Ch. 3 - Evaluating a Firm’s Financial Performance and Measuring Cash Flow

1. Ch. 3 - Evaluating a Firm’s Financial Performance and Measuring Cash Flow Ó 1999, Prentice Hall, Inc.

2. Financial Statements

3. Balance Sheet Assets Liabilities & Owners Equity Current Liabilities Accounts Payable Notes Payable Accrued Salaries Long-Term Liabilities Mortgage Debt Debentures Owners’ Equity Common Stock ($1 Par) Add’l Paid In Capital Retained Earnings Current Assets Cash Marketable Securities Accounts Receivable Inventories Fixed Assets Land Plant & Equipment less: depreciation

4. Income Statement REVENUE - Cost of Goods Sold GROSS PROFIT - Operating Expenses NET OPERATING INCOME (NOI ) or EARNINGS BEFORE INTEREST & TAXES (EBIT) - Interest Expense - Income Taxes NET INCOME - Dividends on Common & Preferred Stock RETAINED EARNINGS

5. Cash Flow Statement Cash collected from customers - Cash paid to suppliers - Operating Cash Outflows (marketing, administrative and interest payments) - Cash Tax Payments +/- Cash Flow from Investments acquired or sold + Receipts from new stock issue + Increased borrowing - Repayment of debt principal - Common Stock Dividend Payments Cash Flow Generated

6. Cash Flow Statement Cash collected from customers - Cash paid to suppliers - Operating Cash Outflows (marketing, administrative and interest payments) - Cash Tax Payments +/- Cash Flow from Investments acquired or sold + Receipts from new stock issue + Increased borrowing - Repayment of debt principal - Common Stock Dividend Payments Cash Flow Generated

7. Cash Flow Statement Cash collected from customers - Cash paid to suppliers - Operating Cash Outflows (marketing, administrative and interest payments) - Cash Tax Payments +/- Cash Flow from Investments acquired or sold + Receipts from new stock issue + Increased borrowing - Repayment of debt principal - Common Stock Dividend Payments Cash Flow Generated

8. Financial Statement Analysis • Are our decisions maximizing shareholder wealth?

9. We will want to answer questions about the firm’s • Liquidity • Efficient use of Assets • Leverage (financing) • Profitability

10. 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.

11. Example:CyberDragon Corporation

12. CyberDragon’s Balance Sheet ($000) Assets: Liabilities & Owners' 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 50,190Total 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

13. CyberDragon’s Income Statement Sales (all credit) $112,760 Cost of Goods Sold (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

14. CyberDragonOther 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

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

16. What is CyberDragon’s Current Ratio?

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

18. What is CyberDragon’s Current Ratio? 50,190 = 1.97 25,523 If the average current ratio for the industry is 2.4, is this good or not?

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

20. What is the firm’s Acid Test Ratio? 50,190 - 27,530 = .89 25,523

21. What is the firm’s Acid Test Ratio? 50,190 - 27,530 = .89 25,523 S’pose the industry average is .92. What does this tell us?

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

23. What is the firm’s Average Collection Period? 18,320 = 59.3 days 112,760 / 365

24. What is the firm’s Average Collection Period? 18,320 = 59.3 days 112,760 / 365 If the industry average is 47 days, what does this tell us?

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

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

27. What is the firm’s Operating Income Return on Investment (OIROI)? 11,520 = 14.07% 81,890

28. What is the firm’s Operating Income Return on Investment (OIROI)? 11,520 = 14.07% 81,890 • Slightly below the industry average of 15%.

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

30. What is their Operating Profit Margin?

31. What is their Operating Profit Margin? 11,520 = 10.22% 112,760

32. What is their Operating Profit Margin? 11,520 = 10.22% 112,760 • This is below the industry average of • 12%.

33. What is their Total Asset Turnover?

34. What is their Total Asset Turnover? 112,760 = 1.38 times 81,890

35. 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.

36. What is the firm’s Accounts Receivable Turnover?

37. What is the firm’s Accounts Receivable Turnover? 112,760 = 6.16 times 18,320

38. What is the firm’s Accounts Receivable Turnover? 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?

39. What is the firm’s Inventory Turnover?

40. What is the firm’s Inventory Turnover? 85,300 = 3.10 times 27,530

41. What is the firm’s 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?

42. 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.

43. What is the firm’s Fixed Asset Turnover?

44. What is the firm’s Fixed Asset Turnover? 112,760 = 3.56 times 31,700

45. What is the firm’s 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?

46. 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.

47. 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)

48. 15,000 = 15% ROE = 100,000 How does Leverage work? • Suppose we have an all equity-financed firm worth $100,000. Its earnings this year total $15,000.

49. 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 =

50. 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.