# Chapter 4 PPT

```Chapter 4
Evaluating
a Firm’s Financial
Performance
Learning Objectives
•
Explain the purpose and importance of
financial analysis.
•
Calculate and use a comprehensive set of
measurements to evaluate a company’s
performance.
•
Describe the limitations of financial ratio
analysis.
4-1
THE PURPOSE OF
FINANCIAL ANALYSIS
4-2
The Purpose of
Financial Analysis
Financial Analysis using Ratios
• A popular way to analyze the financial statements is
by computing ratios. A ratio is a relationship
between two numbers, e.g., a given ratio of A:B =
30:10 means A is 3 times B.
• A ratio by itself may have no meaning. Hence, a
given ratio is compared to:
– ratios from previous years
– ratios of other firms and/or leaders in the same industry
4-3
Uses of Financial Ratios:
Within the Firm
• Identify deficiencies in a firm’s performance
and take corrective action.
• Evaluate employee performance and
determine incentive compensation.
• Compare the financial performance of
different divisions within the firm.
4-4
Uses of Financial Ratios:
Within the Firm
• Prepare, at both firm and division levels,
financial projections.
• Understand the financial performance of the
firm’s competitors.
• Evaluate the financial condition of a major
supplier.
4-5
Uses of Financial Ratios:
Outside the Firm
Financial ratios are used by:
• Lenders in deciding whether or not to lend to a
company.
• Credit-rating agencies in determining a firm’s credit
worthiness.
• Investors (shareholders and bondholders) in
deciding whether or not to invest in a company.
• Major suppliers in deciding to whether or not to
extend credit to a company and/or in designing the
specific credit terms.
4-6
MEASURING KEY
FINANCIAL
RELATIONSHIPS
4-7
Question 1
How Liquid Is the Firm? Can It Pay Its Bills?
• A liquid asset is one that can be converted
quickly and routinely into cash at the
current market price.
• Liquidity measures the firm’s ability to pay
its bills on time. It indicates the ease with
which non-cash assets can be converted to
cash to meet the financial obligations.
4-8
How Liquid Is the Firm?
Liquidity is measured by two approaches:
– Comparing the firm’s current assets and current
liabilities
– Examining the firm’s ability to convert accounts
receivables and inventory into cash on a timely
basis
4-9
Measuring Liquidity:
Perspective 1
Compare a firm’s current assets with current
liabilities using:
– Current Ratio
– Acid Test or Quick Ratio
4-10
Table 4-1
4-11
Table 4-2
4-12
Current Ratio
• Current ratio compares a firm’s current assets to
its current liabilities.
• Equation:
Home Depot = \$13,479M ÷ \$10,122M = 1.33
• Home Depot has \$1.33 in current assets for every
\$1 in current liabilities. Home Depot’s liquidity is
marginally lower than that of Lowe’s, which has a
current ratio of 1.40.
4-13
Acid Test or Quick Ratio
• Quick ratio compares cash and current assets (minus
inventory) that can be converted into cash during the
year with the liabilities that should be paid within the
year.
• Equation:
Home Depot = (\$545M + \$1,085M) ÷ ( \$10,122M) =
0.16
• Home Depot has 16 cents in quick assets for every
\$1 in current debt. Home Depot is more liquid than
Lowe’s, which has 12 cents for every \$1 in current
debt.
4-14
Measuring Liquidity:
Perspective 2
• Measures a firm’s ability to convert
accounts receivable and inventory into cash:
– Average Collection Period
– Inventory Turnover
4-15
Days in Receivables
(Average Collection Period)
• How long does it take to collect the firm’s
receivables?
• Equation:
Home Depot = (\$1,085M) ÷ (\$20,399M/365) =
19.41 days
• Home Depot (at 19.41 days) is slower than Lowe’s
(at 16 days) in collecting accounts receivable.
4-16
Days in Inventory
• How long is the inventory held before being sold?
