evaluating a firm’s financial performance evaluating a firm’s financial performance , prentice...

Evaluating a Firm’s Evaluating a Firm’s Financial PerformanceFinancial Performance

, Prentice Hall, Inc.

Financial Statement Financial Statement AnalysisAnalysis

Are our decisions Are our decisions maximizing shareholder maximizing shareholder wealth?wealth?

We will want to answer We will want to answer questions about the questions about the firm’sfirm’s

•LiquidityLiquidity

•Efficient use of AssetsEfficient use of Assets

•Leverage (financing)Leverage (financing)

•ProfitabilityProfitability

We will want to answer We will want to answer Questions about the firm’sQuestions about the firm’s

•LiquidityLiquidity

•Efficient use of AssetsEfficient use of Assets

•Leverage (financing)Leverage (financing)

•ProfitabilityProfitability

Financial RatiosFinancial Ratios

• Tools that help us determine Tools that help us determine the financial health of a the financial health of a company.company.

• We can compare a company’s We can compare a company’s financial ratios with its ratios financial ratios with its ratios in previous years in previous years (trend (trend analysis)analysis)..

• We can compare a company’s We can compare a company’s financial ratios with those of financial ratios with those of its industry.its industry.

AssetsAssetsCashCash 2,5402,540

Marketable securitiesMarketable securities 1,8001,800

Accounts receivableAccounts receivable18,32018,320

InventoriesInventories 27,53027,530

Total C.ATotal C.A 50,19050,190

Plant and equipmentPlant and equipment43,10043,100

less accum. dep.less accum. dep. 11,40011,400

Net plant & equipNet plant & equip.. 31,70031,700

Total assetsTotal assets 81,89081,890

Liabilities & EquityLiabilities & Equity

Accounts payableAccounts payable 9,7219,721 Notes payable Notes payable 8,5008,500

Accrued taxes payable Accrued taxes payable 3,2003,200

Other current liabilities Other current liabilities 4,1024,102 Total current liabilities Total current liabilities 25,523 25,523

Long-term debt (bonds)Long-term debt (bonds) 22,00022,000

Total liabilitiesTotal liabilities 47,523 47,523

Common stock ($10 par) Common stock ($10 par) 13,00013,000

Paid in capital Paid in capital 10,00010,000

Retained earningsRetained earnings 11,36711,367

Total stockholders' equity Total stockholders' equity 34,36734,367

Total liabilities & equity Total liabilities & equity 81,89081,890

ABC LtdBalance Sheet

As on 30th June ….

Sales (all credit)Sales (all credit) 112,760112,760 Cost of Goods SoldCost of Goods Sold

(85,300)(85,300) Gross ProfitGross Profit 27,460 27,460 Operating Expenses:Operating Expenses:

SellingSelling (6,540) (6,540) General & AdministrativeGeneral & Administrative (9,400)(9,400) Total Operating ExpensesTotal Operating Expenses (15,940)(15,940)

Earnings before interest and taxes (EBIT)Earnings before interest and taxes (EBIT) 11,52011,520 Interest charges:Interest charges:

Interest on bank notes:Interest on bank notes: (850) (850) Interest on bonds:Interest on bonds: (2,310)(2,310) Total Interest chargesTotal Interest charges ((3,160)3,160)

Earnings before taxes (EBT)Earnings before taxes (EBT) 8,3608,360 TaxesTaxes (assume 40%) (assume 40%) (3,344) (3,344) Net IncomeNet Income 5,016 5,016

ABC Ltd.ABC Ltd. Income Statement Income StatementFor the period ending on 30For the period ending on 30thth June,…. June,….

ABC ltdABC ltdOther InformationOther Information

Dividends paid on common stockDividends paid on common stock 2,8002,800

Earnings retained in the firmEarnings retained in the firm 2,2162,216

Shares outstanding (000)Shares outstanding (000) 1,3001,300

Market price per shareMarket price per share 2020

Book value per shareBook value per share 26.4426.44

Earnings per share (EPS)Earnings per share (EPS) 3.863.86

Dividends per shareDividends per share (DPS)(DPS) 2.152.15

Liquidity RatiosLiquidity Ratios

•Do we have enough Do we have enough liquid assets to meet liquid assets to meet approaching obligations?approaching obligations?

What is ABC Ltd.’s What is ABC Ltd.’s Current RatioCurrent Ratio??

What is ABC Ltd.’s What is ABC Ltd.’s Current RatioCurrent Ratio??

50,19025,523 = 1.97

What is ABC Ltd.’s What is ABC Ltd.’s Current RatioCurrent Ratio??

