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Evaluating a Firm’s

Financial Performance

 2002, 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.
ABC Ltd
Balance Sheet
As on 30th June ….
Assets Liabilities & Equity
Cash $2,540
Marketable securities Accounts payable 9,721
1,800 Notes payable 8,500
Accounts receivable Accrued taxes payable
18,320 3,200
Inventories 27,530 Other current liabilities
Total C.A 4,102 Total current liabilities
50,190 25,523
Long-term debt (bonds)
Plant and equipment
22,000
43,100
Total liabilities 47,523
less accum. dep. 11,400
Common stock ($10 par)
Net plant & equip. 31,700
13,000
Total assets 81,890 Paid in capital 10,000
ABC Ltd.
Income Statement
For the period ending on 30th June,….
Sales (all credit)
$112,760
Cost of Goods Sold
(85,300)
Gross Profit
27,460
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
ABC ltd
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
Liquidity Ratios

• Do we have enough
liquid assets to meet
approaching obligations?
What is ABC Ltd.’s
Current Ratio?
What is ABC Ltd.’s
Current Ratio?

50,190
25,523 = 1.97
What is ABC Ltd.’s
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 firm’s Acid
Test Ratio?
What is the firm’s Acid Test
Ratio?

50,190 - 27,530 = .89


25,523
What is the firm’s Acid Test
Ratio?

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?
What is the firm’s Average
Collection Period?

18,320 = 59.3 days


112,760/365
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?
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)?
What is the firm’s
Operating Income Return
on Investment (OIROI)?

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

11,520 = 14.07%
81,890
•Slightly below the industry
average of 15%.
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.
What is their Operating
Profit Margin?
What is their Operating
Profit Margin?

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

11,520 = 10.22%
112,760

•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 firm’s Accounts
Receivable Turnover?
What is the firm’s Accounts
Receivable Turnover?

112,760 = 6.16 times


18,320
What is the firm’s Accounts
Receivable Turnover?

112,760 = 6.16 times


18,320

ABC Ltd.’s 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?
What is the firm’s Inventory
Turnover?

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

85,300
27,530 = 3.10 times

ABC Ltd.’s 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?
What is the firm’s Fixed
Asset Turnover?

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

112,760
31,700 = 3.56 times

If the industry average is 4.6 times, what


does this tell us about ABC Ltd.?
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.

15,000
100,000
ROE = = 15%

(ignore taxes for this example)


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 ABC Ltd.’s Debt
Ratio?
What is ABC Ltd.’s Debt
Ratio?

47,523 = 58%
81,890
What is ABC Ltd.’s Debt
Ratio?

47,523 = 58%
81,890
If the industry average is 47%, what
does this tell us?
What is ABC Ltd.’s 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 firm’s Times
Interest Earned Ratio?
What is the firm’s Times
Interest Earned Ratio?

11,520
3,160 = 3.65 times
What is the firm’s Times
Interest 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 ABC Ltd.’s
Return on Equity (ROE)?
What is ABC Ltd.’s
Return on Equity (ROE)?

5,016
34,367 = 14.6%
What is ABC Ltd.’s
Return on Equity (ROE)?

5,016
34,367 = 14.6%

The industry average is 17.54%.


What is ABC Ltd.’s
Return on Equity (ROE)?

5,016
34,367 = 14.6%

The industry average is 17.54%.


Is this what we would expect,
given the firm’s leverage?
Conclusion:

Even though ABC Ltd. has


higher leverage than the
industry average, they are
much less efficient, and
therefore, less profitable.
The DuPont Model

Brings
together:

• Profitability
• Efficiency
• Leverage
(Net Profit Margin) X (TA Turn Over)
(1-Debt Ratio)

= Net Income X Sales ÷ ( 1- Total


Debt )
Sales Total Assets Total
Assets

= 5,016 X 112,760 ÷ ( 1- 47,523)


112,760 81,890 81,890

== 14.6%
The DuPont Model
Net Profit Total Asset
ROE =Debt x / (1- )
Margin Turnover
Ratio
The DuPont Model
Net Profit Total Asset
ROE =Debt x / (1- )
Margin Turnover
Ratio
= x /(1- )
Net Income Sales
Total Debt
Sales Total Assets
Total Assets
The DuPont Model
Net Profit Total Asset
ROE =Debt x / (1- )
Margin Turnover
Ratio
= x /(1- )
Net Income Sales
Total Debt
= TotalSales
x
Assets / (1 -
Total Assets )
5,016 112,760
The DuPont Model
Net Profit Total Asset
ROE =Debt x / (1- )
Margin Turnover
Ratio
= x /(1- )
Net Income Sales
Total Debt
= TotalSales
x
Assets / (1 -
Total Assets )
= 14.6%
5,016 112,760

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