 # Chapter 4.

## Presentation on theme: "Chapter 4."— Presentation transcript:

Chapter 4

Evaluating a Firm’s Financial Performance

Chapter Objectives Financial Ratio Analysis Dupont Analysis
Limitations of Ratio Analysis Firm Performance and Shareholder Value

Financial Ratios Accounting data stated in relative terms

Financial Ratios Help identify financial strengths and weaknesses of a company by examining: Trends across time Comparisons with other firms’ ratios

Financial Ratios Examine: How liquid is a firm?
Is management generating adequate operating profits on the firm’s assets? How is the firm financing its assets? Is management providing a good return on the capital provided by the shareholder?

How liquid is a firm? Liquidity is the ability to meet maturing debt obligations Measured by two approaches: Comparing cash and assets that can be converted into cash within the year with liabilities that are coming due within the year Examines the firm’s ability to convert accounts receivables and inventory into cash on a timely basis

Measuring Liquidity: Approach 1
Compare a firm’s current assets with current liabilities Current Ratio Acid Test or Quick Ratio

Current Ratio Compares cash and current assets that should be converted into cash during the year with the liabilities that should be paid within the year Current Assets / Current liabilities

Acid Test or Quick Ratio
Compares cash and current assets (minus inventory) that should be converted into cash during the year with the liabilities that should be paid within the year. More restrictive than the current ratio because it eliminates inventories (Current assets – inventory) / Current liabilities

X Company Balance Sheet
Assets Cash \$75 Accounts Rec. \$150 Inventory \$175 Equip/Bldg \$1,200 Acc Dep <\$100> Total Assets \$1,500 Liabilities and O.E. Accounts Pay \$600 L-Term Debt \$500 Total Liabilities \$1100 Owner’s Equity Common Stk \$200 Retained Earn. \$200 Total O.E. \$400 Total L + OE \$1,500

X Company Income Statement
Sales (All Credit) \$2,000 Cost of Goods Sold \$1,200 Gross Profits \$800 Marketing and Admin \$80 Depreciation \$70 Total Operating Exp \$150 Operating Profits \$650 (EBIT or Operating Income) Interest Expense \$50 Income Before Taxes \$600 Taxes \$100 Net Income \$500

X Company Ratio Analysis
Current Ratio current assets/current liabilities 400/600 = .667 Acid-Test Ratio (Current assets – inventory) / current liabilities (400 – 150) / 600 = .416

Measuring Liquidity: Approach 2
Measures a firm’s ability to convert accounts receivable and inventory into cash Average Collection Period Accounts Receivable Turnover Inventory Turnover Cash Conversion Cycle

Average Collection Period
The conversion of accounts receivable into cash, is measured by calculating how long it takes to collect the firm’s receivables Accounts Receivable / Daily Credit Sales

X Company Ratio Analysis
Average Collection Period 150 / (2,000 / 365) = 27.38 Accounts Receivable Turnover 2,000 / 150 = 13.33 Inventory Turnover 1,200 / 175 = 6.86

Accounts Receivable Turnover
How many times accounts receivable are “rolled over” during a year Credit Sales / Accounts Receivable

Inventory Turnover How many times is inventory rolled over during the year? Cost of Goods Sold / Inventory

Cash Conversion Cycle Sum of the days of sales outstanding (average collection period) and days of sales in inventory less the days of payables outstanding. Cash Days of Days of Days of Conversion = Sales + Sales in - Payables Cycle Outstanding Inventory Outstanding

Days of Sales Outstanding
Average Collection Period Accounts Receivable / (Sales / 365)

Days of Sales In Inventory
Average age of the inventory or average number of days that a dollar of inventory is held by the firm Inventory / (Cost of Goods Sold / 365)

Days of Payables Outstanding
Average age in days of the firm’s accounts payable Accounts Payable / (Cost of Goods Sold /365)

Cash Conversion Cycle for X Company
Days of Accts Rec 150 Sales = (Sales/365) = (2000/365) = Outstanding 27.37 Days of Inventory 175 Sales In = (Cost of Goods Sold/ = (1200/365) = Inventory 365) 53.23 Days of Payables = Accts Payable 600 Outstanding (Cost of Goods Sold/ = (1200/365) = 365) 182.50

Is Management Generating Adequate Operating Profits on the Firm’s Assets?
Operating Income Return on Investment (OIROIO) Operating Profit Margin Total Asset Turnover Fixed Asset Turnover Return on Assets

Operating Income Return on Investment
Level of profits relative to the assets or Income generated per \$1 of assets OIROI = Operating Income/Total Assets OIROI = Operating Profit Margin X Total Asset Turnover

Operating Profit Margin
Examines operating profitability Operating Income / Sales

Total Asset Turnover How efficiently a firm is using its assets in generating sales Measures the dollar sales per \$1 of Assets Sales / Total Assets

Fixed Asset Turnover Examines investment in fixed assets for sales being produced Measures the dollar sales per \$1 of fixed assets Sales / Fixed Assets

Alternate OIROI OIROI = Operating Profit Margin X Total Asset Turnover
OIROI = Operating Income Sales Sales X Total Assets

Return on Assets ROA = Net Income / Total Assets

X Company Ratio Analysis
OIROI / = .433 Operating Profit Margin 650 / = Total Asset Turnover 2000 / = Fixed Asset Turnover 2000 / 1100 = 1.82 Alternate OIROI 650 X = ROA / =

How is the Firm Financing Its Assets?
Does the firm finance assets more by debt of equity? Debt Ratio Times Interest Earned

Debt Ratio What percentage of the firm’s assets are financed by debt?
Total Debt / Total Assets

Times Interest Earned Examines the amount of operating income available to service interest payments or The number of times the firm is earning or covering its interest payments Operating Income / Interest

X Company Ratio Analysis
Debt Ratio 1100 / 1500 = 73.33% Times Interest Earned 650 / 50 = 13

Is Management Providing a Good Return on the Capital Provided by the Shareholders?
Return on Common Equity

Return on Common Equity
Accounting Return on the common stockholders’ investment Net Income / Common Equity

X Company Ratio Analysis
Return on common equity Net Income / Common Equity 500 / 400 = 1.25 or 125%

DuPont Analysis An alternative method to analyze a firm’s profitability and return on equity Allows management to see more clearly what drives return on equity and the inter-relationships among: net profit margin, asset turnover, and common equity ratio. Return on Common = ROA / Common Equity Equity Total Assets

ROA Alternative Calculation
ROA = Net Income / Total Assets or Net Profit Margin X Total Asset Turnover (Net Income X (Sales Sales) Total Assets)

DuPont Equation Net Income X Sales / Cmn Eqty Sales Ttl Asts Ttl Asts

Limitations of Ratio Analysis
Difficulty in identifying industry categories or finding peers Published peer group or industry averages are only approximations Accounting practices differ among firms Financial ratios can be too high or too low Industry averages may not provide a desirable target ratio or norm Use of average account balances to offset effects of seasonality