1. Chapter 4

2. Evaluating a Firm’s Financial Performance

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

4. We will want to answer questions about the firm’s
Liquidity
Efficient use of Assets
Leverage (financing)
Profitability
Put on board. Four kinds of ratios.
Liquidity – ability to meet maturing debt obligations. Will company have the resources to pay creditors when time comes.
How Liquid? 1. Current ratio, 2. quick ratio, 3. AR receivable turnover, 4. Inventory Turnover
a. How liquid are assets compared to debt b. How quickly can we convert to cash
Efficient use of assets.
Best way to measure profits relative to assets is operating income (rather than gross profit or net income)
1. Operating income ROI 2. Operating profit margin 3. Gross profit margin 4. Asset turnover ratios Sales / total assets or AR or fixed assets or COGS/inventory
Leverage
How is firm financing its assets – debt or equity. Can they service their debt.
Debt/Assets or Debt to Equity, Time Interest Earned EBIT/interes
Profitability
Are stockholders receiving adequate return on their investment. Can compare to retun of other companies,
Return on Common Equity (exclude preferred stock)

5. 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.
There are limits to ratio analysis.

6. Example: CyberDragon Corporation

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

8. CyberDragon’s Income Statement
Sales (all credit) $112,760
Cost of Goods Sold (85,300)
Gross Profit ,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) ,360
Taxes (3,344)
Net Income ,016
CyberDragon’s Income Statement

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

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

11. What is CyberDragon’s Current Ratio?

12. What is CyberDragon’s Current Ratio?
50,190
25,523
= 1.97

13. 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?
Want to have a high number to be able to pay off current liabilities with current assets (cash, receivables, securities, inventories) Cyber Dragon not as liquid as industry.

14. What is the firm’s Acid Test Ratio?

15. What is the firm’s Acid Test Ratio?
50, ,530
25,523
= .89

16. What is the firm’s Acid Test Ratio?
50, ,530
25,523
= .89
Want this number to be large. Want to have enough current assets to meet current obligations. This firms ratio is lower than industry average. So not as liquid as average.
Suppose the industry average is .92.
What does this tell us?

17. What is the firm’s Average Collection Period?

18. What is the firm’s Average Collection Period?
18,320
112,760/365
= days
Numerator is accounts receivable. Denominator is average amount sold per day. Want denominator to be large because we want to collect a large amount per day. If denominator is large then the number of days to collect will be smaller.
Easy example on board:
Say AR is x2 $36,640
Avg sales per day is $309 per day (112760/365)
36,640/309 = days to collect

19. What is the firm’s Average Collection Period?
18,320
112,760/365
= days
It takes us longer to collect the AR. That costs us money because we usually don’t get paid interest on AR. Also risk of not being paid.
If the industry average is 47 days, what does this tell us?

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

21. What is the firm’s Operating Income Return on Investment (OIROI)?
OIROI is operating income/total assets.

22. What is the firm’s Operating Income Return on Investment (OIROI)?
11,520
81,890
= %

23. What is the firm’s Operating Income Return on Investment (OIROI)?
11,520
81,890
= %
Slightly below the industry average of 15%.
Not doing quite as well as industry.

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

25. What is their Operating Profit Margin?
Operating income divided by sales

26. What is their Operating Profit Margin?
11,520
112,760
= %

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

28. What is their Total Asset Turnover?
Sales divided by total assets

29. What is their Total Asset Turnover?
112,760
81,890
= times
Do we want to have high or low. Want high because we want to generate as much sales with the lowest amount of assets.

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

31. What is the firm’s Accounts Receivable Turnover?
Also dividing sales by AR.

32. What is the firm’s Accounts Receivable Turnover?
112,760
18,320
= times
Want to have a high number. Want to generate sales with the lowest investment in AR

33. What is the firm’s Accounts Receivable Turnover?
112,760
18,320
= times
No. Want to have a large ratio so Cyber Dragon not as efficient as industry.
CyberDragon turns their A/R over 6.16
times per year. The industry average
is 8.2 times. Is this efficient?

