1. 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

2. 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.

3. 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?

4. 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?

5. 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

6. Collection Period & Turnover
Measure the same thing – are reciprocals
365 days = 17.9 X Days = 20.4days
20.4 days 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

7. 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)

8. 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.

9. 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.

10. OIROI Separate OIROI into its two pieces: OIROI = OPM * TAT
= * .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%

11. 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

12. 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

13. 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%

14. 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%)

15. 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)

16. 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)

17. 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.

18. 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

19. 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