chapter 3 - evaluating a firm’s financial performance 2005, pearson prentice hall
TRANSCRIPT
Chapter 3 - Evaluating a Chapter 3 - Evaluating a Firm’s Financial PerformanceFirm’s Financial Performance
2005, Pearson Prentice Hall
Financial Ratio AnalysisFinancial Ratio Analysis
Are our decisions Are our decisions maximizing maximizing shareholder wealth?shareholder wealth?
Identify some of the Identify some of the financial strengths financial strengths and weaknesses of a and weaknesses of a company.company.
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 the Tools that help us determine the financial health of a company.financial health of a company.
We can compare a company’s We can compare a company’s financial ratios with its ratios in financial ratios with its ratios in previous years previous years (trend analysis)(trend analysis)..
We can compare a company’s We can compare a company’s financial ratios with those of its financial ratios with those of its industry.industry.
Example:Example:CyberDragon CorporationCyberDragon Corporation
CyberDragon’s Balance CyberDragon’s Balance Sheet Sheet ($000)($000)
Assets:Assets: Liabilities & Equity:Liabilities & Equity: CashCash $2,540$2,540 Accounts payableAccounts payable 9,7219,721
Marketable securitiesMarketable securities 1,8001,800 Notes payable Notes payable 8,5008,500
Accounts receivableAccounts receivable 18,32018,320 Accrued taxes payableAccrued taxes payable 3,2003,200
InventoriesInventories 27,53027,530 Other current liabilitiesOther current liabilities 4,1024,102
Total current assetsTotal current assets 50,19050,190 Total current liabilitiesTotal current liabilities 25,52325,523
Plant and equipmentPlant and equipment 43,10043,100 Long-term debt (bonds)Long-term debt (bonds) 22,00022,000
less accum deprec.less accum deprec. 11,40011,400 Total liabilitiesTotal liabilities 47,52347,523
Net plant & equip.Net plant & equip. 31,70031,700 Common stock ($10 par)Common stock ($10 par) 13,00013,000
Total assetsTotal assets 81,89081,890 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 & equityTotal liabilities & equity 81,89081,890
Sales (all credit)Sales (all credit) $112,760$112,760
Cost of Goods SoldCost of Goods Sold (85,300) (85,300)
Gross ProfitGross Profit 27,46027,460
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 5,0165,016
CyberDragon’s CyberDragon’s Income StatementIncome Statement
CyberDragonCyberDragonOther InformationOther Information
Dividends paid on common stockDividends paid on common stock $2,800$2,800
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 shareEarnings per share 3.863.86
Dividends per shareDividends per share 2.152.15
1. Liquidity Ratios1. Liquidity Ratios
Do we have enough liquid assets Do we have enough liquid assets to meet approaching obligations?to meet approaching obligations?
What is CyberDragon’s What is CyberDragon’s Current Current RatioRatio??
current assetscurrent liabilities
Indicates a firm’s liquidity, as measured by its liquid assets (current assets) relative to its
liquid debt (short-term or current liabilities).
What is CyberDragon’s What is CyberDragon’s Current Current RatioRatio??
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 Test Acid Test (Quick) Ratio(Quick) Ratio??
current assets - inventoriescurrent liabilities
Indicates a firm’s liquidity, as measured by its liquid assets, excluding inventories, relative
to its current liabilities.
What is the firm’s What is the firm’s Acid Test RatioAcid Test Ratio??
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 Collection Average Collection PeriodPeriod??
accounts receivabledaily credit sales
Indicates how rapidly a firm is collecting its credit, as measured by the average number of days it takes
to collect its accounts receivable.
What is the firm’s What is the firm’s Average Collection Average Collection PeriodPeriod??
If the industry average is 47 days, what does this tell us?
18,320112,760/365 = 59.3 days
2. Operating Efficiency Ratios2. Operating Efficiency Ratios
Measure how efficiently the Measure how efficiently the firm’s assets generate operating firm’s assets generate operating profits.profits.
What is the firm’s What is the firm’s Operating Income Operating Income Return on InvestmentReturn on Investment (OIROI)? (OIROI)?
operating incometotal assets
Indicates the effectiveness of management at generating
operating profits on the firm’s assets, as measured by operating profits relative to the total assets.
•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 Operating Income Return on InvestmentReturn on Investment (OIROI)? (OIROI)?
11,52081,890
= 14.07%
What is their What is their Operating Profit Operating Profit MarginMargin??
operating incomesales
Indicates management’s effectiveness in managing the firm’s income statement, as measured by operating profits relative to sales.
What is their What is their Operating Profit Operating Profit MarginMargin??
•This is below the industry average of 12%.
11,520112,760 = 10.22%
What is their What is their Total Asset TurnoverTotal Asset Turnover??
salestotal assets
Indicates management’s effectiveness in managing the firm’s
balance sheet, its assets - as indicated by the amount of sales
generated per one dollar of assets.
What is their What is their Total Asset TurnoverTotal Asset Turnover??
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??
credit salesaccounts receivable
Indicates how rapidly the firm is collecting its credit, as measured by
the number of times its accounts receivable are collected or “rolled
over” during the year.
What is the firm’s What is the firm’s Accounts Accounts Receivable TurnoverReceivable Turnover??
CyberDragon 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??
cost of goods soldinventory
Indicates the relative liquidity of inventories, as measured by the
number of times a firm’s inventories are replaced during the
year.
