KeownFOF5e CH04

Foundations of Finance
Arthur J. Keown J. William Petty John D. Martin David F. Scott, Jr.
Chapter 4
Evaluating a Firms Financial Performance
Chapter 4 Evaluating a Firms Performance
Learning Objectives
After reading this chapter, you should be able to: Explain the purpose and importance of financial analysis. Calculate and use a comprehensive set of measurements to evaluate a companys performance. Describe the limitations of financial ratio analysis.
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Pearson Prentice Hall
Principles Used in this Chapter

Principle 7: Managers Wont Work the Owners Unless it is their best Interest. Principle 5: The Curse of Competitive Markets Why Its Hard to Find Exceptionally Profitable Markets. Principle 1: The Risk Return TradeOff We Wont Take on Additional Risk Unless We Expect to Be Compensated with Additional Return.
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Financial Ratios
Ratios give us two ways of making meaningful comparisons of a firms financial data:
Trends across time Comparisons with other firms ratios
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Uses of Financial Ratios within the Firm

Identify deficiencies in a firms performance and take corrective actions. Evaluate employees performance and determine incentive compensation. Compare the financial performance of different divisions within the firm
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Uses of Financial Ratios within the Firm

Prepare financial projections, both at the firm and division levels. Understand the financial performance of competitors Evaluate the financial condition of a major supplier.
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Uses of Financial Ratios Outside the Firm

Lenders in deciding whether or not to make a loan to a company. Credit-rating agencies in determining a firms credit worthiness. Investors in deciding whether or not to invest in a company. Major suppliers in deciding to sell and grant credit terms to a company.
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Measuring Key Financial Relationships

How liquid is the firm? Is management generating adequate operating profits on the firms assets? How is the firm financing its assets? Is management providing a good return on the capital provided by the shareholders? Is the management team creating shareholder value?
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How Liquid Is a Firm?

Liquidity is the ability to have cash available when needed to meet its financial obligations Measured by two approaches:
Comparing the firms assets that are relatively liquid Examines the firms ability to convert accounts receivables and inventory into cash in a timely basis
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Measuring Liquidity: Approach 1

Compare a firms current assets with current liabilities
Current Ratio Acid Test or Quick Ratio
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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
Starbucks Example:
Current ratio= $922M / $591M = 1.67
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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. Cash and accounts receivable/Current liabilities
Starbucks Example
Quick Ratio= ($350M + $114M) / $591M =1.05

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Measuring Liquidity: Approach 2

Measures a firms ability to convert accounts receivable and inventory into cash

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Average Collection Period Accounts Receivable Turnover Inventory Turnover Cash Conversion Cycle
Average Collection Period

How long it takes to collect the firms receivables Accounts receivable/(Annual credit sales/365)
Starbucks Example:
Avg. Collection Period = $114M / $1.68M= 68.1 days

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Accounts Receivable Turnover

How many times accounts receivable are rolled over during a year Credit sales/Accounts receivable
Starbucks Example
Accounts Receivable Turnover = $611M / $114M = 5.36X
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Inventory Turnover
How many times is inventory rolled over during the year? Cost of goods sold/Inventory
Starbucks Example
Inventory Turnover= $3,207M / $342M = 9.38X
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Starbucks vs. Peer Group

Ratio
Current Ratio Quick Ratio Avg. Collection Period Accounts Receivable Turnover Inventory Turnover
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Starbucks 1.67 1.05

68.1 days
Peers 2.02 1.54

93 days
5.36X
9.38X
3.90X
8.5X
Is Management Generating Adequate Operating Profits on the Firms Assets?
Operating Return on Assets (OROA) Operating Profit Margin Total Asset Turnover Fixed Asset Turnover
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Operating Return on Assets

Level of profits relative to total assets Operating return/Total assets
Starbucks Example
Operating Return On Assets = $436M / $2,672M = .163 or 16.3%
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Operating Profit Margin

Examines how effective the company is managing its operations Operating profit/Sales
Starbucks Example
Operating Profit Margin = $436M / $4,067M = .107 or 10.7%
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Total Asset Turnover

How efficiently a firm is using its assets in generating sales Sales/Total assets
Starbucks Example
Total Asset Turnover = $4,076M / $2,672M = 1.53X
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Fixed Asset Turnover

Examines investment in fixed assets for sales being produced Sales/Fixed assets
Starbucks Example
Fixed Asset Turnover = $4,076M / $1,750M = 2.33X
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Ratio
Operating Return on Assets Operating Profit Margin Total Asset Turnover Fixed Asset Turnover
Starbucks 16.3% 10.7% 1.53X 2.33X
Peers 14.9% 11.8% 1.26X 2.75X
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How Is the Firm Financing Its Assets?
Does the firm finance assets more by debt of equity?