• Equation:
Home Depot = (\$10,625M) ÷ (\$44,693 ÷ 365)=
86.77days
• Home Depot carries inventory for a shorter time
than Lowe’s (95.80 days).
4-17
Home Depot vs. Lowe’s:
Question #1 Summary
Ratio
Home
Depot
Lowe’s
Current Ratio
1.33
1.40
Quick Ratio
0.16
0.12
Avg. Collection
Period
19.41 days
16 days
Days in inventory
86.77 days
95.80 days
4-18
Question 2: Are the Firm’s Managers
the Company’s Assets?
• This question focuses on the profitability of
the assets in which the firm has invested.
We consider the following ratios to answer
the question:
– Operating Return on Assets
– Operating Profit Margin
– Total Asset Turnover
– Fixed Assets Turnover
4-19
Operating Return on Assets
(ORA)
• ORA indicates the level of operating profits relative
to the firm’s total assets.
• Equation:
Home Depot = \$5,803 ÷ \$40,125M = 0.145 or
14.5%
• Thus managers are generating 14.5 cents of
operating profit for every \$1 of assets
(Lowe’s=10.6%)
4-20
Disaggregation of
Operating Return on Assets
4-21
Managing Operations:
Operating Profit Margin (OPM)
• OPM examines how effective the company is in
managing its cost of goods sold and operating
expenses that determine the operating profit.
• Equation:
Home Depot = \$5,803 ÷ \$67,997M = 0.085 or 8.5%
• Home Depot managers are better than Lowe’s in
managing the cost of goods sold and operating
expenses, as the Operating Profit Margin for Lowe’s
is only 7.3%.
4-22
Managing Assets:
Total Asset Turnover
• This ratio measures how efficiently a firm is using
its assets in generating sales.
• Equation:
Home Depot = \$67,997 ÷ \$40,125M = 1.69X
• Home Depot is generating \$1.69 in sales for every
\$1 invested in assets, which is higher than Lowe’s
(1.45X).
4-23
Managing Assets:
Fixed Asset Turnover
• Examines efficiency in generating sales from
investment in “fixed assets”
• Equation:
Home Depot = \$67,997M ÷ \$25,060M = 2.71X
• Home Depot generates \$2.71 in sales for every \$1
invested in fixed assets, which is much higher than
Lowe’s (2.21X)
4-24
Figure 4-3
4-25
Home Depot vs. Lowe’s:
Question #2 Summary
Ratio
Home
Depot
Lowe’s
14.5%
10.6%
Operating Profit
Margin
8.5%
7.3%
Total Asset
Turnover
1.69X
1.45X
Fixed Asset
Turnover
2.71X
2.21X
Operating Return
on Assets
4-26
Question 3: How Is the Firm
Financing Its Assets?
• Here we examine the question: Does the
firm finance its assets by debt or equity or
both? We use the following two ratios to
– Debt Ratio
– Times Interest Earned
4-27
Debt Ratio
• This ratio indicates the percentage of the firm’s
assets that are financed by debt (implying that the
balance is financed by equity).
• Equation:
Home Depot
53%
= \$21,236M ÷ \$40,125M = 0.53 or
• Home Depot finances 53% of it’s assets by debt
and 47% by equity. This ratio is higher than Lowe’s
debt ratio of 46%.
4-28
Times Interest Earned
• This ratio indicates the amount of operating income
available to service interest payments.
• Equation: Times Interest Earned = Operating
Profits ÷ Interest Expense
Home Depot = \$5,803M ÷ \$530M = 10.9X
• Home Depot’s operating income is nearly 11 times
the annual interest expense and higher than Lowe’s
(9X) due to its relatively higher operating profits.
4-29
Times Interest Earned
Note:
• Interest is not paid with income but with
cash.
• Oftentimes, firms are required to repay part
of the principal annually.
• Thus, times interest earned is only a crude
measure of the firm’s capacity to service its
debt.
