Chapter 4Evaluating a Firm’s Financial PerformanceChapter ObjectivesFinancial RatiosSlide 5Slide 6How liquid is a firm?Measuring Liquidity: Approach 1Current RatioAcid Test or Quick RatioX Company Balance SheetX Company Income StatementX Company Ratio AnalysisMeasuring Liquidity: Approach 2Average Collection PeriodSlide 16Accounts Receivable TurnoverInventory TurnoverCash Conversion CycleDays of Sales OutstandingDays of Sales In InventoryDays of Payables OutstandingCash Conversion Cycle for X CompanyIs Management Generating Adequate Operating Profits on the Firm’s Assets?Operating Income Return on InvestmentOperating Profit MarginTotal Asset TurnoverFixed Asset TurnoverAlternate OIROIReturn on AssetsSlide 31How is the Firm Financing Its Assets?Debt RatioTimes Interest EarnedSlide 35Is Management Providing a Good Return on the Capital Provided by the Shareholders?Return on Common EquitySlide 38DuPont AnalysisROA Alternative CalculationDuPont EquationLimitations of Ratio AnalysisEconomic Value Added (EVA)Chapter 4Chapter 4Evaluating a Firm’s Financial Evaluating a Firm’s Financial PerformancePerformanceChapter ObjectivesChapter ObjectivesFinancial Ratio AnalysisDupont AnalysisLimitations of Ratio AnalysisFirm Performance and Shareholder ValueFinancial RatiosFinancial RatiosAccounting data stated in relative termsFinancial RatiosFinancial RatiosHelp identify financial strengths and weaknesses of a company by examining:–Trends across time–Comparisons with other firms’ ratiosFinancial RatiosFinancial RatiosExamine: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?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 basisMeasuring Liquidity: Measuring Liquidity: Approach 1Approach 1Compare a firm’s current assets with current liabilities–Current Ratio–Acid Test or Quick RatioCurrent RatioCurrent 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 liabilitiesAcid Test or Quick RatioAcid 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 liabilitiesX CompanyX CompanyBalance SheetBalance SheetAssetsCash $75Accounts Rec. $150Inventory $175Equip/Bldg $1,200Acc Dep <$100>Total Assets $1,500Liabilities and O.E.Accounts Pay $600L-Term Debt $500Total Liabilities $1100Owner’s EquityCommon Stk $200Retained Earn. $200Total O.E.$400Total L + OE $1,500X CompanyX CompanyIncome StatementIncome 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 $500X Company Ratio AnalysisX Company Ratio AnalysisCurrent Ratiocurrent assets/current liabilities400/600 = .667Acid-Test Ratio(Current assets – inventory) / current liabilities(400 – 150) / 600 = .416Measuring Liquidity:Measuring Liquidity:Approach 2Approach 2Measures a firm’s ability to convert accounts receivable and inventory into cashAverage Collection PeriodAccounts Receivable TurnoverInventory TurnoverCash Conversion CycleAverage Collection PeriodAverage 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 SalesX Company Ratio AnalysisX 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 = 6.86Accounts Receivable TurnoverAccounts Receivable TurnoverHow many times accounts receivable are “rolled over” during a yearCredit Sales / Accounts ReceivableInventory TurnoverInventory TurnoverHow many times is inventory rolled over during the year?Cost of Goods Sold / InventoryCash Conversion CycleCash 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 ofConversion = Sales + Sales in - PayablesCycle Outstanding Inventory OutstandingDays of Sales OutstandingDays of Sales OutstandingAverage Collection PeriodAccounts Receivable / (Sales / 365)Days of Sales In InventoryDays 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 OutstandingDays of Payables OutstandingAverage age in days of the firm’s accounts payableAccounts Payable / (Cost of Goods Sold /365)Cash Conversion CycleCash Conversion Cycle for X Company for X CompanyDays of Accts Rec 150Sales = (Sales/365) = (2000/365) = Outstanding27.37Days of Inventory 175Sales In = (Cost of Goods Sold/ = (1200/365) =Inventory 365)53.23Days ofPayables = Accts Payable 600Outstanding (Cost of Goods Sold/ = (1200/365) = 365)182.50Is Management Generating Is Management Generating Adequate Operating Profits on Adequate Operating Profits on the Firm’s Assets?the Firm’s Assets?Operating Income Return on Investment (OIROIO)Operating Profit MarginTotal Asset TurnoverFixed Asset TurnoverReturn on AssetsOperating Income Return on Operating Income Return on InvestmentInvestmentLevel of profits relative to the assets orIncome generated per $1 of assetsOIROI = Operating Income/Total AssetsorOIROI = Operating Profit MarginXTotal Asset TurnoverOperating Profit MarginOperating Profit MarginExamines operating profitability Operating Income / SalesTotal Asset TurnoverTotal