Debt Ratio Times Interest Earned
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Debt Ratio
What percentage of the firms assets are financed by debt? Total debt/Total assets
Starbucks Example
Debt ratio = $591M / $2,672M = .221 or 22.1%
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Times Interest Earned

Examines the amount of operating income available to service interest payments Operating income/Interest
Starbucks Example
Times Interest Earned = $436M / $3M = 145.3X

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Ratio
Debt Ratio Times Interest Earned
Starbucks 22.1% 145.3X
Peers 25% 46.0X
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Is Management Providing a Good Return on the Capital Provided by the Shareholders? Are the earnings available to shareholders attractive Return on equity Net income/Common equity
Starbucks Example
Return on Equity = $268M / $208M = .129 or 12.9%

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Ratio Return on Equity
Starbucks 12.9%
Peers 12.0%
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How Is Management Doing Creating Shareholder Value?

These ratios indicate what investors think of managements past performance and future prospects. Two approaches: Price/Earnings ratio Price/Book ratio
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Price/Earnings Ratio
Measures how much investors are willing to pay for $1 of reported earnings Price per share/Earnings per share
Starbucks Example
Price/Earnings Ratio = $35.00 / $0.69 = 51X

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Price/Book Ratio
Compares the market value of a share of stock to the book value per share of the reported equity on the balance sheet Price per share/Equity book value per share
Starbucks Example
Price/Book Ratio = $35.00 / $5.32= 6.58X

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Starbucks vs. S&P Index Price

Ratio
Price/Earnings Ratio Price/Book Ratio
Starbucks 51X 6.58X
S&P 24X 3X
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Economic Value Added (EVA)

Measures a firms economic profit, rather than accounting profit Recognizes a cost of equity and a cost of debt EVA = (r-k) X C where: r = Operating return on assets k = Total cost of capital C = Amount of capital (Total Assets) invested in the firm
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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
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Foundations of Finance

Arthur J. Keown J. William Petty John D. Martin David F. Scott, Jr.

Chapter 4 Evaluating a Firms Performance

Pearson Prentice Hall

Chapter 4 Evaluating a Firms Performance

Principles Used in this Chapter

Pearson Prentice Hall

Chapter 4 Evaluating a Firms Performance

Pearson Prentice Hall

Chapter 4 Evaluating a Firms Performance

Uses of Financial Ratios within the Firm

Pearson Prentice Hall

Chapter 4 Evaluating a Firms Performance

Uses of Financial Ratios within the Firm

Pearson Prentice Hall

Chapter 4 Evaluating a Firms Performance

Uses of Financial Ratios Outside the Firm

Pearson Prentice Hall

Chapter 4 Evaluating a Firms Performance

Measuring Key Financial Relationships

Pearson Prentice Hall

Chapter 4 Evaluating a Firms Performance

How Liquid Is a Firm?

Pearson Prentice Hall

Chapter 4 Evaluating a Firms Performance

Measuring Liquidity: Approach 1

Pearson Prentice Hall

Chapter 4 Evaluating a Firms Performance

Current ratio= $922M / $591M = 1.67

Pearson Prentice Hall

Chapter 4 Evaluating a Firms Performance

Acid Test or Quick Ratio

Quick Ratio= ($350M + $114M) / $591M =1.05

Pearson Prentice Hall

Chapter 4 Evaluating a Firms Performance

Measuring Liquidity: Approach 2

Pearson Prentice Hall

Chapter 4 Evaluating a Firms Performance

Average Collection Period

Avg. Collection Period = $114M / $1.68M= 68.1 days

Pearson Prentice Hall

Chapter 4 Evaluating a Firms Performance

Accounts Receivable Turnover

Accounts Receivable Turnover = $611M / $114M = 5.36X

Pearson Prentice Hall

Chapter 4 Evaluating a Firms Performance

Inventory Turnover= $3,207M / $342M = 9.38X

Pearson Prentice Hall

Chapter 4 Evaluating a Firms Performance

Starbucks vs. Peer Group

Starbucks 1.67 1.05

Peers 2.02 1.54

Chapter 4 Evaluating a Firms Performance

Is Management Generating Adequate Operating Profits on the Firms Assets?

Pearson Prentice Hall

Chapter 4 Evaluating a Firms Performance

Operating Return on Assets

Operating Return On Assets = $436M / $2,672M = .163 or 16.3%

Pearson Prentice Hall

Chapter 4 Evaluating a Firms Performance

Operating Profit Margin

Operating Profit Margin = $436M / $4,067M = .107 or 10.7%