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Chapter 4

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**Evaluating a Firm’s Financial Performance**

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**Financial Statement Analysis**

Are our decisions maximizing shareholder wealth?

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**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)

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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.

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**Example: CyberDragon Corporation**

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**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

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**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

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**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

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

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**What is CyberDragon’s Current Ratio?**

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**What is CyberDragon’s Current Ratio?**

50,190 25,523 = 1.97

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**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.

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**What is the firm’s Acid Test Ratio?**

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**What is the firm’s Acid Test Ratio?**

50, ,530 25,523 = .89

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**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?

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**What is the firm’s Average Collection Period?**

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**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

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**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?

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**2. Operating Efficiency Ratios**

Measure how efficiently the firm’s assets generate operating profits.

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

OIROI is operating income/total assets.

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

11,520 81,890 = %

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**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.

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**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.

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**What is their Operating Profit Margin?**

Operating income divided by sales

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**What is their Operating Profit Margin?**

11,520 112,760 = %

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**What is their Operating Profit Margin?**

11,520 112,760 = % This is below the industry average of 12%.

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**What is their Total Asset Turnover?**

Sales divided by total assets

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**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.

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**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.

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**What is the firm’s Accounts Receivable Turnover?**

Also dividing sales by AR.

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**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

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**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?

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**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.

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**What is the firm’s Inventory Turnover?**

85,300 27,530 = times

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**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

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**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.

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**What is the firm’s Fixed Asset Turnover?**

Back to sales. Sales divided by fixed assets

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**What is the firm’s Fixed Asset Turnover?**

112,760 31,700 = times Want numerator to be high so want a high turnover.

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**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

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**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.

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**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

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**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.

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**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?

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**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

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**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.

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**What is CyberDragon’s Debt Ratio?**

This is a BS only ratio. Debt: total assets.

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**What is CyberDragon’s Debt Ratio?**

47,523 81,890 = 58%

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**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.

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**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.

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**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.

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**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.

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**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

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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?

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**What is CyberDragon’s Return on Equity (ROE)?**

Net income/ stockholders equity

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**What is CyberDragon’s Return on Equity (ROE)?**

5,015 34,367 = 14.6%

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**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.

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**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)

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

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