Ch.

3 - Evaluating a Firms
Financial Performance

2002, Prentice Hall, Inc.

Financial Statement Analysis

Are our decisions
maximizing
shareholder
wealth?

We will want to answer

questions about the firms

Liquidity
Efficient use of Assets
Leverage (financing)
Profitability

We will want to answer

questions about the firms

Liquidity
Efficient use of Assets
Leverage (financing)
Profitability

Financial Ratios
Tools that help us determine the
financial health of a company.
We can compare a companys
financial ratios with its ratios in
previous years (trend analysis).
We can compare a companys
financial ratios with those of its
industry.

Example:
CyberDragon Corporation

CyberDragons
Balance Sheet ($000)
Assets:
Cash
Marketable securities
Accounts receivable
Inventories
Total current assets
Plant and equipment
less accum deprec.
Net plant & equip.
Total assets

Liabilities & Equity:

$2,540
1,800
18,320
27,530
50,190
43,100
11,400
31,700
81,890

Accounts payable
Notes payable
Accrued taxes payable
Other current liabilities
Total current liabilities
Long-term debt (bonds)
Total liabilities
Common stock ($10 par)
Paid in capital
Retained earnings
Total stockholders' equity
Total liabilities & equity

9,721
8,500
3,200
4,102
25,523
22,000
47,523
13,000
10,000
11,367
34,367
81,890

Sales (all credit)

CyberDragons Income
Cost of Goods Sold
Statement
Gross Profit
Operating Expenses:
Selling
(6,540)
General & Administrative
(9,400)
Total Operating Expenses
(15,940)
Earnings before interest and taxes (EBIT)
Interest charges:
Interest on bank notes:
(850)
Interest on bonds:
(2,310)
Total Interest charges
Earnings before taxes (EBT)
Taxes (assume 40%)

Net Income

$112,760
(85,300)
27,460

5,016

11,520

(3,160)
8,360
(3,344)

CyberDragon
Other Information

Dividends paid on common stock

Earnings retained in the firm
Shares outstanding (000)
Market price per share
Book value per share
Earnings per share
Dividends per share

$2,800
2,216
1,300
20
26.44
3.86
2.15

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

What is CyberDragons Current Ratio?

What is CyberDragons Current Ratio?

50,190
25,523

= 1.97

What is CyberDragons Current Ratio?

50,190
25,523

= 1.97

If the average current ratio for the

industry is 2.4, is this good or not?

What is the firms Acid Test Ratio?

What is the firms Acid Test Ratio?

50,190 - 27,530 = .89

25,523

What is the firms Acid Test Ratio?

50,190 - 27,530 = .89

25,523
Suppose the industry average is .92.
What does this tell us?

What is the firms Average Collection

Period?

What is the firms Average Collection

Period?

18,320
112,760/365

= 59.3 days

What is the firms Average Collection

Period?

18,320
112,760/365

= 59.3 days

If the industry average is 47 days,

what does this tell us?

2. Operating Efficiency Ratios

Measure how efficiently the
firms assets generate operating
profits.

What is the firms Operating Income

Return on Investment (OIROI)?

What is the firms Operating Income

Return on Investment (OIROI)?

11,520
81,890

= 14.07%

What is the firms Operating Income

Return on Investment (OIROI)?

11,520
81,890

= 14.07%

Slightly below the industry

average of 15%.

What is the firms Operating Income

Return on Investment (OIROI)?

11,520
81,890

= 14.07%

Slightly below the industry

average of 15%.
The OIROI reflects product
pricing and the firms ability to
keep costs down.

What is their Operating Profit Margin?

What is their Operating Profit Margin?

11,520
112,760

= 10.22%

What is their Operating Profit Margin?

11,520
112,760

= 10.22%

This is below the industry average of

12%.

What is their Total Asset Turnover?

What is their Total Asset Turnover?

112,760 = 1.38 times

81,890

What is their Total Asset Turnover?