If the average current ratio for the industry is 2.4, is this good or not?

50,19025,523 = 1.97

What is the firm’s What is the firm’s Acid Acid Test RatioTest Ratio??

What is the firm’s What is the firm’s Acid Test Acid Test RatioRatio??

50,190 - 27,53025,523 = .89

What is the firm’s What is the firm’s Acid Test Acid Test RatioRatio??

Suppose the industry average is .92.What does this tell us?

50,190 - 27,53025,523 = .89

What is the firm’s What is the firm’s Average Average Collection PeriodCollection Period??

What is the firm’s What is the firm’s Average Average Collection PeriodCollection Period??

18,320112,760/365 = 59.3 days

What is the firm’s What is the firm’s Average Average Collection PeriodCollection Period??

If the industry average is 47 days, what does this tell us?

18,320112,760/365 = 59.3 days

2. 2. Operating Efficiency Operating Efficiency RatiosRatios

•Measure how efficiently Measure how efficiently the firm’s assets the firm’s assets generate operating generate operating profits.profits.

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

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

11,52081,890

= 14.07%

•Slightly below the industry average of 15%.

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

11,52081,890

= 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 the firm’s What is the firm’s Operating Income Return Operating Income Return on Investmenton Investment (OIROI)? (OIROI)?

11,52081,890

= 14.07%

What is their What is their Operating Operating Profit MarginProfit Margin??

What is their What is their Operating Operating Profit MarginProfit Margin??

11,520112,760 = 10.22%

What is their What is their Operating Operating Profit MarginProfit Margin??

•This is below the industry average of 12%.

11,520112,760 = 10.22%

What is their What is their Total Asset Total Asset TurnoverTurnover??

What is their What is their Total Asset Total Asset TurnoverTurnover??

112,76081,890 = 1.38 times

What is their What is their Total Asset Total Asset TurnoverTurnover??

The industry average is 1.82 times. The firm needs to figure out how to squeeze more sales dollars out of its

assets.

112,76081,890 = 1.38 times

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

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

112,76018,320 = 6.16 times

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

ABC Ltd.’s turns their A/R over 6.16 times per year. The industry average

is 8.2 times. Is this efficient?

112,76018,320 = 6.16 times

What is the firm’s What is the firm’s Inventory Inventory TurnoverTurnover??

What is the firm’s What is the firm’s Inventory Inventory TurnoverTurnover??

85,30027,530 = 3.10 times

What is the firm’s What is the firm’s Inventory Inventory TurnoverTurnover??

ABC Ltd.’s turns their inventory over 3.1 times per year.

The industry average is 3.9 times. Is this efficient?

85,30027,530 = 3.10 times

Low inventory Low inventory turnover:turnover:

The firm may have too much The firm may have too much

inventory, which is expensive inventory, which is expensive

because:because:

– Inventory takes up costly Inventory takes up costly

warehouse space.warehouse space.

– Some items may become spoiled Some items may become spoiled

or obsolete.or obsolete.

What is the firm’s What is the firm’s Fixed Fixed Asset TurnoverAsset Turnover??

What is the firm’s What is the firm’s Fixed Fixed Asset TurnoverAsset Turnover??

112,76031,700 = 3.56 times

What is the firm’s What is the firm’s Fixed Fixed Asset TurnoverAsset Turnover??

If the industry average is 4.6 times, whatdoes this tell us about ABC Ltd.?

112,76031,700 = 3.56 times

3. 3. Leverage Leverage RatiosRatios(Financing (Financing Decisions)Decisions)

• Measure the Measure the impact of using impact of using debt capitaldebt capital to finance to finance assets.assets.

• Firms use debt to lever Firms use debt to lever (increase) returns on (increase) returns on common equity.common equity.

How does Leverage How does Leverage work?work?

• Suppose we have an all equity-Suppose we have an all equity-financed firm worth $100,000. Its financed firm worth $100,000. Its earnings this year total $15,000.earnings this year total $15,000.

ROE = = 15%ROE = = 15%

(ignore taxes for this example)(ignore taxes for this example)

15,000100,000

How does Leverage How does Leverage work?work?

• Suppose the same $100,000 Suppose the same $100,000 firm is financed with half firm is financed with half equity, and half 8% debt equity, and half 8% debt (bonds). Earnings are still (bonds). Earnings are still 15,000.15,000.

ROE =ROE =

How does Leverage How does Leverage work?work?

• Suppose the same $100,000 Suppose the same $100,000 firm is financed with half firm is financed with half equity, and half 8% debt equity, and half 8% debt (bonds). Earnings are still (bonds). Earnings are still 15,000.15,000.

