Chapter 4 - Evaluating Financial Performance Financial Analysis – process of assessing financial condition of a firm Principal analytic tool is the financial ratio Understand ratios and what they mean Be sure to read about Nextel on the introductory page to this chapter. However you are not responsible for pages 125 to 128 on the Du Pont Analysis

Ratio Analysis Identify firm’s strengths and weaknesses Comparison of the firm over time or with other firms Industry averages – benchmarks Robert Morris Associates, Dun & Bradstreet Four types of ratios: liquidity, efficiency, leverage and profitability All we are doing is standardizing financial data so we can make comparisons with industry averages or the company’s trend over time.

Ratios and Major Questions How liquid is the firm? Are adequate operating profits being generated? How is the firm financing its assets? Are shareholders receiving an adequate return?

How Liquid is the Firm? Liquidity – ability to meet maturing obligations Enough resources to pay when due? How do liquid assets compare with debt? Compare cash and assets to be converted to cash with debt due in same period Can firm convert receivables/inventories to cash on timely basis? How quick or long?

Liquidity Current ratio – conventional wisdom says 2:1 but there is “the lettuce problem”. Acid test or quick ratio – (CA - Inv)/ CL Collection period – how many days to collect receivables = AR / DCrS = say 20 Turnover – how many times are AR rolled over during a year? = CS/AR = say 18 X By most of these measures, McD less liquid The lettuce problems refers to the company’s unique situation, inventory spoilage. Why also compute acid test? (Inventories least liquid and subject to price change.) DCrS = daily credit sales Its CR and quick ratio are equal to or better than competitors(.7 and .4) but its competitors have 6.5 day receivables turnover or 56 times a year. Why? McD doesn’t extend credit to customers but it has large receivables from franchisees. McD == 24 times, Comp = 56 times

Collection Period & Turnover Measure the same thing – are reciprocals 365 days = 17.9 X 365 Days = 20.4days 20.4 days 17.9 X McD not good at collections (20 days vs. 7) Are longer credit terms good or bad? Competitive necessity or weak management ? Receivables aging – good footnote

Inventory Turnover Turnover Ratio = Cost of Goods Sold (Times per year) Inventory Why COGS? Need cost-based numbers in numerator and denominator If less liquid, greater chance to be unable to pay on time. McD – excellent inventory management (87 times a year versus 35)

Cash Conversion Cycle To reduce working capital, speed up collections, turn inventory faster, slow disbursements Sum of days required to collect + days in inventory - Days of Payable Outstanding DPO = Accounts Payable = say 29 COGS / 365 So we have 20 days in receivables, 4 in inventory less 29 in payables for a negative 5 days. Minus five days is another way of saying we have negative working capital.

Operating Profits – Adequate? Text tells us to use operating profits GP ignores marketing exp; NP includes financing effects OIROI – Operating Income Return on Investment – op profits relative to assets OIROI = Operating Income Total Assets McD generates more income per $ of assets Operating profit margin 23.4% for McD, 6.1% for peers. McD keeps its costs low as by both margins OIROI- McD 15.4% versus 11.6% because more profitable.

OIROI Separate OIROI into its two pieces: OIROI = OPM * TAT 15.4 = 23.4 * .66 Operating Profit Margin = Op. Income Sales Management’s effectiveness in keeping costs in line with sales; McD = very good Now it gets more complicated. To see what’s driving OIROI, need to break it into two pieces, Operating Profit Margin (OPM) and Total Asset Turnover or TAT. 23.4% McD versus 6.1%

Total Asset Turnover TAT = Sales = .66 Total Assets Amount of sales generated by $1 of assets Higher turnover better; good use of asset McD – weak $0.66 in sales per $ of assets Where’s the problem? Check components Versus 1.9 times for peers

Total Asset Turnover McD very weak. But why? Turnover McDonalds Peers Receivables 17.9 X = Bad 56 Inventory 87 Good 35 Fixed Assets .84 Bad 3.2 These don’t add to total asset turnover shown previously (.66 and 1.9) Why? We are excluding cash and a chunk of other assets. Also, each of these items vary in size

OIROI Summary OIROI = Operating Inc. * Sales Sales Total Assets McD effectively keeps costs and operating expenses low, but is not particularly good in managing its assets Overall, they are doing better than the competitors – OIROI = 15. 4% versus 11.6%

How Does Firm Finance Assets? What percentage of assets are financed by debt and how much by equity? Debt includes all liabilities, both short and long-term Debt Ratio = Total Debt Total Assets McD uses significantly less debt (54 vs 69%)

Times Interest Earned TIE – how much operating income is available to meet interest expense? Or, how many times is it covering annual interest? TIE = Operating Income = 7.5 Times Interest Expense McD – no problem in paying int. Op. Inc. could fall to 1/7th of current level and still pay (1/7.5)

Adequate Returns? Are stockholders receiving an adequate return on their investment? Is it attractive compared to other companies? Return on Com Equity = Net Income Common Equity Equity = PV, P-I + RE but no preferred stock McD – profitability fully offsets low leverage McD ROE 20%, competitors 12.8% (McD more profitable)

What Can We Say About McD Its liquidity is average even with low receivable turnover; good on inventory OIROI is good;good profitability offsets low asset turnover Uses less debt than competitors Good Return on Equity; uses less debt but this offset by greater profitability.

Limitations With Ratios Difficult to identify industry categories No exact peers Averages are only approximates Accounting principles differ Ratios can be too high or too low Industry averages include “stars and dogs” However, ratios are still useful tools

Unmentioned Problems Old firm versus new Window dressing Have assets been depreciated? Window dressing Actions to make good at year end Role of “revolvers” Some ratios make you look good, others make look bad Overall – look at several combinations