34. What is the firm’s Inventory Turnover?
Cost of good sold divided by inventory. Inventory is valued at cost of goods sold so need to use that instead of sales. We want it to be low, we want turnover number to be high COGS divided by total inventory. We don’t want inventory sitting around. It cost $$ to borrow to pay for it.

35. What is the firm’s Inventory Turnover?
85,300
27,530
= times

36. What is the firm’s Inventory Turnover?
85,300
27,530
= times
CyberDragon turns their inventory over 3.1 times per year.
The industry average is 3.9 times. Is this efficient?
Cyber Dragon is again doing worse than the industry. Less efficient

37. Low inventory turnover:
The firm may have too much inventory, which is expensive because:
Inventory takes up costly warehouse space.
Some items may become spoiled or obsolete.
If you are carrying 100,000 of inventory and cost of borrowing is 8%, it costs you $8,000 per year to finance.

38. What is the firm’s Fixed Asset Turnover?
Back to sales. Sales divided by fixed assets

39. What is the firm’s Fixed Asset Turnover?
112,760
31,700
= times
Want numerator to be high so want a high turnover.

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

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

42. 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)
If you make $15,000 on $100,000 what kind of percent return are you getting

43. 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
Of course, want to have a high return.

44. 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.
ROE =
The numerator will be somewhat smaller because you need to pay interest on the bonds (8% X $50,000 = $4,000) But the Equity is much, much smaller. So what happens to ROE?

45. 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
50,000

46. 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
50,000
It goes up dramatically. Give example of buying a house. If you buy a $200,000 house and pay cash and the next year sell it for $210,000 – what is your return (10%). But if you mortgage the house and only pay 10% down or $20,000 and then sell it for $210,000 you have a gain of $10,000 (less one year’s interest) you make about $10,000 on an investment of $20,000 or a 50% return.

47. What is CyberDragon’s Debt Ratio?
This is a BS only ratio. Debt: total assets.

48. What is CyberDragon’s Debt Ratio?
47,523
81,890
= 58%

49. What is CyberDragon’s Debt Ratio?
47,523
81,890
= 58%
If the industry average is 47%, what
does this tell us?
Higher the debt the more risk because you have to be sure to be able to make interest payments. It is a trade off for a higher return.
Cyber has high debt relative to its assets.

50. 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?
Not more profitable because you pay interest, but can get a high return for shareholders, Yes riskier.

51. What is the firm’s Times Interest Earned Ratio?
How much income before interest and taxes (EBIT) that you have a available to pay your obligation of interest.

52. What is the firm’s Times Interest Earned Ratio?
11,520
3,160
= times
Want this to be high so that you have enough available to pay interest.

53. What is the firm’s Times Interest Earned Ratio?
11,520
3,160
= times
The industry average is 6.7 times. This
is further evidence that the firm uses
more debt financing than average.
Much more leveraged. Numerator is same but denominator is higher because paying interest. EBIT/interest

54. 4. Return on Equity
Remember this is the Goal of the firm. Can tie managers compensation to this in order to minimize agency problem.
How well are the firm’s managers maximizing shareholder wealth?

55. What is CyberDragon’s Return on Equity (ROE)?
Net income/ stockholders equity

56. What is CyberDragon’s Return on Equity (ROE)?
5,015
34,367
= 14.6%

57. What is CyberDragon’s Return on Equity (ROE)?
5,015
34,367
= 14.6%
The industry average is 17.54%.
Not earning as much as industry. What will happen to stock price if all else is equal.

58. What is CyberDragon’s Return on Equit y (ROE)?
5,015
34,367
= 14.6%
The industry average is 17.54%.
Is this what we would expect, given the firm’s leverage?
The company is more leveraged – has lower equity number and higher debt number. With a lower denominator we would expect a higher ROE. They are more highly leveraged. But the numerator (return) is lower because they are less efficent (not earning enough on its assets)

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