What is the firm’s What is the firm’s Inventory Inventory TurnoverTurnover??
CyberDragon 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 turnover:Low inventory 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 Asset Fixed Asset TurnoverTurnover??
salesfixed assets
Indicates the efficiency with which the firm use its fixed assets to
generate sales.
What is the firm’s What is the firm’s Fixed Asset Fixed Asset TurnoverTurnover??
If the industry average is 4.6 times, whatdoes this tell us about CyberDragon?
112,76031,700 = 3.56 times
3. Leverage Ratios3. Leverage Ratios(financing decisions)(financing decisions)
Measure the Measure the impact of using debt impact of using debt capitalcapital to finance assets. to finance assets.
Firms use debt to lever (increase) Firms use debt to lever (increase) returns on common equity.returns on common equity.
How does Leverage work?How does Leverage work?
Suppose we have an all equity-financed Suppose we have an all equity-financed firm worth $100,000. Its earnings this firm worth $100,000. Its earnings this year total $15,000.year total $15,000.
ROE = = 15%ROE = = 15%
15,000100,000
How does Leverage work?How does Leverage work?
Suppose the same $100,000 firm is Suppose the same $100,000 firm is financed with half equity, and half 8% financed with half equity, and half 8% debt (bonds). Earnings are still $15,000.debt (bonds). Earnings are still $15,000.
ROE =ROE = = = 22%22%
15,000 - 4,00050,000
What is CyberDragon’s What is CyberDragon’s Debt RatioDebt Ratio??
total debttotal assets
Indicates how much debt is used to finance a firm’s assets.
What is CyberDragon’s What is CyberDragon’s Debt RatioDebt Ratio??
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 Interest Times Interest EarnedEarned Ratio? Ratio?
operating incomeinterest expense
Indicates a firm’s ability to cover its interest expense, as measured by its earnings before interest and taxes
relative to its interest expense.
What is the firm’s What is the firm’s Times Interest Times Interest EarnedEarned 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 managers How well are the firm’s managers maximizing shareholder wealth?maximizing shareholder wealth?
What is CyberDragon’sWhat is CyberDragon’sReturn on EquityReturn on Equity (ROE)? (ROE)?
net incomecommon equity
Indicates the accounting rate of return Indicates the accounting rate of return on the stockholders’ investment, as on the stockholders’ investment, as measured by net income relative to measured by net income relative to
common equity.common equity.
What is CyberDragon’sWhat is CyberDragon’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?
5. Other Profitability Ratios5. Other Profitability Ratios
Gross Profit MarginGross Profit Margin Net Profit MarginNet Profit Margin Earnings per ShareEarnings per Share Return on AssetsReturn on Assets
What is CyberDragon’sWhat is CyberDragon’sGross Profit MarginGross Profit Margin (GPM)? (GPM)?
gross profitsales
Measures the percentage of each sales dollar remaining after the firm has paid for its goods.
What is CyberDragon’sWhat is CyberDragon’sGross Profit MarginGross Profit Margin (GPM)? (GPM)?
27,460112,760 = 24.4%
What is CyberDragon’sWhat is CyberDragon’sNet Profit MarginNet Profit Margin (NPM)? (NPM)?
net incomesales
Measures the net income of a firm as a percent of sales.
What is CyberDragon’sWhat is CyberDragon’sNet Profit MarginNet Profit Margin (NPM)? (NPM)?
5,016112,760 = 4.4%
What is CyberDragon’sWhat is CyberDragon’sReturn on AssetsReturn on Assets (ROA)? (ROA)?
net incometotal assets
Determines the amount of net income produced on a firm’s assets
by relating net income to total assets; also called the return on
investment (ROI).
What is CyberDragon’sWhat is CyberDragon’sReturn on AssetsReturn on Assets (ROA)? (ROA)?
5,01681,890 = 6.1%
What is CyberDragon’sWhat is CyberDragon’sEanings per ShareEanings per Share (EPS)? (EPS)?
earnings available for common stockholdersnumber of shares of common stock outstanding
Represents the dollar amount earned on behalf of each outstanding share
of common stock.
What is CyberDragon’sWhat is CyberDragon’sEarnings per ShareEarnings per Share (EPS)? (EPS)?
5,0161,300 = $3.86
Conclusion:Conclusion:
Even though CyberDragon has Even though CyberDragon has higher leverage than the industry higher leverage than the industry
average, they are average, they are much less much less efficientefficient, and therefore, less , and therefore, less
profitable.profitable.
The DuPont ModelThe DuPont Model
Brings together:Brings together:
ProfitabilityProfitability EfficiencyEfficiency LeverageLeverage
Net Profit Total Asset DebtNet Profit Total Asset Debt Margin Turnover RatioMargin Turnover Ratio
Net IncomeNet Income SalesSales Total DebtTotal Debt Sales Total Assets Total AssetsSales Total Assets Total Assets
5,0165,016 112,760112,760 47,52347,523 112,760 81,890 81,890112,760 81,890 81,890
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 DebtNet Profit Total Asset Debt Margin Turnover RatioMargin Turnover Ratio
Net IncomeNet Income SalesSales Total DebtTotal Debt Sales Total Assets Total AssetsSales Total Assets Total Assets
5,0165,016 112,760112,760 47,52347,523 112,760 81,890 81,890112,760 81,890 81,890
The DuPont ModelThe DuPont Model