Evaluating a Firm’s Financial
Performance
Objectives
Financial Ratio Analysis
Dupont Analysis
Limitations of Ratio Analysis
Firm Performance and Shareholder Value
Financial Ratios
Accounting data stated in relative terms
Financial Ratios
Help identify financial strengths and
weaknesses of a company by examining:
– Trends across time
– Comparisons with other firms’ ratios
Financial Ratios
Examine:
How liquid is a firm?
Is management generating adequate
operating profits on the firm’s assets?
How is the firm financing its assets?
Is management providing a good return on
the capital provided by the shareholder?
How liquid is a firm?
Liquidity is the ability to meet maturing
debt obligations
Measured by two approaches:
– Comparing cash and assets that can be
converted into cash within the year with
liabilities that are coming due within the year
– Examines the firm’s ability to convert accounts
receivables and inventory into cash on a timely
basis
Measuring Liquidity:
Approach 1
Compare a firm’s current assets with
current liabilities
– Current Ratio
– Acid Test or Quick Ratio
Current Ratio
Compares cash and current assets that
should be converted into cash during the
year with the liabilities that should be paid
within the year
Current Assets / Current liabilities
Acid Test or Quick Ratio
Compares cash and current assets (minus
inventory) that should be converted into
cash during the year with the liabilities that
should be paid within the year.
More restrictive than the current ratio
because it eliminates inventories
(Current assets – inventory) / Current
liabilities
X Company
Balance Sheet
Assets Liabilities and O.E.
Cash $75 Accounts Pay $600
Accounts Rec. $150 L-Term Debt $500
Inventory $175 Total Liabilities $1100
Equip/Bldg $1,200 Owner’s Equity
Acc Dep <$100> Common Stk $200
Total Assets $1,500 Retained Earn. $200
Total O.E. $400
Total L + OE $1,500
X Company
Income Statement
Sales (All Credit) $2,000
Cost of Goods Sold $1,200
Gross Profits $800
Marketing and Admin $80
Depreciation $70
Total Operating Exp $150
Operating Profits $650
(EBIT or Operating Income)
Interest Expense $50
Income Before Taxes $600
Taxes $100
Net Income $500
X Company Ratio Analysis
Current Ratio
current assets/current liabilities
400/600 = .667
Acid-Test Ratio
(Current assets – inventory) / current
liabilities
(400 – 150) / 600 = .416
Measuring Liquidity:
Approach 2
Measures a firm’s ability to convert
accounts receivable and inventory into cash
Average Collection Period
Accounts Receivable Turnover
Inventory Turnover
Cash Conversion Cycle
Average Collection Period
The conversion of accounts receivable into
cash, is measured by calculating how long it
takes to collect the firm’s receivables
Accounts Receivable / Daily Credit Sales
Accounts Receivable
Turnover
How many times accounts receivable are
“rolled over” during a year
Credit Sales / Accounts Receivable
Inventory Turnover
How many times is inventory rolled over
during the year?
Cost of Goods Sold / Inventory
X Company Ratio Analysis
Average Collection Period
150 / (2,000 / 365) = 27.38
Accounts Receivable Turnover
2,000 / 150 = 13.33
Inventory Turnover
1,200 / 175 = 6.86
Cash Conversion Cycle
Sum of the days of sales outstanding (average
collection period) and days of sales in inventory less
the days of payables outstanding.
Cash Days of Days of Days of
Conversion = Sales + Sales in - Payables
Cycle Outstanding Inventory Outstanding
Days of Sales Outstanding
Average Collection Period
Accounts Receivable / (Sales / 365)
Days of Sales In Inventory
Average age of the inventory or average
number of days that a dollar of inventory is
held by the firm
Inventory / (Cost of Goods Sold / 365)
Days of Payables Outstanding
Average age in days of the firm’s accounts
payable
Accounts Payable / (Cost of Goods Sold /365)
Cash Conversion Cycle
for X Company
Days of Accts Rec 150
Sales = (Sales/365) = (2000/365) =
Outstanding
27.37
Days of Inventory 175
Sales In = (Cost of Goods Sold/ = (1200/365) =
Inventory 365)
53.23
Days of
Payables = Accts Payable 600
Outstanding (Cost of Goods Sold/ = (1200/365) =
365)
182.50
Is Management Generating
Adequate Operating Profits on
the Firm’s Assets?