ROE =ROE = ==

15,000 - 4,00050,000

How does Leverage How does Leverage work?work?

•Suppose the same Suppose the same $100,000 firm is financed $100,000 firm is financed with half equity, and half with half equity, and half 8% debt (bonds). Earnings 8% debt (bonds). Earnings are still 15,000.are still 15,000.

ROE =ROE = = = 22%22%

15,000 - 4,00050,000

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

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

47,52381,890 = 58%

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

If the industry average is 47%, whatdoes this tell us?

47,52381,890 = 58%

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

47,52381,890 = 58%

If the industry average is 47%, whatdoes this tell us?

Can leverage make the firm more profitable?

Can leverage make the firm riskier?

What is the firm’s What is the firm’s Times Times Interest EarnedInterest Earned Ratio? Ratio?

What is the firm’s What is the firm’s Times Times Interest EarnedInterest Earned Ratio? Ratio?

11,5203,160 = 3.65 times

What is the firm’s What is the firm’s Times Times Interest EarnedInterest Earned Ratio? Ratio?

The industry average is 6.7 times. This is further evidence that the firm uses

more debt financing than average.

11,5203,160 = 3.65 times

4. Return on Equity4. Return on Equity

How well are the firm’s How well are the firm’s managers maximizing managers maximizing shareholder wealth?shareholder wealth?

What is ABC Ltd.’sWhat is ABC Ltd.’sReturn on EquityReturn on Equity (ROE)? (ROE)?

What is ABC Ltd.’sWhat is ABC Ltd.’sReturn on EquityReturn on Equity (ROE)? (ROE)?

5,01634,367 = 14.6%

What is ABC Ltd.’sWhat is ABC Ltd.’sReturn on EquityReturn on Equity (ROE)? (ROE)?

The industry average is 17.54%.

5,01634,367 = 14.6%

What is ABC Ltd.’sWhat is ABC Ltd.’sReturn on EquityReturn on Equity (ROE)? (ROE)?

5,01634,367 = 14.6%

The industry average is 17.54%.Is this what we would expect,

given the firm’s leverage?

Conclusion:Conclusion:

Even though ABC Ltd. has Even though ABC Ltd. has higher leverage than the higher leverage than the industry average, they are industry average, they are much less efficientmuch less efficient, and, and therefore, less profitable.therefore, less profitable.

The DuPont ModelThe DuPont Model

Brings together:Brings together:

•ProfitabilityProfitability

•EfficiencyEfficiency

•LeverageLeverage

(Net Profit Margin) X (TA Turn Over)(Net Profit Margin) X (TA Turn Over)

(1-Debt Ratio)(1-Debt Ratio)

= = Net IncomeNet Income XX SalesSales ÷÷ (( 1- 1- Total Total

DebtDebt )) Sales Total Assets Total Sales Total Assets Total

AssetsAssets

= = 5,0165,016 X X 112,760112,760 ÷ ÷ (( 11-- 47,52347,523)) 112,760 81,890 81,890112,760 81,890 81,890

=== 14.6%

Net Profit Total Asset Net Profit Total Asset Debt Debt

Margin Turnover Margin Turnover Ratio Ratio

ROE = x / (1- )The DuPont ModelThe DuPont Model

Net Profit Total Asset Net Profit Total Asset Debt Debt

Margin Turnover Margin Turnover Ratio Ratio

Net IncomeNet Income SalesSales Total DebtTotal Debt

Sales Total Assets Sales Total Assets Total AssetsTotal Assets

ROE = x / (1- )

= x /(1- )

The DuPont ModelThe DuPont Model

Net Profit Total Asset Net Profit Total Asset DebtDebt

Margin Turnover Margin Turnover RatioRatio

Net IncomeNet Income SalesSales Total DebtTotal Debt

Sales Total Assets Total Sales Total Assets Total AssetsAssets

5,0165,016 112,760112,760 47,52347,523

112,760 81,890 112,760 81,890 81,89081,890

ROE = x / (1- )

= x /(1- )

= x / (1 - )

The DuPont ModelThe DuPont Model

ROE = x / (1- )

= x /(1- )

= x / (1 - )

= 14.6%

Net Profit Total Asset Net Profit Total Asset DebtDebt

Margin Turnover Margin Turnover RatioRatio

Net IncomeNet Income SalesSales Total DebtTotal Debt

Sales Total Assets Total Sales Total Assets Total AssetsAssets

5,0165,016 112,760112,760 47,52347,523

112,760 81,890 112,760 81,890 81,89081,890

The DuPont ModelThe DuPont Model