Evaluating a Firm’s Financial Performance Evaluating a Firm’s Financial Performance , Prentice Hall, Inc.

Financial Statement Analysis Are our decisions maximizing shareholder wealth? Are our decisions maximizing shareholder wealth?

We will want to answer questions about the firm’s Liquidity Liquidity Efficient use of Assets Efficient use of Assets Leverage (financing) Leverage (financing) Profitability Profitability

We will want to answer Questions about the firm’s We will want to answer Questions about the firm’s Liquidity Liquidity Efficient use of Assets Efficient use of Assets Leverage (financing) Leverage (financing) Profitability Profitability

Financial Ratios Tools that help us determine the financial health of a company. 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 its ratios in previous years (trend analysis). We can compare a company’s financial ratios with those of its industry. We can compare a company’s financial ratios with those of its industry.

Assets Cash2,540 Marketable securities 1,800 Accounts receivable18,320 Inventories27,530 Total C.A 50,190 Plant and equipment43,100 less accum. dep.11,400 Net plant & equip. 31,700 Total assets81,890 Liabilities & Equity Accounts payable 9,721 Notes payable 8,500 Accrued taxes payable 3,200 Other current liabilities 4,102 Total current liabilities 25,523 Long-term debt (bonds) 22,000 Total liabilities 47,523 Common stock ($10 par) 13,000 Paid in capital 10,000 Retained earnings 11,367 Total stockholders' equity 34,367 Total liabilities & equity 81,890 ABC Ltd Balance Sheet As on 30 th June ….

Sales (all credit) 112,760 Sales (all credit) 112,760 Cost of Goods Sold (85,300) Cost of Goods Sold (85,300) Gross Profit 27,460 Gross Profit 27,460 Operating Expenses: Operating Expenses: Selling (6,540) Selling (6,540) General & Administrative (9,400) General & Administrative (9,400) Total Operating Expenses (15,940) Total Operating Expenses (15,940) Earnings before interest and taxes (EBIT) 11,520 Earnings before interest and taxes (EBIT) 11,520 Interest charges: Interest charges: Interest on bank notes: (850) Interest on bank notes: (850) Interest on bonds: (2,310) Interest on bonds: (2,310) Total Interest charges (3,160) Total Interest charges (3,160) Earnings before taxes (EBT) 8,360 Earnings before taxes (EBT) 8,360 Taxes (assume 40%) (3,344) Taxes (assume 40%) (3,344) Net Income 5,016 Net Income 5,016 ABC Ltd. Income Statement For the period ending on 30 th June,….

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

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

What is ABC Ltd.’s Current Ratio?

50,190 25,523 = 1.97

What is ABC Ltd.’s Current Ratio? If the average current ratio for the industry is 2.4, is this good or not? 50,190 25,523 = 1.97

What is the firm’s Acid Test Ratio?

50, ,530 25,523 =.89

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

What is the firm’s Average Collection Period?

18, ,760/365 = 59.3 days

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

2. Operating Efficiency Ratios Measure how efficiently the firm’s assets generate operating profits. Measure how efficiently the firm’s assets generate operating profits.

What is the firm’s Operating Income Return on Investment (OIROI)?

11,520 81,890 = 14.07%

Slightly below the industry average of 15%. 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. What is the firm’s Operating Income Return on Investment (OIROI)? 11,520 81,890 = 14.07%

What is their Operating Profit Margin?

11, ,760 = 10.22%

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

What is their Total Asset Turnover?

112,760 81,890 = 1.38 times

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

What is the firm’s Accounts Receivable Turnover?

112,760 18,320 = 6.16 times

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

What is the firm’s Inventory Turnover?

85,300 27,530 = 3.10 times

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

Low inventory turnover: The firm may have too much inventory, which is expensive because: The firm may have too much inventory, which is expensive because: –Inventory takes up costly warehouse space. –Some items may become spoiled or obsolete.

What is the firm’s Fixed Asset Turnover?

112,760 31,700 = 3.56 times

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

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

How does Leverage work? Suppose we have an all equity- financed firm worth $100,000. Its earnings this year total $15,000. Suppose we have an all equity- financed firm worth $100,000. Its earnings this year total $15,000. ROE = = 15% (ignore taxes for this example) 15, ,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. Suppose the same $100,000 firm is financed with half equity, and half 8% debt (bonds). Earnings are still 15,000. 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. 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

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. 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

What is ABC Ltd.’s Debt Ratio?

47,523 81,890 = 58%

What is ABC Ltd.’s Debt Ratio? What is ABC Ltd.’s Debt Ratio? If the industry average is 47%, what does this tell us? 47,523 81,890 = 58%

What is ABC Ltd.’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?

What is the firm’s Times Interest Earned Ratio?

11,520 3,160 = 3.65 times

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

4. Return on Equity How well are the firm’s managers maximizing shareholder wealth?

What is ABC Ltd.’s Return on Equity (ROE)?

5,016 34,367 = 14.6%

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

What is ABC Ltd.’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?

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

The DuPont Model Brings together: Profitability Profitability Efficiency Efficiency Leverage Leverage

(Net Profit Margin) X (TA Turn Over) (1-Debt Ratio) = Net Income X Sales ÷ ( 1- Total Debt ) Sales Total Assets Total Assets Sales Total Assets Total Assets = 5,016 X 112,760 ÷ ( ,523 ) 112,760 81,890 81, ,760 81,890 81,890 = = = 14.6%

Net Profit Total Asset Debt Net Profit Total Asset Debt Margin Turnover Ratio Margin Turnover Ratio ROE = x / (1- ) The DuPont Model

Net Profit Total Asset Debt Net Profit Total Asset Debt Margin Turnover Ratio Margin Turnover Ratio Net Income Sales Total Debt Net Income Sales Total Debt Sales Total Assets Total Assets Sales Total Assets Total Assets ROE = x / (1- ) = x /(1- ) The DuPont Model

Net Profit Total Asset Debt Net Profit Total Asset Debt Margin Turnover Ratio Margin Turnover Ratio Net Income Sales Total Debt Net Income Sales Total Debt Sales Total Assets Total Assets Sales Total Assets Total Assets 5, ,760 47,523 5, ,760 47, ,760 81,890 81, ,760 81,890 81,890 ROE = x / (1- ) = x /(1- ) The DuPont Model

ROE = x / (1- ) = x /(1- ) = 14.6% Net Profit Total Asset Debt Net Profit Total Asset Debt Margin Turnover Ratio Margin Turnover Ratio Net Income Sales Total Debt Net Income Sales Total Debt Sales Total Assets Total Assets Sales Total Assets Total Assets 5, ,760 47,523 5, ,760 47, ,760 81,890 81, ,760 81,890 81,890 The DuPont Model