Chapter 4
Evaluating a Firm’s Financial
Performance
Chapter 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






Cash
$75
Accounts Rec. $150
Inventory
$175
Equip/Bldg $1,200
Acc Dep
<$100>
Total Assets $1,500







Liabilities and O.E.
Accounts Pay $600
L-Term Debt
$500
Total Liabilities $1100
Owner’s Equity
Common Stk $200
Retained Earn. $200
Total O.E.$400
Total L + OE $1,500
X Company
Income Statement











Sales (All Credit)
Cost of Goods Sold
Gross Profits
Marketing and Admin
Depreciation
Total Operating Exp
Operating Profits
(EBIT or Operating Income)
Interest Expense
Income Before Taxes
Taxes
Net Income
$2,000
$1,200
$800
$80
$70
$150
$650
$50
$600
$100
$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
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
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
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
Conversion = Sales
Cycle
Outstanding
+
Days of
Sales in
Inventory
-
Days of
Payables
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
Sales
Outstanding
=
Accts Rec
(Sales/365)
=
150
(2000/365)
=
27.37
Days of
Sales In
Inventory
=
Inventory
(Cost of Goods Sold/
365)
=
175
(1200/365)
=
53.23
Days of
Payables
Outstanding
=
Accts Payable
(Cost of Goods Sold/
365)
=
600
(1200/365)
=
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
X
Sales
Total Assets
Return on Assets

ROA = Net Income / Total Assets
X Company Ratio Analysis

OIROI
 Operating Profit Margin
 Total Asset Turnover
 Fixed Asset Turnover
 Alternate OIROI
650
2000

ROA
650 / 1500
650 / 2000
2000 / 1500
2000 / 1100
X 2000
= .433
= .3250
= 1.333
= 1.82
= .433
1500
500 / 1500
= .333
How is the Firm Financing Its
Assets?

Does the firm finance assets more by debt
of 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

Times Interest Earned
650 / 50
1100 / 1500
=
73.33%
=
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 interrelationships 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
(Net Income
Sales)
X
X
Total Asset
Turnover
(Sales
Total Assets)
DuPont Equation

Net Income
Sales
X
Sales
Ttl Asts
500/2000 X
2000/1500
( .25
1.33 )
X
/
/
Cmn Eqty
Ttl Asts
/
400/1500
.267 =
1.245
Limitations of Ratio Analysis



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
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
