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Chapter 4 - Evaluating
Financial Performance
Financial Analysis process of assessing
financial condition of a firm

Principal analytic tool is the financial
ratio

Understand ratios and what they mean
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Ratio Analysis
Identify firms strengths and weaknesses
Comparison of the firm over time or with
other firms
Industry averages benchmarks
Robert Morris Associates, Dun & Bradstreet
Four types of ratios: liquidity, efficiency,
leverage and profitability
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Ratios and Major Questions
How liquid is the firm?
Are adequate operating profits being
generated?
How is the firm financing its assets?
Are shareholders receiving an adequate
return?
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How Liquid is the Firm?
Liquidity ability to meet maturing
obligations
Enough resources to pay when due?
How do liquid assets compare with debt?
Compare cash and assets to be converted to
cash with debt due in same period
Can firm convert receivables/inventories to
cash on timely basis? How quick or long?
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Liquidity
Current ratio conventional wisdom says
2:1 but there is the lettuce problem.
Acid test or quick ratio (CA - Inv)/ CL
Collection period how many days to
collect receivables = AR / DCrS = say 20
Turnover how many times are AR rolled
over during a year? = CS/AR = say 18 X
By most of these measures, McD less liquid
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Collection Period & Turnover
Measure the same thing are reciprocals
365 days = 17.9 X 365 Days = 20.4days
20.4 days 17.9 X
McD not good at collections (20 days vs. 7)
Are longer credit terms good or bad?
Competitive necessity or weak management ?
Receivables aging good footnote
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Inventory Turnover
Turnover Ratio = Cost of Goods Sold
(Times per year) Inventory
Why COGS? Need cost-based numbers
in numerator and denominator
If less liquid, greater chance to be unable
to pay on time.
McD excellent inventory management
(87 times a year versus 35)
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Cash Conversion Cycle
To reduce working capital, speed up
collections, turn inventory faster, slow
disbursements
Sum of days required to collect + days in
inventory - Days of Payable Outstanding
DPO = Accounts Payable = say 29
COGS / 365
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Operating Profits Adequate?
Text tells us to use operating profits
GP ignores marketing exp; NP includes
financing effects
OIROI Operating Income Return on
Investment op profits relative to assets
OIROI = Operating Income
Total Assets
McD generates more income per $ of assets
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OIROI
Separate OIROI into its two pieces:
OIROI = OPM * TAT
15.4% = 23.4% * .66
Operating Profit Margin = Op. Income
Sales
Managements effectiveness in keeping
costs in line with sales; McD = very good
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Total Asset Turnover
TAT = Sales = .66
Total Assets
Amount of sales generated by $1 of assets
Higher turnover better; good use of asset
McD weak $0.66 in sales per $ of assets
Wheres the problem? Check
components
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Total Asset Turnover
McD very weak. But why?

Turnover McDonalds Peers
Receivables 17.9 X = Bad 56
Inventory 87 Good 35
Fixed Assets .84 Bad 3.2
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OIROI Summary
OIROI = Operating Inc. * Sales
Sales Total Assets
McD effectively keeps costs and operating
expenses low, but is not particularly good in
managing its assets

Overall, they are doing better than the competitors
OIROI = 15. 4% versus 11.6%
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How Does Firm Finance Assets?
What percentage of assets are financed by debt
and how much by equity?
Debt includes all liabilities, both short and
long-term
Debt Ratio = Total Debt
Total Assets

McD uses significantly less debt (54 vs 69%)

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Times Interest Earned
TIE how much operating income is available
to meet interest expense? Or, how many times
is it covering annual interest?

TIE = Operating Income = 7.5 Times
Interest Expense

McD no problem in paying int. Op. Inc. could
fall to 1/7
th
of current level and still pay (1/7.5)
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Adequate Returns?
Are stockholders receiving an adequate
return on their investment? Is it attractive
compared to other companies?

Return on Com Equity = Net Income
Common Equity
Equity = PV+ P-I + RE but no preferred stock
McD profitability fully offsets low leverage
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What Can We Say About McD
Its liquidity is average even with low
receivable turnover; good on inventory
OIROI is good;good profitability offsets
low asset turnover
Uses less debt than competitors
Good Return on Equity; uses less debt
but this offset by greater profitability.
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Limitations With Ratios
Difficult to identify industry categories
No exact peers
Averages are only approximates
Accounting principles differ
Ratios can be too high or too low
Industry averages include stars and
dogs
However, ratios are still useful tools
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Unmentioned Problems
Old firm versus new
Have assets been depreciated?
Window dressing
Actions to make good at year end
Role of revolvers
Some ratios make you look good, others
make look bad
Overall look at several combinations

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