial Ratios Outside the Firm
Lenders in deciding whether or not to make a loan to a company.
Credit-rating agencies in determining a firm’s credit worthiness.
Investors in deciding whether or not to invest in a company.
Major suppliers in deciding to sell and grant credit terms to a company.

8. We will want to answer questions about the firm’s
1. Liquidity
2. Efficient use of Assets
3. Leverage (financing)
4. Profitability/Returns
5. Shareholder Wealth

9. Example: CyberDragon Corporation

10. CyberDragon’s Balance Sheet ($000)
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

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12. 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) ,600
Taxes (3,344)
Net Income ,016
CyberDragon’s Income Statement

13. CyberDragon Other Information
Dividends paid on common stock $2,800
Earnings retained in the firm 2,216
Shares outstanding (000) ,300
Market price per share
Book value per share
Earnings per share
Dividends per share

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

15. Current Ratio

16. 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?

17. Acid Test Ratio

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

19. Average Collection Period

20. 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?

21. Accounts Receivable Turnover

22. 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?

23. Inventory Turnover

24. 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?

25. Also … What is the firm’s “Inventory Holding Period” or “Days Sales In Inventory”

26. 2. Operating Efficiency Ratios
Is management generating adequate operating profits on the firm’s assets?

27. Operating Income Return on Investment (OIROI) … also known as Operating Return on Assets (OROA)

28. 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.

29. Operating Profit Margin

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

31. Total Asset Turnover

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33. 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.

34. Fixed Asset Turnover

35. 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?

36. Also consider: A/R Ratios Inventory Ratios

37. 3. Leverage Ratios/How Financing Assets?
Measure the impact of using debt capital to finance assets.
Firms use debt to lever (increase) returns on common equity.

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

39. ROE = = 15% 15,000 100,000 How does Leverage work?
Suppose we have an all equity-financed firm worth $100,000. Its earnings this year total $15,000.
ROE = = 15%
15,000
100,000

40. ROE = How does Leverage work?
Suppose the same $100,000 firm is financed with half equity, and half 8% debt (bonds). Earnings are still $15,000 … less interest.
ROE =

41. ROE = = 15,000 - 4,000 50,000 How does Leverage work?
Suppose the same $100,000 firm is financed with half equity, and half 8% debt (bonds). Earnings are still $15,000.
ROE = =
15, ,000
50,000

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

43. Debt Ratio

44. 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?

45. Times Interest Earned Ratio

46. 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.

47. 4. Return on (Common) Equity … also, Profitability
Is management providing a good return on the capital provided by the shareholders?

48. Return on (Common) Equity (ROE)

49. What is CyberDragon’s Return on Equity (ROE)?
5,016
34,367
= 14.6%
The industry average is 17.54%.

50. 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?

51. 5. Is Management Creating Shareholder Value?
These ratios indicate what investors think of management’s past performance and future prospects.
Price/Earnings ratio
Price/Book ratio

52. What is CyberDragon’s Price/Earnings (P/E) Ratio?20
3.86
= 5.18

53. What is CyberDragon’s Price/Book Ratio?20
26.44
= .76

54. 5. Is Management Creating Shareholder Value? … Cont.
Economic Value Added (EVA) … Based on “economic profit” not “accounting profit”

55. Economic Value Added (EVA)
How is shareholder value created?
If the firm earns a return on capital that is greater than the investors’ required rate of return.
EVA attempts to measure a firm’s economic profit, rather than accounting profit.
EVA recognizes a cost of equity in addition to the cost of debt (interest expense).

56. EVA: Formula EVA = (r-k) X A where: r = Operating return on assets
k = Total cost of capital
A = Amount of capital (or Total Assets)

57. EVA Example
A firm has total assets of $5,000 and has raised money from both debt and equity in equal proportion. Further, assume that cost of debt is 8% and the cost of equity is 16%. Assume the firm earns 17% operating income on its investments.
EVA = (17%-12%)* $5,000 = $250
Where, cost of capital
= .5*(8%) + .5*(16%) = 12%

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

59. Limitations of Ratio Analysis
It is difficult to tell whether company is, on balance, in a strong or weak position.
Inflation and seasonal factors may distort ratios.
Different operating and accounting practices may distort comparisons.
“Window dressing” techniques can make ratios look better than they actually are.
“Average” performance is not necessarily good.
Sometimes it is hard to tell if a ratio is “good” or “bad”.
Difficulty in identifying industry categories or finding peers.
Published peer group or industry averages are only approximations.

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