Operating Income Return on Investment
(OIROIO)
Operating Profit Margin
Total Asset Turnover
Fixed Asset Turnover
Return on Assets
Operating Income Return on
Investment
Level of profits relative to the assets
or
Income generated per $1 of assets
OIROI = Operating Income/Total Assets
or
OIROI = Operating Profit Margin
X
Total Asset Turnover
Operating Profit Margin
Examines operating profitability
Operating Income / Sales
Total Asset Turnover
How efficiently a firm is using its assets in
generating sales
Measures the dollar sales per $1 of Assets
Sales / Total Assets
Fixed Asset Turnover
Examines investment in fixed assets for
sales being produced
Measures the dollar sales per $1 of fixed
assets
Sales / Fixed Assets
Alternate OIROI
OIROI = Operating Profit Margin X
Total Asset Turnover
OIROI = Operating Income Sales
Sales X Total Assets
Return on Assets
ROA = Net Income / Total Assets
X Company Ratio Analysis
OIROI 650 / 1500 = .433
Operating Profit Margin 650 / 2000 = .3250
Total Asset Turnover 2000 / 1500 = 1.333
Fixed Asset Turnover 2000 / 1100 = 1.82
Alternate OIROI 650 X 2000 = .433
2000 1500
ROA 500 / 1500 = .333
How is the Firm Financing Its
Assets?
Does the firm finance assets more by debt
or equity?
Debt Ratio
Times Interest Earned
Debt Ratio
What percentage of the firm’s assets are
financed by debt?
Total Debt / Total Assets
Times Interest Earned
Examines the amount of operating income
available to service interest payments
or
The number of times the firm is earning or
covering its interest payments
Operating Income / Interest
X Company Ratio Analysis
Debt Ratio 1100 / 1500 = 73.33%
Times Interest Earned
650 / 50 = 13
Is Management Providing a
Good Return on the Capital
Provided by the
Shareholders?
Return on Common Equity
Return on Common Equity
Accounting Return on the common
stockholders’ investment
Net Income / Common Equity
X Company Ratio Analysis
Return on common equity
Net Income / Common Equity
500 / 400 = 1.25 or 125%
DuPont Analysis
An alternative method to analyze a firm’s
profitability and return on equity
Allows management to see more clearly
what drives return on equity and the inter-
relationships among: net profit margin,
asset turnover, and common equity ratio.
Return on
Common = ROA / Common Equity
Equity Total Assets
ROA
Alternative Calculation
ROA = Net Income / Total Assets
or
Net Profit Margin X Total Asset
Turnover
(Net Income X (Sales
Sales) Total Assets)
DuPont Equation
Net Income X Sales / Cmn Eqty
Sales Ttl Asts Ttl Asts
500/2000 X 2000/1500 / 400/1500
( .25 X 1.33 ) / .267 = 1.245
Limitations of Ratio Analysis
Difficulty in identifying industry categories or
finding peers
Published peer group or industry averages are only
approximations
Accounting practices differ among firms
Financial ratios can be too high or too low
Industry averages may not provide a desirable
target ratio or norm
Use of average account balances to offset effects
of seasonality
Economic Value Added (EVA)
Measures a firm’s economic profit, rather than
accounting profit
Recognizes a cost of equity and a cost of debt
EVA = (r-k) X C
where:
r = Operating income return on invested capital
k = Total cost of capital
C = Amount of capital (Total Assets) invested in the
firm
Starbucks-(2003)
Balance Sheet-(millions)
Assets Liabilities and O.E.
Cash $350
Accounts Pay $552
Accounts Rec. $114
S-Term Notes $1
Inventory $342
L-Term Debt $38
Other C.A. $116 Total Liabilities $591
Gross Fixed $2,669 Owner’s Equity
Acc Dep <$919> Common Stk $1,017
Total Assets $2,672 Retained Earn. $1,064
Total O.E. $2,081
Total L + OE $2,672
Starbucks-(2003)
Income Statement
Sales $4,076
Cost of Goods Sold $3,207
Gross Profits $869
Marketing and Admin $227
Depreciation $206
Total Operating Exp $433
Operating Profits $436
(EBIT or Operating Income)
Interest Expense $3
Income Before Taxes $433
Taxes $165
Net Income $268
Starbucks-(2003)
Peer Group Ratios
current ratio 2.02
acid-test ratio 1.44
average collection period 93 days
accounts receivable turnover 3.9x
inventory turnover 8.5x
OROA 14.9%
operating profit margin 11.8%
total asset turnover 1.26x
fixed asset turnover 2.75x
debt ratio 25%
times interest earned 46.0x
ROE 12.0%
S&P500 Index P/E ratio 24x
