Evaluating a Firm’s Financial Performance

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

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

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).

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

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.

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.

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

Example: CyberDragon Corporation

CyberDragon’s Balance Sheet ($000) Assets: Liabilities & Equity: Cash $2,540 Accounts payable 9,721 Marketable securities 1,800 Notes payable 8,500 Accounts receivable 18,320 Accrued taxes payable 3,200 Inventories 27,530 Other current liabilities 4,102 Total current assets 50,190 Total current liabilities 25,523 Plant and equipment 43,100 Long-term debt (bonds) 22,000 less accum deprec. 11,400 Total liabilities 47,523 Net plant & equip. 31,700 Common stock ($10 par) 13,000 Total assets 81,890 Paid in capital 10,000 Retained earnings 11,367 Total stockholders' equity 34,367 Total liabilities & equity 81,890

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CyberDragon’s Income Statement Sales (all credit) $112,760 Cost of Goods Sold (85,300) Gross Profit 27,460 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) 8,600 Taxes (3,344) Net Income 5,016 CyberDragon’s Income Statement

CyberDragon Other Information Dividends paid on common stock $2,800 Earnings retained in the firm 2,216 Shares outstanding (000) 1,300 Market price per share 20 Book value per share 26.44 Earnings per share 3.86 Dividends per share 2.15

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

Current Ratio

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?

Acid Test Ratio

What is the firm’s Acid Test Ratio? 50,190 - 27,530 25,523 = .89 Suppose the industry average is .92. What does this tell us?

Average Collection Period

What is the firm’s Average Collection Period? 18,320 112,760/365 = 59.3 days If the industry average is 47 days, what does this tell us?

Accounts Receivable Turnover

What is the firm’s Accounts Receivable Turnover? 112,760 18,320 = 6.16 times CyberDragon turns their A/R over 6.16 times per year. The industry average is 8.2 times. Is this efficient?

Inventory Turnover

What is the firm’s Inventory Turnover? 85,300 27,530 = 3.10 times CyberDragon turns their inventory over 3.1 times per year. The industry average is 3.9 times. Is this efficient?

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

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

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

What is the firm’s Operating Income Return on Investment (OIROI)? 11,520 81,890 = 14.07% Slightly below the industry average of 15%. The OIROI reflects product pricing and the firm’s ability to keep costs down.

Operating Profit Margin

What is their Operating Profit Margin? 11,520 112,760 = 10.22% This is below the industry average of 12%.

Total Asset Turnover

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What is their Total Asset Turnover? 112,760 81,890 = 1.38 times The industry average is 1.82 times. The firm needs to figure out how to squeeze more sales dollars out of its assets.

Fixed Asset Turnover

What is the firm’s Fixed Asset Turnover? 112,760 31,700 = 3.56 times If the industry average is 4.6 times, what does this tell us about CyberDragon?

Also consider: A/R Ratios Inventory Ratios

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.

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)

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

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 =

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 - 4,000 50,000

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 - 4,000 50,000

Debt Ratio

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?

Times Interest Earned Ratio

What is the firm’s Times Interest Earned Ratio? 11,520 3,160 = 3.65 times The industry average is 6.7 times. This is further evidence that the firm uses more debt financing than average.

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

Return on (Common) Equity (ROE)

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

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?

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

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

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

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

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).

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)

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%

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

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.

JOIN KHALID AZIZ ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. CONTACT: 0322-3385752 R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.