Chapter 3 - Evaluating a Firm’s Financial Performance 09/04/08

Chapter 3 - Evaluating a Firm’s Financial Performance09/04/08

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 50,190Total current liabilities 25,523 Plant and equipment 43,100Long-term debt (bonds) 22,000 less accum deprec. 11,400Total 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

CyberDragon’s Income Statement Sales (all credit)$112,760 Cost of Goods Sold (85,300) Gross Profit27,460 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)8,360 Taxes (assume 40%) (3,344) Net Income5,016

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

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

( ) ( ) = ? What is CyberDragon’sCurrent Ratio? current assets current liabilities If the average current ratio for the industry is 2.4, is this good or not?

( ) – ( ) ( ) = ? What is the firm’s Acid Test Ratio? current assets - inventories current liabilities Suppose the industry average is .92. What does this tell us?

( ) ( )/( ) = ? days What is the firm’s Average Collection Period? accounts receivable daily credit sales 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)? operating income total assets • Below the industry average of 20%.

Components of OIROI OIROI = operating profit margin * total asset turnover = (operating income / sales) * (sales / total assets)

( ) ( ) = ? What is their Operating Profit Margin? operating income sales • This is below the industry average of • 12%.

What is their Operating Profit Margin? Operating profit margin = operating income / sales = (total sales – cost of goods sold – general administrative expenses – marketing expenses) / sales

( ) ( ) = ? times What is their Total Asset Turnover? sales total assets The industry average is 1.67 times. The firm needs to figure out how to squeeze more sales dollars out of its assets.

( ) ( ) = ? times What is the firm’s Accounts Receivable Turnover? credit sales accounts receivable CyberDragon turns their A/R over 6.16 times per year. The industry average is 8.2 times. Is this efficient?

( ) ( ) = ? times What is the firm’s Inventory Turnover? cost of goods sold inventory 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.

( ) ( ) = ? times What is the firm’s Fixed Asset Turnover? sales fixed assets 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.

( ) ( ) = ? What is CyberDragon’s Debt Ratio? total debt total assets If the industry average is 47%, what does this tell us? Can leverage make the firm more profitable? Can leverage make the firm riskier?

( ) ( ) = ? times What is the firm’s Times Interest Earned Ratio? operating income interest expense 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’sReturn on Equity (ROE)? net income common equity The industry average is 17.54%. Is this what we would expect, given the firm’s leverage?

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

How does Leverage work? Suppose we are in deep recession, both firms only earn $4000 A: ROE = 4000 / 100,000 = 4% B: ROE = (4000 – 4000) / 50,000 = 0

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

Trend Analysis

The DuPont Model Brings together: • Profitability • Efficiency • Leverage

The DuPont Model ROE = x / (1- ) = x /(1- ) = x / (1 - ) = 14.6% Net Profit Total Asset Debt Margin Turnover Ratio Net IncomeSalesTotal Debt Sales Total Assets Total Assets 5,016112,76047,523 112,760 81,890 81,890

Limitation It is hard to identity the industry category of a firm if the firm engages in multiple business Industry averages are only approximation Accounting practices differ widely among firm Many firms experience seasonality in operation

Chapter 3 - Evaluating a Firm’s Financial Performance 09/04/08