5. Evaluating A Firm’s Financial Performance(ratio Analysis)
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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 Cash $2,540 Marketable securities 1,800 Accounts receivable 18,320 Inventories 27,530
Liabilities & Equity Accounts payable
9,721
Notes payable 8,500 Accrued taxes payable 3,200 Other current liabilities 4,102 Total current liabilities Total C.A 25,523 50,190 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
112,760/365
= 59.3 days
What is the firm’s 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 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 81,890
= 14.07%
What is the firm’s Operating Income Return on Investment (OIROI)?
11,520 81,890
= 14.07%
•Slightly below the industry average of 15%.
What is the firm’s 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 firm’s 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 firm’s Accounts Receivable Turnover?
What is the firm’s Accounts Receivable Turnover?
112,760 18,320
= 6.16 times
What is the firm’s Accounts Receivable Turnover?
112,760 18,320
= 6.16 times
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 = 3.10 times 27,530
What is the firm’s Inventory Turnover?
85,300 = 3.10 times 27,530 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 = 3.56 times 31,700
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 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 equityfinanced firm worth $100,000. Its earnings this year total $15,000.
ROE =
15,000 100,000
= 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 50,000 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 50,000 ROE = 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 = 3.65 times 3,160
What is the firm’s 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 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 = 14.6% 34,367
What is ABC Ltd.’s Return on Equity (ROE)?
5,016 = 14.6% 34,367 The industry average is 17.54%.
What is ABC Ltd.’s Return on Equity (ROE)?
5,016 = 14.6% 34,367 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
112,760
==
X
112,760 81,890
14.6%
÷ ( 1- 47,523)
81,890
The DuPont Model Net Profit ROE =Debt x Margin Ratio
Total Asset
/ (1-
Turnover
)
The DuPont Model Net Profit ROE =Debt x Margin Ratio
=
x Net Income Total Debt Sales Total Assets
Total Asset
/ (1-
)
Turnover
/(1-
Sales
Total Assets
)
The DuPont Model Net Profit ROE =Debt x Margin Ratio
=
x
Net Income Total Debt = TotalSales x Assets 5,016
Total Asset
/ (1-
)
Turnover
/(1-
)
Sales
/ (1 -
Total Assets 112,760
)
The DuPont Model Net Profit ROE =Debt x Margin Ratio
=
x
Net Income Total Debt = TotalSales x Assets
= 14.6%
5,016
Total Asset
/ (1-
)
Turnover
/(1-
)
Sales
/ (1 -
Total Assets 112,760
)
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 Cash $2,540 Marketable securities 1,800 Accounts receivable 18,320 Inventories 27,530
Liabilities & Equity Accounts payable
9,721
Notes payable 8,500 Accrued taxes payable 3,200 Other current liabilities 4,102 Total current liabilities Total C.A 25,523 50,190 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
112,760/365
= 59.3 days
What is the firm’s 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 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 81,890
= 14.07%
What is the firm’s Operating Income Return on Investment (OIROI)?
11,520 81,890
= 14.07%
•Slightly below the industry average of 15%.
What is the firm’s 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 firm’s 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 firm’s Accounts Receivable Turnover?
What is the firm’s Accounts Receivable Turnover?
112,760 18,320
= 6.16 times
What is the firm’s Accounts Receivable Turnover?
112,760 18,320
= 6.16 times
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 = 3.10 times 27,530
What is the firm’s Inventory Turnover?
85,300 = 3.10 times 27,530 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 = 3.56 times 31,700
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 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 equityfinanced firm worth $100,000. Its earnings this year total $15,000.
ROE =
15,000 100,000
= 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 50,000 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 50,000 ROE = 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 = 3.65 times 3,160
What is the firm’s 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 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 = 14.6% 34,367
What is ABC Ltd.’s Return on Equity (ROE)?
5,016 = 14.6% 34,367 The industry average is 17.54%.
What is ABC Ltd.’s Return on Equity (ROE)?
5,016 = 14.6% 34,367 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
112,760
==
X
112,760 81,890
14.6%
÷ ( 1- 47,523)
81,890
The DuPont Model Net Profit ROE =Debt x Margin Ratio
Total Asset
/ (1-
Turnover
)
The DuPont Model Net Profit ROE =Debt x Margin Ratio
=
x Net Income Total Debt Sales Total Assets
Total Asset
/ (1-
)
Turnover
/(1-
Sales
Total Assets
)
The DuPont Model Net Profit ROE =Debt x Margin Ratio
=
x
Net Income Total Debt = TotalSales x Assets 5,016
Total Asset
/ (1-
)
Turnover
/(1-
)
Sales
/ (1 -
Total Assets 112,760
)
The DuPont Model Net Profit ROE =Debt x Margin Ratio
=
x
Net Income Total Debt = TotalSales x Assets
= 14.6%
5,016
Total Asset
/ (1-
)
Turnover
/(1-
)
Sales
/ (1 -
Total Assets 112,760
)
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