112,760 = 1.38 times

81,890
The industry average is 1.82 times.
The firm needs to figure out how to
squeeze more sales dollars out of its
assets.

What is the firms Accounts Receivable

Turnover?

What is the firms Accounts Receivable

Turnover?

112,760
18,320

= 6.16 times

What is the firms Accounts Receivable

Turnover?

112,760
18,320

= 6.16 times

CyberDragon turns their A/R over 6.16

times per year. The industry average
is 8.2 times. Is this efficient?

What is the firms Inventory Turnover?

What is the firms Inventory Turnover?

85,300
=
3.10
times
27,530

What is the firms Inventory Turnover?

85,300
=
3.10
times
27,530
CyberDragon turns their inventory
over 3.1 times per year.
The industry average is 3.9 times.
Is this efficient?

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.

What is the firms Fixed Asset

Turnover?

What is the firms Fixed Asset

Turnover?

112,760
=
3.56
times
31,700

What is the firms Fixed Asset

Turnover?

112,760
=
3.56
times
31,700
If the industry average is 4.6 times, what
does this tell us about CyberDragon?

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.

How does Leverage work?

Suppose we have an all equityfinanced firm worth $100,000. Its
earnings this year total $15,000.

ROE =
(ignore taxes for this example)

How does Leverage work?

Suppose we have an all equityfinanced firm worth $100,000. Its
earnings this year total $15,000.

ROE =

15,000
100,000

= 15%

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 =

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.

15,000
4,000
ROE =
=
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.

15,000
4,000
ROE =
=
50,000

22%

What is CyberDragons Debt Ratio?

What is CyberDragons Debt Ratio?

47,523 = 58%
81,890

What is CyberDragons Debt Ratio?

47,523 = 58%
81,890
If the industry average is 47%, what
does this tell us?

What is CyberDragons Debt Ratio?

47,523 = 58%
81,890
If the industry average is 47%, what
does this tell us?
Can leverage make the firm more
profitable?
Can leverage make the firm riskier?

What is the firms Times Interest

Earned Ratio?

What is the firms Times Interest

Earned Ratio?

11,520
=
3.65
times
3,160

What is the firms Times Interest

Earned Ratio?

11,520
=
3.65
times
3,160
The industry average is 6.7 times. This
is further evidence that the firm uses
more debt financing than average.

4. Return on Equity

How well are the firms managers

maximizing shareholder wealth?

What is CyberDragons
Return on Equity (ROE)?

What is CyberDragons
Return on Equity (ROE)?

5,016
=
14.6%
34,367

What is CyberDragons
Return on Equity (ROE)?

5,016
=
14.6%
34,367
The industry average is 17.54%.

What is CyberDragons
Return on Equity (ROE)?

5,016
=
14.6%
34,367
The industry average is 17.54%.
Is this what we would expect,
given the firms leverage?

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

The DuPont Model

Brings together:
Profitability
Efficiency
Leverage

The DuPont Model

ROE =

Net Profit Total Asset

x
Margin
Turnover

/ (1-

Debt
Ratio

The DuPont Model

ROE =

Net Profit Total Asset

x
Margin
Turnover

Net Income
Sales
x Total Assets
Sales

/ (1-

/(1-

Debt
Ratio

Total Debt
Total Assets

The DuPont Model

ROE =

Net Profit Total Asset

x
Margin
Turnover

Net Income
Sales
x Total Assets
Sales

5,016
= 112,760
x 112,760
81,890

/ (1-

/(1-

Debt
Ratio

Total Debt
Total Assets

47,523 )
/ (1 - 81,890

The DuPont Model

ROE =

Net Profit Total Asset

x
Margin
Turnover

Net Income
Sales
x Total Assets
Sales

5,016
= 112,760
x 112,760
81,890

14.6%

/ (1-

/(1-

Debt
Ratio

Total Debt
Total Assets

47,523 )
/ (1 - 81,890