4-30
Home Depot vs. Lowe’s:
Question #3 Summary
Ratio
Debt Ratio
Times Interest
Earned
Home
Depot
Lowe’s
53%
46%
10.9X
9.0X
4-31
Question 4: Are the Firm’s Managers
Providing a Good Return on the Capital
Provided by the Company’s Shareholders?
• This is analyzed by computing the firm’s
accounting return on common stockholder’s
investment or return on equity (ROE).
• Equation:
• Note common equity includes both common
stock and retained earnings.
4-32
ROE
Home Depot = \$3,338M ÷ \$18,889M
= 0.177 or 17.7%
• Owners of Home Depot are receiving a higher
return (17.7%) compared to Lowe’s (11.1%).
• One of the reasons for higher ROE is the higher
return on assets generated by Home Depot.
• Also, Home Depot uses more debt. Higher debt
translates to higher ROE under favorable business
conditions.
4-33
Figure 4-4
4-34
Question #4 Summary:
Home Depot vs. Lowe’s
Ratio
Home
Depot
Lowe’s
Return on
Equity
17.7%
11.1%
4-35
Question 5: Are the Firm’s Managers
Creating Shareholder Value?
• We can use two approaches to answer this
question:
- Market value ratios (P/E)
• These ratios indicate what investors think of
management’s past performance and future
prospects.
4-36
Price/Earnings Ratio
• Measures how much investors are willing to pay for
\$1 of reported earnings.
• Equation:
Home Depot = \$36.77 ÷ \$2.06 = 17.85X
• Investors are willing pay more for Home Depot for
every dollar of earnings per share compared to
Lowe’s (\$17.85 for Home Depot versus \$16.90 for
Lowe’s).
4-37
Price/Book Ratio
• Compares the market value of a share of stock to the book
value per share of the reported equity on the balance sheet.
• Equation:
Home Depot = \$36.77 ÷ \$11.64 = 3.16X
• A ratio greater than 1 indicates that the shares are more
valuable than what the shareholders originally paid. The ratio
is significantly higher than Lowe’s ratio of 1.95X suggesting
that Home Depot is perceived as having better growth
prospects relative to its risk.
4-38
• Shareholder value is created if the firm earns a return on
capital that is greater than the investors’ required rate of
return.
• EVA attempts to measure a firm’s economic profit, rather
than accounting profit. EVA recognizes the cost of equity in
addition to the cost of debt (interest expense)
4-39
EVA for Home Depot
• Operating Return on assets = 14.5%
• Total assets = \$40.125 billion
• Assume cost of capital = 10%
• EVA = (14.5% – 10%)* \$40.125b =
\$1.806b
4-40
Question #5 Summary:
Home Depot vs. Lowe’s
Ratio
Price/Earnings
Ratio
Price/Book Ratio
Home
Depot
Lowe’s
17.85X
16.90X
3.16X
1.95X
4-41
THE LIMITATIONS OF
FINANCIAL RATIO
ANALYSIS
4-42
The Limitations of
Financial Ratio Analysis
• It is sometimes difficult to identify industry
categories or comparable peers.
• The published peer group or industry averages are
only approximations.
• Industry averages may not provide a desirable
target ratio.
• Accounting practices differ widely among firms.
• A high or low ratio does not automatically lead to a
specific conclusion.
• Seasons may bias the numbers in the financial
statements.
4-43
Key Terms
• Accounts receivable turnover
ratio
• Acid-test (quick) ratio
• Asset efficiency
• Current ratio
• Days in inventory
• Days in receivables (average
collection period)
• Debt ratio
• Financial ratios
• Fixed asset turnover
•
•
•
•
•
•
•
•
•
Inventory turnover
Liquidity
Operating profit margin
Operating return on assets
(OROA)
Price/book ratio
Price/earnings ratio
Return on equity
Times interest earned
Total asset turnover
4-44
Figure 4-1
4-45
Figure 4-2
4-46
Table 4-3
4-47
Table 4-3 (cont.)
4-48
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