Financial Management

Chapter 3 - Evaluating a
Firms Financial Performance
2005, Pearson Prentice

Hall
Financial Ratio Analysis

Are our decisions
maximizing
shareholder
wealth?
We will want to answer

questions about the firms
Liquidity
Efficient use of Assets
Leverage (financing)
Profitability
We will want to answer

questions about the firms
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 companys
financial ratios with its ratios in
previous years (trend analysis).
We can compare a companys
financial ratios with those of its
industry.
Example:
CyberDragon Corporation
CyberDragons Balance
Sheet ($000)
Assets:
Liabilities & Equity:
Cash $2,540 Accounts payable

9,721
Marketable securities 1,800 Notes payable
8,500
Accounts receivable 18,320 Accrued taxes payable
3,200
Inventories
27,530 Other current liabilities
4,102
Total current assets
50,190
Total current liabilities
25,523
Plant and equipment 43,100 Long-term debt (bonds)
22,000
less accum deprec.
11,400 Total liabilities
47,523
Net plant & equip.
31,700
Common stock ($10 par) 13,000
Total assets
81,890
Paid in capital
10,000
Retained earnings
11,367
Total stockholders' equity
34,367
Total liabilities & equity
81,890
Sales (all credit)

$112,760
CyberDragons
Cost of Goods Sold
(85,300)
Income Statement
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
(3,160)
Earnings before taxes (EBT)
8,360
Taxes
(assume 40%) (3,344)
Net Income
5,016
CyberDragon
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
26.44
Earnings per share
3.86
Dividends per share
2.15
1. Liquidity Ratios
Do we have enough liquid assets

to meet approaching obligations?
What is CyberDragons Current

Ratio?

Ratio?
current assets
current liabilities

Ratio?
50,190
25,523
= 1.97

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 firms Acid Test Ratio?
current assets - inventories

current liabilities
50,190 - 27,530 = .89

25,523
50,190 - 27,530 = .89

25,523
Suppose the industry average is .92.
What does this tell us?
What is the firms Average Collection

Period?

Period?
accounts receivable
daily credit sales

Period?
18,320
112,760/365
= 59.3 days

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

firms assets generate operating
profits.
What is the firms Operating Income

Return on Investment (OIROI)?

operating income
total assets

11,520
81,890
= 14.07%

11,520
81,890
= 14.07%
Slightly below the industry

average of 15%.

11,520
81,890
= 14.07%
Slightly below the industry

average of 15%.
The OIROI reflects product
pricing and the firms ability to
keep costs down.
What is their Operating Profit

Margin?

Margin?
operating income
sales

Margin?
11,520
112,760
= 10.22%

Margin?
11,520
112,760
= 10.22%
This is below the industry average of

12%.
What is their Total Asset Turnover?
sales
total assets
112,760 = 1.38 times

81,890
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 firms Accounts

Receivable Turnover?

credit sales
accounts receivable

112,760
18,320
= 6.16 times

112,760
18,320
= 6.16 times
CyberDragon turns their A/R over 6.16

times per year. The industry average
is 8.2 times. Is this efficient?
What is the firms Inventory

Turnover?

Turnover?
cost of goods sold

inventory

Turnover?
85,300 = 3.10 times

27,530

Turnover?
85,300 = 3.10 times

27,530
CyberDragon 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 firms Fixed Asset

Turnover?

Turnover?
sales
fixed assets

Turnover?
112,760 = 3.56 times

31,700

Turnover?
112,760 = 3.56 times

31,700
If the industry average is 4.6 times, what
does this tell us about CyberDragon?
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.
ROE =
(ignore taxes for this example)

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

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

15,000 - 4,000
ROE =
=
50,000

15,000 - 4,000
ROE =
=
22%
50,000
What is CyberDragons Debt Ratio?
total debt
total assets
47,523 = 58%
81,890
What is CyberDragons Debt

Ratio?
47,523 = 58%
81,890
If the industry average is 47%, what
does this tell us?
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 firms Times Interest

Earned Ratio?

Earned Ratio?
operating income
interest expense

Earned Ratio?
11,520 = 3.65 times

3,160

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 firms managers

maximizing shareholder wealth?
What is CyberDragons
Return on Equity (ROE)?
net income
common equity
5,016 = 14.6%
34,367
5,016 = 14.6%
34,367
The industry average is 17.54%.
5,016 = 14.6%
34,367
The industry average is 17.54%.
Is this what we would expect,
given the firms leverage?
Conclusion:
Even though CyberDragon has

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

Brings together:
Profitability
Efficiency
Leverage
The DuPont Model

ROE =
Net Profit x Total Asset

Margin
Turnover
/ (1-
Debt
Ratio
The DuPont Model

ROE =

Margin
Turnover
Net Income
Sales
x Total Assets
Sales
/ (1-
/(1-
Debt
Ratio
Total Debt
Total Assets
The DuPont Model

ROE =
=
=

Margin
Turnover
Net Income
Sales
x Total Assets
Sales
5,016
112,760
112,760
81,890
/ (1-
/(1-
Debt
Ratio
Total Debt
Total Assets
47,523 )
/ (1 - 81,890
The DuPont Model

ROE =
=
=

Margin
Turnover
Net Income
Sales
x Total Assets
Sales
5,016
112,760
= 14.6%
112,760
81,890
/ (1-
/(1-
Debt
Ratio
Total Debt
Total Assets
47,523 )
/ (1 - 81,890

Financial Management

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Chapter 3 - Evaluating a

Firms Financial Performance

2005, Pearson Prentice

Financial Ratio Analysis

We will want to answer

We will want to answer

Liabilities & Equity:

Cash $2,540 Accounts payable

Sales (all credit)

Dividends paid on common stock

Do we have enough liquid assets

What is CyberDragons Current

What is CyberDragons Current

What is CyberDragons Current

What is CyberDragons Current

If the average current ratio for the

What is the firms Acid Test Ratio?

What is the firms Acid Test Ratio?

current assets - inventories

What is the firms Acid Test Ratio?

50,190 - 27,530 = .89

What is the firms Acid Test Ratio?

50,190 - 27,530 = .89

What is the firms Average Collection

What is the firms Average Collection

What is the firms Average Collection

What is the firms Average Collection

If the industry average is 47 days,

2. Operating Efficiency Ratios

Measure how efficiently the

What is the firms Operating Income

What is the firms Operating Income

What is the firms Operating Income

What is the firms Operating Income

Slightly below the industry

What is the firms Operating Income

Slightly below the industry

What is their Operating Profit

What is their Operating Profit

What is their Operating Profit

What is their Operating Profit

This is below the industry average of

What is their Total Asset Turnover?

What is their Total Asset Turnover?

What is their Total Asset Turnover?

112,760 = 1.38 times

What is their Total Asset Turnover?

112,760 = 1.38 times

What is the firms Accounts

What is the firms Accounts

What is the firms Accounts

What is the firms Accounts

CyberDragon turns their A/R over 6.16

What is the firms Inventory

What is the firms Inventory

cost of goods sold

What is the firms Inventory

85,300 = 3.10 times

What is the firms Inventory

85,300 = 3.10 times

Low inventory turnover:

Inventory takes up costly

Some items may become spoiled

What is the firms Fixed Asset