FOFch 04

Ch.
4 - Evaluating a Firm’s
Financial Performance
, Prentice Hall, Inc.

Financial Statement Analysis
 Are our decisions maximizing

shareholder wealth?
We will want to answer
questions about the firm’s
 Liquidity
 Efficient use of Assets
 Leverage (financing)
 Profitability
We will want to answer
questions about the firm’s
 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 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.
Example:
CyberDragon Corporation
CyberDragon’s
Balance Sheet ($000)
Assets: Liabilities & Equity:
Cash $2,540 Accounts payable 9,721
Marketable securities 1,800 Notes payable 8,500
Accounts receivable 18,320 Accrued taxes payable 3,200
Inventories 27,530 Other current liabilities 4,102
Total current assets 50,190 Total current liabilities 25,523
Plant and equipment 43,100 Long-term debt (bonds) 22,000
less accum deprec. 11,400 Total liabilities 47,523
Net plant & equip. 31,700 Common stock ($10 par) 13,000
Total assets 81,890 Paid in capital 10,000
Retained earnings 11,367
Total stockholders' equity 34,367
Total liabilities & equity 81,890
Sales (all credit) CyberDragon’s Income $112,760
Cost of Goods Sold Statement (85,300)
Gross Profit 31,500
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) 8,600
Taxes (3,344)
Net Income 5,016
CyberDragon
Other Information
Dividends paid on common stock $2,800

Earnings retained in the firm 2,216
Shares outstanding (000) 1,300
Market price per share 20
Book value per share 26.44
Earnings per share 3.86
Dividends per share 2.15
1. Liquidity Ratios
 Do we have enough liquid assets
to meet approaching obligations?
What is CyberDragon’s Current
Ratio?
Ratio?
50,190
25,523 = 1.97
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 firm’s Acid Test Ratio?
50,190 - 27,530 = .89

25,523
50,190 - 27,530 = .89

25,523
Suppose the industry average is .92.

What does this tell us?
What is the firm’s Average Collection
Period?
Period?
18,320
112,760/365 = 59.3 days
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

firm’s assets generate operating
profits.
What is the firm’s Operating Income
Return on Investment (OIROI)?
11,520 = 14.07%
81,890
11,520 = 14.07%
81,890
•Slightly below the industry
average of 15%.
11,520 = 14.07%
81,890
•Slightly below the industry
average of 15%.
•The OIROI reflects product
pricing and the firm’s ability to
keep costs down.
What is their Operating Profit
Margin?
Margin?
11,520 = 10.22%
112,760
Margin?
11,520 = 10.22%
112,760
•This is below the industry average of

12%.
What is their Total Asset Turnover?
112,760 = 1.38 times

81,890
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 firm’s Accounts
Receivable Turnover?
112,760 = 6.16 times

18,320
112,760 = 6.16 times

18,320
CyberDragon turns their A/R over 6.16

times per year. The industry average
is 8.2 times. Is this efficient?
What is the firm’s Inventory
Turnover?
Turnover?
85,300
27,530 = 3.10 times
Turnover?
85,300
27,530 = 3.10 times
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 firm’s Fixed Asset
Turnover?
Turnover?
112,760
31,700 = 3.56 times
Turnover?
112,760
31,700 = 3.56 times
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 equity-
financed firm worth $100,000. Its
earnings this year total $15,000.
ROE =
(ignore taxes for this example)

 Suppose we have an all equity-
financed firm worth $100,000. Its
earnings this year total $15,000.
15,000
ROE = = 15%
100,000
 Suppose the same $100,000 firm is
financed with half equity, and half
8% debt (bonds). Earnings are still
$15,000.
ROE =
$15,000.
ROE = 15,000 - 4,000 =

50,000
$15,000.
ROE = 15,000 - 4,000 =

50,000
22%
What is CyberDragon’s Debt Ratio?
47,523 = 58%
81,890
47,523 = 58%
81,890
If the industry average is 47%, what
does this tell us?
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 firm’s Times Interest
Earned Ratio?
Earned Ratio?
11,520
3,160 = 3.65 times
Earned Ratio?
11,520
3,160 = 3.65 times
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 firm’s managers

maximizing shareholder wealth?
What is CyberDragon’s
Return on Equity (ROE)?
5,015
34,367 = 14.6%
5,015
34,367 = 14.6%
The industry average is 17.54%.

5,015
34,367 = 14.6%
The industry average is 17.54%.

Is this what we would expect,
given the firm’s 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 x Total Asset
Margin Turnover
/ (1- Debt
Ratio
)
The DuPont Model
Margin Turnover
/ (1- Debt
Ratio
)
= Net Income
Sales x Sales
Total Assets /(1- Total Debt
Total Assets )
The DuPont Model
Margin Turnover
/ (1- Debt
Ratio
)
= Net Income
Sales x Sales
Total Assets )
= 5,016
112,760 x 112,760
81,890 / (1 - 47,523
81,890 )
The DuPont Model
Margin Turnover
/ (1- Debt
Ratio
)
= Net Income
Sales x Sales
Total Assets )
= 5,016
112,760 x 112,760
81,890 / (1 - 47,523
81,890 )
= 14.6%

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Ch.

, Prentice Hall, Inc.

 Are our decisions maximizing

Dividends paid on common stock $2,800

If the average current ratio for the

50,190 - 27,530 = .89

50,190 - 27,530 = .89

Suppose the industry average is .92.

If the industry average is 47 days,

 Measure how efficiently the

•This is below the industry average of

112,760 = 1.38 times

112,760 = 1.38 times

The industry average is 1.82 times.

112,760 = 6.16 times

112,760 = 6.16 times

CyberDragon turns their A/R over 6.16

CyberDragon turns their inventory

The firm may have too much

If the industry average is 4.6 times, what

(ignore taxes for this example)

ROE = 15,000 - 4,000 =

ROE = 15,000 - 4,000 =

Can leverage make the firm more

The industry average is 6.7 times. This

How well are the firm’s managers

The industry average is 17.54%.

The industry average is 17.54%.

Even though CyberDragon has

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